Welcome to The GERM Report by Dan Graeber, a commentary on the intersection between geopolitical events and the price of oil. GERM stands for Geopolitical Energy and Risk Monitoring. Our indicator is based on the expected price volatility by the end of the current trading week.
Risk level: Red
RED: Severe (+/- 4%) ORANGE: High (+/- 2%) YELLOW: Elevated (+/- 1%) BLUE: Guarded (+/- ½%)
THE BOOSTER SHOT
- Wars are often the consequence of economic pressure.
- It goes without saying that the risk premium is high
- The Carter Doctrine is back in vogue.
Attacks on Saudi Aramco facilities sent the price of Brent crude oil up more than 14 percent last Monday, raising questions not only about Middle East stability but also global energy security. Weaponry ostensibly linked to Iran was able to evade US-made missile defense systems, a protective cloak that should arguably be the best in the world, sidelining 5 percent of the world’s total crude oil production capacity. At first relegating the durability of the Carter Doctrine to others because of robust oil production, the US government said it will bolster Saudi security with additional air and missile defense capabilities. The Trump administration has been vocal about its desire to avoid war, though its ever-tightening financial restraints are invoking a defensive response from Tehran. It is often the case that non-military issues quickly turn into military matters, so it will require deft diplomacy to avoid war in the Middle East. For the economy, the subsequent rise in crude oil prices may be the pressure that reverses one of the longest expansions in global history.
Barring the historic rise in the price of oil on Monday and the Tuesday correction, the week in Brent was relatively subdued. As expected, traders in the latter part of the week were more concerned about Fed Chair Jerome Powell than the pressures of imminent war. In the end, Brent finished the week up 6 percent to close trading Friday at $64.28 per barrel.
US Defense Secretary Mark Esper announced last week that perhaps hundreds of US troops would accompany air and missile defense support systems to the Middle East to deter another swarm of weaponry from endangering global energy security. Esper insisted the support would be defensive in nature and protect the free flow of maritime traffic through the Strait of Hormuz. Another element of the deployment, he said, would be “to ensure we protect and defend the international rules-based order, and try and convince the Iranians to get back on the diplomatic path.”
The problem with that statement is that the Iranians had already traveled the diplomatic path through the multilateral nuclear agreement brokered under President Obama. The agreement, however, left certain threats in place, according to the Trump administration. The Iranian proxies engaging in asymmetrical warfare in the Middle East are concerning for Trump. By engaging in economic warfare against the Islamic republic, the Trump administration is trying to choke off the tacit financial support for rogue elements like the Houthi forces in Yemen. Iran can defend its position by noting it indeed had no direct role in the attack, while forcing the US defense secretary to acknowledge that an advanced, multi-layered system of military force is necessary in the region because “no single system is going to be able to defend against a threat like that.”
The impulse to use force, be it economic or military, is to coerce change in the behavior of an adversary. The Trump administration insists it is not on a war footing, but it does want change. For Iran, Foreign Minister Mohammad Javad Zarif said that while he was confident Iran would not start a war, he was not confident that it was avoidable. That places a significant risk premium under the price of oil as the blanket of threat covers some of the world’s most ample reserves.
Wars are often the consequence of economic pressure. In response to the large-scale dumping of British manufactured goods in the United States after the War of 1812, manufacturers in the northern US pushed for a form of protectionism to ensure they could compete. Tariffs on British goods protected the northern industries and jobs from foreign competition, though for the south, those tariffs represented a transfer of wealth to the north through the higher prices for manufactured goods. Economic frustrations between the agrarian south, which leaned on slave labor to compete, and the manufacturing belts in the north eventually led to civil war. In 1939, President Roosevelt nullified a commercial treaty with Japan and continued to tighten the screws on Tokyo until, left with few sources of raw goods like steel and oil, the Japanese resorted to military action on Pearl Harbor. Situations like these, where economic pressures lead to war, have repeated themselves time and again throughout history.
There is a direct correlation to economic development and conflict. The more economic players that are able to play the game, the less the chance of war. Trade is a unifying force. There has been no major outbreak of war like World War II because states are too integrated and comingled for definitive separation in a globalized world. Trade links makes war too much of a gamble. But if goods can no longer cross borders, troops will. States will look to gain wealth through fighting when trade is no longer beneficial. At the most basic level, a state will pursue survival through conflict when it runs out of economic options. Cutting the constraints of trade poses a serious threat, as history has shown, to economic, energy and global security.
Political theater will be at its finest this week as world leaders head to New York for a meeting of the UN General Assembly. At stake may be the case for war or the case for peace. On Monday, US Federal Reserve officials testify about the state of the economy, while ECB President Mario Draghi testifies before the European Parliament. The University of Michigan showed a surprisingly upbeat sentiment for consumers in its latest survey so Tuesday’s official reading of US consumer confidence for September will be an important bellwether. Wednesday brings a post-tropical-depression look at US inventories of crude oil and gasoline. Thursday is a treasure trove of US data, with the latest GDP reading in the spotlight. And Friday brings more survey data from the University of Michigan as well as US durable goods orders for August. Brent moved into a tight tunnel late last week, but expect a new test in the $65 range. It could be a rough ride for the week ahead, with another bounce of plus or minus 4 percent conceivable. The Red alert remains in place.