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Paradigm shift. The end of the petrodollar approaches, can America withstand the disruption?

The petrodollar system is being undermined by exponential growth in technology and shifting geopolitics.

In 1974, the United States agreed to purchase oil from Saudi Arabia, provide weapons, guarantee the preservation of Saudi oil wells, and provide unconditional cover for the brutal dictatorship.

In return, the Saudi Arabia agreed to invest the dollar proceeds of its oil sales in U.S. Treasuries, financing America’s appetite for spending, and fueling America’s hegemony, and 20 trillion dollar debt.

Via Zerohedge

Still, the underlying concept of how Petrodollar recycling, or as some call it, petrocurrency mercantilism works, leaves some confusion. So in order to alleviate that, here courtesy of Cult State, is a quick and simple primer that should hopefully answer all questions. From CultState:

So what is petrocurrency mercantilism?

It’s when a national bank and an energy producer collude to generate artificial demand for a currency at the expense of the purchasing power of other currencies.

The flowchart below shows how it all works.

The Coming Renaissance of Macro Investing: via Barrons

In the summer of 1974, Treasury Secretary William Simon traveled to Saudi Arabia and secretly struck a momentous deal with the kingdom. The U.S. agreed to purchase oil from Saudi Arabia, provide weapons, and in essence guarantee the preservation of Saudi oil wells, the monarchy, and the sovereignty of the kingdom. In return, the kingdom agreed to invest the dollar proceeds of its oil sales in U.S. Treasuries, basically financing America’s future federal expenditures.

Soon, other members of the Organization of Petroleum Exporting Countries followed suit, and the U.S. dollar became the standard by which oil was to be traded internationally. For Saudi Arabia, the deal made perfect sense, not only by protecting the regime but also by providing a safe, liquid market in which to invest its enormous oil-sale proceeds, known as petrodollars. The U.S. benefited, as well, by neutralizing oil as an economic weapon. The agreement enabled the U.S. to print dollars with little adverse effect on interest rates, thereby facilitating consistent U.S. economic growth over the subsequent decades.

An important consequence was that oil-importing nations would be required to hold large amounts of U.S. dollars in reserve in order to purchase oil, underpinning dollar demand. This essentially guaranteed a strong dollar and low U.S. interest rates for a generation.

Given this backdrop, one can better understand many subsequent U.S. foreign-policy moves involving the Middle East and other oil-producing regions.

Recent developments in technology and geopolitics, however, have already ignited a process to bring an end to the financial system predicated on petrodollars, which will have a profound impact on global financial markets. The 40-year equilibrium of this system is being dismantled by the exponential growth of technology, which will have a bearish impact on both supply and demand of petroleum. Moreover, the system no longer is in the best interest of key participants in the global oil trade. These developments have begun to exert influence on financial markets and will only grow over time. The upheaval of the petrodollar recycling system will trigger a resurgence of volatility and new price trends, which will lead to a renaissance in macro investing.

Let’s examine these developments in more detail. First, technology is affecting the energy markets dramatically, and this impact is growing exponentially. The pattern-seeking human mind is built for an observable linear universe, but has cognitive difficulty recognizing and understanding the impact of exponential growth.

Paralleling Moore’s Law, the current growth rate of new technologies roughly doubles every two years. In the transportation sector, the global penetration rate of electric vehicles, or EVs, was 1% at the end of 2016 and is now probably about 1.5%. However, a doubling every two years of this level of usage should lead to an automobile market that primarily consists of EVs in approximately 12 years, reducing gasoline demand and international oil revenue to a degree that today would seem unfathomable to the linear-thinking mind. Yes, the world is changing—rapidly.

Alternative energy sources (solar power, wind, and such) also are well into their exponential growth curves, and are even ahead of EVs in this regard. Based on growth curves of other recent technologies, and due to similar growth rates in battery technology and pricing, it is likely that solar power will supplant petroleum in a vast portion of nontransportation sectors in about a decade. Albert Einstein is rumored to have described compound interest (another form of exponential growth) as the most powerful force in the universe. This is real change.

The growth of U.S. oil production due to new technologies such as hydraulic fracturing and horizontal drilling has both reduced the U.S. need for foreign sources of oil and led to lower global oil prices. With the U.S. economy more self-reliant for its oil consumption, reduced purchases of foreign oil have led to a drop in the revenues of oil-producing nations and by extension, lower international demand for Treasuries and U.S. dollars.

ANOTHER MAJOR SECULAR CHANGE that is under way in the oil market comes from the geopolitical arena. China, now the world’s largest importer of oil, is no longer comfortable purchasing oil in a currency over which it has no control, and has taken the following steps that allow it to circumvent the use of the U.S. dollar:

– China has agreed with Russia to purchase Russian oil and natural gas in yuan.

– As an example of China’s newfound power to influence oil exporters, China has persuaded Angola (the world’s second-largest oil exporter to China) to accept the yuan as legal tender, evidence of efforts made by Beijing to speed up internationalization of the yuan. The incredible growth rates of the Chinese economy and its thirst for oil have endowed it with tremendous negotiating strength that has led, and will lead, other countries to cater to China’s needs at the expense of their historical client, the U.S.

– China is set to launch an oil exchange by the end of the year that is to be settled in yuan. Note that in conjunction with the existing Shanghai Gold Exchange, also denominated in yuan, any country will now be able to trade and hedge oil, circumventing U.S. dollar transactions, with the flexibility to take payment in yuan or gold, or exchange gold into any global currency.

– As China further forges relationships through its One Belt, One Road initiative, it will surely pull other exporters into its orbit to secure a reliable flow of supplies from multiple sources, while pressuring the terms of the trade to exclude the U.S. dollar.

The world’s second-largest oil exporter, Russia, is currently under sanctions imposed by the U.S. and European Union, and has made clear moves toward circumventing the dollar in oil and international trade. In addition to agreeing to sell oil and natural gas to China in exchange for yuan, Russia recently announced that all financial transactions conducted in Russian seaports will now be made in rubles, replacing dollars, according to Russian state news outlet RT. Clearly, there is a concerted effort from the East to reset the economic world order.

ALL OF THESE DEVELOPMENTS leave global financial markets vulnerable to a paradigm shift that has recently begun. In meetings with fund managers, asset allocators, and analysts, I have found a virtually universal view that macro investing—investing based on global macroeconomic and political, not security-specific trends—is dead, fueled by investor money exiting the space due to poor returns and historically high fees in relation to performance. This is what traders refer to as capitulation. It occurs when most market participants can’t take advantage of a promising opportunity due to losses, lack of dry powder, or a psychological inability to proceed because of recency bias.

A current generational low in volatility across a wide spectrum of asset classes is another indicator that the market doesn’t see a paradigm shift coming. This suggests that current volatility is expressing a full discounting of stale fundamental inputs and not adequately pricing in the potential of likely disruptive events.

THE FEDERAL RESERVE is now in the beginning stages of a shift toward “normalization,” which will lead to diminished support for the U.S. Treasury market. The Fed’s total assets stand at approximately $4.5 trillion, or five times what they were prior to the financial crisis of 2008-09. The goal of the Fed is to “unwind” this enormous balance sheet with minimal market disruption. This is a high-wire act a thousand feet in the air without a safety net or prior practice. Additionally, at some not-so-distant future date, the U.S. will need to finance enormous and growing entitlement programs, and our historical international sources for that financing will no longer be willing to support us in that endeavor.

The market participants with whom I met theoretically could have the ability to accept cognitively the points made in this article. But the accumulation of many small losses in a low-volatility and generally trendless market has robbed them of confidence and the psychological balance to embrace any new paradigm proactively. They are frozen with fear that the lower- return profile of recent years is permanent—ironic in an industry that is paid to capture price changes in a cyclical world.

One market legend with whom I spoke suggested he wouldn’t have had the success he enjoyed in his career had he begun in the past decade. Whether or not this might be true, it doesn’t mean that recent lower returns are to be extrapolated into the future, especially when these subpar returns occurred during the quantitative-easing era, a period that is an anomaly.

I have been fortunate to ride substantial bets on big trends, earning high risk-adjusted returns using time-tested techniques for exploiting these trends. Additionally, I have had the luxury of not participating actively full-time in macro investing during this difficult period. Both factors might give me perspective. I regard this as an extraordinarily opportune moment for those able to shed timeworn, archaic assumptions of market behavior and boldly return to the roots of macro investing.

The opportunity is reminiscent of the story told by Stanley Druckenmiller, who was promoted early in his investment career to head equity research at a time when his co-workers had vastly more experience than he did. His director of investments informed him that his promotion owed to the same reason they send 18-year-olds to war; they are too dumb to know not to charge. The “winners” under the paradigm now unfolding will be market participants able to disregard stale, anomalous concepts, and charge.

RELATEDLY, THERE IS a running debate as to whether trend-following is a dying strategy. There is plenty of anecdotal evidence that short-term and mean-reversion trading is more in vogue in today’s markets (think quant funds and “prop” shops). Additionally, the popularity of passive investing signals an unwillingness to invest in “idea generation,” or alpha. These developments represent a full capitulation of trend following and macro trading.

Ironically, many market players who wrongly anticipated a turn in recent years to a more positive environment for macro and trend-following are throwing in the towel. The key difference is that now there is a clear catalyst to trigger the start of the pendulum swinging back to a fertile macro/trend-following trading environment.

As my mentor, Bruce Kovner [the founder of Caxton Associates] used to say, “Nobody rings a bell at key turning points.” The ability to properly anticipate change is predicated upon detached analysis of fundamental information, applying that information to imagine a plausible world different from today’s, understanding how new data points fit (or don’t fit) into that world, and adjusting accordingly. Ideally, this process leads to an “aha!” moment, and the idea crystallizes into a clear vision. The thesis proposed here is one such vision.

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