Zoltan Pozsar - War and Commodity Encumbrance - The Secular End of Lowflation
This is a summary of Zoltan Poszar’s newest piece from December 2022. It’s a much more comprehensive report compared to that of November 2022. To maintain the main points he is making, this summary got longer than the previous one.
Encumbrance plays a significant role in Zoltan’s article. What does it mean? The concept of "encumbrance" in finance refers to the use of collateral in specific trades, which can limit its use in other trades and potentially lead to scarcity of collateral. In this case, the collateral is oil and gas traded between China and its trading partners, making it unavailable to Western markets. This leads to inflation.
War affects commodity markets. The actions of heads of state are more important than central banks' actions in shaping the global economic order.
The G7 of the East (consisting of the BRICS - Brazil, Russia, India, China, and South Africa - countries) is building a new multipolar world order. The financial relationship between China and Russia has implications for the future of the US dollar and liquidity in the US Treasury market. Bretton Woods III is taking shape with the motto "our commodity, your problem."
China is building a "special relationship" with Russia and all of OPEC+ through its relationship with Saudi Arabia and the GCC. The GCC - Gulf Cooperation Council is a political and economic alliance of six countries: Bahrain, Kuwait, Oman, Qatar, Saudi Arabia, and the United Arab Emirates.
This marks the birth of the petroyuan and an increase in China's control over OPEC+'s oil and gas reserves.
President Xi’s Speech at the China-GCC Summit
China's visit to the Gulf Cooperation Council (GCC) marks the first China-Arab States Summit in history. The invoicing of oil in renminbi could hurt the dollar's value and lead to more inflation in the West.
Key points from the speech:
In the next 3-5 years, China is prioritizing all-dimensional energy cooperation with GCC countries, including the import of large quantities of crude oil and natural gas, cooperation in the upstream and downstream sectors, and the use of the Shanghai Petroleum and Natural Gas Exchange platform for RMB settlement in oil and gas trade
China and GCC countries may also engage in currency swap cooperation and advance the m-CBDC Bridge project
What are the results of the cooperation between China and GCC?
The US has sanctioned half of OPEC, that have 40% of the world’s oil reserves. These are lost to China. Russia, Iran, and Venezuela account for about 40% of the world’s proven oil reserves and are selling oil to China at a steep discount. Going forward, oil and gas may not be available to the West at low prices due to encumbrance by the East.
China plans to increase its oil and gas purchases from GCC countries and pay for them in renminbi over the next three to five years. This induces a shift away from the use of US dollars in international trade.
The market has not yet fully realized that the emerging multipolar world results in smaller cross-currency bases and larger commodity bases. What follows are higher inflation rates in the West. Inflation traders do not seem to be pricing in any geopolitical risk when determining five-year forward five-year breakevens because the breakevens are determined by taking central banks' inflation targets as a given and considering liquidity rather than doing top-down or bottom-up analysis.
China, the Largest Trading Partner and Importer of oil in the world
The cooperation marks a new paradigm in energy cooperation. China is the largest oil importer and has different priorities than the US did in the past. This involves not just taking oil for cash and arms but also investing in the region and leveraging regional expertise in the upstream sector, and collaborating on the production of new energy equipment.
China’s manufacturing expertise and large workforce make it the perfect partner for developing infrastructure projects and factories. This marks a shift from "oil for arms" (which the US used in the 70s when working with mostly underdeveloped and crisis-ridden countries) to "oil for development" and is a win-win for both sides.
The GCC can use the renminbi they earn from selling oil and gas to China to buy data centers, telecommunications equipment, and space projects or even convert it to gold.
The old paradigm of US security guarantees for Saudi Arabia in exchange for access to affordable oil and Saudi Arabia recycling petrodollars in US banks and Treasuries is no longer relevant due to shifts in wealth, power, and priorities.
Renminbi Convertibility to Gold
In 2018, before the BRICS Summit, China launched a renminbi-denominated oil futures contract on the Shanghai International Energy Exchange. Since 2016/2017, the renminbi has been convertible to gold on the Shanghai and Hong Kong Exchanges.
→ “Money is as money does, and convertibility to gold beats convertibility to dollars.”
The m-CBDC Bridge Project
Project mBridge or the m-CBDC Bridge Project enables real-time, peer-to-peer, cross-border, and foreign exchange transactions using CBDCs. The project is undertaken by the PBoC, the Bank of Thailand, the HKMA, and the Central Bank of the United Arab Emirates and would allow bypassing the US dollar and its network of Western correspondent banks.
These are direct currency swap lines between the countries. China will purchase more LNG and large quantities of oil from GCC countries and use the m-CBDC Bridge project. And even better, the RMB is convertible to Gold!
All I care about is that you don’t pay for imports from me in US dollars, because I have enough US dollars already and I don’t want to add to my sanction risk.
Zoltan - “I” is China
Russia has been requesting oil payments from India in United Arab Emirates dirhams, which are members of the m-CBDC Bridge and can be sold for renminbi, which can then be used to buy infrastructure equipment from China or be exchanged for gold.
The m-CBDC is not necessarily the only currency swap line for commodities that could be used. India and the United Arab Emirates are working on a rupee-dirham payment mechanism to bypass the US dollar in bilateral trade, including oil and gas purchases from the UAE. A multipolar world!
These new currency systems are coming to life fast. India and the UAE are working on settling oil and gas trades in dirhams by 2023, and China is asking the GCC to fully utilize Shanghai’s exchanges to settle all oil and gas sales to China in RMB by 2025.
China’s Taking the Lead Position in OPEC+
OPEC+ includes Russia, Iran, the GCC, and various oil-producing countries in the Middle East, Latin America, Africa, and Indonesia.
China is starting to dominate OPEC+ and is seeking to pay for oil and gas from GCC countries in renminbi over the next three to five years.
China has a special relationship with Russia and has been paying for Russian oil in renminbi at a discounted rate. Putin remarked: “China drives a hard bargain.”
Iran and China have had a special relationship since March 27, 2021, which is a 25-year “deal” in which China committed to invest $400bn into Iran’s economy in exchange for a steady supply of Iranian oil at a steep discount. The deal mentions these specific points:
- China can buy oil, gas, and petrochemical products at a guaranteed discount of 12% to the 6-month rolling mean price
- The discount adds 6-8% on top of risk-adjusted compensation.Venezuela and China have had a trade agreement for oil in renminbi since 2019.
President Xi pitched the same deal it has with Iran to the GCC, where oil and gas are exchanged for investments in downstream petrochemical projects, manufacturing, and infrastructure. Because the GCC is not sanctioned, China didn’t include the discount but asked for renminbi settlement.
Let’s look again at each country’s oil reserves and the deals that China is currently making with them:
Source: Worldometer
The US sanctioned Venezuela, Iran, Iraq, Russia, and many other countries with the world's highest oil reserves.
Russia, Iran, and Venezuela holding approximately 40% of the world's proven oil reserves are selling oil to China at steep discounts in exchange for renminbi. China is also courting the GCC countries, which hold a further 40% of proven oil reserves, to accept renminbi for their oil in exchange for transformative investments.
The increasing use of renminbi for oil and gas purchases and investments in downstream petrochemical industries in the Middle East and elsewhere means that more value-added will be captured locally at the expense of industries in the West.
This will lead to commodity encumbrance, or the East dominating the supply of commodities and rehypothecating them to the West for profit.
China has become a major exporter of Russian LNG to Europe, and India a major exporter of Russian oil and refined products to Europe.
International Reserve Currency - BRICS-style
President Putin, with Sergei Glazyev in charge, has announced plans for an "international reserve currency" - BRICS coin - based on a basket of currencies from BRICS countries (Brazil, Russia, India, China, and South Africa), with the weight of each currency in the basket determined by the amount of natural resources the country reserves for the backing of the new economic system.
This system would involve bilateral swap lines with trading partners to provide financing for co-investments and trade financing, as well as a form of de jure commodity encumbrance.
Saudi Arabia, Turkey, and Iran have all applied to join the BRICS. The Shanghai Cooperation Organization (SCO) has granted dialogue partner status to Saudi Arabia and Qatar and started procedures to admit Iran as a member.
The SCO is the "NATO of the East," and the BRICS is a WEF-like meeting of the "G7 of the East."
The Belt and Road Initiative aims to create a peaceful "garden of civilizations" in the Middle East, but tensions and competition for resources could complicate this.
These developments suggest that China and Russia are working together to build a new economic and monetary system and that countries in the Middle East are joining them, which could lead to higher inflation and interest rates in the G7 countries.
Conclusion
To summarize with one blunt statement: Inflation for the West.
The new paradigm shift the East and South are creating is amidst an already inelastic oil supply.
In the last decade, all growth in global oil production came from US shale and Canadian tar sands. Saudi Arabia is “pumping” at capacity and will only be able to boost output by one million barrels per day by 2025 and then “no more.”
Due to the sanctions the US applied to ~40% of the world’s oil reserves, China had the freedom to create trade partnerships with them. That means of that inelastic supply:
China will get a big share at a discount, invoiced in renminbi.
China will export more downstream products at a wider margin.
China lures more companies like German BASF with discounted energy prices.
Iran, with Chinese capital, will do more downstream exports too.
GCC countries, with Chinese Capital, will do more downstream with renminbi too.
Resource Nationalism is increasing, not only for oil and gas but also for other commodities like lithium and battery metals. The market doesn’t seem to price these as a driver of inflation.
Large amounts of money are being used to reduce risks of inflation.
Inflation expectations do not consider geopolitical risk.
The control of certain commodities is impacting the future path of inflation in the West in specific regions, which is a real risk known as commodity encumbrance.
Five-year forward five-year breakeven inflation expectations make little sense.
While in the past 50 years, geopolitics didn’t matter, now we’re reaching the secular end of “lowflation.” Not only in commodities but also in labor from countries like China and India as they are rising their wealth level.
Under Bretton Woods III, commodity encumbrance could lead to inflation printing above inflation targets.
Over the next 3-5 years, global oil and gas production is expected to be inelastic, with China getting a larger share at a discount and exporting more downstream products, leading to potential inflation and import substitution in the West.