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Prepared by Philip Gotthelf

Saudi Arabian Bonds

(October 20, 2016) According to the Saudis, they have seventy years of reserves that can be used to monetize their new bond issue. With yields mimicking the 1990s, there should be little wonder why investors snapped up the $17.5 billion offering. On the surface, it looks like a quality offering at a great price. However, with rates that suggest "junk" status, caution is the watchword. In particular, one line in The Wall Street Journal (WSJ) front page article caught my attention. Saudi Arabia's offering was the largest ever for a "developing country." I did not know the largest OPEC producer was considered a developing country. Yet, when you read the financing description Saudi Arabia does look like a nation needing economic development.

A few decades ago we used the expression "Third World." I am assuming the term was abandoned because it was not considered politically correct. The reference was to Africa, Asia, and Latin America. OPEC members were generally considered to be part of the First World; whatever that might have been. According to Wikipedia, Third World nations were simply not aligned with NATO or the Communist Bloc. The NATO alliance was the First World and the Communist Bloc was the Second World. Using such criteria, there should be no conflict with the politically correct when using such terminology.

I provide this background because there would be implications that Arab nations were members of the Second World while Israel was a First World country. Economic development would have nothing to do with world designations. We must reference "developed" versus "undeveloped" countries to define socioeconomic conditions. This is where things become interesting. Shortly after World War II, nations like China and Russia were far behind Western Europe and the United States in social standards and wealth distribution. Still, they were considered developed nations. In reality, the lack of capitalist structure in the Communist Bloc became the good fortune of North America and Western Europe.

I have frequently mentioned that Russia or the Commonwealth of Independent States (CIS) that was formerly the Soviet Union (U.S.S.R.) spans eleven time zones, encompassing the largest land mass of any nation or group of states. Within those eleven time zones are virtually every natural resource from forests to fossil fuels to minerals, water, and even farmland. Since all these resources were managed by the State, there was no profit incentive driving development. This permitted the United States and Western Europe free reign over the global export market.

In contrast, Japan joined the First World after being defeated in World War II with the extra luxury of not needing a military budget. As part of the agreement, Japan was foreclosed having any significant standing army or military capability. This meant that Japan could dedicate all resources toward its domestic economy. Look at the result. By the 1970s, Japan assumed the position as the second largest economy. Of course, this was before the European Union united as a single economy. Consider that the small Island Nation outperformed Russia and China. It's mind-boggling!

To be sure, self-inflicted economic constraints were lifted in China after their leaders began adopting the Hong Kong economic model. Since the British Hong Kong lease expired, China has created the second largest economy. The good news is that Russia's President Putin has taken his country backward toward the former communist model, slowing economic development and progress. Still, there is sufficient capitalism within Russia to present the ultimate economic threat within a matter of a few decades.

Through all of this the Middle East has represented a non-conforming group of manufactured nations. With the exception of Egypt, all of the Middle East countries were created by imperialist occupiers like the British and French. Saudi Arabia became independent in 1932, Syria in 1920, Lebanon in 1943, Iran in 1935, Iraq in 1932. The borders were drawn up by Western powers between the Great Wars. Prior to imperial intervention and occupation, the region was divided among Persia and the Ottoman Empire.

Here's the crazy thing. From ancient times through the Middle Ages, Persia and the Ottomans had progressive economies and advanced social structures. It was only after Western intervention that social and economic structures deteriorated. Ironically, neither Persia nor the Ottoman Empire remained dominant when the world moved into the Industrial Age and Fossil Fuel Economy.

From World War II forward, the Middle East became strategic because of oil. All politics and conflicts revolved around economic control. The West created a false economy based upon a single asset; oil. Unfortunately, none of the Middle East players evolved from their fossil fuel economies. This is where these nations remain today with the exception of Egypt, Jordan, and Lebanon. As far back as the 1980s, I wrote several REPORTS about the precarious economic model that dominated the Middle East and majority of OPEC members. I warned that the Oil Model would eventually collapse.

Saudi Arabia is a desert. It has not developed any natural resources other than oil which makes up 90% of its revenue. The Royal Family has promoted a dependant society under a strict Islamic theocracy. In fact, most of the active workforce is foreign. Now that Saudi Arabia is faced with the decline in fossil fuels it has decided to diversify its economy. The problem is that there is nothing to diversify. The $17.5 billion debt offering has no significance relative to the enormous task of economic redevelopment. This is a multi-decade undertaking that will easily span two generations.

This suggests that long term Saudi Arabian debt is not a smart gamble. We have seen the speed with which fracking and horizontal drilling transformed the energy sector. In less than a decade the economics have been completely altered. Crude oil traded above $100/bbl in July of 2014. The economic dislocation is unimaginable. Moreover, long term volatility is unparalleled. In 2005, crude oil traded under $30/bbl. By 2008, it soared above $145/bbl. When you have the capacity to generate 200% of a baseline budget from a single commodity, nothing else seems to matter. Now, Middle East nations are dependent upon the rest of the world for just about everything from food to building materials and technology.

The Russia Factor

Russia has had a managed economy since the Communist Revolution. The United States has enjoyed a rotating unplanned government since inception. Every four to eight years we elect a new president and experience a new administration. This election cycle the U.S. voter is coming to grips with the ineffectiveness of our system. Donald Trump has demonstrated in the bluntest way that politicians do not get things done because they are more concerned about the votes than real progress. Perhaps that is a good thing. We can never know.

Russia and China are accustomed to centralized planning. Putin looks at the Middle East as an extension of his economic model as does China. The Middle East is one of their markets. So, as the United States contemplates internalizing as suggested by Donald Trump, our competitors are focusing on market expansion. As we discuss how our jobs have moved to Mexico, Russia is developing plans to move jobs to Syria and Iran.

I find it truly perplexing that the U.S. has no foreign policy. For sure, President Obama is an anti-colonialist who believes that the U.S. and Western Europe must be diminished as imperialist powers. Barak Obama is the son of a Kenyan. The African perspective is very different and President Obama has reflected that perspective in drafting his foreign policy. To be fair, President Bush '43 lacked a cohesive foreign policy. His insistence upon invading Iraq was a devastating decision. Now, neither Trump nor Clinton has a foreign policy. This is why Putin is free to formulate and execute his plan.

The world's consumer electronics are made in China. As Hillary correctly pointed out, processed steel and aluminum are made in China. Cars and other durables are made in Mexico, China, and Japan. Clothing is made in China and India. I can go down the list. It is fair to say that the exporting countries want to convert Middle East petro dollars into exports. The United States has farm machinery and industrial process equipment, some planes and plenty of military hardware. We used to have the agricultural export market, but that has been infringed upon by South America, Australia, and eventually the Ukraine. The world is whipping our ass!

Russia is at the head of the pack. I wrote about the Ukraine and why it is a critical part of the Russian agenda. Yet, the U.S. and European Union fail to recognize the real motivation behind Putin. Instead, our leaders view the Ukraine from a humanitarian perspective and strategic alliance. In truth, the Ukraine may be better off under Russia's wing in the evolving economic era because Russia is up and coming while the U.S. and Western Europe are in economic decline.

Who Will Control Commodities?

I am not so presumptuous as to say, "You heard it first here!" I admit that I don't read everything and I am not up on European news and political commentary. I can say that my vantage point appears to have some unique elements when evaluating the current political contest. None of my perspective is reflected in U.S. policy or anything proposed by either candidate.

For commodity traders the evolution represents a potential problem. Currently, commodity markets reside in the U.S., Asia, and Western Europe. Russia, China, and India are not in control, yet. If Russia manages to capture the Middle East market while developing its commodity potential, the influence will be disruptive. We already see this in the recent crude oil rally. The move is a conjuration of prospective OPEC cutbacks. Warning! Russia is the world's largest oil producer. Imagine Putin in control of both Russian production policy and Middle East quotas. It is a game changer and I believe it is Putin's ultimate goal.

Putin wants to broker all Middle East business. He knows he can do it through Iranian and Syrian proxy. He is taking a calculated risk with Saudi Arabia and other OPEC members that may align with the West, but Russia has the ultimate stick… its huge natural resources. If Russia manages to control the Ukraine… its breadbasket… It will further diminish North American and Western European leverage. At the same time, Russia can bypass the U.S. and Western Europe with a direct China relationship. China becomes the processing arm for Russia's raw materials as well as Russia's "brokerage agent" for Asia.

Let me bring you back to the infamous Sumitomo copper scandal. This huge Japanese trading company cornered the world copper market, driving up prices in a speculative scheme. It cost the world billions and eventually cost Sumitomo its cash and reputation. That was a single private sector commodity trading house. Imagine how such a scheme would play out if executed by a Russian--Chinese alliance. Think of the possible commodity price volatility.

Donald Trump and Hillary Clinton are blind to these potential developments. This is because they don't have the familiarity and neither do any of their economic advisors. The political advisors haven't got a clue about the economics and are only concerned with political power. They don't understand that economic control is political power. My concern is that our commodity markets will quickly become secondary. The nations that control the flow of raw commodities and the processing into finished goods win. Do you think either of the presidential candidates will pivot the U.S. position to change the developing dynamic? So far, I don't see it. This story is not about jobs… but, it is. The end game is about commodities and our politicians are too stupid and ignorant to grasp the implications.

October 20, 2016
Philip Gotthelf
Commodity Futures Forecast
P.O. Box 566, Closter, New Jersey

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