Rabobank: The Petroyuan News Suggests China Is Preparing For US Sanctions

By Michael Every of Rabobank

Lost Rents of Arabia

It’s a Fed decision day today, but the changing world we live in means this really isn’t the most important thing going on – or at least it’s not what people are talking about most. Let’s start with the ivory tower thinkers in D.C. with ‘Hiking Season’ from Philip Marey, who notes: “Starting a hiking cycle in the midst of a geopolitical crisis may seem counterintuitive, but for the Fed the Russian invasion of Ukraine, and the subsequent sanctions, are essentially an additional negative supply shock.” Which is exactly what the market is pricing by calling for 7 hikes this year – though Philip only expects 4, which makes a lot more sense when you consider how much money is being sucked out of the US economy by rising inflation. I will add that his title, and that backdrop, reminds me of the Bugs Bunny/Daffy Duck cartoon where each try to persuade hunter Elmer Fudd that it is either rabbit season or duck season, before all end up finding out it is in fact Elmer Season. Given how disastrous rate hikes are going to be in what is now a war economy, it will be central banks in the firing line in time.

Indeed, today conversations revolve around the war: President Zelenskiy saying he accepts Ukraine won’t join NATO, which was never on the cards anyway, and his upcoming address to the US Congress today, where he will again ask for a No-Fly Zone seen as an escalation by some; Putin’s comment that “Kyiv is not serious about finding a mutually acceptable solution”; and Poland, which along with the Czech and Slovenian heads of government, just visited Zelenskiy in Kyiv in person, calling for a NATO peace mission “protected by armed forces” to help Ukraine.

US markets rallied anyway yesterday, despite Russia looking like it is going to default on US dollar sovereign debt again today, as in 1998 (anyone remember LTCM?), because apparently economic war against an oil producer means cheap oil now. Who knew?! Partly that’s due to very low liquidity, as even the largest commodity trading houses fear a 2008 ‘nickel and dime’ moment and are already having to raise billions to cover margin calls. Partly it is due to China locking down again – although its miraculous/ridiculous data yesterday say otherwise. But let’s just say that some also say there is now an inverse Plunge Protection Team working in oil, like it does in stocks: and they meet today.

War and oil is also the focus, along with the US dollar and sanctions, on the back of the headline that Saudi Arabia is in talks with China to sell oil for CNY. Obviously, this is a much larger deal than the $2.6 billion purported India-Russia oil deal floated Monday, and in line with present pace of escalation in this metacrisis. This time we are talking $56 billion in oil and related petro-chemical exports, and $27 billion in Saudi imports, taking 2019 as a base. The reaction to this news has generated mixed responses. Some are cheering; some making faces like Macaulay Culkin in ‘Home Alone’; and others say ‘Meh!’. I am in the ‘Meh!’ camp because:

1. This is an obvious follow up to the threats made in the recent MBS puff-piece in The Atlantic.
2. Even the Wall Street Journal exclusive says the talks have been ongoing for six years(!)
3. $56 billion is hardly the entire $2.6 trillion global oil market, even if this is Saudi Arabia.
4. Even if we assume all Saudi-China trade switches to CNY, that is $320 million per working day vs. the $6.6 trillion global daily FX market – and note I am using dollars not CNY for easy comprehension here, which makes my point for me.
5. @anasalhajji underlines why the oil market needs a base currency that is liquid, which CNY is not, freely tradable, which CNY is not, and stable, which CNY only is because it does not meet the other two criteria, and because it is on/off soft pegged to the US dollar.
6. Even a move to oil priced in a basket of currencies is hugely complex to maintain across OPEC partners – which is why it has not happened yet.
7. Saudi Arabia’s own currency is pegged to the US dollar, so it would be exchanging complete shielding from FX volatility for FX volatility – unless CNY also remains pegged to the US dollar.
8. Saudi Arabia would end up accumulating lots of CNY, which is of no use unless everyone else makes the same shift; and CNY does not meet the criteria to expand from its current base, for the reasons just shown.
9. Indeed, with China being accused of perhaps helping Russia militarily in Ukraine, there won’t be any Western adoption of CNY. Perhaps emerging markets will do so, but that bloc would then gradually, or rapidly, detach from the US and the West. Good luck with that.
10. Saudi Arabia would probably still price oil in dollars given its own balance sheet, and just allow (some) Chinese oil payment in CNY; and
11. The Saudis would then sell those CNY back to China for dollars immediately.

Yet geopolitically this news is highly significant. First and foremost, it suggests China is preparing for possible US sanctions. Do the math on what implies on multiple fronts.

Second, the original Middle East deal was the Saudis priced oil in US dollars and kept it flowing, and the US military protected them. Then the Iraq War and extremism bled the US of any enthusiasm for the region. At which point, as some see it, the Obama White House decided the country that regularly burned the US flag, Iran, was best placed to be the new regional hegemon. Others see the 2015 nuclear deal as a wise attempt to prevent Iran getting nukes and having another unwinnable Gulf war… hoping Tehran will decide not to get nukes after the deal’s sunset. Guess which view the Saudis take?

To try to bridge that gap, President Trump tightened the screws on Iran and made Riyadh his first foreign visit, which greeted him with swords, a Lord of the Rings Palantir thing, and a Saudi Zoolander Centre for Kids Who Can’t Read Good And Want to Do Anti-Extremism Good Too. Now the Biden White House won’t even pick up the phone and is pressing ahead with what even a former US negotiator describes as a weaker version of the Iran nuclear deal. Guess what view the Saudis take of that? That the US security guarantee is no longer valid. And how do they resolve that? By kissing up to China and hoping that as Iran does the same Beijing will not allow any conflict between the two. But how well did that work out with Russia and Ukraine?

Many in the region worry the present US policy path will end up with the war the US wants to avoid, just as Ukraine did. This tends to happen to retreating hegemons who Can’t Do Military Retreat Good But Still Want to Do Global Hegemony Good Too. I suspect the US will be back in Riyadh with swords and purple orbs at some point. And oil and currency markets will still be dollar denominated at that time. And energy prices will not be down 40% in a week.

For now, however, the US is clearly closer to seeing ‘Lost Rents of Arabia’ as the flow of economic rents it charged the Saudis for protecting it dry up; but Saudis also have to decide if they want all their kids to go to schools in Beijing or Moscow rather than Miami or LA.

Meanwhile, the geopolitics-markets world keeps turning. Yesterday saw the EU endorse a plan to slap import levies on iron and steel, cement and aluminium produced in countries with lower environmental standards – or the so-called Carbon Border Adjustment Mechanism (CBAM). It still needs to go before the EU parliament, but as things stand, it will mean green protectionism is these areas. And China, going all in on coal, will be top of the list, along with Russia, of countries on the wrong side of the new green wall. Is that CNY positive?

North Korea also just launched what might be an ICBM, taking it closer to having a nuke that could hit the US. Is that US dollar negative?

And away from all the hoo-hah over oil, Brazil potash prices are going up like a rocket at 1,100, up 238% y/y; US cornbelt ammonia looks the same at 1,475, up 127% y/y; as does Egypt Urea spot at 1,100, up 175% y/y. That is anything but ‘Meh!’ And, if sustained, it means higher global food prices – which are priced in dollars, not CNY.