Capitalism Gone Wild

By John Mauldin

Recession is coming. We can debate the timing, but the economy will turn decisively downward at some point. My own analysis, looking at the data available on April 4, says recession isn’t likely this year but unfortunately looks very probable in 2020.

In addition to when it will happen, there’s also the question of how deep the next recession will be. A shallow downturn wouldn’t be fun, but compared to the last one might feel relatively refreshing.

Alas, I don’t think we will be that lucky. I think the opposite: The next recession will be deeper, longer and far more painful to many more people than your average recession, and could persist as long as the last one. That is because the next recession in all likelihood will be truly global. If you sailed through 2007–2009 without your lifestyle changing, I wouldn’t assume it will happen that way again.

Ironically, but not surprisingly, it will be the response to the last recession that makes the next one so much worse. Part of the reason is that investors once again “learned” that if you simply stay the course, the market will get you back to where you were and more. The massive move into low-fee index investing instead of active management will make the next recession more painful.

You must understand that 75% of today’s wealth is in the hands of retirees and pre-retirees. Most have a significant portion of their money in index funds, and they’re going to see significant erosion of their retirement assets. I’m thinking especially of those depending on public pensions, which are heavily weighted to a form of index investing. Public pensions are already significantly underfunded (in general) and a bear market will make them even more so. It will be painful and I can assure you it will cause a lot of political angst. Today I’ll tell you why I think this. It may be one of the more important letters I’ve written in the recent past, so read carefully.

Unwise Investment

Central bankers have a well-worn playbook for handling recessions. Cut interest rates, increase liquidity, and otherwise make more capital available to the private sector. This helps businesses hire more workers and raise wages. Then gradually remove all the stimulus as growth recovers. (Usually, at least. Greenspan waited too long to tighten after the 2001 recession and begin raising rates, creating the dynamics for the subprime crisis.)

The playbook truly fell apart in 2008. The system had so much debt that adding yet more of it didn’t have the desired effect. As noted, easy money from the last crisis had created the situation. Even dropping short-term rates to effectively zero didn’t help because it was creditworthiness, not interest costs, that kept people and businesses from borrowing.

The Bernanke Fed’s answer was quantitative easing—essentially a way to stimulate lending at longer maturities. It had an effect but not the intended one. Instead of going to productive use, the new stimulus helped banks deleverage and public companies leverage up and repurchase their own shares, or as we will discuss below, simply buy their competition and short-circuit the “creative destruction” cycle. This pushed asset prices, i.e. the stock market, higher and made it appear recovery was underway. Unfortunately, the “recovery” was the slowest recovery on record.

All that cash eventually trickled through the economy, not to people who would spend it on useful goods and services, but to yield-starved investors. Why were they starving? Because the Fed was keeping rates low. They had little choice but to take more risk, which is what the Fed wanted them to do in the first place. So they plunged money into venture capital, private equity, IPOs, emerging markets, and everything else they could find with potentially decent capital gains and/or yields.

The result was a massive wave of investment, some good and some, well, let’s just say based on hope and little else. And as we know, hope is not a solid investment strategy. Some businesses that had good stories (the so-called unicorns) found themselves covered with cash by investors for whom hope sprang eternal. Eager to show they could turn the cash into gold, the companies sought to emulate the Amazon model, using money to buy growth without profit. In the hopes of going public at some point and cashing in, they kept the game alive. Think Lyft. (Note: I like Lyft and wish them nothing but success. But still…) Investors, because they wanted to believe the story they were investing in was true, watched and waited.

They’re still waiting. And here we are.

Zombie Companies

Back in November 2018 (which now seems like about 30 years ago) I wrote about a Bank for International Settlements study of “zombie” businesses. Looking at the 32,000 publicly-traded companies in 14 advanced economies, they found 12% were both

  • At least 10 years old, and

  • Had an interest coverage ratio below 1.0 for three consecutive years.

In other words, these companies weren’t making enough revenue to pay back their loans, much less cover their other expenses and earn a profit.

Note, these were not startup companies. All were at least 10 years old and still in business despite their inability to make any money. Here was my conclusion at the time.

Faced with a probable loss, lenders always face a temptation to “extend and pretend.” They convince themselves that another year or another quarter will let it turn into a sterling borrower who pays in full and on time. And more often than not, the zombie company has a charismatic CEO or founder who can charm lenders.

Now, there are perfectly understandable, human reasons for this. No one wants to force people out of their homes or put a company out of business and leave its workers jobless. But capitalism requires both creation and destruction. Keeping zombies alive hurts healthy companies. BIS found it actually reduces productivity for the entire economy.

The other side is that lenders must lose their money, too. Those who make irresponsible lending decisions have to face market discipline or they will keep doing it, causing further problems. Unfortunately, we do the opposite. Bailouts and monetary stimulus over the last decade generated a lot of unwise lending that is not going to end well.

Many (possibly most) of these zombie companies should fail. Or, more accurately, they will fail either suddenly in a crisis, or in slow motion if their lenders won’t bite the bullet. There really are no other options. And when they do, it will hurt not only their lenders but their suppliers, workers, and shareholders.

That, my friends, is how recessions begin. If we’re lucky, it will occur gradually and give us time to adapt. But more likely, given high leverage and interconnected markets, it will spark another crisis.

Now a Bank of America Merrill Lynch study finds roughly the same thing: 13% of developed-country public companies can’t even cover their interest payments. They are either borrowing more cash to pay off previous loans, or issuing equity to hopeful (too hopeful) investors.

While it’s easy to say these investors are making poor decisions, they’re not doing it in a vacuum. They’re trying to earn positive returns in a world where central bankers have made positive returns an endangered species. This means everyone is operating with distorted information and incentives. We’re in a hall of mirrors, so no surprise some people crash into the glass.

None of this is “natural.” It’s not the free market gone wild. It is the result of a manipulated market. The manipulators are what went wild. Sadly, they’ve only just begun…

Gummed-Up Economy

We have another problem I also described recently: Capitalism Without Competition. A large and growing part of the economy is effectively “owned” by powerful monopolies or oligopolies that face little competition. They have no incentive to deliver better products at lower prices or to get more efficient. They simply rake in cash from people who have no choice but to hand it over.

This would be impossible if we had true capitalism, at least as Adam Smith, et al., envisioned it. Even if we generously concede that some businesses really are natural monopolies, most aren’t. The industries we now see dominated by a handful of companies got that way because the incumbents found some non-capitalistic flaw to exploit.

In theory, this problem should solve itself as technology and consumer preferences change the conditions that let the monopolies arise. Yet it isn’t happening. Axios outlined the problem in a recent article on farm bankruptcies.

Across industries, the U.S. has become a country of monopolies.

  • Three companies control about 80% of mobile telecoms. Three have 95% of credit cards. Four have 70% of airline flights within the U.S. Google handles 60% of search. The list goes on. (h/t The Economist)

  • Similarly, just four companies control 85% of U.S. corn seed sales, up from 60% in 2000, and 75% of soy bean seed, a jump from about half, the Agriculture Department says. Far larger than anyone — the American companies DowDuPont and Monsanto.

As we have reported, some economists say this concentration of market power is gumming up the economy and is largely to blame for decades of flat wages and weak productivity growth.

“Gumming up the economy” is a good way to describe it. Competition is an economic lubricant. The machine works more efficiently when all the parts move freely. We get more output from the same input, or the same output with less input. Take away competition and it all begins to grind together. Eventually friction brings it to a halt… sometimes a fiery one.

The normal course of events, when politicians and central banks don’t intervene, is for companies to grow their profits by delivering better products at lower prices than their competitors. It is a dynamic process with competitors constantly dropping out and new ones appearing. Joseph Schumpeter called this “creative destruction,” which sounds harsh but it’s absolutely necessary for economic growth.

With creative destruction now scarce as zombie companies refuse to die and monopolies refuse to improve, we also struggle to generate even mild economic growth. I think those facts are connected.

Uncreative Destruction

Some of this happened with good intentions. Creative destruction means companies go out of business and workers lose their jobs. Maybe a new competitor will hire them eventually, but they suffer in the meantime. Politicians try to help but finding the right balance is hard.

I assign greater blame to the central bankers, not just the Fed but its peers as well. For whatever theoretically good reason, they kept short-term stimulus measures like QE, ZIRP, and in some places NIRP in place far too long. The resulting flood of capital short-circuited the creative destruction process.

A lot of this happens under the radar. You’ve probably seen stories about the Lyft IPO and other unicorns that will soon go public. This is news because it’s now so unusual. The number of listed companies is shrinking because a) cheap capital lets them stay private longer and b) the founders and VCs often “exit” by selling to a larger, cash-flush competitor instead of going public. An economy in which it is easier and cheaper to buy your competitors rather than out-innovate them is probably headed toward stagnation.

The Drive for Scale

It is almost a sidebar, but this concept of “scale” is another important point. My usually-bearish friend Doug Kass wrote this week that Amazon will be at $3,000 within a few years and $5,000 by 2025. If it was anybody but Doug Kass I would have probably ignored such massively bullish analysis.

I won’t summarize his entire letter here, but the thought it triggered in me was that Amazon now has scale. How do you compete with that?

I was in southern Wisconsin on Tuesday, meeting with a group of current and potential investors in biotech company Galectin Therapeutics (GALT). I have a little skin in that game, so I took a day between meetings. After dinner I was talking with some of my fellow attendees. I asked one what he did and he is in the business of trying to merge or buy his competitors. Because the world now demands that he become bigger and leaner, he has to create “scale” or die. It was in a business that I didn’t think was naturally demanding scale.

The host for our Wisconsin meeting was Dick Uihlein. If you are in North America, you have probably bought something from Uline. Shipping boxes, tape, janitorial supplies, you name it. They have more than a dozen huge warehouses stocked with everything you can imagine. Their motto is order it today, get it tomorrow. And they make it work. Walking into one warehouse that is literally a quarter-mile long, that is so clean you could eat off the floor, and watching small orders literally flow from the 20-foot stacked shelves and rows hundreds of feet long, is amazing. They are growing at 14% a year and are now $8 billion+. (The fact that Dick and Liz Uihlein are two of the greatest and most generous humans on the planet does my heart good…)

But literally, how do you compete with companies like Uline and others like them? Technology and great management create scale that dominates the potential market… and make it difficult for new competition.

Between technology and ultracheap money we have short-circuited Schumpeter’s creative destruction. It is like watching the small farmer disappear. Your heart is with them but the market demands scale. Can small farmers producing locally grown food survive? Absolutely. But it is a niche market, favoring entrepreneurial farmers, not the average small farmer of yesteryear. That world is gone.

And as the world demands scale, cheap money helps it go even faster. Understand this: Cheap money is not going away. Neither is technology and the drive for scale. We can cheer for the “small farmer,” but the reality is that the world is moving to fewer competitors and larger businesses. And as I write that, I literally find myself sighing. I hate writing those words. But I can’t avoid reality. The world is changing and we must deal with it.

Helicopter Governments

You may have heard about “helicopter parents,” hovering over their children to ward off any and all threats. The problem is they keep the children from gaining independence. Similarly, helicopter monetary and fiscal policy that seeks to protect the economy can instead accomplish the opposite.

Access to capital is necessary for economic growth, but free and/or subsidized capital is its long-term enemy. Managers and entrepreneurs have less incentive to innovate and operate efficiently when they can always count on another VC funding round or leveraged loan. When they don’t actually have to compete with more innovative competitors thanks to low-cost capital and their huge scale, creative destruction gets short-circuited. We no longer live in the world Schumpeter envisioned.

That’s not a complaint, just reality. I am old enough to have read numerous stories lamenting the small farmer’s demise. And I sympathetically read them, agreeing it was sad, yet happily buying lower-priced food. “Scale” in so many businesses really matters.

This doesn’t mean the Fed should keep interest rates extra-high. That would create different problems. The real barrier is this group of people who sit around a table in Washington and make decisions affecting the entire economy. That’s bad enough, but they do it based on incomplete data and flawed models.

This is a terrible situation but here’s the worst part: It isn’t going to change.

The Fed will keep manipulating interest rates downward, capital will stay cheap, businesses will keep wasting it and investors will keep believing this time is different. They’ll be partly right. This time will be different but not in the happy way they think.

The result will be a US economy that increasingly resembles Japan’s… stuck in a loop, dependent on other countries over which it has little influence or control, with an economy going sideways while a demographic tidal wave strikes.

Where does that lead? For Japan, it’s meant 30+ years in a holding pattern. I’m not sure the US will be so lucky. But at the very least, we’re going to see a decade of little or no growth and a whole lot of pain.

We could have avoided this by accepting a little more pain in the last recession. In hindsight, I’m not sure QE accomplished anything useful. For capitalism to work, lenders who make poor decisions must lose their money, not get bailed out. While I reluctantly agreed that QE1 was sadly necessary (in the words of my friend Paul McCulley, it was “responsibly irresponsible”), I still believe QE2 and QE3 were overkill. Central bankers gone wild… And not just in the US…

Our incentive structures are now so distorted I don’t see any way out. A much bigger crisis is coming and it’s going to hurt. You can either deny it or prepare for it. I know which I’m doing.

Cleveland, Chicago, Dallas, and SIC

“You need a root canal soon,” are not words you want to hear. Shane decided I needed to get my teeth cleaned and set up an appointment with her dental group here in Dallas. And I did need to get one tooth examined as there was some swelling. That simple cleaning turn into a 2½-hour ordeal, and now instead of flying back to Puerto Rico Friday we will stay over the weekend, get the root canal on Monday, and then fly home Tuesday.

I have one last eye checkup in Cleveland later this month, then I will fly to Chicago for a few days to join Brian Lockhart, Geoff Eliason, and their Peak Capital Management team for their annual client conference.

The Strategic Investment Conference is a little more than one month away. It seems like almost every day I’m doing at least one phone call with speakers and panels, coordinating what you will hear to make sure the “flow” of information works. Shannon Staton has been working on the details of the conference for many months, and she is the reason the conference runs so smoothly. If you can’t attend in person you really should get the Virtual Pass.

And with that I will hit the send button, as I have an appointment right down the street with Kyle Bass to catch up with him personally and talk about what he will be presenting at the conference. It’s a lot more fun when you can do that conference call in person. You have a great week!

Your thinking about scale analyst,

John Mauldin
Chairman, Mauldin Economics

When and Why the Suppliers of Oil Matter

More often than not, it doesn’t matter where oil comes from. But the exceptions to this rule can be critical.

By Phillip Orchard


There have been several key changes in the global energy landscape in recent years. The surge of U.S. crude production, the reimposition of sanctions on Iran, efforts by OPEC to goose prices, instability in producers like Venezuela and Libya, and rapacious appetites in emerging economies have reconfigured long-established oil flows across the world. Last week, for example, newly released data showed Saudi crude exports to the U.S. Gulf Coast dropping to nearly a fifth of levels a year ago. The week before, Saudi Crown Prince Mohammed bin Salman made high-profile visits to Pakistan, India and China to woo new buyers and investors.

There are countless dimensions to the geopolitics of energy security. Price swings can lead to a surge in prosperity and clout in one country while wreaking havoc on the internal politics of another. Countries have routinely proved willing to meddle in the internal politics of oil-rich states to protect commercial energy interests. Territorial disputes become an order of magnitude more explosive when energy riches are at stake.

But the geopolitical importance of where an importer gets its crude from, or to which countries a producer sells its oil, tends to be overstated – and often overvalued by policymakers. More often than not, it just doesn’t matter. As a general rule, a barrel of oil is easy to move, easy to blend with barrels from another producer to meet quality requirements, and easy for importers to buy at market prices. It’s a largely fungible commodity sold on a deeply integrated global marketplace. Still, there are exceptions to this rule, in which trade is driven by non-market motives and in which crucial dependencies can take root. And as the current upheaval in oil markets shakes out, it’s the exceptions that are worth watching most closely.
A ‘Global Bathtub’?
Economists often refer to the international oil market as a “global bathtub” – one with many spigots and many drains, but one holding the bulk of the world’s oil supply with broad consistency in value. This is because oil is generally a global commodity. Most crude is cheap to move across a variety of modes of transportation, from ships (responsible for around half of all oil shipments) to trains to pipelines, without having to be substantially altered to accommodate any particular one (unlike, say, natural gas, which must be liquefied before loading on a ship and then regasified after offloading). The ease and low cost of modern ship-born transportation (it can cost less than $2 to move a barrel of oil from the Middle East to the U.S. or East Asia) means any country with a viable port terminal can buy crude from just about anywhere in the world.

Prices can sometimes differ slightly from one region to another because of political, geographic and infrastructure factors, and quality can vary. But since various grades can be blended together to meet the processing specifications of a refiner, the spread between most grades is relatively narrow, ensuring that importers typically have ample choice in suppliers at market rates. Ultimately, a barrel of oil from Saudi Arabia usually ends up having comparable value to a barrel from Angola. Fungibility often allows the market to function globally in scale.

A useful comparison is natural gas. The commodity cannot be moved around the globe nearly as cheaply or easily as crude, so prices vary considerably more from one regional market to another. This is beginning to change as countries build out infrastructure for LNG. But the liquefaction process and associated infrastructure are still expensive enough – accounting for as much as 30-40 percent of the price of the commodity – to make LNG uncompetitive against compressed natural gas transported via pipeline in most cases. As a result, countries are far more likely to remain dependent on pipelines to meet their natural gas needs – and besides, pipelines themselves are expensive to build, and they are captive to a small number of suppliers (and vice versa). In the past couple decades, natural gas dependencies have taken on greater geopolitical importance than those stemming from crude. For example, Russia’s cutoff of natural gas supplies to Europe via Ukraine at the height of winter in 2006, 2009 and 2014 illustrated how an exporter can leverage natural gas dependencies for strategic gain.

Countries are rarely able to weaponize oil in such a manner. Exporters may band together to try to limit supply to affect global prices, as demonstrated with mixed success repeatedly by OPEC. Two countries may operate outside the global market by forging special arrangements that serve narrow commercial or strategic aims. (Around a fifth of global production is not sold on markets.) But in these situations, the global oil market otherwise still functions normally, with most importers still able to ensure stable supplies from various sellers at market rates priced transparently against a handful of benchmarks. Countries can easily avoid long-term dependencies. A major exporter like Saudi Arabia is rarely in a position to exploit its energy relationship with a major buyer like India in service of strategic aims. In other words, Riyadh can’t expect to gain much by threatening to cut off oil supplies if New Delhi doesn’t, say, end its partnership with Iran on the strategically important Chabahar port. It may take some time for India to adjust, and the risk of a short-term economic crunch may be problematic. But any leverage Riyadh has would be fleeting, as India eventually could just boost imports from a combination of Qatar, Nigeria and any number of other suppliers instead.

And for all the industry upheaval it has triggered, the shale revolution in the U.S. and elsewhere won’t change this dynamic. The introduction of a new major oil exporter – one that happens to be the world’s largest oil consumer, the protector of global sea lanes and a non-OPEC member, to boot – will only help ensure an environment of plentiful supply and unhindered flows across the global commons.
The Exceptions
There are several exceptions to the global bathtub where oil buyer-seller relationships are determined by factors beyond supply and demand – and, thus, where it can matter quite a bit geopolitically from where an importer gets its crude or to whom a producer is selling it. In these circumstances, dependencies are most likely to form, and an importing country’s desire for the lowest possible price of crude could take a back seat to its broader strategic interests.
When Buyers Lack Sellers
This dynamic typically involves landlocked countries that cannot easily draw from the global bathtub, tethering them to suppliers by train or pipeline (or to transit states through which the crude is transported). Belarus is one such example. In 2017, Belarus produced enough oil to meet only around one-fifth of its consumption. It purchased more than 99 percent of its crude imports, valued at $5.23 billion, from Russia but accounted for just 5.5 percent of Russian oil exports that year. There’s a clear dependency here – and one that Russia, which sees Belarus as indispensable to Russian security, has a strategic interest in leveraging. Indeed, the two are locked in a yearslong dispute over plans to remove discounts on Russian oil – re-exports of which account for nearly a third of Belarus’ export revenue – with Moscow occasionally sharply reducing oil flows to the country in an attempt to strongarm Minsk into compliance. The dispute may be motivated, at least in part, by Minsk’s occasional efforts to find some strategic balance between Russia and the West. Regardless, Belarus is in an uncomfortable position. On March 1, Belarusian President Alexander Lukashenko announced that the country was exploring alternative sources of oil, potentially via ports in Ukraine and the Baltics, though Minsk has made several such proclamations in the past.

Dependencies can also stem purely from geopolitical isolation. North Korea is the most prominent example. The U.N. sanctions implemented in 2016 have only deepened its near-total oil dependence on China and, to a much lesser extent, Russia. In the unlikely event that China deemed it worth the risk of pushing the North to the brink of collapse, it could impose a blanket embargo on oil exports to the Hermit Kingdom.
When Sellers Lack Buyers
The second exception typically occurs when geographic, economic and geopolitical conditions limit the number of buyers available to an exporter. This often involves situations where a country’s crude cannot be moved to port easily or cheaply, making producers more dependent on markets that can be served by pipelines or, less often, rail. Canada, for example, has to sell nearly all of its oil mined in its central provinces to the United States, creating a growing dependency on its mercurial southern neighbor. Geopolitical factors like sanctions can also restrict producers’ access to the global market and force them into dependencies. The most prominent example here is Iran, which has been forced to court buyers that are willing to buck U.S. pressure since oil sanctions were reimposed in November.

Russia, meanwhile, is grappling with both geographic and geopolitical constraints on its oil exports. The bulk of Russia’s vast untapped unconventional reserves are located in eastern Siberia, half a continent away from the closest major port at Kozmino. The only realistic way for Russia to get the crude to market has been by building the 3,000-mile (4,800-kilometer) Eastern Siberia–Pacific Ocean pipeline, work on which began in 2005. Theoretically, the pipeline enables Russia to dump its crude into the global bathtub. And as recently as 2011, 75 percent of the pipeline’s crude went to Japan, South Korea and the U.S. But in an era of low oil prices, considering the high cost of building and maintaining the pipeline, it has made economic sense to send more than 90 percent of the ESPO crude to the closest major consumer market: China. In 2017, 21 percent of Russian crude went to China. Last year, Russian exports to China increased another 19 percent. New cross-border pipeline spurs are expected to cement China’s position as the primary consumer of ESPO crude for the foreseeable future.

Geopolitical factors have contributed to Russia’s eastward turn as well. As Russia reasserted itself in Eastern Europe over the past decade, it had to contend with the possibility that Western sanctions would sever its access to key markets – particularly Europe, which historically has been Russia’s primary buyer. As a result, even before global oil prices collapsed in 2014, Moscow had been increasingly looking east for buyers. In 2013, for example, Moscow locked itself into a 25-year supply agreement with China. China needs a lot of oil and has a strategic interest in reducing its vulnerability to a potential maritime blockade that would leave it starved for energy. But for the time being, Russia will need Chinese buyers more than China will need Russian crude, creating a modest Russian dependency on Beijing. Russia understands as much and so has explored ways around it, including the pioneering of shipping routes through the Arctic and its renewed, albeit cautious, efforts to settle a World War II-era territorial dispute with Japan.
When Peddling Problematic Crudes
The third exception typically involves producers whose particular grade of crude can’t easily be blended with everything else sloshing around in the global bathtub. Examples of problematic grades include heavy (high viscosity), sour (containing high sulfur content and other impurities) crude, often produced from oil sands. Before being blended with other crudes, the heaviest, most sour grades must be refined at specialized facilities that are in short supply, limiting the availability of buyers.

The obvious example here is Venezuela, home to the world’s largest technically recoverable oil reserves, much of which is of poor quality. Refineries capable of handling this type of oil are few and far between. Thus, despite being on strained terms with the U.S., to say the least, for the better part of two decades, most Venezuelan crude has continued to flow to the U.S., though it has dropped to just below 50 percent from more than 70 percent in the 1990s. In 2017, its only other major buyers were India and China. The vulnerability created by this dependency has been made abundantly clear with the recent imposition of U.S. sanctions, as well as with U.S. efforts to redirect revenue from the Venezuelan-owned Citgo (which Caracas has used to get a cut of downstream profits) to the Venezuelan opposition.

Occasionally, the availability of sellers for certain importers can likewise be limited by demands for specific types of crude. South Korea’s petrochemical industry, for example, relies almost entirely on condensate – a form of ultra-light crude that’s derived as a byproduct from natural gas production – from the massive South Pars field, which is shared by Iran and Qatar. Seoul has said it will eventually comply with U.S. sanctions on Iran. But South Korean importers have reportedly struggled to find affordable alternatives and will have to pay hundreds of millions of dollars to overhaul their refineries to handle new sources – something they are reluctant to do given that sanctions on Iran could ostensibly be lifted in the near future if a new nuclear deal is reached or the next U.S. president strikes a new course with Tehran.
When Preparing for a Darker Day
Underpinning the theory of the global bathtub is the assumption of certain conditions that, while present today, are by no means guaranteed to be permanent. Most important, it assumes the absence of a great power conflict that would threaten to cut off sea lanes, put a premium on short supply lines, and potentially carve the world into competing blocs with major strategic interests in denying each other the oil needed to fuel their war machines.

Historically, major importers have acted as though such a conflict was a possibility. During the Cold War, for example, part of what drove the U.S. involvement in the Middle East was the need the keep reliable sources of oil within reach – and out of communist hands – in case a major war broke out with the Soviet Union. We’re still seeing this sort of behavior today, even though the threat of a major war erupting is low. As mentioned, China’s willingness to lock itself into a long-term supply agreement with Russia stems, in part, from its concern about the ability of the U.S. and its allies to cut off China-bound oil traveling through the Malacca Strait or the first island chain. This is also a driver of certain Belt and Road Initiative projects such as a major pipeline to the Indian Ocean through Myanmar, and Chinese pipelines to Central Asia.

Still, even despite the surge in oil bought from Russia, more than 80 percent of China’s oil imports travel through these chokepoints and the easily blocked Myanmar pipeline. If China has a growing dependency, it’s not on Russia but on free and open maritime trade. Accordingly, the more important geopolitical development is the buildup of Chinese maritime forces aimed at deterring a potential blockade. Similarly, Japan’s overwhelming dependence on maritime trade for its energy needs, and its concern about China’s creeping dominance of its littoral waters, is compelling Tokyo’s own naval buildup. It’s not all that important to Japan where its oil comes from – just that sea lanes remain open. In other words, for energy-hungry powers such as these, the focus is less about preparing for the possibility that the global oil market ceases to function and more about preventing a doomsday scenario from emerging in the first place.

Ivan Rogers on Brexit

"What Surprises Me Is the Extent of the Mess"

Interview Conducted by Jörg Schindler

As the UK ambassador to the European Union, Ivan Rogers had a front-row seat as Brexit negotiations got underway. In an interview, he speaks with DER SPIEGEL about the mistakes made in London and the huge challenges that remain.

Ivan Rogers, 58, was the UK ambassador to the EU for three years before resigning on Jan. 3, 2017. He stepped down after the revealing of an internal memo, in which he was sharply critical of the British government and forecast significant problems for the Brexit negotiations. His book, "9 Lessons in Brexit," appeared in early February.

DER SPIEGEL: Sir Ivan, did you expect such a political mess when you resigned two years ago?

Ivan Rogers: I knew that it would be a long, tortuous and potentially conflictual process. That doesn't surprise me. What does surprise me is the extent of the mess and the fact that four weeks before the deadline, the political class is unable to come to any serious conclusion about what kind of Brexit they want. Of course, Brexit is a revolutionary moment, but I have never seena political crisis like this in my professional career.

DER SPIEGEL: Prime Minister Theresa May this week cleared the way for a Brexit delay. Is a no-deal scenario off the table for now?

Rogers: It would be a mistake to conclude that. I think there is a serious possibility that we are still paralyzed after March, with no resolution. There will then be a risk that we end up with a no-deal exit in June or July. I don't think there is an appetite in lots of European capitals to simply roll forward extensions while we are still working out where to go.

DER SPIEGEL: Is the British political system broken?

Rogers: It's not in a healthy state. These are tumultuous times, and I think the political elite has fractured in both parties. You could argue, if you're supremely optimistic, that it's a testimony of the strength of the British system that it still exists and functions in a fashion despite the extent of turmoil we've gone through. The British system can cope with a lot.

DER SPIEGEL: Former Labour and Tory parliamentarians have formed the Independent Group in parliament. Can they play a role similar to the En Marche movement in France?

Rogers: It's far too early to judge. It's an attempt to reoccupy the center ground at a very interesting moment. I worked for Tony Blair and David Cameron, who were the dominant figures in British politics in the last 25 years. Both were centrist figures and deliberately occupied the center ground. That became the tradition of British politics: Unless you occupy the center, you are finished. After the financial crisis and a period of austerity, the center here has since largely collapsed, and the public is deeply alienated from both big parties. In both parties, populists on the left and the right have gained a much bigger influence. At the moment, we don't have serious, established center-left or center-right figures who command public confidence.

DER SPIEGEL: Would a different prime minister have done better than Theresa May?

Rogers: They would have had different priorities. Immigration and the free movement of people is the central question for Theresa May. She wants to reduce the numbers of people coming into the UK both from inside and outside the EU. The consequence was always obvious: Once you end that, you can't have free movement of goods, services and capital. So you have to leave the single market. And if you want a fully autonomous trade policy, you cannot stay in the customs union either.

DER SPIEGEL: The Europeans didn't expect that.

Rogers: They found that quite shocking. The way Theresa May prioritized that very early on indicated to the Europeans that we would be going much further out of the European Union than Norway and Switzerland, or even Turkey, which has a customs union agreement with the EU. In all honesty, I don't think she fully understood what a dramatic rupture that would have been. Since then, she has tried to edge things back. But her problem is: Having started with a hardline position, every time she's moved a little bit back, the right wing of her party cries betrayal. I think other prime ministers could have done it in a different fashion.

DER SPIEGEL: May is not the only British politician who doesn't totally understand the European Union.

Rogers: This is an endemic problem. I am one of the few who has worked for the bulk of my career on European issues. British politicians don't understand what the single market or the customs union is or how the EU really works. This is a problem in many member states, but it is worse here. I have worked with several prime ministers very closely. Although all of them have been very able people, none of them have had a deep understanding how the European Union works. They don't have an emotional attachment to the EU, because we've always had a rather mercantile relationship with our neighbors.

DER SPIEGEL: What is your view of the role the EU has played in the negotiations. Do you think they trying to "punish" the UK as many Brexiteers claim?

Rogers: I don't. If you deliberately leave the club, it has automatic consequences, and some of them are unpleasant. Of course there is a risk: For the British public, who has no reason to understand every detail, it looks as if the Europeans have set up a process to maximize the British pain. I don't think they have.

DER SPIEGEL: Have the Europeans done everything right?

Rogers: They have set up a very well-structured technocratic process which delivers legal text. But I think that European leaders spent too little time thinking about how the future of the continent should look after Brexit. That is a mistake.

DER SPIEGEL: What should it look like?

Rogers: My argument would be that there is still an awful lot of common ground and common values. It's not that the relationship between Britain and France or Germany is bad. But I have never seen a thinner relationship in my lifetime. There is an awful lot going wrong in the world at the moment. But I don't think the European political elites are talking to each other anything like as much as they did 20 years ago.

DER SPIEGEL: Whose fault is that?

Rogers: Overwhelmingly, the Brits have to take the responsibility for this, because it's the British political class who increasingly lost interest in Europe. But let's assume Brexit happens and we remain out for the foreseeable future: Europe will then have 65 million people 20 miles offshore, theirbiggest single trading partner on this side of the planet and your biggest security partner. And this at a time when you've got trouble to the east and trouble to the south. The British role in this can be important. The German political elites have to think hard: How are we going to work together?

DER SPIEGEL: Otherwise?

Rogers: Otherwise, you will see the divergence that has already started getting worse and Britain increasingly concluding that it has nothing to do with you and drifting to the other side of the Atlantic, which geographically we can't, but mentally we can. It would be tragic if Britain were to turn its back on the continent.

DER SPIEGEL: Unfortunately, the political declaration regarding the future relationship is rather vague and opaque. When it comes to the second stage of the negotiations, which are to lay the groundwork for a free-trade agreement, will we see the same chaos all over again?

Rogers: I think so. It's opaque because the British wanted it opaque. We don't really know where we want to go. Therefore, the other side has agreed to a document which is full of ambiguity. That's very clever, but it doesn't solve any problems. The Europeans are saying: Until you tell us something more coherent and intelligent about where you want to go, we can't really have a debate with you. I understand that. But I don't think that's good enough. I think the Europeans also need to tell us what kind of relationship they want. Just sitting back and watching until London has sorted out its chaos is an understandable reflex. But it's not the right one.

DER SPIEGEL: How long will it take to sort out the future relationship?

Rogers: Much longer than many people think. The planned trade deal is not "the easiest in human history," as Liam Fox has claimed. It's not easy to solve for one simple reason: This is the first trade deal in history where partners are seeking to get further apart. All trade deals I've ever worked on were about getting closer together and dismantling barriers to trade. We are now deliberately re-erecting barriers, seeking a thinner relationship than the one we have. We like the free trade with Europe, but not the European institutions. Well, that's not on offer.

That's why the next step of the negotiations will be conflictual again. The Europeans will say: There must be a reason why you wanted to leave and diverge from our model, please tell us what degree of divergency you want and why. You only need to say it that way to realize that this will not take months, but years.

DER SPIEGEL: There are some in London who would like you to come back to help sort out the mess. Is that something you would consider?

Rogers: I didn't resign because I refused to deliver Brexit. I said to my staff on the morning of the referendum: If you can't work for a government that is committed to delivering Brexit, don't work here. My heart was always behind giving the country what it had decided and delivering the best possible Brexit. I am happy to do anything I can to contribute to getting my country to the right place in the next 10 or 20 years. But it's a totally hypothetical question.

Nobody in government will ask me to get back into the political circus any time soon.