Commodities and Crises
Shocking price movements go from commodity traders’ screens to reality. Expect significant market corrections, a fundamental change in valuation metrics, inflation, recession, supply shocks, and long-term attractive high-yielding investments in energy and commodities. Or not.
Nothing is Smooth or Predictable
Russia’s marginalization will not be a smooth transition or seamless flipping of a switch – as is unrealistically hoped. Russia’s economy, not even in the world’s top 10, should not necessarily cause global mayhem if disrupted or sidelined. However, since the Soviet Union collapsed, the chain of dependence linking Russia to the world’s economy has strengthened and grown more complex.
Russia ranks number one, two, and three, respectively, among the world’s exporters of natural gas, oil, and coal. Russia supplies Europe with most of its energy and accounts for half of such essential elements as 50% of the US’s uranium imports. It supplies 10% of the world’s aluminum and copper, and 20% of battery-grade nickel. Its dominance in precious metals such as palladium, critical to the automotive and electronics industries, is even greater. It is also a major supplier of grain, especially wheat, and fertilizer.
Russia’s exports of raw materials have been spared the kind of comprehensive bans the West has imposed on other sectors. The US announced an embargo on Russian oil on March 8th, but, since it doesn’t buy much Russian oil, this is more for show than substance. Less dramatically, Britain announced phasing out oil purchases this year. However, growing signs the West could go further have shocked commodities markets.
Let’s Talk Energy…and Nickel
Recently, Brent crude rose to $139 a barrel, double its December 1, 2021 price, before falling back to $113. Price swings were violent in gas too: on March 8th contracts linked to the European wholesale gas price surged by a third to $316 per MWh, 18x their level a year ago, as Russia threatened to retaliate by withholding energy to the West.
On the same day, the London Metal Exchange suspended nickel trading for only the second time in its 145-year history because nickel was more than double its previous record price. Other metals hit or neared all-time highs.
Shocked and Stunned
The depth and breadth of these price shocks are unprecedented. A core-commodity index compiled by Thomson Reuters has risen by more than in any period since 1973. In the week ending March 4th, it showed its biggest increase since 1956. Beyond trading floors, hysteria is not yet visible. The calm is unlikely to last.
Prices Become Reality
If tensions rise further, energy and metals may have to be rationed. Extreme challenges for businesses and personal lives will hit hard. The rich world would sputter, but poor countries could go bust. In the end, Russia may buckle, but not before it inflicts extreme pain on the rest of the world. Russia will use its fortitude, which it, probably rightfully, believes is well beyond the capability of all other nations. Deprivation is part of Russia’s long-term strategy.
Time to Panic
Commodity markets are panicking because there is no margin of safety. Many markets were tight before the Ukraine war, and now there are immediate shortages and few options. Increasing global demand from a post-lockdown economic recovery swept up available energy and metals. Supply had not caught up in the post-covid pre-Ukraine wartime. Bottlenecks were emerging, and now shortages are extreme.
Supply is vanishing since the invasion of Ukraine. Some Russian oil is still flowing out, but new supplies are no longer moving. Western firms are pre-empting possible sanctions and are avoiding a public backlash by stopping all business with Russia.
Finance for Russian trades has stopped. Banks are not taking chances and large commodities traders (like Glencore) fear being cut off from bank funding, their lifeline if they continue to deal with Russia. All stop.
Remember Global Supply Chains?
Shipping and logistics are interrupted globally. Forget about the Black Sea, or any Russian ship landing in any port regardless of whether or not it is carrying vital commodities. Also, those ships are quite likely to be intercepted by NATO countries regardless of destination.
Idle cargo, volatile prices, shipping bottlenecks, margin calls, missed debt payments to commodities traders, and global commerce and shipping is an unprecedented logistical mess and, almost literal, train wreck.
Russia exports a little less than 8 million barrels of oil per day, half of which goes to the EU. Theoretically, China could buy more from Russia, but that requires redirecting flows that are potentially subject to additional sanctions. Most importantly, Western payment systems are not accessible, so commodities trading can grind to a halt, and developing any new systems, as suggested by China, will take years to scale.
Russia’s oil supply will be mostly off the market, and many other commodities will be affected. Russia has pledged to respond to a full-blown oil embargo by curtailing gas exports to the West. Limits on coal sales would also be painful and complicate Europe’s effort to shift away from gas. As its supply deteriorated, the share of the EU’s imports of coal coming from Russia is 80%.
Russia’s oil and coal supply will simply not get to market. Its gas-storage facilities are almost full. It does not have a big enough fleet to ship coal to Asia. It is clogged and there are no obvious alternatives that can make a meaningful difference.
Can supply from elsewhere mitigate these losses. When it comes to oil, the US is targeting a 10% increase in its daily output. To fill the gap, OPEC needs to play an important role. A combination of increased output from OPEC and lifting sanctions on Iran may add 3 million barrels per day (the world produces, in aggregate, approximately 100 million barrels per day), so this does not seem material enough. Even emergency stocks, while a help, will not make a difference and take too long to arrive in any event.
Gas by Any Other
LNG and other new gas supplies will be essential for Europe. It could start importing more but that requires “regasification” capacity (for converting liquefied gas back into gas), which is simply not available or insufficient.
How Was This Possible?
Impassioned speeches won’t rebalance the market and generate supply. Undoubtedly, there will be a forced reduction of available energy and commodities and a brutal reduction of available essential products and services for the rest of the world.
Rationing, soaring prices, demand destruction (as consumers adjust to limited supply and high prices) will dramatically impact global economic growth, with potentially devastating effects on developed economies. Soaring inflation may be more endemic than hoped, and pricing for fundamental commodities, such as oil is likely to skyrocket. Oil at $200 per barrel is not an absurd assumption.
The Golden Days of the Pandemic
This hellish scenario would take a huge toll on firms and people. Demand destruction in metals would add to the pain. Aluminum shortages will impact the making of anything from cars to cans. A nickel scarcity could halt electric-vehicle production.
All this will hobble rich economies. Predictions for slower growth, or even recessionary negative growth may be understating the ultimate outcome.
Emerging markets will have enormous current-account deficits. Oil at $150 a barrel for a year would cause the current-account balances of 37 oil importers to sink by an average of 2.3 percentage points. That would have a dramatic negative impact on all emerging market economies, especially those currently under stress, such as Turkey, Argentina, Chile, and Brazil.
Even the mighty economic behemoth, China, would see an unwelcome economic impact, both from domestic price increases and supply shortages, to greatly reduced global trade.
Inflation Stays High
Hopefully, the Ukraine tragedy subsides quickly, but, economically, inflation will remain. High prices will outlast sanctions. Russia is disreputable, risky, and marginalized. As its capital markets and export proceeds struggle to recover, investment in commodity production will dwindle. Together with a loss of skills and assets, this will cause capacity to shrink.
Beyond 2022, higher interest rates and slower global growth most likely trigger a market correction, perhaps at an exorbitant cost. As discounts rates rise and growth assumptions lower, many stocks based assumptions that low interest rates and high growth would sustain for many years will see dramatic repricing and much lower valuations.
Energy and commodities, and the businesses associated with them, are in for a very bumpy ride, but there is a fundamental sustainability to their cash flow and long-term attractiveness as world supply reorders. That which is essential prevails.
The luxury of thinking we have halcyon days of global growth and geopolitical stability may not be with us for some time to come. It is perhaps time to plan for that now.