The Sound of Silence
We thought he would. We deduced he would.
We prayed he wouldn’t.
But then again, why wouldn’t he?
In a world short of commodities, he controls nearly 11% and 17% of global oil and gas production. Ponder that for a moment while knowing that a 1-2% deficit of either will lead to oil prices going parabolic. Against such a backdrop, he has all the leverage. The human element has never been part of the calculus. Assassinations, public poisonings, torture, and false imprisonments provide ample evidence of that. So throw all our liberal ideologies and love for man out the window. The poker player we’re facing doesn’t care. It’s a cold calculus of leverage and pain points, and he’s correctly and accurately deduced ours.
A three pronged attack. Cruise and short/medium range ballistic missiles. Land forces assaulting from Belarus, Russia and via the sea. Airborne assaults to capture key strategic objectives. An annexation of a country by 1 person from 44 million.
Sanctimonious speeches from global leaders followed each step. Initially weak sanctions celebrated each objective captured.
As we’re apt to do, the West likes to throw money at our issues, but last week it was our sanctions vs. his Sukhois. This’ll do we tell ourselves. This is enough. Well, it better be.
Cost of Doing Business
For him, sanctions are merely the cost of doing business. It’s the price paid, the friction cost for a land and legacy grab. Beyond widespread condemnation and vilification, his life and the lives of his coterie will continue just as lavishly and opulently as it has before, absent a few yachts of course. Still, he cares little about what you think. Reputation? Better to be feared and respected that liked, or worse . . . dismissed. Such is the life of a psychopath, and a 72 year old one at that, hellbent on cementing his legacy. Besides . . . friction cost? He’s the owner of one of the world’s largest gas station, farm and mine, which means sanctioning his goods means we’ll be the ones chafing in the end. Thanks for subsidizing my invasion . . . suckers.
This wass the perfect time. It wasn’t going to get any better. We were recovering globally and our thirst for every molecule of energy was never stronger, yet our appetite to secure those sources was never weaker. ESG, climate change, all manner of short sighted, politically popular, but potentially dangerous decisions have culminated in our current position of energy insecurity. That scarcity in energy, coupled with shortages in other basic materials and minerals will have widespread implications. In our last quarterly letter, we wrote:
Let’s be clear though, scarcity didn’t cause a despot to invade a sovereign and peaceful country, but it certainly created the backdrop to make it feasible. If you don’t believe that, then simply ask why our “broad and harsh” sanctions continuously tiptoe around energy? Would we be more or less willing to fully sanction Russia and cleave it from the financial world by shutting off its access to the SWIFT system (which allows banks to transact worldwide) if oil prices were at $60/barrel vs. $90/barrel today?
Does it Hurt Now?
The initial set of sanctions were arguably weak and bearable by Russia. Sure it will hurt in the short-run, but nothing major. We’re ratcheting up the pressure now. As this weekend saw the West block certain Russian banks’ from accessing the global SWIFT system, effectively cutting off the banks from the global financial system. Headline from the Wall Street Journal below:
The new rounds of sanctions will cut off or severely complicate purchases for all manners of commodities. If you can’t pay for it or receive payment for it, then the transactions simply can’t be made. Gazprombank, one of Russia’s larger banks that serves the oil and gas industries, was excluded from the block, but there will be repercussions.
Most importantly, the SWIFT attack, if we can call it that, means the West is trying to cut Russia off from its ~$630B of foreign reserves, 2/3rds of which sits outside of Russia. Preventing banks from freely moving those assets severely hampers Putin’s ability to fund its invasion. It also accelerate the timeframe for completing the invasion. Russia’s GDP totals ~$1.5T, and a ~$640B foreign reserve can paper over some of the pain if the economy takes a 20% hit. Remove almost $400B from the piggy bank though means the digital clock on this foreign adventure becomes a ticking one. It also means the Russian Ruble free falls. With less accessible foreign reserves, an imploding economy, a quickly devaluing currency, global sanctions/country risk, and soon to be rampant inflation, who’d want to hold the Ruble? Furthermore, the commodity sales to China, the buyer of last resort, are now returning RMBs. Many counterparties also wouldn’t want RMB in return given China’s strict capital controls. So therein lies Russia’s conundrum, dwindling cash, weakening currency, and increasing financial/global/economic isolation.
This is Us
So those are sanctions, and those are Russian issues. For the West, many of our issues will come down to a few key figures:
2%: Russia and Ukraine combined account for about 2% of the global GDP. Russia, for all of its landmass, Russia’s economy is effectively the size of Texas or Spain;
Russia exports 17% of the world’s NG and 11% of the world’s oil (Germany receives ~40% of its NG from Russia);
Russia and Ukraine supply 11% and 7% of the world’s wheat, respectively. Ukraine supplies 22% of the world’s corn;
Russia supplies 11% of the world’s precious metals.
In full, the disruption (Russia) and destruction (Ukraine) of these economies will have major repercussions, not because of their absolute size, but because of the commodities they provide. Energy to power our society, heat our homes and produce our goods are under threat. Food that fills our bellies and quells are hunger are under threat. Being hangry will have enormous geopolitical implications for many countries (again see our point on scarcity above).
It’s Early Days
Some of our readers will note that we didn’t write an article earlier this week. We wanted to let the wave of emotions, hot takes, and snap judgements subside. This is a complicated and multivariate issue for which we’ll have to begin creating string diagrams on the wall for. We have more questions than answer, and some are:
What if Putin wins? How do we deescalate from here? How does he extricate himself from the global banishment? If he doesn’t, how does he not weaponize the very item that you didn’t want to sanction (i.e., oil and gas)? If he feels pain, doesn’t he make you feel the same in return? A kinetic war turns to a cyber/financial war? How legitimate is his nuclear threats? Has he begun to move his tactical and strategic nuclear weapons?
What if Putin loses? Does he weaponize oil and gas as well? Does he step-up cyberattacks on the West’s financial systems and infrastructure? Threatening its way of life as we’ve threatened his? Does he retreat within Ukraine and bifurcate the country? Does that restore some portion of wheat and corn production, but still not provide a full recovery, nor for energy?
How much will oil supplies be physically disrupted? Sure the cost to transact have ratcheted up significantly these past few days, but will they actually disrupt the flow of barrels? Will oil prices continue their ascent? At what stages does demand destruction enter the picture. When demand destruction collides with a structural shortage, which one wins?
What are the implications for Iran? As they return to power and energy exports emerge from the black market, does that embolden their proxy wars? Does it embolden our sanctions on Russia since Iran’s increasing production backfills some of the lost barrels from Russia?
What are the implications for China? Weakening the petrodollar/USD hegemony by agreeing to purchase Russia’s unwanted oil and gas will have implications going forward. The West’s weaponization of SWIFT, and it’s attempt to collapse the Russian economy will surely galvanize China to create its own RMB backed system. More Belts & Roads Initiatives? . . . then there’s . . . Taiwan.
So many questions. Many of them will need to be thought through, if not now, then later. What we know for certain, however, is what we knew before. As shortages grip the world, it will become increasingly destabilized.
As we barrel into 2022, as the structural undersupply takes hold, countries that produce key commodities will see their geopolitical leverage climb increasingly higher. Countries that clearly do not share similar values as the West. Much of this, however, is of our own making. Our capitalistic fervor to always take things to excess (e.g., fund unprofitable shale production growth that nearly bankrupted the US oil industry twice this decade plus funding woefully inadequate ESG projects) means we’ve weakened ourselves. We’ve made ourselves vulnerable to the whims of a cold cold man. So what we’re left with is handicapped supplies, increasing demand, and hoping others can cover the commodity shortage.
Self-Help? No
You’d think we’d first engage in some self-help, but that help isn’t coming, at least for the coming year and at least for energy. From just a sampling of the first quarter calls, the only thing rebounding in US shale isn’t oil production, but costs.
20% increase in capital expenditures . . . for a 2-3% in production growth in 2022. For a world looking around to see who will produce more, the US is pointing at others.
For our readers, we continue to recommend staying long commodities (i.e., energy, minings/minerals and even financials). If the very basic things are getting more expensive, you’ll want to own these things and only give them up when others pry them away for a king’s ransom.
Ultimately, so many questions. Very little answers. One thing’s for certain though, like shale, we’ll all soon be paying more for less. We better hope less really is more, because that’s what we’re going to get.
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