Financial Markets Flash - 8 MARCH 2022 -

Situation of the commodities market in the context of the Russian-Ukrainian conflict

Overview of the commodities market and an attempt to ascertain future prospects, in conditions that remain highly uncertain...

Benjamin LOUVET, Commodity fund manager - OFI AM
Benjamin LOUVET
Commodity fund manager - OFI AM

Summary

  • On 24 February, Russia launched an armed offensive and entered the territory of Ukraine, triggering condemnation by many nations and the implementation of unprecedented economic sanctions, notably targeting Russian banks (disconnection of the international banking communication system SWIFT) and the country’s Central Bank, whose assets abroad were frozen. A number of personalities and oligarchs are also involved.
  • Sanctions were implemented in an attempt to spare the institutions necessary for the normal functioning of trade in commodities, of which Russia is a major producer and exporter.
  • The conflict has led several shipping companies to suspend their activities with Russia, and the financing of operations with a country under sanctions and the insurance of transport are difficult to guarantee, which means that trade has been seriously disrupted. The cessation of air traffic also adds complexity to trading.
  • The supply of oil, coal and industrial metals could therefore be constrained. In an economy where most resources were already under pressure from demand generated by the post-pandemic recovery, energy, metals and agricultural commodities have already seen their prices soar.
  • The world is not in a position today to function in the short term without Russian fossil resources, whether oil, gas or even coal. If there is even a partial disruption of supply, prices will have to rise to a level sufficient to begin to destroy demand. We estimate this level at $120/$130 a barrel for oil. But given the amount of demand to be destroyed, especially if countries decide to stand up to Russia by banning Russian gas themselves, the rise could be more significant and black gold could head above $150 a barrel.
  • All of these factors should encourage greater awareness of our dependence on fossil fuels and the urgent need to accelerate the transition to low-carbon energy. But this will secure the future, not solve our short-term problem.
  • The situation is the same for metals. Palladium, nickel and aluminium are the most affected. It is difficult to set price targets at this stage.
  • Risks to agricultural markets are equally serious, but less so in Europe and the United States. On the other hand, they could lead to serious destabilisation in North Africa, which is heavily dependent on cereal imports. This is what happened in 2011 after the surge in grain prices. The price of wheat has just risen 38% in one week!

On 24 February 2022, Russian President Vladimir Putin ordered his army to enter Ukraine. The West’s response to this aggression was a series of sanctions aimed at isolating Russia economically by banning it from international trade.
But Russia, and to a lesser extent Ukraine, are major countries in the production and international trade of raw materials. This situation has therefore led to very high pressure on the prices of several essential products. Gas in Europe, aluminium and rapeseed have all reached new all-time highs, while copper and zinc are getting closer. The price of oil has also risen above $130 a barrel for the first time in 14 years.

An overview of the commodities market and an attempt to outline the outlook, in conditions that remain highly uncertain...

FOSSIL FUELS

Today, it is the energy sector that is attracting attention. Europe is extremely dependent on fossil fuels from Russia. In the first half of 2021, Russia accounted for 54% of our solid fossil fuel (coal) supplies, 46.8% of our gas imports and 24.7% of our oil requirements (source: Eurostat).

This is why, when defining economic sanctions and in particular the exclusion of Russia from the SWIFT transaction confirmation system, the West wanted to leave the possibility for the Russians to continue trading in energy products.

OIL

Russia produces about 11 million barrels per day and exports just over half of that. Approximately 2.5 million barrels go to Europe, a third of which through the Druzhba pipeline which transits through Belarus. The rest is sent by oil tanker.

China receives about 1.6 million barrels per day, half of which arrive by pipeline and half by oil tanker. The other partners (notably the United States), which are further away, also receive their oil by tanker.

All of this is important. While exports to China by pipeline are not in question, those to Europe via the Druzhba pipeline are. This pipeline passes through Belarus, which is also under sanction, as President Lukashenko has allowed the Russian army access to Belarusian territory to facilitate its entry into Ukraine. For the time being, however, Belarusian banks are not under sanction, nor does it appear that crude oil is affected.

The Russian banks most active in the oil and gas market have also been spared. But with the limits of permissible transactions not well defined, many institutions are reluctant to trade with Russians in the current context. They all remember the sanctions suffered by European companies that traded with Iran while it was under sanctions.

The situation is more problematic for the more than 3 million barrels per day that are exported by oil tanker. The main shipping companies have decided to suspend all their activities in Russian ports. In addition, it is very difficult to find a way to insure cargoes in the current context. For example, in recent days, the Russian oil company Surgutneftegas has repeatedly offered shipments of Russian “Ural” oil (a good quality Russian oil benchmark) which, even at a $20 discount to the Brent benchmark price, could not find buyers! Moreover, even if all these obstacles were to be removed, the price of sea freight has already quadrupled in a few days, adding almost $4 per barrel transported.

So, if we assume that pipelines could continue to function normally, there is a risk that international oil supply could be cut by just over 3 million barrels per day.

Before assessing the possibility of making up for this loss of Russian supply, it is important to note that this problem, if it persists, could further threaten Russia’s future production. If in the very short term the Russians will be able to store this oil while waiting to find customers, but if the situation were to persist, they would be obliged to interrupt production by shutting down their wells. However, shutting down an oil well is a very complex procedure. But most importantly, any shutdown will jeopardise future production when the well is brought back on line. In a world where the balance between supply and demand for black gold was already difficult to ensure before the conflict, it could be even more difficult to ensure once the fighting ends.

In the immediate future, is it possible to ‘replace’ Russian oil? In the very short term, the first course of action is to resort to oil stocks.

The International Energy Agency (IEA), an organization created by OECD countries after the oil crises of the 1970s to help them manage their energy policies, requires its members to hold stocks that can cover 90 days of their consumption at all times. The IEA held an extraordinary session a few days ago and decided to release 60 million barrels, half of which come from US stocks. The impact on the oil price was almost nil, as operators considered this number to be clearly insufficient.
Moreover, as stocks are a last resort, historically, their release has never succeeded in bringing down oil prices in the long term. We recall that Joe Biden already resorted to this weapon at the end of last year, without being able to halt the rise in the price of black gold...

The other hope lies in a potential return of Iranian oil to the international market. Negotiations are progressing between the Islamic Republic and Western nations to revive the Iranian nuclear deal on which the United States had turned its back, which would pave the way for the lifting of sanctions on Iran and the return of Iranian oil to the market. But the recoverable output here would only partially solve the problem. We estimate that Iran could add between 1.2 and 1.3 million barrels per day to what it already produces.

It should also be noted that Iran is historically a country that gets along well with Russia. It is therefore not certain that it will put all of its goodwill into a rapid resolution of negotiations.

There is also talk of lifting sanctions on Venezuela. Beyond the moral problem this might pose, the Venezuelan oil system is in such a state that it will take months before it can reproduce a significant volume.

There remains a small theoretical potential in OPEC countries, which have been gradually raising their production target by 400,000 barrels per day every month since the middle of last year. But many of them are failing to raise production in line with their quotas, and OPEC+ is now behind schedule.

However, it seems that Saudi Arabia still has some room for manoeuvre, but this is unlikely to be enough to fill the gap, even if Iran were to return to the market.

If the Western countries that are lining up against Russia were to ban Russian oil, as is currently being discussed between the Americans and Europeans, the shortfall would be even greater.

In such a situation of imbalance, only a very significant increase in the price of oil will make it possible to adjust supply to demand. This will lead to a rapid increase in production and/ or the destruction of part of demand.

In terms of increasing supply quickly, given that it takes 5-7 years to develop a new conventional oil field, all eyes are now on US unconventional oil, also known as shale oil. Shale oil wells can be put into production within a few months.

But US producers do not seem to be ready to meet this demand. For example, the head of Pioneer Resources, one of the largest US shale oil producers, said a few days ago that even with oil at $150 a barrel, he would not increase production by more than 5% this year.

There are two reasons for this. First, investors demand profitability from shale producers. From 2008 to 2018, producers sought to increase their productivity by any means, without concerning themselves with profitability. As a result, the industry as a whole has only had one quarter over the last 10 years during which positive free cash flows were generated.
The reason for this lack of profitability is simple: a shale oil well sees its production drop by 70% in 18 months, requiring constant new drilling just to keep its production constant. Increasing it is very capital intensive.

But there is another problem in addition to the financial balance. A few weeks ago, the Wall Street Journal reported on a study by oil industry expert Rystad, which indicated that most of the high-quality wells in the US shale basins had been drilled. Therefore, companies have no choice but to limit their production growth if they want to survive. For example, many of them would see their entire reserves depleted in less than 5 years if they returned to the 15% growth rates we had before 2018.

This leaves only one solution: destroy demand. It is clear that a commodity market cannot be in deficit (we cannot consume what we have not produced). To do this, it is necessary to find the price at which consumers give up using fossil fuels. For example, by limiting their car travel. During the previous price spike between 2008 and 2011, we saw an impact on demand above $100 per barrel. Since then, growth and inflation have meant that, all other things being equal, this threshold is now higher. We therefore believe that the threshold for demand destruction is now at least $120 to $130 per barrel. But given the amount of black gold demand to be destroyed, especially if the US bans Russian oil and is joined by Europe, prices will probably have to rise above $150 a barrel to balance the market.

In conclusion, while there are short-term solutions to deal with a Russian supply shortfall, in the event of a prolonged conflict the only truly effective solution to balance the market will be to destroy demand by pushing oil prices to at least $150 a barrel.

GAS

The gas market poses different problems from those posed by the oil market. First, unlike oil, OECD countries do not have strategic gas stocks. The flow is therefore very significant. If supply disruptions were to be limited to the pipeline through Ukraine, the impact could be limited, although prices would be affected. The best evidence of this is that the flow has already slowed considerably, with Citigroup estimating that the flow in January was less than half that of last year, and only a quarter of deliveries in 2019.

But if Vladimir Putin were to decide to go further and cut off gas supplies to Europe completely, the situation would be unmanageable, as there would be no back-up solution. There are not a multitude of ways of transporting gas, as Patrick Pouyanné, head of TotalEnergies, reminded us: either you have pipelines or you transport it by ship. If the pipelines are no longer operational, we have to fall back on supplies by ship from other sources.

But to transport gas by ship, mainly from Australia, Qatar and the United States, it has to be compressed and liquefied, to obtain liquefied natural gas (LNG). This requires specific facilities at the start for liquefaction, and at the end for regasification. Between the two, you need suitable ships.

It appears, according to Citigroup, that there is surplus regasification capacity in Europe which could theoretically absorb a good half of the losses generated by a pipeline shutdown. However, the liquefaction terminals are now designed to meet the usual demand for LNG and these facilities cannot be increased overnight. Patrick Pouyanné mentioned a minimum period of 3 years in recent days.

There is therefore a capacity to increase our LNG deliveries, but this will be done by capturing part of the supply that has so far been planned for other destinations. This would have a calming effect on prices. Europe, however, has a geographical advantage, especially for US LNG: the shorter distance between the US and Europe than to Asia makes it a more attractive destination for carriers to operate more rotations.

However, market specialists also point out that the bulk of European LNG import capacity is located on the western side of the European continent, in France, England and Spain. And the cross-border pipeline networks for distributing this gas to Eastern Europe are insufficient, as is the capacity to reverse the flow to the East. The Spanish gas connections across the Pyrenees are so inadequate that they are useless.

One regulator called the ability to move all this gas into Europe a pipe dream.

Another problem is that, in the medium term, the other major supply partners in Europe are likely to see their production decline in the coming months and years. Norway, the second largest source of supply with just over 16% of our imports, has passed its production peak and should therefore gradually reduce its deliveries. As for the Netherlands, which had significant resources thanks to the Gröningen field, the country has decided to close it in mid-2022 because of the environmental risks due to the earthquakes generated by its exploitation. And the government reiterated a few days ago that, despite the international context, it had no plans to reverse its decision. This field, which produced 54 Bcm (billion cubic metres) in 2013, i.e. more than the consumption of a country like France, is expected to produce only 3.9 Bcm this year.

In conclusion, it seems important to underline that a complete halt in Russian gas supply could only be resolved by a very sharp rise in prices in order to destroy demand. This is not good news, because even if our consumption will drop as winter ends, the low level of our stocks will force us to quickly replenish them to prepare for next winter. The situation is further exacerbated by the unavailability of nuclear power in France and the planned nuclear closures in Germany. The only way to limit the impact of even a partial reduction in the flow of Russian gas is through sobriety, as the impossibility of rapidly increasing gas supply will lead us straight into an increasingly competitive market. Otherwise, the alternative is to substitute this energy with coal, which would be bad news for climate change.

COAL

Here again, Europe is very dependent on Russia. While energy transactions have normally been excluded from the scope of economic sanctions, many players are reluctant to engage in trade with Russian counterparties. The other issue is the lack of certainty about possible deliveries due to logistical problems. Several Russian coal producers have already had to declare force majeure on several of their deliveries, due to problems with delays, particularly in rail traffic. The risks of chartering ships are also high. A coal ship supervised by Cargill was hit by a shell in Ukrainian waters in the Black Sea on 24 February.

Replacing Russia is not easy. The country is the world’s third largest exporter, accounting for 15% of global exports. Australia and Indonesia, the world’s largest exporters, are trying to help balance the market, but it seems difficult to release such volumes in a short time.

As a result, prices have soared. The coal benchmark on the Newcastle contract has thus risen in a few days from $224 per tonne a week ago to $400 per tonne today (as of 3 March). This is 5 times the price of last year.

It should be noted, however, that the rail infrastructure in the East is not sufficiently developed for China to be a significant partner for Russian companies, which could encourage them to do everything possible to find solutions and maintain the flow to Europe.

So, it appears that, whatever fossil fuel source we are talking about, operating with even just limited supplies from Russia is extremely problematic. As long as the situation has not returned to normal and operators are not able to provide transport under good conditions, with no credible and sustainable alternative available in the short term, the price increase is likely to continue until demand is significantly destroyed. This could have a major impact on our economies.

The other consequence of this conflict is that the current difficulties could make the climate challenge secondary to the urgency of the situation. The Germans have already mentioned the possibility of delaying the closure of their coal-fired power stations.

On the contrary, all this should make us realise that a rapid exit from fossil fuels is in our best interests in the fight against global warming and the preservation of our energy independence. It is therefore urgent to change the scale of the energy transition and accelerate the development of low-carbon energy. However, it should be noted that the time scales are very different and that renewables will ensure our energy independence in the future, but will not solve our short-term supply problem.

METALS

Metal prices were already rising sharply before the Russian invasion of Ukraine. Industrial metals listed on the London Metal Exchange (LME) were already priced immediately above their forward price (backwardation) as traders were willing to pay a premium to ensure they had the commodity now.

This tension was caused by the strong global economic recovery, which led to an acceleration of demand, in a context where logistical problems were still numerous.

This was compounded by the European energy crisis during the winter. Soaring energy prices in Europe have forced a number of industrial companies to close down, at least temporarily, production capacities that have become unprofitable.

The Ukrainian crisis comes at a very bad time in this context. And Western sanctions could quickly make the situation even more complex, as Russia is a major supplier of several metals that are essential to industrial activity. Once again, there are few short-term solutions, as stocks are low and new mining capacity takes at least 5 years to open.

In addition, there are the consequences of the fears of interruption to deliveries. Manufacturers, who were sellers of futures contracts to hedge their future supplies, are being forced to cut these positions and buy back their futures positions at any price in order to avoid considerable margin calls, especially on positions backed by uncertain deliveries.

PALLADIUM

Russia is the largest producer of the metal, accounting for almost 45% of world production. It is also the leading exporter.

Palladium is an essential metal for the automotive industry, which consumes more than three quarters of production every year in the manufacture of catalytic converters, mainly for petrol-fuelled vehicles. The catalytic power of this metal helps to reduce pollution from exhaust fumes.

After “dieselgate”, the scandal that hit Volkswagen in 2015, demand for petrol vehicles has risen sharply. Similarly, the development of ever heavier vehicles and the tightening of environmental standards have meant that demand for this metal has continued to increase.

For this reason, there has been a chronic shortage of palladium, with demand exceeding supply every year for the past 10 years! Russian palladium is therefore irreplaceable until the car fleet is fully electric (note that there is more palladium in the exhaust of a plug-in hybrid vehicle than in a combustion engine vehicle).

Beyond the fears that stakeholders may have in dealing with this metal, as is the case with hydrocarbons, there is another, logistical, problem in the shorter term. In retaliation for the Russian invasion, Europe closed its airspace to aircraft from Russia.

However, palladium is transported by air and more specifically on scheduled flights. As all of these have been suspended, it is now difficult to transport this metal.

According to information available, car manufacturers have about 3 months of stocks. Beyond this period, the lack of Russian palladium could be a constraint for the automotive sector.

Again, the shortage generated by the lack of metal has led to a sharp appreciation in the price of palladium, which will continue until it leads to a reduction in demand, as supply cannot adjust quickly. The price of palladium, which fell to $1,550 an ounce last November due to the drop in automobile production, is already back at close to its all-time highs of $3,019 an ounce reached last May.

NICKEL

Russia is the world’s third largest producer of nickel and the largest producer of primary nickel products, such as refined nickel for electric vehicle batteries.

For the time being, the country’s main metal producers have been spared sanctions, but many of the companies in this sector are run by oligarchs close to Vladimir Putin, such as the CEO of Norilsk Nickel, Vladimir Potanin. He is not currently on the sanctions list.

The impact of such sanctions could be significant, as 37% of Russian exports are destined for the Netherlands, and 16% for Germany. If supply chain difficulties were to disrupt the delivery of this metal, which is not the case at the moment, this could have a significant impact on the automotive sector in particular, as electric mobility relies heavily on this metal. This would drive up the price of batteries and give a considerable advantage to Chinese manufacturers, who would have to keep their supplies intact and even be able to increase their supplies by recovering some of the Russian exports. They could also acquire the metal at a reduced price, as China is the only significant outlet for Russian companies.

The price of nickel is therefore likely to remain under upward pressure. However, some countries could increase their production. This is particularly the case in Indonesia. On the other hand, European production could be reduced: this industry is very energy-intensive and the rise in the price of gas could thus lead some companies to have to reduce their activity.

ALUMINIUM

Russia is the world’s third largest producer and third largest exporter of aluminium. Russia’s Rusal International PJSC is also the largest aluminium producer outside China, exporting 46% of its production to Europe.

For the time being, imports do not seem to have been reduced.

However, there is great concern: Maersk, the shipping company that handles the transportation requirements of the Russian producer, has interrupted its traffic to and from Russia.

Furthermore, Rusal could be among the next targets, should international sanctions be tightened. In 2018, the company had already been subject to US sanctions, which led to huge price pressure.

Tensions could be all the greater as aluminium stocks are already low, having more than halved on the LME in a year.

Finally, the company was forced to suspend production of alumina (a precursor of aluminium) in Ukraine due to the situation in the country. Aluminium producers usually have about a month’s worth of stock to ensure their production.

Russian aluminium production could therefore be constrained, either by a lack of alumina, a new set of international sanctions, or by transport problems. In the last two cases, the Russians could try to sell more to China, which has tended in recent months to reduce its production because of the high pollution generated by the production of this metal. Aluminium prices should therefore remain under pressure and possibly continue to rise if the conflict continues.

OTHER INDUSTRIAL PRODUCTS

Other metals, such as tungsten and titanium, pose similar problems because of Russia’s large share of world production and trade. They could penalise the aeronautics industry in particular, which needs titanium for the manufacture of aircraft.

Although Russia is not a major player in the copper market, which is also already under severe pressure, any unavailability of the metal from Russia could tip the market into a production deficit. This would cause prices to rise until demand is reduced sufficiently to balance the market.

Ukraine is also a major supplier of neon gas, which is essential for the operation of lasers used in the production of semiconductors. The reduction in the production of these components had already had a strong impact on car production last year.

Finally, vehicle production could also be impacted in Europe by the lack of specific wiring and harnesses.

The German company Leoni had to close two of its production plants for these materials located in Ukraine.

AGRICULTURAL PRODUCTS

We also cannot ignore the impact of this conflict on food security. Russia is the world’s largest wheat exporter, Ukraine the fifth largest and also the fourth largest exporter of maize. It is also a major player in the barley and oilseed market because of its sunflower cultivation.

In the short term, two major fears are pushing up agricultural commodity prices. The first is that it is difficult to see how Ukraine, a country at war and with most of the adult male population called upon to defend the country, will be able to harvest its crops normally. The war could also result in the destruction of some of its agricultural equipment.

The second is again related to restrictions on maritime transport, through which the bulk of exports pass. While Europe and the United States are not at risk of running out of wheat, there is a real risk for importing countries, notably the Maghreb countries and in particular Egypt, which is the world’s largest importer of this grain. The need for imports will be all the more significant as Morocco has experienced a historic drought this year.

It should be recalled that soaring grain prices are considered one of the main reasons for the food riots in North Africa in 2011, which led to the “Arab Spring”.

Depending on weather and climatic incidents, we can hope to offset part of the losses if harvests are good in North America (the United States and Canada are respectively the second and third largest exporters in the world) and in Europe (France is the fourth largest exporter). Stocks, on the other hand, are relatively low and were expected, before all these events, to be at their lowest level for five years by the end of the 2022 season. Volatility will therefore remain the order of the day, with very significant upside risk.

Another concern is that Russia and Belarus are also two of the major players in the production of the basic fertiliser components, ammonia and potash. Sanctions on these two countries could therefore jeopardise future agricultural yields by reducing the availability of these products.

Document completed on 07/03/2022

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