A few weeks ago I expressed some skepticism that sanctions would be effective against Russia for anything easy to move - and that skepticism appears to have been justified. Investors wanting to play the risk of war piled into energy and metals - things that Russia produces a large share of global output of. It worked…. for a week.
Since then palladium and aluminum are back down to where they started more or less and even oil has round tripped. Things that are harder to ship and move around like wheat are still elevated. Once again, it is all about logistics and sanctions and they can operate quite separately.
Recent news suggests that sanctions compliance by India, China and Saudi will be weak when it comes to major commodity inputs and things that might drive inflation. India may purchase Russian oil and China and Saudi have announced they will be restarting work on a petrochemical complex in Liaoning that will almost certainly be fed by Russian crude - the Chinese partner here is Norinco, China’s major armaments producer. I can only infer that US-Saudi relations are now approaching the zero lower bound, if one exists.
Combined with recent Chinese announcements on coal production and the start of key Mongolian rails it seems the energy supply shock is cancelled — for now — along with any jump risk for commodities trading houses. Instead we are facing a demand shock: what happens if half of China switches to work from home for a few months? If you are in energy, a lot.
But back to sanctions: on this point I suspect that there is going to be safety in numbers. The US cannot reasonably sanction India, China and Saudi Arabia at once and so the flow of many commodities is likely to continue albeit with logistical constraints. I do suspect though that there will be some red lines around weapons and military aid that would be unwise for anyone to cross: it is hard to push back against India saying it is trying to feed its people but a mid size industrial group dealing spare parts for weapons systems could find itself getting the more recent Oligarch experience. Going forward though this is going to be a “masks off” moment for the EU and the US: realpolitik is back and there are limits to what these countries will do against their short term interests. This may be no surprise for India and China but it is quite clear years and years of military support and engagement in Saudi Arabia have been a poor investment.
What should be the response in the US and EU? Ultimately there are a number of bad actors and enablers of bad actors who effectively run on fossil fuel exports. That much is now very clear. To that end a combined emissions and energy security policy should aim for:
An aggressive energy transition to reduce leverage to fossil prices.
Much lower fossil prices in general to weaken these actors
A mechanism by which to achieve this
I recently read the Employ America proposal for the Biden administration to execute a kind of “curve control” in oil: sell spot to reduce prompt prices, buy futures to allow shale producers to hedge thus allowing the SPR to empty now and refill later. This could be extended beyond the SPR to significantly more production outside of the US interior to providing longer term hedges to allow offshore drilling to resume. These projects are hard to fund right now and liquidity out the curve in oil is limited. Bringing these projects online would lead to a supply shock and inflict significant pain on Russia and Saudi. The challenge would be to avoid Jevon’s paradox - to this end the US could link gas taxes to crude prices: price goes down, tax goes up and vice versa. This would also allow the government to be hedged on revenues: if they write collars for deep water producers then they are revenue neutral because when oil falls they get a greater tax take and when oil rises they get gains on the hedges. The government could wind down this activity if oil becomes too oversupplied or if the energy transition moves quickly enough to make it no longer necessary: at a certain point oil might be a problem, but it would not be the US’ problem. This process could also run in parallel with an ongoing appraisal of how reliable Saudi Arabia is and how much the US needs to hedge its exposure to the country.
If this sounds like a large politically motivated trading house then yes: that is exactly what I am suggesting. Oil is politics and it is now abundantly clear that in an age of activist ESG investors Exxon cannot and will not function as an extension of the US government. The deep state is a cool story but somewhat oversold at this juncture. If oil matters for now - and it does - then the US and EU and others should not be shy about being in this markets anymore than rates. It is quite clear that producers can politicize these markets so why not customers?
The US cannot reasonably sanction India, China and Saudi Arabia at once?
Especially after this: Mar. 14, 2022: “In two weeks, China, Russia, Armenia, Belarus, Kazakhstan, and Kyrgyzstan will reveal an independent international monetary and financial system. It will be based on a new international currency, calculated from an index of national currencies of the participating countries and international commodity prices” Sputnik News.
Along with the new currency, Russia and China will also reveal their Unfriendly Nation Lists..
Once Eurasia, Africa, ASEAN, the Middle East, and Latin America commit, no nation can afford to stay out the world’s biggest, fastest growing, stablest, frictionless market.
More Global 500 corporations call it home than any other country.