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Russia’s invasion of Ukraine has already caused a tragic human toll. It also brings yet another disruptive shock to a global economy already coping with persistent supply chain disruptions and fast-rising inflation. The clearest and most immediate economic impact of the conflict will be stronger and more durable inflationary pressures, driven by a negative supply shock to energy and some agricultural commodities—as detailed in the remainder of this note.
While pronounced, this inflationary shock should not offset the robust momentum of the global economy’s ongoing recovery from the pandemic shutdowns, powered by very expansionary fiscal and monetary policies. The growth impact should be muted in the United States, though an adverse effect on business confidence is likely. Europe will suffer more, given its significant dependence on energy imports from Russia. The European Central Bank (ECB) therefore seems likely to delay its plans to remove monetary stimulus—whereas Federal Reserve Chair Jerome Powell has signalled the US central bank will almost certainly go ahead with a first rate hike this month.
The inflationary shock seems set to be prolonged—as argued in the sectoral discussions below. The longer-term impact on growth will depend on how the conflict evolves and whether economic sanctions might be extended to impose a harsher squeeze on Russia’s energy sector. While uncertainty remains very high, our working assumption at this stage sees higher inflation for longer but only a moderate negative impact on US growth.
Below, our industry sector specialists take a closer look at the price moves in certain commodities and examine the longer-term implications for inflation and growth.
Russia is the world’s third-largest oil producer, behind the United States and Saudi Arabia. Russia’s January 2022 production was over 11 million barrels per day (mmbbls/d).1 Additionally, Russia is the second-largest oil and refined products exporter, behind Saudi Arabia. In December 2021, Russia exported around 5mmbbls/d of oil and nearly 3mmbbls/d of refined products.2 About 60% of Russia’s exports were directed to Europe and roughly 20% to China, in each instance both via pipeline and seaborne routes.
Western governments have not yet implemented direct sanctions on Russian oil and gas, but there have already been significant impacts on Russian oil trade flows. For example, in recent days press reports indicate a trading house offered a cargo of Russia’s flagship Urals blend oil at an unheard-of discount of over US$18 per barrel versus Brent crude oil, but found no buyers. In fact, there are now widespread reports of traditional buyers, including European refineries, unwilling to buy Russian oil either for reputational reasons or due to uncertainty over ultimate sanctions. Even some Asian buyers, including China and India, are reportedly holding off on buying Russian oil for now. Moreover, seaborne oil shipping from Black Sea ports may be curtailed as long as the war is ongoing. Some market observers have pegged lost Russian oil exports at 2 to 4mmbbls/d (or more), at least temporarily.
If some Russian crude is stranded for a period of time, there are potential sources of incremental oil supply; however, the size of Russia’s exports on the global market could make this disruption difficult to compensate for. First, International Energy Agency (IEA) member countries agreed on 1 March to release 60 million barrels of oil—a volume equal to roughly 60% of daily global demand—from strategic petroleum reserves. This is a short-term one-time measure but nonetheless could plug a small supply gap for a limited period of time. A commitment from IEA members to release additional stockpiles could help calm markets. A longer-term source of incremental supply may come if the United States lifts sanctions on Iran, which could release perhaps 1mmbbls/d of incremental supply—plus potentially an incremental short-term surge from Iranian oil in storage. Finally, core OPEC members, primarily Saudi Arabia and the United Arab Emirates, have incremental spare production capacity.
The actual amount of OPEC spare capacity is a hotly debated topic, with the US Energy Information Agency pointing to more than 4mmbbls/d of spare capacity currently whereas other market observers estimate OPEC may have less than 2mmbbls/d of current spare capacity. The OPEC+ alliance held its monthly meeting on 2 March.3 This meeting was incredibly short (reportedly less than 15 minutes) with the group’s press release astoundingly pointing to an outlook of a well-balanced market and that current volatility was related to geopolitical developments and not changes in market fundamentals. We anticipate the next meeting on 31 March could be much more interesting.
The other major swing producer in recent years is US shale. Expectations for incremental US oil production in 2022 compared to 2021 broadly range from 0.6 to 1mmbbls/d.4 Public independent exploration & production companies have generally shifted to a capital allocation framework of low production growth to generate free cash flow to pay down debt and return capital to shareholders in the current price environment. Production growth discipline could be tested if oil prices continue to run higher, and we have even heard hints in public commentary from large US producers in recent days that the Russian invasion could result in some change of mindset. Still, even short-cycle shale oil could require at least two to three quarters to surge production given planning cycles and overall supply chain issues. In fact, in light of limited availability of labour and certain materials and services, it remains to be seen how much US shale could realistically surge production.
Without some portion of typical Russian exports, even if the aforementioned sources of incremental supply can step up, the market could be facing a situation later in 2022 where there is very little remaining available spare capacity globally. That is a scenario which generally can lead to rising and volatile oil prices. If the supply side cannot meet global demand, oil prices could then shift to being governed by a price that destroys demand. While difficult to pinpoint the price where demand destruction would happen in earnest, a price of as high as US$125 or US$150 per barrel is plausible. Should oil prices run to that range, some level of demand destruction coupled with a surge of OPEC and US shale production perhaps could sow the seeds of considerably lower prices in the intermediate term.
On the other hand, even if the war ends quickly, it is conceivable that Western oil & gas companies could shun Russian oil for a long period of time, potentially resulting in a tighter supply/demand balance than we otherwise could have seen, all while energy security moves back to the top of mind of many governments. In fact, multiple supermajors, which have been quite focused on environmental, social and governance-related demands of investors in recent years, quickly after the invasion made announcements they would stop investing in and exit projects in Russia.
European Natural Gas
The conflict between Russia and Ukraine has resulted in the resurgence in European gas and power prices, both of which have increased over 120% from mid-February. Russia provides 30%-40% of the continent’s gas, and natural gas accounts for 20% of Europe’s total energy needs.5 Russia is Europe’s largest gas supplier, and in turn Europe is the largest customer for Russian gas.
While this suggests that Russia has an advantage given its ability to control gas flows to Europe and ultimately put pressure on Europe’s economic growth, European Union (EU) gas imports are crucial for the Russian government, in terms of revenues, and Russia has very limited capacity to redirect flows away from the EU to elsewhere. Consequently, we think that the costs to Russia of cutting supplies to Europe is high, and not our central scenario.
With the rising geopolitical risk, Europe is expected to accelerate its energy transition by reducing its reliance to Russian gas, better diversifying its gas supplies, and increasing renewables capacity. That said, this will not happen overnight, and it will take time for these changes to be material. In the short term, security of energy supply is paramount, and countries with a high reliance on Russian gas, such as Germany, Italy and the Netherlands, must make decisions to quickly remove energy supply concerns. The role of nuclear energy in the energy mix could be revisited, as demonstrated by the German government’s consideration of keeping nuclear power plants online to reduce energy insecurity.
The surge in gas and power prices will be passed through to end-user consumers unless governments decide to take action. The EU is allowing member states to reduce impacts on consumers, as seen in many European countries, such as France and Spain. Political interference is unlikely to abate in the near term, putting additional pressures on the utility sector.
The future path of European gas and power prices will depend to a large degree on how the Russia-Ukraine conflict plays out. Assuming that Russia does not end up cutting natural gas supplies to Europe, we believe that prices should still remain elevated compared to levels prevailing before last summer given the need to refill depleted gas storage. A reasonably mild winter (and likely some marginal demand destruction) helped save the continent from the worst-case scenario of running out of gas this winter. Nevertheless, storage levels at winter’s end this year will be at the low end of the historical range since 2010, and liquified natural gas (LNG) is tight globally.
There is an air pocket in LNG supply growth upcoming and it takes a lot of time and capital to build more US LNG export capacity. Europe will need to outbid Asia for LNG cargoes if it wants more LNG to be in a better storage position heading into next winter. Even before Russia’s invasion of Ukraine, the futures markets were pricing in significantly higher natural gas prices for next winter as well as the following winter than the levels that prevailed in spring of last year. If Russia does cut natural gas supplies to Europe, then storage heading into next winter could very well be worse than last year.
The upshot is that natural gas and power prices in Europe are likely to stay elevated for the foreseeable future no matter the outcome of the Russia-Ukraine conflict, with negative implications for inflation and growth. While consumers in certain European countries may be somewhat shielded from high power prices, businesses are likely more exposed, though may have some time to prepare given typical 12-24 month regulatory lags for utilities to pass along higher costs. Spot natural gas prices in Europe have recently been as much as 10 times greater than prices in the United States; should expensive natural gas in Europe become a long-term structural issue, it will be important to keep an eye on the global competitiveness of some parts of the broader European industrial economy.
The Russia-Ukraine conflict has also sent prices for certain food commodities soaring, with wheat up 40% year to date (YTD) and corn up 25% YTD. This reflects the fact that the two countries were expected to contribute about 25%-30% of the world’s exported wheat supply in 2021-2022 and approximately 20% of the world’s exported corn supply (with Ukraine accounting for the vast majority of this figure), as well as meaningful amounts of other agricultural commodities.6 Port closures in Ukraine, transportation disruptions, and restrictions on financing for Russian commodities have all played a role.
Disruptions to the planting and harvest seasons, compounded by labour and transportation issues resulting from the conflict, have the potential to impact the global markets for these agricultural commodities for the next 2-3 years, and lead to elevated food prices for the foreseeable future.
The global supply of fertiliser also stands to be impacted. Roughly 10% each of nitrogen production and phosphate exports comes from Russia/Ukraine, and nearly 31% of the global potash capacity is located in Belarus/Russia.7 Further complicating matters, European natural gas currently sets the marginal cost for nitrogen fertiliser, a global commodity. Some European nitrogen fertiliser production was already idled in late 2021 due to high European gas prices; this contributed to a tight global market even before the onset of the war. In fact, on March 2, management from major US nitrogen producer CF Industries stated publicly it expects to see nitrogen inventories “as low as we’ve ever seen”.
Year-to-date price changes for fertilisers have been relatively muted ahead of the start of planting season in the Northern Hemisphere, in part because the markets aren’t very liquid and the last price data points were from before the invasion. That said, the recent price plateaus are up considerably versus recent years, with most fertiliser grades having doubled or more than tripled in 2021. Given the potential supply disruptions and an already tight global market for fertilisers, this will be another key area to watch in the months ahead.
Considering that wheat and corn are not only direct inputs to food products but also feed for cattle, chicken, and pigs, and that fertiliser is a crucial input for modern farming, food price pressures are likely to be broad-based, significant in magnitude, and longer-lasting. Again, the implications for inflation and growth are negative, in this case leading to reduced disposable income for consumers and potential margin squeezes for food companies and restaurant operators.
The ramifications from the paradigm-shifting Russia-Ukraine conflict are likely to create some tough cross-currents for economies and central banks around the world to navigate over the next year and perhaps beyond. Investors will similarly have to think through complex implications and nimbly position portfolios accordingly.
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1. Source: IEA (2022), Russian supplies to global energy markets, IEA, Paris https://www.iea.org/reports/russian-supplies-to-global-energy-markets.
3. OPEC+ is an alliance of oil producers, including members and non-members of the Organization of the Petroleum Exporting Countries.
4. Sources: IEA, EIA, OPEC. There is no assurance any estimate, forecast or projection will be realised.
5. Source: Eurostat.
6. Source: United States Department of Agriculture Foreign Agricultural Service. There is no assurance any estimate, forecast or projection will be realised.
7. Source: Nutrien Factbook, 2020.