Investability Bulletin 09/03/21: Hard Choices

Cutting Russian commodities out of the economy is proving harder than you’d think

Photo by Adriano Ruiz

What if instead of measuring the size of your economy based on make-believe stuff like Zoom and Netflix, you value your economy on actual hard assets, like nickel, palladium or wheat? Or oil…then Russia as the 12th largest economy becomes more like the 2nd or 3rd most systemically important nation to the global economy.

Russia accounts for roughly 11% of global oil supply, 17% of global natural gas supply, 11% of global wheat production and a tenth of industrial metals production. Like I said before, are markets even close to pricing in the total collapse of the world’s 12th largest economy? Are they close to pricing for gigantic commodity inflation?
 
So, one could point out that while the West was tearing itself apart over social issues and seeking ways to decarbonize our economies without a proper plan and whatever the cost, Russia was getting on with being a bit of a powerhouse in terms of producing the actual stuff that people actually need. This matters now because the West is cutting off all this supply, and it doesn’t have a ready replacement.

And so, when people say Russia’s economy is tiny, ‘it doesn’t matter’, they miss the point that it was tiny compared to some la-la-land way of looking at how much stuff is ‘worth’. In a world when hard assets are king, Russia has some aces. But it needs to deploy them, and that is getting harder and harder – the game is shifting from high stakes poker to Russian roulette…or, worse still, towards a Mexican standoff. .
 
So, to markets and it’s been a case of Vix front end pushing up, oil back up, gold rallying to new cycle high and close to all-time highs. The dollar has come back a touch, but DXY remains above 99. US stock markets swung lower on Tuesday after the worst session since 2020. The Dow Jones had been up almost 600pts but ended down 185pts. The S&P 500 fell 0.7%, further into correction; the Nasdaq slipped by 0.3%, deeper into the bear market.  The S&P 500 finished under our 4,200 marker but futures indicate it will rally when Wall Street opens later.
 
Snapback: European stock markets are enjoying a bounce this morning – some sense that the recent moves were oversold, valuations attractive…bear market rally as stagflation is coming. Nevertheless, today it’s the beaten down autos and travel & leisure stocks doing the lifting. Banks also higher amid broad-based rally for European shares. FTSE 100 +1.5%, DAX +3% at the open. 
 
US and UK to ban Russian oil…as I said it was only a matter of time…tightens the screw on Moscow and piles pressure on Europe to follow, where it would make a far bigger difference. EU says it is looking at how to reduce demand for Russian gas by two-thirds before the end of the year…huge shift but can it be done? Still leaves a third on the table. Imports of Russian oil, petrol products made up 8% of US total shipments last year. As for Britain, in 2020 Russia was around 11% of UK’s total crude imports around 18% of UK’s diesel imports. Britain will step up its production of oil and gas in response.  
 
Shell’s decision to exit Russia came only a couple of hours before the US/UK announcements so it would have had to follow suit anyway. “We are acutely aware that our decision last week to purchase a cargo of Russian crude oil … despite being made with security of supplies at the forefront of our thinking – was not the right one and we are sorry.”  Shell says “intent to withdraw from its involvement in all Russian hydrocarbons” in a “phased manner” “As an immediate 1st step, company will stop all spot purchases of Russian crude oil.  It will also shut its service stations, aviation fuels & lubricants operations in Russia”. 
 
Key to market pricing right now is immediate oil – is Saudi Arabia willing to be the producer of last resort? Apparently not; the Saudis and UAE have declined calls with President Biden during the crisis as they appear unwilling to stem rising crude prices. US production will start to rise but it takes time. Iranian deal seems further away again…so Brent is at $130 but liable to extreme volatility and price swings in either direction.
 
Meanwhile, unconfirmed but apparently accurate reports that Putin has instructed a ban on the export of products and raw materials outside the Russian Federation until December 31…fire with fire. The list of what’s banned has not been defined. McDonald’s, Coca-cola and Starbucks have also bowed to pressure and are pulling out of Russia. Who’s left?
 
On inflation, China producer price inflation was up 8.8%, just ahead of expectations, but the slowest pace in eight months. 
 
Finally a word from BofA: “There is no clear off-ramp for Russia. Our base case assumes months of uncertainty, tough sanctions and high energy prices. Russia is entering a deep recession, Europe will slow significantly, RoW will slow modestly.” 
 
Company updates:
 
Polymetal – reports that all its operations in Russia and Kazakhstan continue undisrupted and provides an update on the impact of economic sanctions and the most recent changes in the capital control legislation in Russia. The company intends to pay the dividend announced on March 2nd but says it is currently unclear whether the Company will be able to remit dividends from its Russian subsidiaries to the holding company level. Management thinks that targeted sanctions on the company remain unlikely, but are not impossible 
 
Petropavlosk – does not consider that its shares or debt instruments are securities in which dealings are restricted under sanctions. No member of the Group has to date been named in the sanctions against Russia announced by the United Kingdom, United States, European Union and other nations. Management warn a significant risk at present is the potential disruption to the supply chain, but point out that the company continues to sell gold, as before, to domestic commercial banks at London fixing and is therefore not affected by export controls at this time. 
 
Evraz – the company does not consider itself to be an entity owned by, or acting on behalf or at the direction of, any persons connected with Russia and thereby caught by sanctions. In a statement today it says that in relation to certain shareholders; namely, Roman Abramovich, Alexander Abramov and Alexander Frolov, it cannot be certain as to whether such individuals are “connected with Russia”. 
 
Jefferies upgraded Caterpillar to buy from hold, arguing the war in Ukraine and the surge in commodities prices should boost the stock. “Recent turmoil in Eastern Europe fundamentally reshapes global commodity markets, driving structurally higher pricing and after years of underinvestment capacity additions and supply diversification will be necessary in both mining and oil & gas sectors, though new projects will take time,” says Jefferies. “CAT has historically been a strong hedge to commodity and general inflation.” 

At the smaller end of the construction industry, concrete levelling equipment specialist Aim-traded Somero Enterprises delivered a top notch set of results only tempered by a sensibly muted  outlook statement. Sales +51%, PTP +81% and diluted EPS +85% and net cash +19% to $42.1m, highest level ever. The company is returning excess cash to shareholders and ploughing investment into expanding capacity at its US facility by a third. We like this business – it’s cyclical but shines on growth quality metrics, and are lowly valued on a forecast PE of less than 10.  
 
EVs…you need nickel. It’s not just expensive on ‘fear’ and short squeezes, it’s expensive because supply is super tight. In a note about Ford’s EV ambitions, Morgan Stanley stressed that “no amount of capital can create new nickel mines by 2024”. So, we remain short of nickel – and many other metals – that are required for EVs…

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