April 15, 2022


Economic War and the Commodity Shock

A discussion on sanctions and global commodity markets

The war in Ukraine has unleashed both geopolitical and economic strife, and nowhere is the latter clearer than in the volatile commodities market. Commodities prices have fluctuated wildly since the Russian invasion began and the US-led coalition retaliated with extraordinary sanctions on Russia’s financial system and trade networks. Few outside the American intelligence community expected Russia to invade; even fewer expected Russia’s rivals to so forcefully and swiftly confront the belligerent power with such a sweeping raft of economic sanctions.

While diplomatic relations with Russia have been deteriorating for more than a decade, the Western attempt to sever all economic relations with the country may mark a historical turning point. For the first time in decades, the world finds itself in an economic crisis originating not with the financial sector, but in the real economy. The economic disruptions of war itself and the breakdown of financial and trade ties with Russia—a global commodities powerhouse—have had repercussions around the world. Rising fertilizer prices are threatening the viability of Peruvian rice farms. The loss of Ukrainian neon production is driving up costs for Taiwanese chip manufacturers, already squeezed for capacity in recent years. The blockade at the port of Odessa threatens a general food crisis for the Middle East and North Africa. And the metals exchanges are in disarray as pricing chaos pushes margin calls ever higher.

To shed light on the economic confrontation between the West and Russia, and how it may be reordering the global economy, we spoke with Bloomberg columnist Javier Blas, co-author of The World For Sale: Money, Power, and the Traders Who Barter the Earth’s Resources, and Cornell historian Nicholas Mulder, author of The Economic Weapon: The Rise of Sanctions as a Tool of Modern Warn. A recording of the full conversation can be viewed here. This transcript has been condensed and edited for clarity.

A conversation with Javier Blas and Nicholas Mulder

ALEX YABLON: What was happening in commodity markets before the war broke out, and before sanctions were imposed?

JAVIER BLAS: The commodity market was already going through a period of stress before Russia invaded Ukraine, for several reasons. Investment in new production capacity came down significantly over the last few years, and lower prices led financiers to leave the sector. Pressure from climate change and attempts to reduce reliance on fossil fuels have played a role, and all of this has combined to tighten the market, as demand recovered fully after two years on Covid-19. Before the invasion, we were already seeing high prices across a spectrum of commodities from copper in metals, to crude oil and coal in energy, to corn in the agriculture market.

I would have expected prices in 2022 to be higher than in 2021 even if the war had not started. But the market has tightened beyond expectations. The cost of oil is now at $100, agricultural commodities are reaching all-time highs, and metals are trading at incredible levels. If you had asked me if we would ever see the price of nickel at $100,000, I would have said absolutely not, but that happened only a few weeks ago—doubling the previous peak of about $50,000 in 2007.

AY: What sanctions have been imposed? And what is the relationship between the actual economic measures that the West has imposed and then the self sanctioning and fear that has spread through the markets?

NICHOLAS MULDER: We’ve seen a dramatic ratcheting up of existing pressure. There were already sanctions on Russia since 2014, but they hadn’t had a major effect on markets. (In April 2021, the US Treasury put sanctions on Russian sovereign debts. It caused a small ripple for about a day or so in Russian government bonds, which quickly subsided.) Since December, there had been a conscious effort to develop the prospect of a severe sanctions package in response to the Russian military buildup. The aim was to deter Russia by raising the cost of them undertaking any action. 

Some of those sanctions kicked in two days before the invasion, when Putin recognized the Donetsk and Luhansk People’s Republics. Since then, we have seen a torrent of sanctions in a number of packages—the EU is now already on to its fifth package—that have gone for sectors that hitherto hadn’t really been affected. The SWIFT decoupling was announced first for a small number of financial institutions, and the list has now grown and new institutions have recently been added, which is progressively blocking every Russian financial institution from access to the SWIFT international telecommunications network. 
It’s now difficult to make new foreign direct investments in Russian equities and enterprises. Another major move is the very wide-ranging export ban on sensitive high-tech components from Russia, aspects of which had been pioneered by the Trump Administration in 2018–2019 to target China. At that time they focused on discrete companies, but these are used against the nation as a whole. And finally, the sanction that many have seen as the most dramatic was the freezing of a large part of the assets of the Russian Central Bank. This raises questions about the future of dollar hegemony, and how Russia will accumulate earnings, and brought attention to how potential embargoes against remaining Russian commodities exports may play out, precisely now that a large part of accumulated earnings of hydrocarbon exports have been frozen.

But in this high price market, there are of course still exports taking place, and we are looking at very large daily and weekly revenues that those exports are bringing in. That is where the focus of discussion about future sanctions will be in the next days and weeks.

AY: What are you watching for as those raw materials that drive the Russian economy do come under sanctions?

NM: In the weeks leading up to the invasion, as the military buildup started reaching critical force, a number of commodity prices went up in anticipation. There were even people speculating that this was part of the plan—the military buildup was a way of actually raising the price of Russia’s most valuable exports. Of course, militarily, heavily armed petro states have this Munchausen-like power to raise the price of their own vital exports.

The speed with which these measures were imposed triggered a major reaction by the global corporate sector, and this is why the sanctions against Russia have become such an incredible global macroeconomic event. They went hand in hand, of course, with widespread moral outrage and public relations concerns over continuing to do business with Russia as it’s waging this war of aggression in Ukraine, but some of these companies ordinarily weren’t really troubled by human rights concerns before the war. One explanation for this is that there’s clearly a fear of future sanctions, which leads to overcompliance. I think that has pushed up closing prices massively.

The war is the direct cause of Ukraine not being able to export—shipping through Odessa is blocked. In Russia, it’s not so much military factors as much as the global corporate backlash against the Russian economy. Insurance , shipping, and many other factors are much more difficult to arrange. In Europe, a point has been reached where all the relatively painless sanctions have been imposed, and now a pretty acute and heated political argument over burden-sharing is emerging: the recent EU package that included transports and shipping immediately led small member states like Malta, Cyprus, and Greese, with large merchant marines, to push for carve outs. There are no painless options left, and it’s going to be a question of who takes the burden. Different sectors will hit different countries in that regard.

AY: Are reputational risk and moral outrage the kinds of things that normally weigh heavily on commodity producers? Javier, your book doesn’t us give that impression.

JB: Commodity traders usually put morals to one side and describe themselves as apolitical. The same commodity traders that were happy to deal with Pinochet in Chile were at the same time doing business with Castro in Cuba. They didn’t care about politics, they only cared about money. Now, some of these traders rely on banking finance, and the banks do care about where you do business because they have shareholders. That is the point of pressure, but we are seeing that at the moment that exports are still flowing out of Russia. 

The back of the envelope calculation is that every day, the world is paying Russia roughly about a billion dollars a day for its natural resources. The bulk of that is coming from oil and gas, with a bit of coal, metals, and agricultural commodities. As long as it remains legal, commodity traders will do it. The justification that they will give is, “We are here to provide business, we are supplying the products that are on demand. So if the world wants to stop demanding those products, we’re happy to stop supplying them.”

AY: Right, and they are not just continuing to flow. You noted recently that gas flows are at an all time high.

JB: In the gas market in particular, gas that flows through pipelines that connect Russia to Europe via Ukraine have been rising over the last few weeks. They hit a four-month high earlier this week. This is due to how long term contracts for gas work, but there is also an incentive for European utilities to buy today and maximize their volumes from Gazprom, because it’s cheaper than to buy on the spot market.

AY:  Is there precedent for such a diplomatic effort to isolate and coerce not just a producer of oil but a producer of basically every major commodity? Russia is the largest commodity exporter in the world, central to the world supply of so many raw materials, and it is being cut out of the world economy.

JB: We have seen examples in the past where we have tried to drive exports of a particular country to almost zero, preventing that country from exporting its oil. Iran is an example, but perhaps a better example is Iraq after the invasion of Kuwait in 1990, when the United Nations imposed an embargo on Iraqi oil. That embargo stayed in place for many years after the war ended. But Iraq was effectively only a supplier of oil. The problem is, as you note, that Russia is a major supplier of multiple commodities. There are very few things in the world made of natural resources where you can say, “This piece of hardware that I have on my hands contains no commodities from Russia.”

In many cases, the commodities produced by Russia are taken for granted, because they don’t play a massive role in the global economy like oil. But the disruptions hold massive repercussions for the rest of the global economy. Neon and chips are one example, titanium is another. Russia is one of the world’s largest producers of titanium, and this super strong metal is used on alloys for the aerospace industry. Boeing and Airbus are going to have trouble with titanium shortages if we impose sanctions.

NM: We have more historical experience trying to sever the imports of commodities going into countries than we have with trying to prevent exports of commodities. If you think about crucial commodity cut offs, there are many interwar examples, some of which I study in my book. In the Cold War period, there were embargoes against states like Rhodesia and South Africa. They actually were also commodity exporters, mainly of metals, but they were all poor in oil. Oil was always a crucial commodity, and there was a big international effort around embargoes. Much of the commodity trading industry also tried to find ways of getting around it very ingeniously. 

It’s only really since Iraq in the 1990s, which led to the Oil-for-Food Program, and then more recently, Iran and Venezuela, that the international community has tried to reduce commodity exports of countries to zero. It seems that it is more difficult to restrict exports than imports. They both have leakage, but one of the main issues is that in order to stop commodity exports, you need to be able to close off all the potential markets that they might be able to go into. In a world economy that is as complex as ours, there are many ways of intermediating these trades. Even in the Iran case, despite the maximum pressure campaign, the UAE and Malaysia have been very important conduits for Iranian oil exports to China. Even on the very small scale, hundreds and thousands of dirt motorbikes in Balochistan bring oil across the border into Pakistan where it can be sold at an incredible premium on street markets. 

We still have yet to see what the long-run effect will be from the use of oil exports embargoes as a strategic weapon, but it does seem to inflict severe damage. Venezuela is a good case of that: the oil sector depends on foreign technology, and the restriction has led to an enormous collapse in oil production, reducing GDP by three quarters of what it was in 2013. In Russia, the question is: how can you do that not just for oil and gas, but against potentially all these other things? Is that even possible? Are there substitutes available? Is there sort of fungibility of resources in our global supply chain?

AY: You’ve said before that you are concerned that we could be on the verge of the first sanctions induced global recession. What raises that specter for you?

NM: It is not a certainty, and there’s a lot that we can do to avert it. Advanced countries that have already had quite a lot of stimulus, where incomes are not the problem, are relatively buffered. But in the developing world, the higher prices of quality imports really eat into the welfare and the wellbeing of people. 

From a global macroeconomic stability standpoint, we are in far from ideal circumstances to be using sanctions—let alone at this size. In the global financial cycle, there’s already a flow out of emerging markets and into the core of the world credit system, the dollar-based system. This was already an issue in terms of rising debt servicing costs for much of the Global South, and now there’s a heightened price of importing commodities that are much more expensive—food, energy, and so on.

In Asia and Europe, there’s a serious chance that much of global growth will be eroded this year. The US is in a slightly better position, but the question is how long it can hold on. I was at a meeting earlier this week with some economists where one of them actually said that they estimate the chance of the hard landing in the US also being something like 35 to 40 percent, simply because inflation expectations have gotten so out of kilter.

AY: Javier, you alluded to the nickel crisis from a few weeks ago. Why has the crisis put so much stress on commodity exchanges and the financial side of commodity production? What are the economic consequences if traders can’t make their margin calls, if exchanges continue to freeze up?

JB: What we have seen is a rapid shock to the system. We can use the example of nickel to explain the situation. Nickel was a market that was slightly on a deficit, but there was an expectation that perhaps this year would see a surplus. A Chinese metal tycoon known as Big Shot had gone short on nickel, expecting the price to go down. But when Putin invaded Ukraine, the market saw the worst case scenario—losing access to Russia’s nickel supply—and the price went up.

When you buy or sell a financial commodity product by a future on the exchange like the London Metal Exchange, you just pay a fee, an initiation margin call, and then your broker buys on your behalf the full position. If the market moves against you, you pay a bit more margin, and if the market goes in your favor, you get a bit more money from your broker. As the market was starting to go up, the Big Shot position was underwater and the brokers were demanding more money from this position. When the whole market is caught in that situation, we get a short squeeze, which forces everyone who was betting on the downside to buy back their positions because they are facing billions of dollars of margin calls. It got to a point where the market went up 250 percent in about thirty-six hours, with margin calls in the billions. The exchange had no option but to shut down trading. This is a very unusual situation; it only happens once every few decades that a major commodity market has to shut down.

What if a similar situation were to happen in the oil, wheat, or gas market? What would be the consequences for the global economy? Are the commodity traders and the commodity exchanges “too big to fail”? Their failure will bring chaos to the global economy not through the credit channel but through the real economy, perhaps through shortages or crippling high prices.

AY: One interesting recent story is that Tesla managed to escape the nickel crisis because it had a much more integrated supply chain for these vital metals. What does this tell us about the commodity markets? Could these stresses lead big firms to pursue vertical integration?

JB: The current structure of the market is very much a result of forces in the global economy since World War Two. Oil in particular is more recent. Until the mid 1980s, oil was a vertical industry where Exxon would produce oil in Exxon wells, to be refined in ExxonMobil refineries, to be sold on Exxon petrol stations. That market broke apart with the wave of nationalization of the 1960s and 1970s, particularly in the Middle East. All of a sudden, different petro states in the Middle East, North Africa, West Africa had oil to sell for the first time. They didn’t have foreign investors, so they called the commodity traders to buy and sell on the spot this new freely tradable oil. That was the birth of the modern industry as we know it today.

The industry in general over the last few years has grown accustomed to the globalization wave and just-in-time inventories. I think that is going to change with the war—everyone is going to try to hold more stocks or perhaps move to vertical integration. 

Commodity trading is a sector which is opaque and privately owned in general. Only a few families and individuals own these companies, they are not listed on the market, and they don’t need to disclose as much information. Some companies won’t even say how much money they make every year or who owns the companies. Policymakers have already woken up to this industry that is very large, hidden in plain sight, and completely unregulated.

AY: In your book, Nick, you describe how in the run up to World War Two, the specter of sanctions provoked powers like Germany, Italy, and Japan to sort of build up resource autarky. In this context, Russia is starting off from a very different position: they have the resources, and the sanctioners are the importers. Is the situation reversed here?

NM: There are useful similarities to be drawn between the 1930s and now, but one big difference is that the 1930s in the wake of the Depression was a period of global deflation. Today, you also have over thirty industrial democracies in the North Atlantic and in Asia that have imposed severe sanctions against one of the world’s largest emerging markets.

It’s important to keep in mind that proceeding with the oil and gas embargo, for example, in Europe, has further global macro implications for the rest of the world. There’s going to be a bidding war for a limited amount of liquified natural gas (LNG). The gas that Europe is not getting through pipelines from Russia will have to come through ships at some LNG terminal. Europe is directly competing with the world, especially with Asia, which moved much earlier already to LNG imports. To my mind, that points to the need for some sort of global gas consumption quota system. 

There’s a temptation to use very powerful interest rate hikes to lower demand so that the price can be brought down. But I think that demand should be organized through diplomacy rather than destroyed through interest rate hikes. That’s a challenge, but you could think in terms of the reverse of the exporters conundrum. We don’t need only OPEC action, but we actually need a kind of OPEC for gas consumption, so we avoid a bidding war and keep global price pressures manageable. Today, we must manage an inflationary environment, we’re not dealing with the consequences of deflation, and we have more tools available than in the 1930s. The central issue is burden-sharing.

Watch the full discussion here.

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