We are looking at a very uncomfortable winter. The West has underestimated the size of the challenge that is fighting an economic war with Russia and the pain that he can inflict on our economies.
The amount of gas in Europe’s storage tanks is bang on average for this time of year and will reach the 80% full deadline on August 31 according to our calculations – a full month before the October 1 deadline the European Commission set at the start of the war. Yet gas prices are well over ten-times higher than normal.
Inflation in the UK just hit 10% for the first time in three decades and some banks are forecasting it will go as high as 18%. The rest of Europe is a hair’s breadth away from reaching double digits. The IFO index that measures confidence in Europe has plunged, as did the last European PMI manufacturing index which dropped like a stone to 44, S&P reported this week.
Germany says it is 6-8 weeks away from moving up to the last step on the EU energy crisis warning scale of “emergency” that will trigger rationing and energy surcharges in Germany are projected to be €1,000 per household. In the UK they could be an extraordinary GBP5,000.
How is it possible to do this? There is plenty of gas in the system. Economies were bouncing back after the pandemic and both Russia and Ukraine are on course to have bumper harvests. Russia is going set an all-time new high for wheat this year of around 95mn tonnes, up some 15mn tonnes from normal. Ukraine of course will bring in less than normal thanks to the war, but it still has 20mn tonnes in silos from last year and will still bring in another 20mn tonnes from that that can be gathered. But it's Russia’s key role in all these sectors, and more, that gives Putin the power to affect the prices so drastically. And that is his most powerful weapon.
Putin is playing mind games with the West that are designed to drive up costs, inflation and speculation that wound the West at its most vulnerable point – in the pocket.
Gazprom just announced it will turn off Nord Stream 1 gas flows completely for three days at the end of this month and gas prices soared on the news to the point where Germany says they are approaching an “unsustainable” level when it will declare an emergency, even though there is sufficient gas in the system.
LNG prices are also close to “unsustainable” levels thanks to the EU’s mad scramble to fill the tanks ahead of winter where the cost becomes so high it makes more sense to turn half the economy off than pay as you lose less money.
Just over a year ago bne IntelliNews did a piece saying that Russia’s reliance on imported precision tools was its sanctions soft underbelly long before it became a thing, but now that machinery has been comprehensively sanctioned it has doomed Russia’s economy to stagnation. However, what is becoming increasingly apparent is that our financial system is our soft underbelly.
Our system is set up to run well in normal times. There is very little wiggle room built in as redundancy is not profitable. There is risk management and hedging of course, but these measures are designed to counter the regular swings and bumps of the economic cycle. But they are not designed to deal with the “black swan” events of really big and more likely than you’d expect tail end risks as Nassim Nicholas Taleb has so eloquently described. That includes Russian President Vladimir Putin losing the plot and starting a full scale war in Europe and then weaponizing every commodity he has got to inflict as much pain on us as we are trying to inflict on him with our “massive package” of sanctions.
Car parts are delivered just in time and the stock for the supermarket shelves is kept at an average needed to just make sure there is enough to meet demand during the regular Monday-Sunday cycle, with a bit more at Christmas. When we get into a crisis with really big swings this system rapidly breaks down.
For example, at the start of the war there was a run on flour and cooking oil here in Berlin and the shelves emptied. But the supermarkets said there was no shortage, it’s just their supply chain collapsed when the demand became abnormally high. Think of it as a “baking bank run”. Banks only keep enough cash on account to meet “normal” withdrawal demands and if everyone asks for their cash at once they collapse.
This set-up pervades most of our system: banks, cars, supermarkets. It’s even now spreading into our grocery consumption where we are being encouraged to forego the weekly shopping run to Sainsbury’s and order our food from a “hyperfast delivery service” that will arrive in 15 minutes.
It's the essence of the “profit maximising” mentality that our market system is based on; the pursuit of “efficiency”, which is grounded in statistics based on when things are “normal.”
The same is going on with gas. The tanks were 77% full yesterday, smack in the middle of deliveries over the last five years. There is plenty of gas. There is no shortage. But that hasn’t stopped the prices jumping to over $3,000 per thousand cubic metres last week – twenty times the average rate. Why? It’s simply because demand is abnormally high, but changes to the way markets are run that introduced a lot of financial speculators that have never seen a barrel of oil or a bushel of wheat has also had a major effect.
“The disconnect between perception and reality became apparent in 2006, when food prices began to rise despite increasing global supply. Excited by booming emerging markets, financial investors took advantage of the Commodity Futures Modernization Act (2000), which removed the Franklin D. Roosevelt–era regulations that had restricted outside speculation,” Rupert Russell the author of Price Wars: How the Commodities Markets Made Our Chaotic World said in a recent blog. “The sober markets of the 1980s and 1990s were dominated by the physical traders of commodities, be they farmers, food processors, oil refineries, or jet airlines, who bet according to their firsthand knowledge and not on the latest headline.”
But that demand is not from consumers of gas, but financial investors. The volume of money in the capital markets vastly exceeds the value of gas being traded or consumed so that is what is pushing prices up, not a shortage.
Famines are not caused by a shortage of food, at least not at first. They are caused by the cost of food rising above the level that poor people can afford and that is the fault of the financial speculators. And it has already happened.
Soaring food and fuel prices has already pushed 71mn of the world’s most vulnerable people into extreme poverty. High prices haven't triggered another Arab Spring, but it has already caused protests in Argentina, Chile, Cyprus, Greece, Guinea, Ghana, Ecuador, Indonesia, Iran, Kenya, Lebanon, Palestine, Peru, Sudan, Tunisia and Albania. Sri Lanka is the most extreme case where an actual shortage of fuel led to the government being toppled and the president fleeing the country. In Africa half a dozen counties have already turned to the International Monetary Fund (IMF) for help as they can no longer afford to run their counties. In the US I keep reading that the coming recession makes Joe Biden unelectable in the next race and the Democrats will be hammered in the mid-terms this year.
The effect of financial speculation was clearly evident in the price of wheat futures in Chicago over the last few months. When the talk of a “global food crisis” started US retail investors ploughed $4.5bn into commodities in a single week. When the story changed to “global recession” in June they left just as abruptly. Prices of wheat have been on a rollercoaster ride until suddenly normality was restored by the Istanbul grain deal on July 22 when prices returned to earth and finally reflected the bumper harvest forecasts.
Putin’s war has not created a Malthusian nightmare of too little food and fuel for too many people. There was plenty of wheat available, but the threat of a shortage that was then amplified by the traders. Russian and Ukrainian exports are 30% of the traded grain but only 0.9% of total production. Moreover, this year is going to see a record crop for Russia (see the piece in our data section). It was the anticipation of a food crisis that drove up prices and as soon as the Istanbul deal was done the prices collapsed and are now below pre-war levels.
That is the problem: as soon Putin drives the mere expectation of things moving outside the bounds of “normal” then the speculators jump in and amplify those fears so the market swings radically off to one side. Too much rootless money is chasing these commodities and Putin’s ability to mess with supplies and distribution at the margin can screw with everyone’s head. It is his most powerful weapon against us.
Gas and wheat have been in the firing line so far, but Putin has the means to knock multiple markets out of kilter and introduce abnormal conditions. When the war started the London Metal Exchange (LME) had to shut down nickel trading for a week after prices skyrocketed to insane levels merely on the possibility that Nornickel would be sanctioned. (It wasn’t.)
Gazprom's three-day shutdown of NS1 is part of this same mind game. It makes almost no difference to the amount of gas arriving in Europe that week, but it instantly pushed prices up 20-fold after the announcement. And Putin is already hinting at new games. Kazakhstan reported this week that its oil exports via the CPC pipeline have been slowed due to “technical” problems, which analysts have taken as a threat to President Kassym-Jomart Tokayev to behave and support Russia.
We have walloped the Russian economy with the tech sanctions, but Putin is walloping us back by simply knocking the markets out of the narrow “normal” band they are used to working in.
The counter is of course to return the markets to normal mode. How do you do that? Counterintuitive (and unpleasant) as it sounds, that means you need to trade with Russia and make things predictable again. That doesn’t mean you can’t sanction Russia, or reduce the amount of gas, oil or fertiliser you buy to squeeze the Russian budget. But it has to be done slowly and carefully to bring maximum effect. So far all the sanctions have managed to do is allow Russia to make more money than it has ever made before and the side effect is to enhance the power of Putin’s best weapons.
Again, counterintuitive as it sounds, doing things like banning all Russia’s oil exports to Europe in December and February will just make things worse as it makes the markets even more abnormal than they already are. It works as a sanctions strategy only if you can switch to an alternative source of oil at more or less the same price and without supply bottlenecks – which of course you can’t do. For something like gas there is no choice to resume normal trade but reduce it as much as you can and then take the time to build all those solar panels to replace it. Only then will our tech sanctions really start to work. And Russia can’t escape the stagnation those sanctions doom it to.
If we don’t do this we have to ask how long can the UK survive with inflation at 18%? How will the rest of Europe’s population react when their economies sink into stagflation and people start to lose their jobs or get pulled below the poverty lines thanks to unaffordable gas and grocery bills. We have to acknowledge Putin’s power to disrupt the markets and we are helpless to prevent that. If we do go down that road, then we need to put the European economies on a war footing and prepare the population for Battle of Britain type hardships.
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