While the world has been very vocal in terms of the promised and actual sanctions against Russia, Vladimir Putin seems to be completely unperturbed and is continuing to go about his business as he sees fit. While certain politicians believe that they can inflict irreparable damage to Russia, thus far Putin and his administration appear somewhat unconcerned. Holding the “European Energy joker card” in their pack probably has something to do with it…
The old war games that were played out between the West and Russia are here again it seems. But this time, they borrow more from finance than from military. A defiant Russia “invaded” the Crimea region supposedly to protect it from a pro-European Ukraine as Putin was angry with the deposition of Ukrainian President Yanukovitch which was turning the Ukraine ever more towards the dreaded EU. Both the United Nations and NATO condemned the act of annextion and promised to apply “severe” sanctions to Russia. Fat lot of good this did with Putin advancing further into the Ukraine and backing a referendum in Crimea which turned out an unbelievable 97% support for Crimea becoming part of Russia.
One week after the referendum, as Russia prepares to incorporate Crimea and the US and EU into here, various sanctions have been imposed on key wealthy Russians in the hope of exerting a tempering influence on Putin and his administrations ambitions. But, with more than a 30% dependence on Russian natural gas for its energy needs just how far can the EU really go relative to the US? With Russia being a heavy exporter of oil and natural gas, is it really plausible that European leaders will, metaphorically, cut off their nose to spite their face?
The words emanating from Obama and in particular Merkel with regards to the Russian acts have certainly been stiff so far. But, their actions, so far at least, haven’t correlated with what their mouths have said. The worst they have been able to do so far is merely freeze the accounts of a handful of Russian oligarchs and forbidding them visiting the EU and the US.
As with the Cyprus case, connected Russian oligarchs actually started withdrawing the bulk of their funds from the West a while and certainly much before sanctions were effectively applied. With regards to the travel sanctions, well, if they have to sacrifice their annual visit to Courchevel and quaff fine champagne in the Black Sea, so be it they are likely saying! Of course there is always Latin America or the Caribbean and the Maldives at their feet..!
The largest Russian corporations such as Gazprom, Sberbank, VTB and Tukoil have also been withdrawing their funds held at Western banks during the last few weeks and repatriating cash to Russia. At the same time, while credit ratings haven’t been changed so far, many Western banks have also frozen any credit to Russian corporations which they perceive as being an increased risk re doing business with. Investors have also been pulling money out of Russia with the equity market suffering a severe plunge in recent weeks. YTD the Russian TSI is down almost 20% while the S&P 500 is just a little shy of its all time high.
The decline in Russian equities this year, in unison with other emerging markets started with the FED’s tapering actions but the pace of losses increased as soon as the West start talking about sanctions imposed to Russia.
We can see from the chart above that commodity prices have been rising this year and in the case of natural gas, the price veritably exploded at the peak of the Crimea crisis, although it has corrected the rally in recent days. If for some reason this conflict escalates, what do you think will happen to these prices, in particular to natural gas? Any retaliation from Russia that puts a cap on natural gas delivery to Europe would quickly lead to a boom in natural gas prices with very negative consequences across Europe. In fact Europe is in an uncomfortable position, which of course will deter the EU from letting the conflict escalate too much.
As a whole, the EU imports one third of its natural gas and oil from Russia with Gazprom being a company that is actually larger than many countries around the world, not only in terms of the value of its overall production but also due to its political power, as it is baked into the Russian government. The dependence on Russian natural gas amounts to 100% in the case of Estonia, Finland, Latvia, and Lithuania and it is significant in almost all other countries as you can see from on the table below.
Germany and Italy depend 36% and 27% respectively on Russian gas, but the two alone are responsible for almost half of all imports coming from Russia in the direction of the EU. In the case of the Ukraine, the country is the largest non-EU importer of natural gas from Russia and has a dependence of two thirds on Russian gas. This picture alone tells us that sabre rattling at the most is all the EU can do at Putin. Russia really does hold the joker cards here.
Besides the natural gas issue, there is also another problem related to commodities that can lead to inflation and misery throughout Europe if EU leaders aren’t cautious. Ukraine is known as the bread basket of Europe due to its agricultural production. The country produces and exports significant amounts of grain, vegetables, milk, meat, sugar beets, and sunflower seeds. If for some reason an armed conflict starts in the region, food prices will skyrocket.
Thus in conclusion, contrary to Obama’s and European leader’s calls, Russia won’t be pushed out in the cold from and international investment picture. At first, as ever, capital flew out of the country but as opportunities pile, the incentive for investors to return to the country and invest in many resource-rich companies will inevitably occur again. Investors can be assured that the world is not going to go too far on sanctions to the point that Russia would seriously suffer otherwise the country would simply retaliate and inflict similar, if not greater damage to the world. At the same time, a further escalation of matters will likely cause a spike in commodities that would of course benefit Russian companies.
The opportunity of all this? The 20% rout in the Russian stock market, which was already trading at generationally low levels, is likely to be good opportunity to invest in the market at this point. This can be played either via outright Russian ETF’s such as the RSX or RBL or certain UK listed Russian companies – we are presently accumulating stock in Exillon Energy and are poised for a classic “buy the fear/troops on streets/blood on the ground” scenario on any further weakness.