Global markets choose death by commodities

• Western sanctions on Russia are set to tighten significantly after the announcement on February 26 to bar selected Russian banks from accessing the SWIFT international payment system as well as to target its Central Bank’sreserves. While details on the implementation of these additional sanctions have not been released, with carve-outs likely still allowing for energy and food trades, the hurdles that these sanctions will create for financial payments are likely to exacerbate the recent Russian commodity supply shock, already visible as Western and Chinese traders halting shipments.
• What remains critical in our view is that commodity markets need to reflect not only these difficulties in paying for Russia’s exports but, with little left to sanction, the risk that Russian commodities eventually fall under Westernrestrictions, an outcome no longer being ruled out by the US administration. Barring a breakthrough in peace negotiations, we believe this leaves commodity prices having to rally sharply as we see demand destruction as now the only significant remaining balancing mechanism, with Russia a key exporter of most commodities that were already facing exceptionally tight inventory levels and low spare production capacity.
• For oil, this represents $110/bbl to $120/bbl short-term price upside should 2 to 4mb/d of demand destruction be required to compensate for a commensurate one-month loss of Russian exports. Key to this significant upside is that the price induced shale supply response would no longer be a suitable rebalancing mechanism for such a potential large and immediate supply shock, with Russia’s crude and petroleum product exports of 7.3 mb/d, 6 mb/d of which clears through the now shut seaborne market. Further, even a redirection of oil flows to the East would still tighten global markets, as it would require a 12-day increase in transit time, the equivalent to the loss of 90 million barrels. The pipeline nature of gas flows to Europe, limiting shippers’ liability, and the ability for European consumers to ramp-up flows from contracted volumes, suggest a greater downside risk to Russian oil than gas exports in the short-term.
• The only potential short-term supply response would need to come from OPEC, as a surge in Saudi and UAE production as well as a lift of Iran’s US secondary sanctions would likely lead to a c. 2 mb/d increase in supply over the next couple months, with a coordinated global SPR release helping bridge the gap. While such an outcome becomes increasingly likely the more Russia is ostracized from the global economy, driving core-OPEC, Iran and the West closer together, it would nonetheless come at the expense of a complete depletion of the global oil market’s spare capacity, still warranting much higher oil prices.
• Net, the range of near-term price outcomes for commodities has become extreme, given the concern of further military escalation, energy sanctions or potential for a cease-fire. In the very short-term, we see risks skewed to significant further upside and are raising our 1-month Brent price forecast to $115/bbl (from $95/bbl previously), with significant upside risks on further escalation or longer disruption. Importantly, even if near-term price volatility reaches unprecedented levels, our longer-term bullish under-investment thesis is very much intact and reinforced by these events.
• More broadly, we expect the price of consumed commodities that Russia is a key producer of to rally from here – this includes oil, European gas (and hence aluminum), palladium, nickel, wheat and corn. In the case of agricultural prices, this reflects the fact that Russia and Ukraine represent nearly a quarter of global wheat and corn exports in the face of already tight inventories, with diesel farming input costs set to rally and with potential for disruptions to global fertilizer exports given Russia’s significant market share.
• The outlook for gold prices is harder to call in the short-term, in our view, but still bullish medium-term. On the one hand, gold’s unique role as the currency of last resort will likely be apparent if restrictions on Russia’s Central Bank accessing its offshore reserves leave it leveraging its large domestic gold stockpiles to continue foreign trade, most likely with China. Yet, on the other hand, the required large sales of gold at below market prices, given the limited appetite outside of China for such trade settlement, would emphasize its potential limited scale in the future, with few other countries able to use gold as such a currency of last resort. Ultimately, the recent escalation with Russia create clear stagflationary risks to the broader economy, driven by higher energy prices, which reinforce our conviction in higher gold prices in coming months and our $2,150/toz price target.
• Industrial metal flows out of Russia have also been reduced sharply over the past week as western buyers remain similarly hesitant in the context of sanction uncertainty and escalation. Even with trade exemptions, it is unlikely that metals export volumes will normalize quickly, with heavy logistical disruptions to metals flows through the Black Sea, both from Ukraine itself but also Kazakhstan and Uzbekistan (which are important routes for copper and zinc). With materially reduced export volume out of Russia, Kazakhstan and Uzbekistan, all the base metal markets will face accelerated tightening in the near-term against a backdrop of already multi-year low visible inventories. This will support a further rally in prices across physical premia, flat price and time spreads. Aluminium and nickel stand as the most exposed base metals given Russia’s significant supply role.