Thursday, March 3, 2022

"Hit by Friendly Fire"; "The West’s Most Potent Weapon"

"Hit by Friendly Fire"
by Jim Rickards

"The Russian advance into Ukraine continues, with Russia taking the key city of Kherson today. That’s big. Kherson is a chokepoint on the Dnieper River that flows from the Black Sea to Kyiv. A rough analogue would be Grant's capture of Vicksburg on the Mississippi in the Civil War. When you control the river, you control commerce and military resupply to the interior. Meanwhile, the important cities of Kharkiv and Mariupol are under siege. When they fall, Putin will have a line of control from Kherson to Kharkiv and a land bridge from Luhansk to Crimea. This traps Ukrainian forces behind the line. Odessa is next.

The media have been hyperventilating about Putin being "bogged down" outside Kyiv. But Kyiv is last on the menu, not first. The Ukrainian people are being urged to form a resistance and to engage in guerrilla tactics. Many likely will. But that call strongly suggests confidence in the ability of the regular Ukrainian forces to stop Russia is fading fast.

But of equal or greater significance for much of the world is the financial aspect of the war. Financial sanctions on Russia have dominated the headlines this past week, as leaders of the EU, the U.S. and NATO have unleashed a barrage of economic and banking sanctions.

The greatest casualty has been the Russian ruble (RUB), which has collapsed about 50% in the past 10 days relative to the dollar and the other major currencies. One impact of this in Russia was a run on banks and ATMs by citizens trying to get what currency they could, probably to spend it on food and staples before prices went up. A grossly devalued ruble will certainly cause inflation in Russian prices, although that does not happen all at once.

Normally, the Central Bank of Russia (CBR) would intervene with its dollar reserves to support the ruble, but Russia’s dollar reserves were frozen by U.S. and other nations’ financial sanctions and by a prohibition of CBR use of SWIFT for dollar transfers. An action to freeze the assets and transactions of a major central bank is unprecedented since the end of the Cold War, but that’s exactly what happened this week.

The CBR responded to the freeze with the next-best tactic, which was to impose capital controls and raise interest rates to 20% in an effort to stabilize the ruble. Those measures seem to be working in the short run. But the ruble collapse can presage major instability in the international monetary system.

Suddenly, dollar-denominated obligations of Russian entities that rely on ruble earnings may go into default because the ruble revenues are insufficient to pay the debts and because rubles can’t be converted to dollars due to exchange controls. Those losses will end up on the books of the lenders in Europe and the U.S., which may cause further financial distress.

The SWIFT prohibitions on Russian banks are also not a free lunch in terms of putting pressure on Russia. Every buyer has a seller, and every sender has a receiver. If Russian banks cannot transact on SWIFT, that means Western banks that are counterparties will take the hit. As Western banks scramble to cover their open positions, there will be dumping of collateral and other assets that may disrupt financial markets. Unlike a stock market crash, this kind of interbank distress does not happen all at once. It can take days or weeks to play out. Still, those ripple effects or spillovers are coming.

We’re probably in the opening stages of a major global liquidity crisis. What happens in Russia doesn’t stay in Russia. These types of markets are dangerous for investors who are unfamiliar or not paying attention. I encourage you not to be one of them. Below, my senior analyst, Dan Amoss, shows you the most potent weapon that the U.S. and Europe have against Russia. Read on."
"The West’s Most Potent Weapon"
By Dan Amoss

"As more sanctions are put on Russia by NATO countries, we must look ahead to the economic consequences for the West when Putin responds. What will oil supplies along with severed supply chains look like for global economies when that happens? We will unpack these questions today… A wave of public support from around the world is encouraging Ukraine in its valiant resistance. Americans naturally sympathize with Ukrainians. When an army crosses a sovereign border, we support those defending their families and communities in an unnecessary war of aggression. Our prayers go out to all who are suffering.

With that said, you need to protect your portfolio, especially in times like these. Let’s consider a likely financial market scenario that is based on what’s happened in the past week and where things stand as of today.

Leaders of the EU, the U.S. and NATO have unleashed a barrage of economic and banking sanctions. But they’re being naïve if they think cutting off Russia economically won’t have grave economic consequences for the West. Leaders should be forthright with constituents about how much economic damage Putin can inflict when he hits back in the weeks ahead — primarily through weaponizing oil and gas supplies.

More oil and gas supply available at lower prices is the best way to gain negotiating leverage against Putin, a man who is willing to kill civilians as part of his “negotiating” process. This is not the time for the EU or U.S. to double down on a wind-and-solar agenda, because an overdose of wind and solar has decimated German industry in the past few months. An immediate and dramatic increase in oil and gas exploration would be the most potent weapon to fight back against Putin. Doing so would be far more effective and lasting than banking sanctions, which risk uncertain worldwide financial and economic blowback.

Efforts to crash Russia’s financial system ignore an obvious fact: Payments go one way, goods and services go the other. In the case of Russia, we’re mostly talking about energy and food. Jim Rickards has covered this topic in his Twitter feed, which you should follow for his thoughts. Early this week Jim tweeted: "Stocks to open down big. Who knows where they go from there? That’s not the threat. The danger is in the banking system, interbank loans, eurodollars, repos and other leverage based on Treasury bill collateral. It’s easy to smash Russia. It’s impossible to know what comes next."

[As an aside: I find Twitter to be an enormously valuable tool for researching investments, but discipline is a must. It’s easy to get distracted by noise and miss signals. So much noise is shouted by ignoramuses. With practice, one can do a decent job of filtering signals from noise. Stick to subject matter experts, and elders who have vastly more life experience, and you’ll be well served.]

Going back to the main theme: Encouraging more U.S. energy production is vital not because it’s a popular Republican talking point. It’s vital because the plain facts show insufficient capital spending to meet global oil demand at today’s price. This can extend to Europe too, which has neglected to invest in the oil and gas that’s still offshore in the North Sea. Norway has done a decent job investing, but the British and Dutch have gone “all in” on wind, leaving untapped oil and gas in their sectors of the North Sea.

Western oil companies have not invested enough in drilling projects to offset potential supply reductions from Russia. Banks, oil-trading firms and refineries are balking at importing Russian oil. That means prices could keep rising until demand is destroyed. For oil demand to fall enough to match the sharp drop in available supply, higher prices are required.

Jim and I have spent the past week reading and communicating about what’s unfolding in Ukraine, and its implications for financial markets. We are thinking about the implications for inflation if many links in the global supply chain for commodities get severed and rerouted. Creating new links would take time and will be costly.

For instance, Germany cannot snap its fingers and get the liquefied natural gas (LNG) import terminal that its political leaders now desire. Nor can the U.S. boost its LNG export capacity very quickly. Capacity is already very tight. Cost blowouts on LNG terminal construction projects drove engineering and construction companies into bankruptcies. Building more U.S. LNG export capacity would be very costly. It was barely feasible when steel prices were a fraction of today’s prices. Now? The fully loaded cost of gas liquefication would have to rise significantly to finance what would be much higher plant construction costs.

What about energy transportation? Oil tankers may have to steam for many more miles if refineries around the world can no longer accept Russian crude. Refineries may have to invest to handle a change in crude types. Pipelines networks would have to be reimagined. All this is just the beginning of what it would take to transition to a less efficient, more duplicative, more multipolar global commodities trading system.

What if Russia becomes a pariah state like Iran or Venezuela and must sell its commodities on the black market to autocrat-tolerant buyers like China? It’s an open secret that China imports lots of Iranian oil on the black market even though Iran is under harsh international sanctions.

My point is this: If delicate, densely interconnected trade and payment links around the globe get rearranged, it’s going to be very costly. There’s no sugarcoating it. Duplicating supply chains would take a decade or more, raise marginal production costs and lower standards of living (mostly through inflation). The good news is economies would be more resilient and less fragile after a long rebuilding and reshoring process. The bad news is that it’s going to take a long time and for many it will be a painful process.

Also, we need to be realistic about how much more economic activity may be directed by wasteful government budgets. “We need more subsidies! Price controls! Loan guarantees! And more!” say the control freaks who all too often rise to the top in politics. If only it were that easy. Unfortunately, it’s not."

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