Russia’s invasion of Ukraine highlights critical vulnerabilities in the commodities system
Prices for industrial commodities surged higher in February, as a combination of strong demand and a limited supply response led to market tightness.
Russia’s invasion of Ukraine highlighted critical vulnerabilities in the commodities system, as it is a crucial supplier in many areas. Thermal coal led the way higher once more with a 49% m/m rise in February, with Brent oil up 13% and aluminium and nickel up by around 8%. Copper was a notable exception, and prices were little changed, with headwinds coming from an oversupplied physical market in China.
Russia’s invasion of Ukraine in late February has heightened fears about an energy crunch. Russia is the world’s second-largest gas producer, the third latest oil producer, and a major coal producer and exporter.
Europe looks particularly vulnerable to supply shortages, as the region relies on Russia for around 35% of its gas. Apart from energy, Russia supplies many vital commodities to the West. These include aluminium, nickel, platinum and palladium.
The picture is very fluid, but at the start of March, the US, UK, EU, and other allies imposed a wide range of sanctions to damage the Russian economy. Politicians, officials and oligarchs close to President Putin had their assets frozen, as did the central bank. Russia’s banks were removed from SWIFT, vital for accessing the USD financial system. The Russian rouble plunged by 35% in a few days. Flights into the EU from Russia were halted.
Commodity exports will not be subject to sanctions because this would damage consumers as much as Russia, leaving the two locked in a Prisoner’s Dilemma. Both are better off with the status quo, as they rely on each other.
However, oil traders, consumers and shipping companies are not following the rulebook. They are avoiding Russian cargoes as much as possible, fearful of being caught by sanctions or seeing their reputations damaged. Furthermore, Germany has halted the approval process for the Nord Stream 2 pipeline due to boost Russian gas imports.
Given the concern about natural gas supplies, it was no surprise to see thermal coal prices surging higher once more. Demand looks buoyant as countries seek to diversify their energy supplies in the tail-end of the northern hemisphere winter.
In Europe, coal inventories fell to record lows in December, and utilities are boosting coal’s share in the power sector. Investors are leaning on producers to produce less for environmental reasons, but consumers still need to find trustworthy energy sources.
Meanwhile in China…
In China, the economy is being helped by new stimulus measures (including interest rate cuts and extra government spending), and power demand looks strong after the Lunar new year holiday. While the government has been pursuing a green energy agenda, this is not as important as avoiding power blackouts and keeping the economy stable.
Coal production in the country rose 5% in 2021 and reached a record high last year, while power generation was up 9%. The Chinese government is concerned about high coal prices and is trying to block hoarding and manipulative market behaviour. Similar to Europe, China is struggling to move away from fossil fuels.
Gold prices have been boosted in recent weeks by safe-haven buying due to the Ukraine crisis, with a move back above USD1,900/oz. While prices are up 6% m/m, the backdrop of rising inflation and concern about the military conflict had a surprisingly small impact. One reason is that financial markets have not been too unsettled yet by the latest developments in Europe, with a sharp drop in late February, followed by a bounce back. The S&P 500, for example, is up by 1% m/m (1 March). Similarly, investor inflows into ETFs turned higher in mid-February, but there was no panic. According to data from the World Gold Council, 16 tonnes (t) of gold were purchased in the week ending 25 February, with 110t bought so far this year.
The outlook for commodity prices is unusually uncertain.
Energy prices look set to remain high and volatile, with oil price direction likely to be determined by the OPEC+ group. OPEC spare capacity is still significant and should limit the upside for prices in the weeks ahead, particularly given the threat of releases from strategic stockpiles if nothing is done in upcoming OPEC+ meetings.
Meanwhile, thermal coal prices look set to remain high, despite the northern hemisphere heading into spring, reducing the demand for heating. Gold will ultimately act as the canary in the coal mine. Expectations of higher interest rates are creating significant headwinds, but there is now scope for prices to extend upwards as central banks become more cautious and the Ukraine crisis encourages more safe-haven investment.