The game in Ukraine has taken a new turn, with the referendum vote Sunday in favor of Russia. This appears to have encouraged investors. However, it is early in the Great Game. One of the players is a master chess player. We’ve seen two pieces move – Putin and Obama – but we are early in the game.
The scale of this conflict has been portrayed by both sides in a light favorable to their voters. We here at ALM prefer to look at it objectively. Let’s revisit what has been happening:
1) It is clear the US has been backing anti-Russian parties in Ukraine. This began some time ago.
2) It is clear the Russians are bothered by this.
3) It is clear that the Russian economy is barely moving; the ruble has been in free-fall. Russian leaders of business, the so called Oligarchs, are very unhappy with Putin’s handling of the economy. Money is fleeing Russia. They remember what happened in Cyprus.
4) Putin is politically exposed as the upper income electorate and business are not very happy with him. He is more vulnerable than Western media would indicate. His strength is in the lower income levels which respond well to the chest-thumping of pride.
5) Ukraine borders are a relatively recent political creation and has weak democratic structures in place, with a very lopsided pro/anti-Russian population. Ukraine itself dates back centuries, but he borders are recent constructions.
6) The Black Sea is of enormous military significance to Russia.
7) The US has a destroyer in the Black Sea, roughly equivalent to having a Russian warship anchored off of the US submarine facilities in Groton Connecticut or New York repair shipyards. This is hardly stabilizing.
8) The Chinese economy weakened dramatically from last year. Domestic demand has not improved as expected. Two years ago, many analysts thought that China needed 8% real GDP growth to maintain the social structure. By our estimate, we are near a 6% (or below) level. Recent Chinese exports have also weakened materially.
9) China shares a common border, and relatively porous border, with Russia.
10) A porous border and a Russian strongman in power are not what any country wants in a neighbor.
11) The US tested a withdrawal from the Strategic Petroleum Reserve this week, of 5 million barrels, selling it at $99/barrel. This amount is a pittance compared to US use. According to the government, “The United States consumed a total of 6.87 billion barrels (18.83 million barrels per day) in 2011.” About 57% of this was imported. However, Russian oil is expensive and must be shipped by rail in many places. They are not a low cost producer. They would be one of the first to be displaced if cheap oil hit the market. Based on 2010 data, 5 million barrels is about a 1/2 day of Russian exports.
Let’s combine these observations:
Putin and Obama clearly dislike each other, on a personal level. So it’s not surprising they have been quietly poking at each other. Recent economic weakness in China and Russia has strained their internal business-political ties. Businesses are in trouble, bankruptcies of the connected are happening. There are lots of tinder piles in both places.
Russian business is very concerned, and their outbound money flows began in earnest with the banking forfeiture in Cyprus, and increased with Ukraine. The US fracking revolution has taken one of the larger buyers of crude out of the global market. There does not appear to be any reductions in output here near term. The Russian primary source of foreign exchange has decreased; their currency has followed oil revenues lower. Ukraine has also not paid for its Russian gas it delivered to Europe, which hasn’t helped either. Lastly, there are reasons to believe the Russian military has been emboldened by the continued reign of Assad in Syria.
The Chinese economic slowdown has been relatively smooth, but it isn’t a new event. There has been much talk about copper prices falling recently. The consensus view is China’s slowdown and lower trade with the US have reduced demand. However, China has had a past tendency to allow prices to fall and then quietly built up inventories. As of the writing of this piece, we have not seen evidence of this buying returning. We have heard public comments about new infrastructure building/stimulus made by Chinese officials, but the price of copper hasn’t responded. Why is that?
Perhaps the Chinese authorities are also looking to take Putin down a notch. With a weak economy, they don’t want Putin’s antics further reducing global trade and business. Putin appears to be using Crimea to stay in power – and to improve relations with the military and reduce the influence of the Russian Defense head who is a potential political challenger.
We believe the facts above point to a “weaponization” of both copper and crude oil by the US and China. A drop in copper prices increases bankruptcy risk for Chinese businesses using copper instead of Yuan currency deposits as a store of value. Since some businesses are using copper as collateral for loans, a drop in prices pressures the businesses indirectly from their lenders. Stronger and better connected businesses could take over weakened firms, without the public interference of the politicians.
Russian firms have also reported to us aggressive forced takeovers/pressures from the Kremlin. The businessmen would like to see Putin gone or at least politically weakened.
Obama also needs to look presidential and strengthen his influence going into the presently difficult (for him) November US elections.
This framework favors all involved parties.
While we admit that this is conjecture, it also appears to tie the actions of late to public events. What would convince us that this is more than a simple spat?
We believe the recent release of oil from the SPR was not to test the ability to deliver, but to test the potential speed of delivery. If the US chooses to dump crude from the SPR, it would cut into Russian oil revenues through the global oil arbitrage trader community. This framework has merit, if US oil exports rise suddenly and soon.
The US has reduced its adverse language on both Syria and Iran recently, both of whom get financial and military support from Russia. Turkey, who has had political differences with Washington recently and appears to have a growing conservative Islamic political influence is also surrounded by the Black Sea, Syria, and Georgia. Turkey is important to the long range goals of the US, as Islamic country with a secular government. The changed focus of the US away from Iran and Syria toward Russia – along with a US warship between Russia and Turkey – suggests a plan to forget the cubs and pressure the bear directly.
Here at ALM Advisors, it makes us wonder if this is an attempt to instigate Russian Spring.