In the past two weeks the world has seen unprecedented events for which there is no road map for how to navigate. I will not recite all of the events other than to say that most ‘experts’ did not think Putin would choose to embark upon a full scale invasion of Ukraine. In addition, nobody foresaw the scope and magnitude of sanctions that the West has imposed upon Russia. It’s worth noting that while Russia only accounts for 2% of world GDP, it has an enormous endowment of natural resources, and Russia is a large producer and exporter of these commodities.
Each year, Russia accounts for….
- 17% of global natural gas production
- 11% of global oil production
- 11% of global wheat production
- 11% of global precious metals production
- 10% of global industrial metals production
If we add in the fact that Ukraine and Belarus have also essentially been taken offline then we can quickly conclude that the Russia/Ukraine conflict and the resulting economic sanctions have removed a significant chunk of global commodity production. In particular, agricultural commodities such as wheat and potash are now set to experience huge supply/demand deficits. There simply isn’t a way to replace Russian production in niche metals like palladium, or in industrial metals such as nickel.
Already the market has begun to sharply adjust prices higher in order to help balance the supply/demand curves. Russian President Putin announced today that he has banned the export of any Russian raw materials and productions throughout the remainder of 2022. This creates a situation in which certain commodity prices will have to move to high enough levels that a significant portion of global demand for them is destroyed.
One of the oldest adages in commodity markets is that “the cure for high prices is high prices….” – Markets are putting this adage to the test by sending the prices of multiple commodities including crude oil, nickel, and wheat soaring:
Crude Oil
Nickel
Wheat
What has transpired in the nickel market in the last 48 hours is worthy of some extra commentary because it has never happened before and is likely to have lasting ramifications for commodity markets.
In summary, China Construction Bank and Chinese mining company Tsingshan Nickel appear to have put on a giant short position in LME nickel futures. The short position is reportedly 200,000 tonnes in notional size. At a normal nickel price of let’s say $10/lb this short position is roughly US$4.5 billion in notional size. Big, but not insanely big for a large producer that is expected to produce 800,000 nickel-equivalent tonnes in 2022.
The problem is that when the market moves against a hedge position of this size it generates margin calls, the exchange is going to ask for more money to be posted up as collateral to cover some of the mark-to-market losses. Remember, futures trading is a zero sum game. For every dollar gained on one side of the trade there is a dollar lost on the other side. As nickel prices moved into full short squeeze mode at the Sunday night futures open and throughout Monday’s trading session, suddenly the CCB/Tsingshan nickel short was showing a $5 billion mark-to-market loss and margin calls were triggered.
Nickel did a 3x in the span of roughly two weeks, that has never happened before. This is an unheard of move for what is normally a very stable base metals market.
In addition, the LME (London Metals Exchange) has changed the rules of the game in the middle of the game. Trading in nickel has been suspended, trades have been canceled, and physical delivery of maturing contracts has been deferred.
It’s important to understand that if a small trader like myself triggered a bunch of margin calls and blew up nobody would care. My positions would be liquidated and my carcass would be swept aside. Trading would continue and I would become just another failed futures trader. However, when the blow-up is so big and the counterparty is one of the largest players in the market then the rules of the game are changed.
Yes, it’s a rigged game.
I have no idea how this situation will play out, just as I have no idea how Russia/Ukraine will play out. However, I do know that in the last few weeks we are being forced to completely reassess everything. And I mean everything.
Commodities are moving into a scarcity phase globally and this can’t be a good thing for economic growth, corporate earnings, and equity valuation multiples.
There will be a concerted effort made to try to calm things down by western governments, but I fear that it is too late (and governments are incompetent anyway). Natural resources are critical to each nation’s national security and that means that they are more valuable than they were in the past. Expect some countries (Chile, Peru, etc.) to increasingly nationalize their largest mining operations, and other projects that we previously deemed to not be permittable, to suddenly get fast tracked through the permitting process.
We are entering a new commodity world order, a world in which the rules of the game will be rewritten and many of the assumptions we have operated under for a long time no longer hold true. While I am very much operating under the premise that “nobody knows anything”, including myself, I have to conclude that North American resource projects will be valued at an even higher premium in this new commodity world order. In addition, ownership of physical metals as opposed to derivatives and ETFs will become more in vogue than ever before.
Eric Coffin of HRA-Advisory nicely summed up the bullish thesis for gold in his latest subscriber alert:
“Sanctions and cross border actions against banks, including the Russian central bank and oligarchs, highlight the value of an asset that is no one else’s liability. Several central banks have reiterated the importance of gold for them as a balance sheet asset that underpins their other currency holdings.”
In a world in which central bank fx reserves held by foreign central banks can be frozen in an instant, gold is an essential store of value that both central banks and private citizens will increasingly seek to shelter their wealth and preserve their purchasing power.
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