Updated: May 25
As the Russian invasion of Ukraine reached the five month mark this past weekend, the global economy has since been put on the fast track to rising inflation and a global economic slowdown. Earlier this week, the IMF cut its FY/2022 global GDP target from +3.6% this past April to +3.2%, with the U.S. downgraded from +3.7% to +2.3% Note that these projections came before the U.S.’ -0.9% Q2 GDP contraction as announced on July 28. Though the inflationary pressures and strains on the economy were already present since the end of last year, Russia’s invasion of Ukraine only accelerated the global economic uncertainty. With the coordinated and targeted sanctions announced by a coalition of western countries on Russia since the start of the war on February 24, one of the consequences has been increased strain on global supply chains, increased energy uncertainty and accelerated fears of a recession. Earlier in the week, state-owned Gazprom announced that it would be reducing gas flows to Europe to 20% of capacity, thus further dampening the economic outlook of Europe as the continent attempts to find alternatives ahead of the winter season. As European gas rationing has loosely been agreed to, there is no question that the spike in energy prices will remain in the shorter term (YTD, NYMEX natural gas is up +130%, while in Europe, ICE Dutch natural gas has increased by over 400% to reach levels above the equivalent of $60 per Mbtu). As inflation becomes more entrenched, some projections are calling for a 2%-3% European economic contraction this year. Given these conditions, frustration/unrest has been building on both sides of the Atlantic – among other protests, European farmers have been protesting high fertilizer prices, while in North America, the discontent brought upon by higher inflation has plunged the Biden administration to its lowest approval rating (approximately 35%) since entering office. In light of this backdrop, coupled with Russia finding new customers (China and India) for its natural resources, there has been increasing skepticism over the effectiveness of the sanctions.
The narrative more recently taking shape in the west has been one questioning whether the self inflicted pain brought upon by the concerted sanctions on Russia have been having the desired effect… or if in fact Russian state coffers are benefiting from the high commodity prices with the population in general feeling minimal economic impact. That narrative is categorically false, the sanctions are in fact having the desired effect, the Russian economy is imploding and these effects will only be compounded with the passage of time. Here are some points to consider in order to set the record straight:
Russian Natural Gas: Given Europe’s effort to (finally) wean itself off of Russian natural gas, Russia has decided to preemptively cut the gas flow to Europe, in retaliation for Europe’s mothballing of the Nordstream 2 pipeline, along with all the imposed economic sanctions. In an effort to redirect the flow of its gas south, Russia has signed extensive Asian cooperation and trade agreements in an attempt to sell its natural gas to China and India instead. Though energy exports to both China and India have indeed reached unprecedented levels, this is more so the case for oil rather than natural gas. Note that there is essentially no LNG capacity for additional Russian natural gas to Asia. In FY/2021, Russia sold approximately 33 bcm (billion cubic meters) of gas to Asia, most of it in LNG form via Yamal LNG and Sakhalin2. Finding a new home for the approximately 180 bcm sold to Europe in FY/2021 will be no easy (let alone near-term) task. Via pipeline, the only available route to Asia has already been at capacity (10 bcm) via the Power of Siberia pipeline, launched in 2019. This a very small transit volume. Though expansions are envisioned, natural gas is not fungible. If the infrastructure isn’t there yet to reach new customers, the lost 180 bcm annually to Europe will clearly not be able to reach any new Asian customers, in any significant volume. Not now, not anytime soon. Construction of the $25.0B Arctic 2 project is still estimated to be half complete. Once fully operational, the project would double Russia’s LNG capacity in the Arctic. Note however that given the Ukrainian invasion and the threat of western sanctions, many the foreign entities that have promised to finance a large part of the project have had second thoughts on participating through to project completion. Much has been publicized about the joint Russia/China contract agreement (signed in early 2022) for 30+ years of unprecedented amounts of natural gas. The fact of the matter is that the infrastructure and pipeline network needed for this to become a reality is far from available. Russia has a very abundant resource which effectively has nowhere to go right now.
Russian Oil: It is true that since the invasion, both China and India have been importing record numbers of Russian oil. Indian imports are expected to reach 1.0M bbls per day, with China’s import number being a close second right behind. The simple reason for this is that Russia is selling its oil at deep discount to the Urals spot market – a discount as much as $30 per barrel. Given that massive discount, its no wonder that Russian oil has recently surpassed Iraqi oil and Saudi oil as India’s top oil import. Coupled with the fact that Russian oil is on the expensive side to pump (it isn’t exactly light, sweet or easily accessible) profit margins for Russia’s state-owned energy companies are very squeezed. Add to the fact that most of the exported oil is seaborn transport, you can quickly see how the profit margins get squeezed very quickly. Russia still manages to rake in approximately $35B per month from the sale of its oil and gas exports which is without doubt a sizeable amount, however that amount is nowhere near what it could be if the right infrastructure, the right pricing and the absence of sanctions were in place.
Russian Economy: Following the Ukrainian invasion, many western companies have unilaterally pledged (mostly) to leave the Russian market. These companies range from the very recognizable retail plays that we all see at our local malls to global manufacturing, tech and financial companies. Thus far, over 1,000 western companies representing approximately 40% of Russia’s GDP have announced exits or a curtailment of operations. Among a much larger group, some of the most recognizable names include the following:
Retail: Uniqlo, H&M, Ikea, Canada Goose, Nestle, Nike, TJX and Unilever
Finance/Professional Services: American Express, BofA, Citigroup, Mastercard, Visa, Deutsche Bank, Societe Generale, Goldman Sachs, JP Morgan, BCG, Bain, McKinsey & Company and the Big Four accounting firms.
Food: McDonalds, Carlsberg, PepsiCo, Heineken, Starbucks, Yum Brands, Restaurant Brands International and Mars
Tech: Apple, Amazon Web Services, Ericsson, Cogent, Google, IBM, Intel, LG Electronics, Microsoft, SAP, Sony, Nokia, Siemens and Uber
Manufacturing: Caterpillar, Hitachi, Michelin, Renault, Stellantis, Tata Steel and Volvo
Travel/Logistics: Marriott, Airbus, American Airlines, Boeing, Delta Airlines, Hyatt, Hilton, FedEx, DHL, Sabre, United Airlines and UPS
Energy: BP, Exxon Mobil and Shell
Note that the vast majority of the companies that have pledged to stop doing business in or with Russia have done so at large exit related writedowns. That said, it is estimated that western companies employed approximately 10%-15% of the Russian workforce, representing a midpoint of nearly 8.0M of the working aged population. Though many thought that China will quickly step in to fill the void by flooding the Russian market with its products, the Chinese have been cautious (to date) wanting themselves to steer clear of any sanction related penalties. In the isolated case example of Airbus, Boeing and Sabre all deciding to leave Russia, the vast majority of the Aerofleet planes will no longer have access to replacement parts while Russians are no longer able to book flights using the worldwide Sabre global ticketing system. In a country that spans 11 time zones, losing the capacity to fly (even just domestically, for passengers or cargo) will make things extremely difficult in the years ahead as the hardware ages and will require maintenance/replacements. Even the homegrown Ilyushin passenger jets and Tupolevs rely a great deal on western components. The secondary effect of these corporate exits coupled with the sanctions have some estimates projecting Russian unemployment to be near the 40% rate. Moreover, with export restrictions on just about any high tech components (namely semi conductors) a brain drain from arguably the country’s brightest and youngest generation has already started. Some estimates have projected nearly 500,000 of the country’s youngest and most educated or technically skilled have already fled. Not that Russia was much of a hotbed of innovation to begin with, but with a brain drain this massive, any such notion of Russian innovation is all but finished at this point.
Russian Finances: Much has been made about the Ruble losing nearly 50% of its value, reaching a low of 136 to the $USD in the few days following the invasion of Ukraine in late February. Fast forward to now and the Ruble has recovered to its pre-invasion exchange rate. Many see this recovery as a sign of normalization and point to it as further evidence that the sanctions are having a negligible effect on the Russian economy. This is false. The Ruble’s recovery can be specifically attributed to the very strict rules imposed by the Russian Central Bank. A series of strict controls were imposed to artificially prop up the ruble in the aftermath of its sharp decline. Some of the measures include an outright ban on any individual wanting to withdraw more than $10,000 out of the country, and the introduction of a 12% tax on dollar purchases. Given that overhang, the currency itself is no longer freely traded in the international forex markets. Add to that that trade with the EU and the west has fallen by 50% (few are exporting to Russia nowadays), there just isn’t much need to sell rubles anymore.
Additionally, Russia has been running budget deficits to do what they can to prop up the economy and finance the war. Who is financing these deficits you may ask ? no third party syndicate, all of this is internal. As mentioned previously, though Russia still collects approximately $35.0B per month from energy exports, they have been burning through their foreign exchange reserves at an alarming rate - $75.0B since the start of the war. On top of that, of the nearly $600.0B in rainy day funds Putin has accumulated pre-war, $300.0B is frozen given that countries such as the U.S., Japan and Europe have restricted access (this $300.0B may be eventually used for Ukraine’s reconstruction). Running budget deficits and drawing down from that much the country’s reserves (during a period of elevated commodity prices) can only be a bad sign which will not be sustainable for much longer.
We exited from all of our Russian investments earlier this year.