Ukraine Crisis, Part 2: Mis-Priced Risks

by: Zoltan Ban


Ukraine and Western diplomats fell into a trap at the Geneva meeting, due to a self-enforced belief in the validity of own position. Geneva deal exposes and highlights illegitimacy of Kiev government.

Recent display of Western diplomatic incompetence may be a sign that we can expect further mishandling of the situation, including possibly unleashing a destructive economic conflict.

The only way out, which still offers the option of avoiding significant economic consequences, is a Western retreat from its position.

One of the most important lessons we never seem to learn in life is the possibility of the occasionally severe downside we can experience when we decide not only to lie, but start believing our own lies. In Part 1 of this two part series on the Ukraine crisis I examined some of the opportunities which should not be overlooked, such as the upside for Steel producers such as US Steel (NYSE:X), or companies involved in manganese production such as BHP Billiton (NYSE:BHP). Ukraine is a major exporter of both products, therefore there is a strong likelihood of increasing prices due to disruption, which can benefit the companies I just mentioned. For part two of this two part series I want to explain the current situation and point out the possible risk to investments due to the evolving events, with a focus on the consequences of different policy paths.

When the pro-Western, anti-Russian protests gripped Ukraine and eventually toppled the democratically elected "dictator" Yanukovic, few people in the West ever stopped to question the legality and legitimacy of the new government. It is a pro-Western government therefore it automatically stands for freedom and democracy, the argument goes. On the other hand, people in the Eastern part of Ukraine who rose up with the assistance of Russia and refused to recognize the right of the new Kiev government to rule over them were automatically declared illegitimate.

When interpreting the Geneva agreement which the US, EU, Ukraine and Russia signed, we automatically believed the illegal government buildings seizures only refer to separatist groups in Eastern Ukraine. It is the interpretation falsely cited in the media, even though the agreement does not specify any such detail. To our surprise, when we started demanding that government buildings in Eastern Ukraine be vacated by separatist protesters, the response from the separatists was that since the Kiev government is just as illegitimate, so they better do the same as agreed in Geneva.

I suspect that this will be the response we can expect from now on from the new self-appointed Eastern Ukraine regional authorities and from Russia as well. After all, everyone signed on to the deal and it is hard to argue that the Western-backed movement spearheaded by extremist groups such as Svoboda and the Right Sector which ousted the democratically elected president of Ukraine has any more legitimacy than the Russian-backed separatist movement. Some may be tempted to point at the fact that those militias in the East receive military hardware support and that is what makes them illegitimate. It is hard to argue however that weapons support is any more illegitimate than the money and effort allegedly spent by the US in shaping and encouraging the anti Yanukovic movement, which Victoria Nuland's intercepted conversation and other statements clearly show to be the case.

I see an equally dangerous trend towards misinterpreting and understanding the financial risks involved given this geopolitical situation. Based on media coverage, official government statements as well as the reader response to previous articles I wrote on this subject, it seems to me that there is an established consensus that in the event of an economic confrontation or even an unintended disruption due to events on the ground in Ukraine, the main financial threat is to Russia, with only relatively minor consequences for everyone else.

The market seems to be in agreement, with Russia suffering capital outflows, the stock market is down for the year by almost 20% so far and the rouble is down significantly as well.

Euro to Russian Rouble Exchange Rate data by YCharts

All of this is in anticipation of an economic confrontation between the West and Russia. Meanwhile, the western and global markets are doing just fine, hovering near all time record highs in many countries, meaning that investors believe they are safe. It is with this attitude in mind that some people are invoking the prospect of shutting Russia out of the global financial system, or other measures meant to completely isolate Russia economically as an actual option the West has as a last resort in order to push for a victory in the current standoff (link). They could not be more wrong.

Total economic war not an option.

Russia is currently by far the biggest net exporter of fossil fuels. It exports over 7 mb/d of crude oil, about 14 Bcf/d (440 Mcf/d) of natural gas and about 140 million tons of coal per year. Measured in barrels of oil equivalent it comes out to over 11 mb/d. It is true that Russia is highly dependent on these exports for state revenue from royalties, as well as maintaining its favorable trade balance. Of the over $500 billion Russia exports every year, about 80% is fossil fuels.

On the other side of the equation however are the fossil fuel importers. We do not import these fossil fuels from Russia because we love Russia. We import because we have no choice. There is a reason why crude prices increased about 500% since the year 2000, it is most certainly not because we live in an era of plenty supplies or viable alternatives.

Based on the following observation I made many times in regards to the past and present relationship between liquid fuel supply growth and potential global economic growth, the relationship can best be expressed in the following way:

1.5% yearly growth potential due to yearly efficiency gains + (% yearly increase in liquid fuels X 2) = yearly global potential growth.

If we look at last year, where an increase in liquid fuels production of just over 1% matches more or less with the 3% global growth rate, or if we look at the average growth rate over past few decades, versus the average yearly increase in liquid fuel supplies, we see that the model is more or less approximately accurate. Working this model in reverse, assuming that global spare capacity is limited, the initial shock to the global economy in response to the loss of Russian oil exports can be as high as a 15% correction to growth, which will lead to a global recession deeper than 10%. For comparison, the 2009 global downturn was -0.7% and we found it to be a very rough situation.

The most affected region will most likely be Europe since it is the most directly dependent on the oil imports from Russia and also because of other economic ties which would be disrupted. Europe also happens to be the most financially vulnerable as the 2008 financial crisis has demonstrated. It is hard to predict what the secondary effects would be given that such a deep recession would most likely trigger massive debt defaults, beyond our ability to bail out the financial system. We have no way of knowing where and when the tailspin would stop. One thing that is certain however is that the level of economic pain would be comparable to what Russia would feel.

Less drastic measures.

The so-called 'non-nuclear, nuclear option' I described above is not currently being considered as a serious option. I hope that most policymakers have a clear understanding of why that should be the case. What is being considered is a gradual ratcheting up of sanctions, hoping that Russia will not retaliate, therefore keeping the pain on one side of the equation. This too is a mistaken calculation in my opinion, because once sanctions become more serious, Russia will likely retaliate in kind. Many people seem unaware of this because most are focused on the energy issue, but Russia can retaliate brutally in response to western sanctions due to EU export ties to Russia.

Unlike Russian exports to EU, which are mainly fossil fuel related, EU exports to Russia are largely made up of manufactured goods and services, most of which are not essential to Russia's economy, because most goods such as automobiles can be sourced from other parts of the world for no additional cost, or better yet can be produced by domestic producers. Many intermediate goods can also be replaced in relatively short time intervals and with little additional cost incurred.

Source: European Commision

So while all the talk has been about the need of the EU to reduce its reliance on gas imports from Russia, the reality is that a perhaps equally important economic connection to Russia is the EU's reliance on the Russian consumer for its manufactured goods and services. Russia has been in a race with Germany for the position of Europe's number one car market for a few years now. The EU sells about $15 billion worth of automobiles in Russia every year. The loss to the automakers alone in terms of manufacturing jobs if Russia was to stop importing cars would be in the tens of thousands, with indirect losses amounting to hundreds of thousands of jobs. Car sales make up only 10% of total EU exports to Russia, so as we can see the economic damage that Russia could inflict on the EU, without significant self-inflicted pain as a result is not to be scoffed at. It is important to keep in mind that this comes within the context of a European Union which already suffered through more than half a decade of economic crisis, leading to the current 12% unemployment rate and a resulting rise of the destructive far-right Euro-skeptic political movements in almost every member state.

The gas issue (out of the hands of EU and Russia).

There is thus far little evidence that either the EU or Russia have a desire to end the gas trade between the two sides. It is very important for both economies, but due to the current situation, the gas may stop flowing as soon as this year. Depending on the circumstance, this time it may be a long while before the gas will flow again once it stops.

There are two main scenarios which are likely to lead to a cessation of gas deliveries from Russia to the EU, via the Ukraine. The first scenario is one we are already very familiar with. It involves Ukraine not being able to pay for its gas imports. In this case I foresee a relatively short duration disruption, which will be ended by the EU picking up the tab for part of Ukraine's gas bills, effectively taking over the role of Russia as a provider of subsidised gas from previous years.

The more dangerous and increasingly likely scenario is one where gas flows will be disrupted due to a civil war breaking out. In this case, there will be very little that either side will be able to do in order to get the gas flowing again. An internal conflict in the Ukraine could last for years, depriving the EU of much needed gas and Russia of billions of dollars in revenues each year. Both sides would suffer serious economic consequences as a result.

There is also another long-term threat which might mainly affect the EU and it is almost exclusively due to its misguided policies. As the 2011 IEA report points out, the Ukrainian pipeline infrastructure is in urgent need of billions of dollars worth of repairs. Russia has been aware of this, that is partly why it started working on the South Stream project as an alternative to get its gas to the EU, bypassing Ukraine, thus also resolving the geopolitical threat. The EU however recently put all collaboration on the project on hold (link).

Given that Russia will likely sign a deal with China this year to export about 38 billion cubic meters of gas per year by the end of the decade, it means that the EU as a market for its gas will become less important (link). There may also be a deal with Japan coming soon, given that Japan expressed a lot of interest in having a pipeline built between the island nation and Russia. As a result of these considerations it is entirely possible that the EU will find itself in a terrible situation. Russia may reconsider the South Stream deal once deals in Asia will be secured. Meanwhile, the Ukrainian pipeline system will slowly disintegrate given that no one will be willing to invest in fixing it. To make matters worse, the EU's second largest natural gas provider, Norway, may be facing declining production in coming years. So the EU may become less reliant on Russian gas, just as it wishes to, but it will not be a happy outcome by any means. The EU may get stuck importing more expensive LNG, which Japan currently pays about 50% more than EU pays for Russian gas.


As we can see, there is no scenario likely to play out this year as long as everyone holds the current line, which if it is to have at least some effect on Russia's economy will not also affect the EU and as a result the global economy. It makes therefore no sense to assume that Russian assets are the only dangerous holdings that investors need to get rid of. This seems like a terrible miscalculation of risk.

There is in fact only one scenario which can still avoid negative economic consequences. It is the solution I pointed out a month and a half ago as the only way out, which is for the West to step back (link). It is after all the action of the West, which pushed Ukraine into this internal upheaval by asking it to chose between the EU and Russia. They should have known that Ukraine was already a very divided society and did not need any more gasoline to be poured on the fire. They should also be aware now that we hold no winning hand. At best, it is a mutually destructive option that can be played if we continue with the current policy and it will in no way benefit us.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.