Ukraine Crisis: The End-Game Is Set

 |  Includes: BHP, ESR, GUR, RSX, X
by: Zoltan Ban


Ukraine crisis is entering the stage where all involved from outside can find no point to pushing their agenda any further, therefore, a disengagement is desired.

Russia's intentions were badly misunderstood, which is something we can now see more clearly. No further annexations likely. Russian assets should rebound.

United States and Russia relatively unaffected economically due to crisis. Main victims are the EU and Ukraine.

Ukraine geopolitical event will have lasting effect on the global economy, which we are already seeing in the form of the Russia-China gas deal or EU-Russia decline in trade.

At the beginning of April, I wrote an article explaining why the Ukraine crisis was not a logical reason to sell Russian assets to the extent that the markets did, and therefore, Russian assets presented a potential opportunity. It turns out there were enough people out there who also saw an opportunity starting in late March, because the ruble and the (NYSEARCA:RSX) both made up for half the losses suffered since the beginning of the year.

RSX Chart

RSX data by YCharts

It is understandable why many people saw reason to sell and very few people saw the opportunity. The truth is that perception of reality on this crisis was so distorted by rhetoric and perceptions coming from the media and officials that those who are not familiar with the region never had a chance to understand it. It is therefore also understandable why the economic ramifications of the current crisis are also missed.

Russia will not annex Eastern Ukraine

Russia's policy was badly misunderstood due to its annexation of Crimea. This move led to the hysteria we witnessed in Central Europe and the Baltics where EU and NATO countries demanded protection from the evidently expansionist, aggressive Russian menace. Reality is that Russia's Crimea annexation was a response to the NATO and EU push towards its borders, which it sees as a provocation. To put it into context, it would be like Mexico deciding to make very good friends with China and inviting it to set up military bases there. I think we all know what the US reaction would be. Russia acted to salvage a bare minimum of its strategic position in the Black Sea region by taking over Crimea, where there was genuine popular support on behalf of the local population to join Russia.

When it comes to the rest of the Russian speaking regions of Ukraine, the benefits would in no way make up for the downsides. Yet most people bought into the narrative that Russia is fomenting unrest in order to create a pretext for intervention to annex the region. The narrative fits very conveniently if we also buy the narrative that the concerns of ethnic Russians in Ukraine are not valid. While the story may have been made to fit, it does not fit the interests of Russia.

We had a very good lesson in the past decades with regard to the costs involved for a more prosperous state to annex a less developed region in the form of Germany's reunification. By some estimates, it cost as much as 2 trillion euros ($2.7 trillion) between 1990 and 2009 (link). The population of East Germany was just slightly larger than that of the Eastern part of Ukraine, and the difference in GDP per capita was also comparable to the current difference between Russia and Ukraine. It goes without saying that if Russia was to spend a similar amount of money on annexing this region, it would be a huge economic disaster, especially given that we are talking about Russia, not Western Germany. Russian officials are very aware of this, even if they do not say it in public.

The annexation of Crimea will also come at a huge economic cost, even though it is a much smaller, more manageable territorial expansion. In this case, however, we have to understand that Russia had costs involved in not annexing Crimea. Russia was paying over $500 million per year in rent for the naval base in Sevastopol, and now it no longer has to. Not to mention that it no longer needs to keep Ukraine happy in order to keep the base, so no need to subsidize Ukraine's gas anymore. Russia estimated that it spent over $35 billion on subsidies and other aid to Ukraine in past years. Being free of such burdens comes out to billions of dollars in savings, which can be channeled to the economic integration of Crimea.

If the current situation leads to a federalization of Ukraine, where Russia will carry some influence in some of the regions, perhaps so much influence that it might be able to block any potential NATO bases being set up on the coast of Ukraine or near Russia's border, then Russia will take it happily and might even offer these autonomous regions some economic aid. Russia would be able to perhaps influence Ukrainian public policy through these regions, if need be. On balance, it is a situation Russia can live with, even though it is not the ideal result, which would have been a Ukraine firmly in its sphere of influence.

The United States comes away with something as well, and no direct loss

One of the main concerns the United States had in past decades was a Europe that may become overly unified, and therefore, a viable strategic and economic competitor in the world. Aside from the fact that Europe produces many manufactured products, which are in direct competition with American products on the global market, there is the reserve currency issue. The reserve currency status is very important to the US, and the euro is perhaps one of the main long-term threats to diminishing the role of the US dollar (link). The events of the past months all but ensured that at least for a decade or so, Ukraine will be hostile towards the Russian state. It will behave in an antagonistic manner and it will serve as a wedge between the EU and Russia. With Poland and other states in the region also deeply suspicious of Russia, there is now a complete geographical and political barrier between Russia and Western Europe. Europe's economy will be much weaker as a result. There is a cost involved in maintaining this new situation. Ukraine's economy is far from viable, therefore, the United States will have to pony up some aid together with the EU. The costs will be considered to be worth it.

The EU and Ukraine are clear losers

If there is one actor in this where we can say with certainty that not only there was very little to be gained from the current policy but much to lose, that entity is the EU. The fact that the EU became involved in this and actually triggered the crisis by asking the divided Ukrainian society to choose between the EU and Russia is ironic, given that the EU stands to lose the most outside of Ukraine. Some interest in Ukrainian farmland may have been one of the catalysts of this policy. The EU appeared especially eager to make a deal with Ukraine after China made a deal that could see 3 million hectares of farmland under Chinese control (link). Given how much there is at stake in its relationship with Russia, there is no logic to making such a strong move towards antagonizing it and taking a hostile stance, even if it was meant as a play for Ukraine's farming capacity.

Now that the deed is done, it is time to count the benefits versus the downsides, and it is not looking good for Ukraine and Europe. Ukraine lost a chunk of territory, which it is unlikely to get back any time soon. As of 2013, it was the fifth poorest country in Europe with a GDP per capita of $3,900, compared to $34,000 for the EU average and $14,000 for Russia. In direct consequence of the current turmoil, it will probably be the second poorest country by the end of this year, with only the Republic of Moldova worse off. Within a decade, Ukraine could become the poorest country in Europe, due to a number of factors that will be a drag on the economy.

The obvious and immediate drag will be the loss of subsidized Russian gas, as well as a Russian disengagement from Ukraine as a trading partner. Whether Russia will export gas to Europe through a new pipeline called South Stream, or give up on the project in favor of concentrating on projects such as the one Russia just signed with China, we have no way of knowing yet. One thing that is for certain is that within a decade, Ukraine will no longer be a transit country for Russian gas, which means it will lose billions of dollars it currently collects in transit fees. Add to it IMF reforms that will shut down huge sectors of Ukraine's industry, leaving hundreds of thousands or perhaps even millions out on the street, as well as the resulting social upheaval, which will most likely translate in numerous episodes of collapse of law and order just as we are seeing now, and the future Ukraine has embarked on is increasingly obvious.

Some may be tempted to predict that after a decade or so of turmoil, Ukraine will rise as a much healthier economy and will benefit from eventual membership in the EU. That assessment is wrong on two counts. Unlike countries such as Poland or Romania, which went through a similar process in the 1990s, Ukraine will be going through it in a new era economically speaking. The world's economy is forecast to grow in the 3% range for the next few decades compared to over 4% on average in the past. Within this context, countries such as Ukraine, Egypt, Syria and others gripped by upheaval will find it very hard to recover. Second of all, the EU never wanted to have Ukraine as a member and never will. It is a large country, which will be hard to integrate. It would require far more support in the form of EU cohesion funds than other countries from Eastern Europe. I foresee a very clever game played by the EU, which will demand, as is customary, that all joining members establish good relations with all neighbors. A continuing claim on Crimea, which Russia just annexed, will make it very hard for the Ukraine to fulfill this one very important precondition for EU membership.

Of note here is the fact that there are many foreign firms that could benefit from this situation, such as BHP Billiton (NYSE:BHP) and US Steel (NYSE:X). Ukraine's steel and manganese exports will likely suffer through this process. This is going to mean a significant boost in prices, which should favor many companies involved in production.

As far as negative consequences for the EU, there are many. First of all, it is now stuck playing the role of Ukraine's economic sponsor that Russia played up until recently. There are already some suggestions that the EU will help Ukraine pay for the $3.5 billion it owes to Russia for gas delivered but not yet paid for, in order to avert a cutoff of supplies in June (link). If Russia demands that Ukraine pay the average European price, it will mean a roughly $2.5 billion per year increase from the previously subsidized price, which Ukrainians cannot afford, therefore, I foresee the EU will pay in order to keep the gas flowing. There are also many other costs involved in offering Ukraine this new partnership. It is money the EU can hardly justify to pay while the average rate of unemployment in the union is 12%.

While much media attention as well as official rhetoric was focused on EU desires to lessen reliance on Russian energy due to the current conflict, little attention was paid to Russia's desire to diversify away from the EU as a trading partner. This will impact not only energy, but also the trade in manufactured goods, which is more or less a one-way street in the EU's favor. Over $100 billion in manufactured goods are exported from the EU to Russia every year, according to EC data. Most of these goods are easily replaced with goods manufactured in Asia. As Russia seeks new markets for its energy in Asia, it will also make concessions on manufactured import duties and regulations to its new energy customers. The gradual loss of the Russian market will be a drag on the EU economy, which is already shaping up to be the worst performer since the beginning of the 2008 global crisis.

The prospect of a gradual or perhaps not so gradual loss of a significant portion of Russian natural gas supplies is also likely to negatively impact yearly EU growth for the next few decades. As I pointed out already, Ukraine will cease to be a viable transit country for Russian gas. The infrastructure is simply not going to cope without massive investments meant to repair the aging pipelines, and there is no one willing to invest given the drama associated with Ukraine in the past decade. The only sure way to secure continued delivery of similar volumes of gas from Russia at present is to go ahead with the South Stream project. That project, however, is being delayed by the current crisis, and in the meantime, Russia just signed an almost similar sized project with China. The deal with China will also contain a clause potentially expanding the size of the project to as much as 60 billion cubic meters (2 trillion cubic feet) per year, which is a similar volume to current gas transiting through Ukraine (link). I also foresee a major gas deal with Japan coming soon, because the Japanese have expressed a clear interest for it (link). There is now a chance that the South Stream project will be cancelled.

For all the talk about US LNG and Mediterranean gas coming to the rescue of the EU, the long-term future if it is to be without a significant portion of Russian gas will be bleak for the EU. Norway is currently the EU's second largest source of gas, just behind Russia. Norway is likely to peak and suffer a similarly spectacular production decline as we have seen in Britain's portion of the North Sea within about a decade or so, or perhaps sooner. Norway's export volume to the EU declined slightly in 2013 compared with 2012 (link). Shale gas drilling in countries like Poland and Hungary produced little gas and much disappointment so far. In the Mediterranean, stories about North African gas neglect to mention that the region is geopolitically unstable. Stories about Israel's new-found gas riches neglect the fact that Israel is likely to use a large portion of the gas to power desalination plants it is building, therefore, it will never become a large-scale exporter. Not to mention that the gas gives Israel a strategic advantage in the region that it is unlikely to want to blow on massive gas exports. Stories about gas found in Cyprus are blown way out of proportion given the actual volumes found so far.

A combination of US, Australian, Middle Eastern and African LNG will likely be made available to the EU in the coming decade in adequate volumes. The price they will have to pay will be significantly higher than the price of Russian gas. This is the last thing that the EU needs given that it is already suffering from lack of competitiveness in comparison with major global peers and serious internal imbalances due to the common euro currency, which does not fit the needs of all the members.

I expect the current Ukraine crisis will shave a few more very precious tenths of a percentage point in growth every year for the next decade or two. Given the already grim projections of almost stagnation-like growth prospects projected by the EC and other institutions, this may be just enough to push the European Union deeper into danger of social unrest and a continued rise of the extreme right in EU politics, which will eventually tear the union apart (link).

Taking all these things into consideration when it comes to the economic effects, Russia looks good because it just got rid of a dependent state it kept subsidizing and the crisis also gave it the necessary motivation to finally re-direct its attention away from the stagnated EU and towards the more dynamic East. The so-called sanctions, which never posed a major threat to its economy, will soon disappear. The United States can walk away with some success to show and few negative consequences, so we can call it a slight win, even though the desire may have been for more. The EU and Ukraine are the ones left holding the bag, which is reason to be unhappy, but there is nothing left to play for, therefore, an acceptance of a final conclusion of the crisis is desirable.

Aside from a continued rebound of Russian assets for the rest of the year to pre-crisis levels, disruptions of economic activities in the Ukraine should be expected throughout the rest of the decade and perhaps beyond. Steel, manganese and perhaps soft commodity prices will be influenced by the internal upheaval, therefore people should continue to watch the events as they unfold. Deals such as the one just signed between Russia and China will re-shape the global economy. While Russia just demonstrated that it can find new customers for its main exports, the EU will have a hard time replacing the loss of the Russian market for its manufactured goods, which is something that is already underway (link). The Ukraine crisis may now move to the internal stage, with outside forces seeking to disengage, but this geopolitical event will have very powerful effects on the global economy.

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.