How the Threat of War is Roiling Commodity Markets

Recent geopolitical events have triggered a slowdown in both global growth and international trade.

Global economic headwinds appear to be intensifying. Geopolitical tensions are surfacing in different ways throughout the world, including international economic disagreements, potential wars, and social unrest.

Political, economic, and social events that impact international relations and trade are referred to as 'geopolitical events.'

Fear of a potential invasion of Ukraine by neighboring Russia has been felt across the global commodity market.

A Russian invasion of Ukraine could be a dramatic risk-off event that could send shockwaves across markets. Stocks could plummet and commodities prices could skyrocket.

Traders need to fully recognise the risks a conflict would pose to the commodities market, particularly natural gas.

On the other hand, political instability in Latin America, US interest rates hike, Middle East's uphill battle with rising energy prices are some of the key factors that may impact the commodity market.

To help you understand the current scenario in the commodity markets, we reached out to Vijay Bhambwani, editor of the Fast Profits Daily video newsletter, and Weekly Cash Alerts at Equitymaster.

Vijay has profitably traded commodities for many years using his home-grown trading system. He has been an active trader since 1986.

Read on for a very insightful interview...

Equitymaster - There are multiple flash points in the world right now, from the perspective of a war breaking out. Let's take Russia and Ukraine first. How's that playing out...and how's that impacting your favourite commodity, natural gas?

Vijay - Financial markets don't like uncertainty, strife, and disruptions. The situation in Eastern Europe is triggering all that and more.

Russia (exported 130 billion cubic meters of gas in 2021 to Europe) is quite simply one of the largest suppliers of natural gas in the world. Holding back gas supplies from Europe is threatening to cripple economies.

Not only that but other smaller gas suppliers are using this as an opportunity to create shortages. Algeria (exported 34 billion cubic meters of gas in 2021) has restricted supplies to Spain via Maghreb pipeline.

Kazakhstan has played truant on its supply contracts to Europe too. On Friday, 4 December 2021, Russia announced an alternate pipeline to China to supply gas for 30 years. This means gas will be sold to the highest bidder. This means the West will depend more on Iran and Qatar for higher gas supplies.

Intraday price movements of 10-15% is getting frequent. Where statistical ßeta (pure price volatility) is concerned, my system shows the reading to be at decade and a half highs.

Extreme ßeta reading make 'widow maker trades.' When a trader is confronted by volatility that records 6 months of ßeta being logged in one week, it's a matter of time before you get caught on the wrong foot in a trade.

That results in extreme drawdowns to your capital. It's easy to lose money but twice as difficult to make it back. A trader spends time and energy in just getting back even.

A far simpler (and admittedly difficult to digest) strategy would be to take a fetal position and conserve resources for better times. Keeping the powder dry as we traders call it.

Equitymaster - You have spoken about Russia's larger game plan. If that plays out, how do you see that impacting the commodity markets? Is there a trading opportunity in there?

Vijay - It's my deduction that Russia will not stop at Ukraine. Mikhail Gorbachev's Glasnost policy (more transparency) left the erstwhile Soviet Union splintered and fragmented into independent minded nations.

Putin wants to leave a legacy of a 'unifier' who brought back "lost grounds" into the Russian fold. They may expand their 'interests' to Lithuania for example. Baltic and Balkan states offer 'interests' to Russia too.

Russia is the largest non-OPEC supplier of fossil fuels. Its actions will unnerve energy markets. The implications are likely to be felt by currencies, commodities, equities, and bond markets to varying degrees. I choose to bet long on human misery and go short on human happiness in the near term.

Choosing the safe haven of bullion is a good bet. Bullion maybe subdued till the US mid-term elections are not done and dusted. Once that is out of the way, I think VUCA (volatility, uncertainty, complexity, and ambiguity) will boost bullion prices.

Chances of chronically high inflation are an additional positive for bullion. This is why the Bank of England (BoE) chose to raise interest rates. I expect other big economies to follow suit.

Equitymaster - The Middle East is not unfamiliar with war. But this time around the equations appear to be different. How should one read this and how do you see this impacting the price of oil and gas?

Vijay - MENA (Middle East & North Africa) are typically geographies with strong arm administrations and / or rulers. They demand higher degree of obeisance from their civil populace. This obeisance has to be paid for. Many nations are therefore frequently doling out money to keep people towing the line.

The Arab spring has frightened monarchies. They are loosening controls, granting more freedom, and social security. All this costs money. The only things that many of the MENA nations depend on for finance are oil and gas. This explains why prices are being pushed up.

Covid stretched their finances and energy prices collapsed in 2020. That left gaping holes in their finances. The current jump in energy prices is at least partially triggered by "engineered" supply constraints so these nations can raise their cash flows. Other exporters like Russia don't mind playing along since they get better prices for their exports.

Energy prices may remain elevated. And if they show signs of falling, we may see "geo-political tensions" erupt almost conveniently to raise prices again.

Having said that I think the OPEC is extremely smart as a cartel. They won't go for the "overkill." The idea is to milk the markets, not kill it. So even if triple digit prices may be seen briefly, they may not hold.

The other aspect is how many nations like Saudi Arabia, Abu Dhabi are issuing shares in their oil companies to overseas investors. Many more nations are raising debt via bonds. That means accountability, pressures, and "influences" from overseas institutions. You can't take money from western nations via equity and/or bonds and force down astronomical oil prices down their throats. Not without repercussions.

On Friday 4 February 2022 Saudis announced the possibility of a US$50 bn follow on initial public offering (IPO) of Saudi Aramco. This means oil prices need to remain propped up (at least attempt to remain propped up) till the IPO is done and dusted.

Equitymaster - How do you see rising US interest rates impacting commodity prices. And your update on the absence of a commodity supercycle.

Vijay - Commodity prices have jumped due to the excessive supply of free money first, foremost, and always. Money (capital) wants returns on investment. That means higher prices. The justifications for high or low prices are always ready in the top shelf of big ticket players.

The rally in prices is built largely on extreme leverage. As long as C-o-C (cost of carry or financing costs) is low bulls don't mind holding existing long positions or even adding more buys.

The equations change dynamically when coupon rates rise. Since leverage is extremely high, even a 0.25% - 0.50% will upset many leveraged traders' calculations. After an extended bull phase, a bit of selling can trigger a snowball effect as falling prices trigger more and more selling.

Systems (AI) based stop loss orders exacerbate the situation. Pure alpha hedge funds can then head for the exit door from longs leading to a "crowded exit."

Much will of course depend on the magnitude of the rate hikes. If it is 25-50 bps, I feel markets may see a significant slowdown in the upthrust. If the hikes exceed 75 - 100 bps there can be sharper falls.

Then a "feeding frenzy" might get triggered. Like a big shark dying in the ocean and smaller fishes come to feed on its carcass. Large hedge funds using extreme leverage or holding high ßeta investments like oil & gas, copper, nickel, lumber etc may see their holdings dovetail. It will invite smaller funds to short these commodities leading to a snowball effect.

Look at Ark Investments. It has "Anti Ark" trading instruments betting that Ark Investments will go down. This is the feeding frenzy that can get escalated. Whether it is the SE Asian currency crisis of 1997-98, dotcom bust of 2000, the global financial crisis of 2008, hedge fund implosions have triggered significant declines in markets.

I don't think there is a commodity "supercycle" let alone a grand supercycle. We have engineered supply shortages and a bull market fed by easy money. Labor shortages and demand for higher wages are additional reasons why prices are pushing higher. These issues can and will get addressed.

At the end of the day, the best cure for high commodity prices is - high commodity prices. Demand destruction, search for alternates, will cool prices over time.

Equitymaster - Tell us about the situation in Latin America and how it can impact commodity prices.

Vijay - Latin America (LatAm) is a natural resources rich geographical area. This region is a swing producer - they can swing prices of resources they export due to the size of their export trade.

These nations have been hit hard by Covid and their governments need money for stimulating their economies. These countries are historically mis-managed, are relatively more corrupt and suffer from chronic and high inflation. They also nurse sizable dollar denominated debt from international lenders.

The pandemic has seen lakhs of people dying of Covid and joblessness is rising. There is increasing unrest. Socialism and / or soft communism is being accepted. Peru saw people electing Pedro Castillo to power in 2021. He is a hardcore socialist.

A few weeks ago, Chile elected a very young socialist Gabriel Boric as President. Castillo wanted to "re-negotiate" mining leases with companies mining metals. The move was aimed to raise revenues from natural resources exports. Gabriel Boric had assured his voters of similar objectives. Mining companies have very deep pockets, political, and military muscle and can easily cause political unrest. Castillo is now backing off instead of taking "big money" head on.

One of the largest natural resources exporter Brazil is suffering for high inflation, weak currency and rising unemployment. Ditto with Argentina. It's another big LatAm nation with similar difficulties and interest rates that fluctuate between 40-70%.

Both have sizable debt and falling currency, rampant inflation, and zooming interest rates. Argentina renegotiated terms of US$58 bn of debt with the IMF (international monetary fund).

History is a good witness and teacher rolled into one. Whenever resource rich nations run out of money, they dig deeper into the earth and export more resources. If they are reeling under debt burden like LatAm nations are, their creditors take their resources at below market prices.

A smart trader should keep his/her ears to the ground and wait for these signals from LatAm. I feel price declines (whenever) they come, will be triggered by LatAm.

Equitymaster - What's happening in Asia?

Vijay - Money is a universal language. Only the local dialects differ. Asian commodity exporters are economically distressed for the same reason as LatAm. We in Asia were the most affected by the 1997-98 crisis. Our economies may have healed but not totally. Besides, the pain of the crisis lingers on.

Joko Widodo (President of Indonesia) announced a ban on Nickel exports soon after I partnered with Equitymaster in 2019. The ban was to come into effect from 2020. He blinked at the last minute and scrapped it due to financial reasons.

He is again toying with the idea of commodities export ban. This time Indonesia is far more vulnerable than it was in 2019. Can they afford to miss the export revenue looking at the sovereign debt they hold?

Like I mentioned earlier, when bigger commodity exporters are causing deliberate shortages, even the smaller ones are acting belligerent.

Equitymaster - Give us the overall picture for 2022 when it comes to commodities trading. How should traders be placing themselves to profit from it.

Vijay - A savvy trader is like a python. A python doesn't feed daily. But when it does, it swallows an entire animal of prey at one go.

Right now markets are nervous, on the edge of their seats and are living in suspense. Which is why you see 10-15% price moves intraday.

We need to wait for the interest rates to rise and accelerate. So far it was the smaller economies like Poland, Hungary, Romania, Peru, Argentina, Brazil etc that were hiking rates.

Last week the Bank of England (BoE) let the cat loose among the pigeons by raising rates. It is the first big nation to do so. Money is like water. It flows where there are profits. There will be a flight of capital from lower interest paying nations to higher interest paying nations. This is called "cash carry arbitrage."

Unless Germany, US, France, and Japan raise rates, they will witness threat perception of flight of capital. So cash carry will force others to drive rates higher too.

The manic price rise in all asset classes will possibly be slowed in the first half of the year and possibly even reverse in the second half. That is when markets will respond to conventional studies and trading systems. Predictability will be possible then. Right now we are staring at our trading terminals and news telerate tickers for breaking news to wait and watch where prices are being tossed around.

Once rate hikes sober markets sentiments, it will be action time again.

Happy Investing!