How Petroleum prices impact by any confliction.

IMPACT ON PETROLEUM PRICES BY CONFLICTION

        Markets at the moment are dominated by headlines around Russia and Ukraine now of course any kind of conflict can come with a terrible humanitarian cost so let's hope that can be avoided but by looking at precedence from the past we can gauge what could happen to markets if this does escalate but also which markets could be affected and what the transmission mechanism could be for those markets to be impacted.

        So let's look at the Russia Ukraine conflict in a bit more detail the Russian equity market peaked in October of 2021 and if we track single country exchange traded funds since then you can see that it's the country which has fallen the most Russian equity is down by around 30 percent as I write this blog but that's certainly not true of all countries for example you can see that three of the countries I’ve shown here actually rallied so that's south Africa Taiwan and the uk but if this conflict does escalate into a full-out war then we would expect volatility would spill out further into broader equity markets I think it's helpful to look at some historical conflicts to see how they affected markets in the past and some journalists from Bloomberg picked up on this table which was published by Keith Lerner at truest now what this does is to track the sp500 for one month three months six months and 12 months after a given military event so it starts with pearl harbor in 1941 and it goes through to the Iraq war in 2003 but what's truly remarkable is that if you look at the average response to those events they're generally positive in fact only three of those events still had a negative effect on markets after a 12-month period those are the ones which are highlighted in grey here so that's the suez canal crisis the Arab oil embargo in 73 and 9/11.

So what is it about those events which meant that they were long lasting than the rest well I think it's helpful to decompose the response to these events into a fast component and a slow component the fast component is illustrated nicely with the example of Pearl Harbor so here you can see the equity market fell in response to that shock but it only fell for about three months and then very rapidly recovered now that's the fall in risk appetite which tends to be fairly short-lived which is a response to these scary headlines the thing about fear is that if it doesn't continually get fed by new headlines eventually it dissipates the Arab oil embargo also starts with an initial shock which caused markets to fall very sharply and following that there was a slight recovery but then there was a secondary effect and that was a very negative effect on the us  economy due to the higher oil prices that followed that embargo now that made inflation spike and it had very long lasting effects negative effects on the us economy so whenever you see one of these conflicts you've got to think about that slow response because that's what's really going to impact your portfolio will it cause lasting economic damage now let's look at all of these events on one timeline for the sp500 now this is a log plot because if it wasn't it would just spike up hugely because it's geometric growth but what's really interesting is that many of these events almost have an invisible effect on the sp500 what really dominates is that long-term trend growth which looks linear on this plot the sp gradually grows regardless of all these disasters which occurred during this period the events with names in red such as suez canal, Arab oil embargo and 9/11 are the ones which were more long lasting they lasted at least a year in their impact on the sp now as we've already seen those are more long lasting because of their economic impact these are events which had a bigger economic impact and in order to gauge that there's something else we have to look at amounts the profit generated by the companies in the sp500 so here are those profits again on a log plot because they increased geometrically and what you may be able to see is that the more long-lasting crises are the ones which had the biggest impact on profits so for example after the sewers canal crisis earnings on the sp500 were falling for some years and after the Arab oil embargo earnings were essentially flat for almost a decade so really when you look at the impact on the US equity market you should always be thinking does it affect the earnings if the answer is no then it probably won't have a long lasting impact the impact will be short-lived and it'll just be that rapid response which recovers very quickly because a reduction in risk appetite is not something which is long lasting the transmission mechanism between these conflicts and market prices and equity was usually via the price of oil that's illustrated very clearly with the Arab oil embargo in 1973 where if you look at the price of crude leading up to that crisis it was very stable but literally overnight the price of oil spiked the reason why was that political instability in the region was going to threaten the supply of oil and because demand for oil remained high that would push up oil prices and that's been true of many of these conflicts since then for example when Iraq invaded Kuwait and the Iraq war but if you look at petroleum consumption and imports in the US you can see why it was very exposed at the time the blue line at the top of the graph is US petroleum consumption the brown line beneath it shows you domestic petroleum production and any difference between the two had to be plugged by imports many of those were from the middle east so if there was a disruption to supply the us didn't have any choices in how it could meet its oil demand and if you contrast that with the present day the situation is very different since the mid-2000s you can see the production of petroleum products has increased hugely and that's because of shale oil and consequently the net imports required to meet demand have fallen very dramatically in fact if you look at the net trade in petroleum products you can see that that crossed over the point of zero when there were more exports and imports at around 2010.

For crude oil, us still imports more than it exports but you can see that that's also getting closer to zero so while it still is the case that a spike in oil would be inflationary in the u.s at least for a large sector which is the energy-producing companies a higher price of oil will actually be a positive for those companies this story about Russian Ukraine was one I covered recently in the weekly market roundup.

If this conflict is going to create disruptions it pays to look what Russia is exporting and where those exports are going so in this left  and panel you can see its exports in 2019 broken down by product and the vast majority of them were energy products so that's crude petroleum refined petroleum but also coal products they also exported many industrial metals such as iron aluminum copper but also nickel and also some precious metals such as gold and platinum and if we look at  the export destinations by country here in the right hand panel the pink region is Europe and that dominated their exports so if there is a disruption it'll be primarily Europe which is affected but the red panel to the right here is Asia and those countries would also be affected if we look at Russia’s share of total world oil production in 2020 you can see that it made up 11 of supply so this is certainly a major player and a disruption there would have big consequences on prices globally from a strategic point of view Russia’s natural gas exports are probably even more important than their oil exports that's because they make up over 40 percent of the imports of natural gas in the eu, that's why they've created the Nordstrom 2 pipeline alongside the north stream one pipeline along the bottom of the Baltic and that side stepped Ukraine so this could increase the supply of natural gas from Russia to Europe now the us isn't too keen on that because it supplies liquefied natural gas and it sees Russia as a competitor in servicing that demand from Europe in fact in 2019 it branded its liquefied natural gas as freedom gas of course that was the butt of many jokes at the time but the point is that they wanted to create a strategic alternative created by an ally of Europe rather than a potential adversary in contrast the uk is much less heavily dependent on Russian natural gas in 2020 it only made up about five percent of the uk supply the vast majority came from Norway and about a fifth of the uk supply came from Qatar although the us's freedom gas did make up about 11 of the supply so if the Russian supply cut out certainly from the point of view of the uk we could probably fill the gap another transmission mechanism to markets would be indirect and it would be via the sanctions imposed against Russia now of course the idea behind sanctions is that it makes it too expensive to even contemplate the prospect of war but of course that comes at a cost not just to Russia but also its trading partners so one of the suggestions from the us was that they'd ban Russia from using the swift network now this is like Gmail but for the payment system between banks and they didn't really think this through because many European banks have lent money to Russian companies and wouldn't be able to receive payments if they were locked out of swift and that's what the chair of the financial stability board is saying in this article from the ft basically don't do it don't switch Russia off from the swift network so here are five European banks which have such exposure these are banks which have lent money to Russian companies and which would want their money back and if the swift network was switched off they presumably couldn't receive those payments but what's also worrying is that these banks would form a transmission  mechanism from Russia to European banks and that in turn could create a problem for the European economy fortunately the number of banks is fairly small although the ecb has asked all banks in the euro area to declare exactly what exposures they have so there might be some surprises in store there but the latest iteration of sanctions is more targeted it focuses on individuals mostly oligarchs but also the main banks in Russia so that would be spur bank vtb and Gazprom bank for example so by limiting the ability of these banks and people to do business in the west that would effectively be a very high cost for Russia to enter this conflict Russia also produces some very specialized metal exports so for example it produces 35 of the global supply for palladium and palladium is used in catalytic converters in cars it also produces nine percent of the platinum supply globally and again that's used in catalytic converters so if these supplies were to be cut that would have an upward price pressure on things like cars and that's one sector where we've seen high inflation in developed markets and that's probably not a cost that politicians would be willing to pay in summary then i think the direct effect on u.s earnings but also earnings in other developed markets will be fairly negligible however the indirect effect via inflation could be significant that's because Russian exports are at the core of this inflationary spike that we've seen recently that came from energy products remember but also used cars and trucks and if catalytic converters go up in price that would affect the price of new cars and that could make the inflation situation even worse and I’m not sure that's a price that politicians would be very happy to pay or that markets would be very comfortable with so that could cause equity markets to de-rate because it could cause inflation to stay higher for longer now remember our offer about the weekly market roundup you can learn more about that from the link in the description and as always

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