Ukraine Update

Petro Poroshenko

It was hoped that the high-level delegates meeting held in the Belarus capital, Minsk on August 26 might have yielded the de-escalation of tensions in the Ukraine. It seemed like an opportune moment, bearing in mind that the attendees could not have been more senior with Ukraine president Petro Poroshenko and his Russian counterpart Vladimir Putin arriving in Minsk for the crisis talks. A number of senior EU officials along with leaders from Kazakhstan and Belarus also attended the crisis summit. Their motives were clear; to defuse the skirmishes between the pro-Russian separatists and Ukraine's government forces and guided the two opposing sides towards a diplomatic solution.

Vladimir Putin

But regretfully, the Minsk summit did little to de-escalate the tensions in the Baltic, in fact it may have had the reverse effect of ratcheting up tensions between Russia and its former colony the Ukraine even further. Letting off some steam Russian president Vladimir Putin fired his rounds accusing the Ukraine and its Western supporters, of stalling efforts to reach a new cease-fire and open talks. Ukraine president Petro Poroshenko’s response was nothing more than pouring fuel on the fire. Poroshenko is now considering a provocative move to push back a law which prevents the Ukraine from joining North Atlantic Treaty Organisation (NATO). That would be like poking the bear in the eye. Think about it, would the US welcome Russian Mig fighter jets on its doorstep, in say Mexico!

Flag of NATO

Assuming the Ukraine actually decides to join NATO, a possible worst case scenario, then the Ukrainian crisis would take on another more dangerous dimension. Article 5 of NATO states that an attack on one member is an attack on all. In other words, Russian forces in the Ukraine would then be the catalyst to draw in other NATO European countries into the war to the defence of the Ukraine. Reluctant European leaders would probably tell their weary electorate, sorry but our hands are tied we have an obligation to defend our new NATO member ally, the Ukraine. So localised fighting in the Ukraine could in theory spiral into a European war with Russia. Once things go down that slippery slope it could even descend into a global war, with Russia calling on its allies. Again, this would be the worst case scenario and let’s hope that the situation doesn't implode on those lines.

However, the Ukraine crisis is again more prominent on the trader's radar, particularly following the dashed hopes of the Minsk summit bringing a de-escalation of tension in the region.

How will EU and US policy makers respond to the failed Minsk summit? If the answer is more sanctions on
Russia, which then leads to similar tit for tat profit whacking Russian sanctions on EU businesses, then that would not be a desirable outcome either. The EU economy is battling enough headwinds at the moment, liquidity problems, slowing and contracting economies and mass unemployment in the South. More sanctions are probably the least thing that EU policy makers and businesses want on their plate now. Russia is the European bloc’s third largest trading partner and already the fallout from Russian sanctions is making EU businesses nervous.

NATO member countries (orthographic projection)

For example, when it was released to the press in early August that Moscow was mulling over a proposal to ban western carriers from using Siberian air space for routes to Asian cities. European airline stocks unsurprisingly fell sharply. Air France, British Airways and Lufthansa all use Siberian air space for routes to Asian cities. Flightradar24, an aircraft tracking service, estimates that Lufthansa operated 162 flights that passed through Siberian airspace over the past seven days, while Air France had 133 and British Airways had 93. So any move to ban western carriers from using these Siberian routes would push up their fuel bills.

Moscow's embargo on food imports from the EU, as well as from the United States is hitting hard agricultural producers in the south. European agricultural trade with Russia was worth 12 billion euros in trade in 2013, this year the sector is bracing itself for huge losses, due to the Russian sanctions.

Luigi Negro, advisor to farmers in the Apulia region of Italy, said: “The economic blow we’ve received strengthens the resolve of our own producers, but, at the same time, it’s a cause of great concern as well.”

A trade union representing Spanish Catalonian crop growers and cattle ranchers staged a protest, demanding that the EU compensate them for the revenues lost as a result of the escalation of sanctions, which have closed the Russian market to them. Spanish farmers burned the EU flag in anger over Russia sanctions war. The EU has allocated €125 million to help farmers in the immediate aftermath. Finance group ING has estimated that the annual losses as a result of the blocking of the Russian market will amount to €6.7 billion a year, and could result in the loss of 130,000 jobs.

Furthermore, German utility E.ON posted a 12 percent drop in first-half profits, hit by a weakening economy in Russia, and said it was concerned about the impact of the Ukraine crisis on its most important foreign market.

So the effects of tit for tat sanctions over the Ukrainian crisis are biting. Moreover, the Ukraine is a conduit for Russian gas to central Northern Europe, if Moscow were to turnoff the gas supplies to the Ukraine that would cause a spike in energy costs which would be crippling for an already feeble EU economy.

JPMorgan's Alex Kantarovich, in a recent letter to clients, underscores the severity of the problem, “In the worst case scenario, now appearing more likely, severe pressure on stocks may extend. We believe that with the significant deterioration in the Ukrainian situation, markets may treat this as a Lehman-style shock."

Therefore, the Ukrainian crisis is starting to feature prominently on trader's radar again. Should the situation continue to deteriorate the adverse knock-on effects to businesses would be amplified, thereby hitting bottom line corporate profits. Consequently, that might act as drag on the European economy and that could then delay further those long anticipated UK interest rate hikes.

Energy Series: Natural Gas

Natural gas has been known to man since 1,000 years before Christ. The Oracle of Delphi in ancient Greece was built around a flame that arose from a seepage of natural gas. It is thought that the gas was set alight by lightening but the ancient Greeks were puzzled and amazed by it and believed it came from divine intervention. The Chinese were able to transport gas arising from seepage with the use of bamboo pipe lines. They then, in 500 BC, used the flames created to boil sea water for drinking water.

Natural gas was found and identified in America in 1626 when the French discovered the local indigenous population lighting gas seepage around Lake Erie. In 1821 William Hart noticed bubbles of gas coming to the surface and dug a 27 foot well in Fredonia New York to obtain a larger flow. A self-styled Colonel Drake dug the first natural gas and oil well in the Lake Erie area when he dug down just 69 feet in 1859.

Manufactured gas was produced from coal and first commercialised in 1785 in Britain when it was used to light houses and streets. The Americans followed in 1816 in Baltimore and also used the gas to light the streets.

Gas continued to be used as a source of light throughout the 19th century until Robert Bunsen invented the Bunsen burner which opened up the opportunity to use gas for cooking and heating. Pipelines were then built and gas was used in many more applications with the development of gas cookers, water heaters, boilers and many uses in manufacturing and processing plant.

Natural gas is a commodity that trades in a similar way to oil and is the third largest physical commodity futures contract by volume in the world. Natural gas is a fossil fuel found in deep underground rock formations formed when layers of buried animals, gases and plants buried beneath the ground are exposed to intense heat over many thousands of years. It is a non-renewable source of energy and a bi-product of oil production, however it has its own uses for everyday life in heating and cooking and its price is very much driven by supply and demand. During cold winters the price will rise as demand to heat homes and businesses rise and although summer is usually the period when demand is low, excessively hot periods will also cause the price to rise as air conditioning units are turned up high. Natural gas prices are also affected by adverse weather conditions such as hurricanes as most of the production occurs in and around the Gulf of Mexico and the rigs will be closed down for safety reasons once storm warnings are in force.

Natural gas is a hydrocarbon and once extracted it contains other products such as propane, butane and helium that are extracted from the methane in order to make it commercially viable. It is considered to be an efficient and environmentally friendly fuel as it is the cleanest burning fossil fuel. One barrel of oil has approximately six times the energy content of natural gas.

Almost a quarter of the United States energy consumption is made up from natural gas and the US consumes approximately 25% of world production. It is transported around the country by pipelines. The US is a net importer of natural gas consuming all of its own production and importing the balance mainly from Canada. The first country to extract natural gas in 1825 was the United States.

It is estimated that there is 50 years’ supply of natural gas in the world and, in addition there are 900 trillion cubic metres of unconventional gas available for extraction of which only 180 trillion may be recoverable. The world’s consumption in 2015 will be 3.4 trillion cubic metres of gas per year meaning that world stocks should be sufficient to last 100 years.

Natural gas is the cleanest of fossil fuels, is easy to obtain and to transport, and it is therefore being used more and more by nations in order to keep down their carbon emissions and the cost of energy. It is difficult to store natural gas unless it has been converted to liquid natural gas and huge tankers are necessary in order to transport it around the world.

Natural gas has hit the headlines recently as fears have grown over the dispute between Russia and Ukraine which could threaten supplies to Europe. Russia stopped supplies to Kiev following a dispute over Ukraine’s unpaid gas debts of almost $5 billion which it is refusing to pay. Nearly a third of Europe’s gas demand is met through imports from Russia and it is estimated that half of this is fed through Ukraine. This is not the first time that supplies through the area have been halted following similar instances in 2006 and 2009. Approximately 15% of Europe’s demand is dependent upon Russian gas delivered via Ukraine. If Europe is unable to satisfy its needs from this source they could need to buy higher priced liquefied natural gas in order to meet demand. However Europe is currently sitting on its biggest gas inventories in 3 years with their storage facilities operating at around 65% full at present which is currently sufficient to meet demand.

Natural gas can be traded either directly, or through Exchange Traded Funds (ETFs) or through the shares of companies that process natural gas such as Centrica in the UK.

Natural gas is traded internationally and every week the US reports its gas inventory levels on a Thursday afternoon compared to the previous week. Natural gas is measured in cubic feet and is usually reported in billions of cubic feet (or Bcf).

Natural gas is traded on the New York Mercantile Exchange (NYMEX), US Futures Exchange, Intercontinental Exchange (ICE) and Multi Commodity Exchange (MCX) and the price is quoted in cents per million Btu (mmBTU). A futures contract for natural gas would be traded in 10,000 million British thermal units (Btu) with a tick size of 0.1 cents per mmBTU or $10 per contract. The price of natural gas can be extremely volatile and it is therefore wise to use a good risk management strategy if trying to trade it.

Ukraine vs Gazprom.

Ukraine’s deadline to cough up 1.9 billion USD, part of its 4.5 billion USD debt with Russia’s energy giant, Gazprom, lapsed at 0600 hours on 16 June . The fallout has been immediate with the central gas tap supplying the Baltic nation being promptly turned off. “Gas supplies to the Ukraine have been reduced to zero,” said the Ukrainian Energy Minister Yuri Prodan. Surely, a shivering prospect for Ukraine had it not been due to the fact that the northern hemisphere is entering summer. The Ukraine will now only receive supplies if it pays upfront for the gas, according to a spokeswoman from Gazprom.

Like two titan fighters in a boxing ring, in one corner Russian State energy Gazprom is making its case crystal clear, calling on Kiev to pay off at least one installment of 1.95 billion USD (representing slightly less than half of the total 4.5 billion USD debt or face a blow), and instigating a cut to supplies unless upfront payment is made. In the other corner, Ukraine’s national gas company, Naftogaz is claiming that Gazprom’s fighting below the belt, arguing that the latter has already been overpaid to the tune of billions of dollars. So currently we have Gazprom filing a lawsuit at the Stockholm arbitration court to try to recover the debt, meanwhile in the same court Ukraine's Naftogaz is also filing a counter claim to recover 6 billion USD in what it said were overpayments. Moreover, the Ukrainians are arguing in their corner that they want to pay $268.5 per 1,000 cubic meters of gas, which is the price it had been offered when Viktor Yanukovych the former Ukrainian Prime Minister briefly led the Ukraine from 2002 to 2004. On the ropes and as a sign of possible weakness, Ukraine offered to pay 326 USD last week for an interim period until a deal was reached.

But Gazprom snubbed at the latest offer from the Ukraine and insisted on sticking to the 2009 contract amount of $485 per 1,000 cubic meters. Furthermore, in an attempt to try and strike a deal Gazprom offered to waiver export duties, which would have pulled the price down by about 20 percent to $385 per 1,000 cubic meters, which is pretty much what Russia charges the other European countries. However, the Ukrainians decided not to tango, claiming that the waiver of Russian duties could be retracted at any time and thereby used as a stick to threaten the Ukraine to either come under Moscow’s orbit, or literally pay the consequences.

This game isn’t new to the Ukraine, indeed in the past few years Russia has twice shut off its gas to the Ukraine. Since the Ukraine’s independence from Russia 21 years ago its relationship with Gazprom has been rocky, to say the least. In short, some Ukrainians views Gazprom as an enabler of corruption using intermediary to buy the political classes, although many Ukrainians also believe that the blame lies on their side of the border.

During 2009 the Ukraine received Gazprom gas through a notorious intermediary company called RosUkrEnergo (RUE) registered in Switzerland. RUE, then a monopoly supplier of gas to the Ukraine was able to extract huge monopoly profits by selling the gas at a vastly inflated price to the Ukraine, some believe prices were inflated by as much as 50 percent. This arrangement provided a secret fund to buy Ukrainian politicians. It was dubbed a criminal scheme,” by the Ukraine’s former head of intelligence Oleksandr Turchinov, who then was later fired for investigating it.

In 2009 the then Ukraine Prime Minister, Tymoshenko managed to shake off RUE and buy Russian gas directly from Gazprom but he paid a huge price. Indeed, the Ukraine was paying a markup of 60 percent above a reasonable price for its gas, according to analysts and the inevitable consequence of that was that the Ukraine was falling into ever increasing debt. The Ukraine gas debt was ballooning by 12 billion USD annually. Some Ukrainian officials nervously pointed out that this was Putin’s plot to try and get the Ukraine into an impossible debt spiral, and then use the debt to coerce them to joining a Russian custom union, which would encompass Belarus and Kazakhstan.

For Europe the fear is that any reduction in supply to the Ukraine could indirectly affect Europe, which gets approximately a third of the gas it needs from Russia. Half of the gas entering Europe from Russia is transited through Ukrainian pipe lines.

Previous price disputes led to the “gas wars” in 2006-2009 with Russia accusing the Ukraine of steeling its gas that was destined for Europe. Nevertheless, Gazprom then did reassure European customers: "The gas for European consumers is being delivered at full volume and Naftogaz Ukraine is required to transit it," Gazprom spokesman Sergei Kupriyanov told reporters. In view of the fact that Europe is approaching summer, when gas demands are lower and there are some reserves, the Ukraine may clean this time and not upset its European neighbors by siphoning the gas from their pipe lines.

But perhaps Gazprom is Russia’s Trojan horse. If this is the case then the price of Russian gas is more determined by Moscow’s political agenda, rather than the laws of supply and demand. With Europe heavily hooked on Russian Gas prices are likely to remain high. It’s in Russia’s strategic interests to keep it that way as the higher the price of gas the more leverage Putin has to manipulate Europe’s foreign policy and moreover, continue empire building in the East. The game sounds familiar: get states into an impossible debt spiral, and then coerce them under your orbit. Alas, this is how sovereign states are invaded in the 21 century.

Ukraine’s impact on the stock market

The people of Ukraine have been going through a torrid time recently, with the escalating crisis continuing, but now the global world could be hit also with global markets being plunged into turmoil because of the crisis. There has been a spike in oil and natural gas prices that could reach into consumers’ wallet, just when the European economy was starting to pick up.

Despite these worrying revelations, and the fear that conflict could ensue in the East, analysts believe that there is little risk of global financial contagion or of major blow back to Western economies.

“If this turns into an outright war, it will be a different story,” said Holger Schmieding, the chief economist at the private bank Berenberg in London. He also went on to state: “More likely it will remain a Cold War-style standoff, and if that’s the case the economic damage for the West and the global economy will be limited.”

All this reassurance is not enough for some though, with many investors still feeling unsettled. This is on top of having been already shaken up about emerging-market economies. The main impact was obviously on Russian and Ukrainian markets, with the Moscow Micex index dropping 10.8 percent. The Ruble fell to a record low against the dollar, and there was concerns spreading to currencies in localised countries such as Poland, Turkey, and Hungary.

The concerning figures prompted the Russian central bank to announce a “temporary” 1.5 percentage point rise in its benchmark interest rate target, up to 7 percent. The central bank released a statement in conjunction with the change: “The decision is aimed at preventing the risks for inflation and financial stability arising from the recent increase in financial market volatility.”

Developed markets have also shown worrying signs since the outbreak of tensions also, with companies in exposure to Ukraine and Russia taking the hardest hit. The Euro Stoxx 50 index of European blue chips closed down 3 percent, and the Dow Jones industrial average lost 153.68 points, the equivalent to 0.9 percent. The NASDAQ composite index dropped 30.82 points, or 0.7 percent, to 4,277.30. These figures certainly prove that as long as tensions are still bubbling in the East, then companies in connection with that region are likely to suffer.

Investors have since moved into traditionally safer assets like US bonds and the Japanese currency. Elsewhere, European banking shares were altered by the situation, led by a 9.6 percent decline in Raiffeisen Bank International. This is huge in the world of banking as the Austrian lender is one of the Western leaders most exposed to Ukraine. Generally though, the fallout to the banking sector will be limited somewhat, due to the financial crisis in 2009, where many Western banks pulled back from Ukraine and Russian lenders.