We are now into the third week of the Russo-Ukrainian War and prospects for a quick resolution appear increasingly dim, although we like most of the world, hope for peaceful resolutions as soon as possible. Talks between the Russian and Ukrainian foreign minister broke down yesterday morning, and while there may still be hopes from the Belarussian negotiation track, rhetoric and actions by Russia appear to suggest they aim to escalate the violence and targeting of civilians to break the Ukrainian will to resist.

Markets continue to try to stabilize and rallied on some positive comments from Putin on negotiations this morning. Treasury Secretary Yellen recently told the press that the US may have to endure high prices for a year. CPI numbers yesterday were the highest since 1982 and the effects of the war have not yet made its way into the numbers. Remember though, you must adjust for inflation when deciphering what effect headline prices will have on consumer wallet. Take our recent analysis on oil prices below as a key consideration. The reason commodities sap growth is because they occupy greater portions of consumer wallet, and at least so far, the “wallet-burden” has not eclipsed prior problematic levels.

The effects of the war itself will interrupt production, but the devastating Western sanctions are the primary cause of the spikes so far. The economic sanctions on Russia have been crippling and unprecedented, but as our Head of Research Tom Lee, recently pointed out, the strategy of shooting yourself in the foot to shoot an enemy in the leg, economically speaking, may be unsustainable and may also have unintended consequences.

We pointed out on the day after the invasion in this column that the Russian military had not attempted such a large, combined arms operations since the Battle of Berlin in 1945 and that this action was a much bigger gamble than consensus analysis had let on. We pointed out how “old school” logistics problems and the Ukrainian thaw, a bane to many invaders in the past, could hamper Russian progress. This indeed seems to be the case and the Russians have still not seized major urban centers, other than Kherson, or established the air superiority necessary for military dominance in the country.

Another fundamental miscalculation by the Russians has been their dramatic underestimate of the level of Ukrainian resistance they would face. They were not greeted as liberators and while Ukrainian and Russian estimates may be unreliable, US Intelligence has estimated that Russia has already lost between 2,000 and 4,000 KIA. Our data science team has been monitoring the official statistics from both the Ukrainian and Russian official reports and the US estimate seems to imply that Ukrainian estimates, while probably embellished upwards, are more reliable than the Russian estimates which are likely embellished downwards.

In other words, the amount of Russian military deaths likely exceeds US military deaths from our entire 20-year involvement in Afghanistan. So far, Ukrainian elan seems to be more than a match for Russian firepower despite the unspeakable tragedy befalling civilians in Ukraine because of wanton violence by Russian forces. In some ways, this is one of the more concerning outcomes for the conflicts potential effect on the economy. US and Latin American stocks have proven a relative haven since the Russian invasion.

The Yom-Kippur War and Arab Oil Embargo Are Becoming A Relevant Historical Analog

The Yom-Kippur War was a conflict between Israel and Arab states that began with a surprise attack from its adversaries on two fronts. While the intensity of the conflict will likely be superseded by what is going on in Ukraine right now, given the momentum of military events, the primary effect for markets from the war was the oil embargo by OPEC on the Western countries that supported the Israelis. This unprecedented embargo caused economic havoc, increased the difficulty for a Federal Reserve trying to get a handle on inflation, and even resulted in widespread energy rationing in the United States. The future is always uncertain and in an unprecedented geopolitical situation like we now face, that is even more true.

As you can see, the severity of geopolitical events may not comport with what may seem most severe. Surely the nuclear annihilation the world averted in the Cuban Missile Crisis was one of the most significant risks that humanity ever faced, but the market had very little reaction to it and it was resolved pretty quickly. The Yom-Kippur War’s direct effect on global commodity supply chains made the period after it one of the worst for markets following a major geopolitical event in modern times. The economic tit for tat perhaps has only just begun and the affected commodities are widespread and of crucial importance to the global economy.

If the conflict in Ukraine and associated economic sanctions continue escalating in severity and remain in place for an extended period, the commodity shock could easily exceed that of 1973-1974 in severity and duration. The world economy is significantly more connected now than it was back then, which may also exacerbate the impact. The shortages of key commodities affected by the conflict could also stir more geopolitical unrest across the world as well. Ukraine and Russia account for 12% of the world’s calorie production. They are leading exporters of wheat, but also other cereals and Ukraine is the primary exporter of sunflower oil. Rising bread prices has been consistently tied to political instability in North Africa and other parts of the continent. Rising grain prices were a key catalyst for the Arab Spring.

As former Federal Reserve Chairman Arthur Burns said when opining on the runaway US inflation in the 1970s, the Yom-Kippur War and subsequent embargo came at the worst time for the US economy. Several other factors converged to make inflation strong enough to cause havoc for the US economy. There was loose government financing in regard to the Vietnam War, Richard Nixon devalued the US dollar by abandoning the gold standard, and matters were made worse by widespread crop failures. Thus, the effect on the US energy complex was particularly severe. US spending on oil approximately quadrupled as a result and rationing was required.

In our current situation, our base case was that many of the inflationary pressures were close to peaking, at least those resulting from bungled supply chains. However, the shock from this conflict will likely push the peak of inflation out into the future if it remains sustained. Obviously, this also greatly complicates the already difficult task of the Fed tightening cycle which begins next week. As Ben Bernanke astutely pointed out in a 2004 paper, central banks cannot simultaneously offset recessionary and inflationary effects at the same time. If rates are lowered, it risks adding to inflationary pressure and if they are raised enough to mitigate inflation it may make an economic slowdown from rising commodity prices significantly worse.

The Commodities Most Affected by The Russo-Ukrainian War: Energy

There has been a lot of talk about the potential for Russia cutting off the natural gas supply to Europe. Russia is the number one exporter of natural gas and the lion’s share goes to Europe for geographic reasons. US natural gas is relatively insulated and the price spikes in US futures versus European ones have been dramatically lower. While it won’t happen overnight, US exports to Europe are of course expected to rise as well, which should offset some of the seasonal factors that normally cause demand to drop. Seasonal factors in Europe will also mitigate demand. Thus, it is likely that despite the centrality of Russian supply for European demand, that in the event of a long conflict, the bullish price pressure would be more pronounced for oil than for natural gas. Shocks on the supply-side tend to be more severe.

Russia is the world’s second largest oil exporter behind Saudi Arabia. The US recently announced a Russian import ban, but that was easy enough because Russian imports are miniscule for US needs. Europe’s economies require a slower approach due to their dependence on Russian sources of energy. Most of what was imported by the US goes to US refineries for distillates as “unfinished oil.” The other thing that will mitigate the impact of the sanctions somewhat is that China will likely absorb a lot of Russian crude exports shunned by the West.

However, that will take a lot of time and the infrastructure isn’t there. It may take years before Russia could meaningfully redirect its oil exports. It takes about nine times as long for Russia to ship oil to Asia than Europe. Russia produces 7-8 million bpd in normal times, and with current pipeline and rail infrastructure it could only shift less than a tenth of that to China and Asian markets, and this is if those efforts aren’t further complicated by continually escalating sanctions. So, a lot of Russian supply may exit the market.  

Crude inventories were already very tight before this geopolitical conflagration. Many commodities analysts expect that the conflict could drive crude prices to 2008 highs or even above that if it is sustained. While natural gas is Russia’s main economic cudgel against Europe, the aggressive Western sanctions on Russian energy that have materialized are an effective economic cudgel against Russia, which makes four times as much from oil sales as it does from gas sales. There have been six instances where real oil prices have risen at a breakneck a pace as recently since 1970. All these events preceded recession. However, the energy intensity of the world has steadily declined since then. OPEC and the rest of the world’s spare capacity is unable to respond quickly to the loss of Russian supply and some Energy executives openly discussed the possibility of $200 crude at a recent industry conference in Houston.

Oil prices can stymie growth given their importance in so many areas of the economy and their ability to sap consumer spending power. As is often said on Wall Street, the cure for higher commodity prices is higher commodity prices. Therefore, if oil prices remain high in the event of continued escalation it is possible, they result in sustained demand destruction. Prices could collapse as a result like in 2008, 2014 and 2018. So, the interruption of oil supply and the world’s ability to meet spare capacity very well could cause greater and wider economic devastation than the energy crisis of the 1970s. When you factor in the centrality of Ukrainian and Russian exports to global food supply, it’s easy to see why this event could result in the largest commodity shock in modern history.

Wheat, Other Food Staples, and Fertilizer Inputs

Together, Russia and Ukraine account for nearly a third of global grain exports. Ukraine produces many other key staples like sunflower oil. Both countries have now banned exports of most foodstuffs. Ukraine is banning them as Russian forces resort to siege tactics of major urban centers who have dwindling food supplies. The Russians responded to biting Western sanctions by implementing export bans on many food and agricultural products. It is not just food outputs where Ukraine and Russia are crucial. Belarus, Russia and Ukraine are also key producers of chemicals necessary to produce fertilizers, so the inflationary impact of the conflict will affect food prices from both ends.

While this economic warfare certainly has a direct effect on many prices, the rush toward nationalization of supply lines and autarky may have more prolonged effects if the conflict results in a sustained retreat from global economic cooperation. Many scholars have theorized that the reason inflation has been so persistently low in the past decades was because of the effects of a globalizing economy. A sustained shift toward autarky may make inflation a more prevalent and persistent force than it was in the 21^st century so far. If the war is sustained export bans and destroyed or interrupted production in areas where fighting occurs, along with isolation of Russian supply, it should decidedly benefit American producers and suppliers. As prices soar, the incentive for aggressive planting definitely exists in the United States agricultural heartland.

Global food supplies will likely be affected in three major ways. First the production in Ukraine and Russia will be severely curtailed by the war and sanctions and escalation will make this a worsening factor. Secondly the impact on fertilizer prices may reduce crop yields across the world, particularly in emerging economies. Belarus and Russia produce 40% of the world’s Potash, a necessary ingredient in many fertilizers. The third factor is the current grain shipments are being directly affected by the war. Ships can’t get insurance to travel near the warzone. It is also notable that a lot of maritime workers come from Ukraine and Russia, and prolonged wars always need an ample supply of young men and women to fight them.

The effect on food markets is likely to be severe and as we mentioned earlier, may beget more political instability across many areas of the world. US agri-business will likely benefit and will be a leader in replacing lost supply from sanctions and the conflict. Global wheat stores were already about 31% below their 5-year average.

Industrial Metals

The third major basket of commodities effected is in industrial metals. The breadth of this commodity shock across multiple vital commodities may interplay with each other in unanticipated ways. For example, while the world is reeling from an energy commodity shock it will also have to deal with shortages of key industrial metals necessary for green-energy technologies. The London Metal Exchange (LME) has already suspended Nickel trading for only the second time its century and a half existence. Nickel is vital in the production of batteries in BEVs. Margins are thin on EVs and commodities spikes can greatly complicate auto production plans. Tesla (TSLA-1.92% ) has already raised prices.

Iron ore, steel and aluminum have also been rising. Russia and Ukraine are responsible for a significant portion of the total production of iron ore pellets, a key industrial input. Certain American producers will likely benefit. As one trader pointed out the prints on the screens right now may be shocking, but in about a months-time these price spikes will begin affecting consumers across the world. Russia is the world’s largest Nickel and Palladium producer. It is the second leading producer of Platinum and Aluminum and is a top-five producer of Iron Ore and Steel.

The interruption in the supply of metals, will put added pressure on margins and supply chains in the production of many items. These metals appear in all sorts of end-use products from buildings to high-technology products. In any event, if the conflict continues and sanctions continue escalating, it is possible that the most severe commodity shock in history could occur. This doesn’t necessarily mean a recession will occur, particularly in the United States which is far better insulated from the immediate consequences than many. Nonetheless, we believe in the event of an extended commodity shock, the five stocks below will be poised to benefit. We want to stress a key consideration as well: in the event of a short-term resolution of the conflict, commodity prices will likely come down hard.

5 Stocks For An Extended Commodity Shock

While there is a lot of uncertainty associated with the ongoing conflict, we still believe stocks are compelling from a valuation perspective. In a more alpha driven than beta-driven market, we think there’s opportunity in identifying stocks that may benefit from continued upward pressure on commodity prices. US equities have also proved a relative safe haven so far.

Cleveland Cliffs (CLF-0.10% )

Cleveland Cliffs is a fully vertically integrated US steel producer. The stock has great capital discipline and a pristine balance sheet making it very directly exposed to the rising price of both steel and of iron ore pellets, of which Ukraine and Russia account for about a quarter of global supply. We like the management team of Cleveland Cliffs as well and think it will be a beneficiary in the event of an extended commodity shock. In the event of an extended shock, we see both the top and bottom-line benefitting. Of course, new markets may also open to the company as well.

CF Industries Holdings (CF-0.15% )

This stock was recently added to our Granny Shots portfolio. It is a leading producer of necessary fertilizer inputs that will likely suffer from the supply shocks associated with sanctions and the ongoing war in Ukraine. One of the primary inputs it uses to produce the fertilizer inputs is natural gas. So not only will it benefit from the supply of Russian and Belarussian competitors coming offline but it will benefit from lower input costs than other competitors in Eurasia. The company’s strong operating leverage means it is likely uniquely positioned to benefit from an ongoing shock. It will likely enjoy enhanced pricing power as a large portion of supply in key commodities goes offline.

Union Pacific Corporation (UNP)

Union Pacific is a stalwart American company that is indelibly tied to the movement of commodities of all types across the North American continent. We believe that in the event of an extended commodity shock, the supply chains will have to adapt and Union Pacific will be a key beneficiary of this activity. The railroad industry is an effective oligopoly and Union Pacific has a very strong competitive moat. Furthermore, the company has a strong dividend and a track record of rewarding shareholders through good times and bad. This stock is a good one to have in your portfolio in the event of persistent inflation.

Newmont Corporation (NEM1.22% )

Newmont Corporation is known for gold mining. Russia is the sixth largest gold miner in the world so it will likely benefit from the interruption of supply. The other thing is, as many autocratic nations who are very active in the sovereign wealth world may consider what types of reserves and investments they hold, gold may be a more attractive investment given the effect of Western sanctions on Russia’s ability to access their central bank reserves. The geographic footprint of the company’s mines and assets are favorable given the location of the Russo-Ukranian war. While the company primarily derives it revenues from gold it mines other metals like copper as well.

EOG Natural Resources(EOG1.07% )

EOG Resources is a great American energy play that has diversified exposure to both oil and natural gas. The company has been a leader in extracting energy from shale basins and has a considerably lower cost of production for both oil and natural gas than many competitors. While the shale industry has traditionally been rightfully greeted with a wary eye by investors who have seen a lot of capital destroyed by these firms, we believe the capital discipline and pro-shareholder stance of a leading Energy management team at EOG will continue to reward shareholders as it has over the last months. In addition to being a leading energy manufacturer one particular sweetener for this company is that it also has an industry leading ESG and sustainability profile.