Data as of January 31, 2021. Sources: IEA, EIA, WTIA estimates.
Russia is the third-largest producer of oil after the U.S. and Saudi Arabia, contributing 11% of world production in 2020. It is the second-largest producer of natural gas, after the U.S. Nearly half of its crude exports and three-quarters of natural gas exports go to Europe. President Biden addressed the issue directly during his February 24 comments indicating the U.S. is “closely monitoring energy supplies for any disruption” and coordinating with other countries “toward a common interest to secure global energy supplies.”
If Russian oil were removed from global markets, there would be little chance of making up for the loss elsewhere. We see Saudi Arabia as having a bit of spare capacity but not enough to fill a material reduction from Russia. In the U.S., the major oil players are not in a place to boost production with their current wells, and even with the U.S. being a quick-responding market we think it would take several months to appreciably increase supply.
The wild card is whether Putin would be willing to weaponize energy markets. As his army commenced invasion he warned of “consequences you have never seen in history” for any outside country that took steps to impede him. That has been widely and justifiably been interpreted as an allusion to nuclear weapons. Whether a bluff or not, it is impossible to know whether Putin is willing to withhold energy exports to drive up global prices and inflict inflationary pain on the West. Valentina Matviyenko, a Putin ally in the Russian Senate, said Friday that Russia was preparing counter-sanctions to hit at “weak” spots of Western economies, which could very easily mean energy.
But if Putin were to weaponize energy it could hurt Russia dearly in the short-and long-term. Those exports are important to the Russian economy and bring in foreign currency reserves. In the longer-term it would push nations to seek other sources of energy.
The last consideration is overall inflation which is highly subject to the resolution of the oil and natural gas issues discussed above. In addition, there are several other commodities to consider. Russia and Ukraine produce a combined 29% of global wheat exports. Russia is a major producer of aluminum, copper, and titanium, and also produces 43% of global palladium (used in catalytic converters). Ukraine is the overwhelming top producer of neon, critical to semiconductor manufacturing as well as krypton and xenon. Last, Ukraine is a major producer of corn. Major disruptions to such goods would only exacerbate the supply-chain issues that so many industries have been dealing with for the past year and are an upside risk to inflation.
That said, we do not expect the conflict to drive inflation materially higher in 2022. Global central banks, including the Federal Reserve, Bank of England, and European Central Bank have moved to more hawkish positions over the past two months, meaning they expect to hike interest rates faster and sooner than previously thought. The ECB just recently started looking like it may need to hike rates late in 2022. We expect central banks will be marginally less hawkish in light of the conflict. More important, we expect them to adjust policy accordingly if the conflict affects the outlook.
Geopolitical events are likely to keep volatility elevated in the short term, but our base case does not include a material deterioration in the global economy. In the U.S. we expect solid, above-trend GDP growth of 3% in 2022. We have similarly constructive economic outlooks for regions like Europe and Japan, and see valuations as relatively more attractive outside of the U.S.—offering potentially greater upside should tensions recede. Today’s focus is on the conflict between Russia and Ukraine, but we cannot take our eyes off the outlook for inflation and monetary policy. We are maintaining a modest overweight to equities across major asset classes, funded mainly through an underweight to investment-grade fixed income. Diversification remains paramount in these markets, and we stand ready to adjust portfolios as the situation warrants.