War and Inflation
Updated: May 5
The Russian invasion of Ukraine on February 24th has delivered a massive shock to global markets, especially concerning such commodities as food and oil. The rising prices of such commodities - along with disruptions to global trade caused by the war as well as Western sanctions on Russia - have kicked inflation into high gear worldwide, a trend that was already apparent in 2021 as the world's economies rebounded from the COVID crisis. This notebook attempts to map these events in a series of charts and statistics, portraying a world economy in a state of tumult.
I: Energy Prices Rise
As I detailed out in a previous notebook, Russia is a major exporter of oil. In 2019, Russia was responsible for producing roughly 11 million barrels of oil per day (around 12 percent of world production at the time). Furthermore, its relatively low domestic consumption of 3 million bpd meant that it had 8 million bpd of spare production which it could channel toward exports. This capacity made Russia an attractive source of oil imports for the European Union; in 2019, nearly 27 percent of the EU's oil imports came from Russia.
Hence, it is not surprising that oil markets were shook by a comprehensive raft of sanctions unleashed by the West on Russia, which involved not only oil and gas, but trade and financial transactions in general (these will be augmented by the oil and gas sanctions being prepared by the EU at this moment). The impact of these sanctions has been severe not only for the Russian oil industry itself*, but for the wider world, given the important position held by Russia until now in global oil markets (that being said, this position has made it very difficult for the West to wean itself off Russian oil and gas, as we will see in Section III).
*According to a Reuters report, the Russian economy ministry projects a fall in oil production in 2022 of up to 17 percent.
The result was a comprehensive increase in oil prices. As shown by the BBC chart below, the prices of two benchmark grades of crude oil - Brent crude (from the UK) and West Texas Intermediate (from the US) - have risen to their highest levels since before the oil crash of 2014/15, driven by both the Ukraine war and the rebound in economic activity throughout 2021.
Prices actually increased even further until March 8th, when WTI hit a peak of $123.70 per barrel and Brent hit a peak of $127.98 per barrel. Now, they both hover closer to the $100 per barrel mark (see charts below).
WTI crude oil (USD/bbl.)
Brent crude oil (USD/bbl.)
This boost in oil prices has been a boon for oil supermajors worldwide. BP has just reported its highest quarterly profits since 2008, whilst ExxonMobil unveiled favourable performance compared to the first quarter of 2021*. This, despite the fact that several of these supermajors - BP and ExxonMobil included - are taking multi-billion-dollar hits due to their divestments from projects in Russia.
*Update: To this we might add Shell, which reported record quarterly profits of $9.13 billion on May 5th.
However, it's not just oil that's increasing. In the UK, gas prices have also undergone a significant increase (see chart below).
As the timing makes evident, this trend was already apparent before the Ukraine crisis. According to British Gas, it stems from:
The recovery of global economies from the COVID-19 pandemic,
An unusually cold winter (of 2021) and spring (of 2022), increasing gas demand,
High demand in Asian markets,
Low winds (therefore less renewable energy), and certain other reasons as well.
The resulting crunch for UK gas suppliers spurred Ofgem - the national gas and electricity regulator - to announce on February 3rd (weeks before the invasion) that in April, the energy price cap would be increased by 54 percent from £1,277 to £1,971 per year in direct debit payments.
The shocks to oil and gas have been felt keenly by many worldwide - especially in such energy-import-dependent economies as those of continental Europe. However, perhaps even more serious was the impact delivered by the war and sanctions on global food markets, a reality that spares no one.
II: Food Prices Rise
In March 2022, the food price index - calculated by the UN Food and Agriculture Organization - rose to its highest-ever level, with the specific indices for cereals, vegetable oils and meats also reaching record heights.
Source: UN FAO
The UN Conference on Trade and Development has additionally produced this nice chart - relying on commodity price indices calculated by Bloomberg - that relates agricultural price movements to world political events since 2008.
The Ukraine war has affected food prices so badly because Ukraine and Russia are both significant players in the global agricultural export market (a reality well documented in a recent FAO report on the topic).
Ukraine and Russia are both among the most important producers of agricultural commodities in the world. Between 2016/17 and 2020/21, the two countries jointly accounted for an average of 19 percent of world barley production, 14 percent of wheat production and more than 50 percent of production of sunflower seed, which is used to produce sunflower oil.
Spare production has enabled both Russia and Ukraine to become significant agricultural exporters. This is especially so in the case of products such as wheat, in which Russia accounted for nearly 20 percent of exports, and sunflower oil, in which Russia and Ukraine jointly accounted for nearly 63 percent of exports, in 2021.
The chart below displays the extent to which different countries were dependent on Ukraine and Russia for imports of wheat in 2021. What stands out, I think, is the sheer degree to which many countries in the developing world - particularly in Africa - could be impacted by the present crisis.
Russia's importance in foodstuffs is further augmented by its status as a major exporter of fertiliser. Below are charts displaying Russia's share of the export markets of N (nitrogen), P (phosphate) and K (potassium) fertilisers.
This next chart displays the extent to which different countries are dependent on Russia alone for imports of fertiliser. Again, they accentuate the risk to global food security posed by the Ukraine war and sanctions on Russia.
Rising food insecurity has ignited fears in some quarters of the risk of societal unrest. Since the Arab Spring of 2011, several observers have asserted the role of food insecurity in sparking growing resentment that finally tipped into revolt (see articles on this by Rami Zurayk in the Guardian, Jonathan Keating in Slate and me in Pi Media). Since the Russian invasion of Ukraine, we have already seen violent protests over rising fuel and fertiliser prices in Peru, and similar unrest gripping the island nation of Sri Lanka. We even saw the potent synthesis of inflation and politics in the recent ouster of Pakistani prime minister Imran Khan.
III: Trade Shifts
Indeed, with commodity prices rising across the board, it is perhaps unsurprising that the world has been gripped by the spectre of rising inflation. This is a trend additionally supported by the disruption to global maritime trade caused by the war, sanctions on Russia, and the Russian blockade of Ukraine's Black Sea ports. These factors have initiated major alterations in the world's trade routes. For example, EU sanctions on Russian coal have allegedly spurred Europeans to make up for the shortfall by importing from Australia - a boon to shipping operators given the enormous price increases involved in such a shift. According to al Jazeera, shipping rates for these very-long-range routes increased by as much as 26 percent between February 24th and March 23rd as demand rose.
This phenomenon signals a wider re-alignment of global trade as the West attempts to detach its economies from that of Russia. This is particularly so in the realm of oil and gas, which has caused Europe the biggest headache as it struggles to find alternatives to funding Russia's war effort in Ukraine.
The irony about the efforts of the West to squeeze Russian fossil fuel exports thus far is that in trying to do so, they have precipitated a boost in energy prices, while at the same time maintaining their imports of Russian fossil fuels to a significant degree. The result is that Russia's fossil fuel revenues have actually doubled since its invasion of Ukraine.
As can be seen in two charts below, the EU is far and away Russia's largest customer of fossil fuels. Since the invasion, it has taken steps to mitigate this, including the aforementioned sanctions on coal (though not yet oil and gas). However, its imported energy volumes remain significant.
Purchases of Russian pipeline gas and liquified natural gas (LNG) from the European Union actually increased 10 percent and 20 percent respectively in the two months after the invasion began.
Europe's continued reliance on Russian oil and has made it more difficult for the West to exert diplomatic and moral pressure on third parties to break off energy relations with Russia. For example, when the United States criticised India for its increasing uptake of Russian fossil fuels, New Delhi's top diplomat replied, "If you're looking at energy purchases from Russia, I would suggest that your attention should be focused on Europe".
The moral difficulties with Europe's imports are made more stark given the reliance of the Russian federal budget - and thus its military budget - on oil and gas (according to the International Energy Agency, oil and gas revenues accounted for 45 percent of Russia's federal budget in 2021). This makes for the rather unsurprising correlation between oil revenues and military expenditure.
Source: Transport & Environment
This compromised position has spurred Europe to look for oil and gas suppliers further afield. In late March, the EU struck a deal with the Biden Administration under which the United States would work to send an extra 15 billion cubic metres (bcm) of LNG to the EU this year, with this supplementary figure increasing to an annual 50 bcm by 2030 (still merely a third of the 155 bcm that the EU imported from Russia in 2021). Separately, Germany sealed an energy partnership agreement with Qatar, the world's third-largest natural gas exporter (previously, Germany had refused offers from Qatar due to its enjoyment of cheaper Russian gas). Additionally, Eni, the Italian oil supermajor, inked a deal with the Republic of Congo to finance an LNG project that would eventually allow for an annual supply of 4.5 bcm to Italy when operational.
Thus, what we are seeing may be a comprehensive re-alignment of world trade, with old connections severed and new ones formed. The system may eventually settle to a new equilibrium; for instance, Eva Tzima, a researcher in the shipping industry, claims that “As high consuming nations like China and India are increasingly turning to Russia’s oil that is now more competitively priced, more Middle East supply is becoming available for EU nations, limiting significant disruptions to oil trade". However, until then, we may be experiencing some of the transition pains, of which one might be our current era of high inflation.
Year-on-year inflation in the UK (as measured by the consumer price index) sat at 7.0 percent in March 2022, up from around 6.2 percent in February (inflation from February to March 2022 was 1.1 percent). This is far higher than the Bank of England's target inflation rate of 2.0 percent, causing former BoE official Adam Posen to remark that the central bank had "no choice but to cause a recession when a broad range of prices are rising at such a strong pace"; it was "duty bound to bring inflation down".
Source: Office for National Statistics
In response to the general rise in inflation across economies worldwide, central banks have began implementing interest rate increases. Yesterday, the Financial Times reported that the BoE was "poised" to increase rates to 1.0 percent on Thursday, their highest level since 2009, after a series of increases already taken*.
**Update: as of May 5th, they have now done this!
Source: Financial Times
The US Federal Reserve* is also expected to imminently increase its federal funds target rate 0.75 - 1.0 percent range**, 50 basis points above its current level of 0.25 - 0.75 percent. It raised rates to its current level on March 16th, in what was the Fed's first rate increase since 2018. The target rate is widely expected to exceed 2 percent by the end of this year.
*The Fed's target inflation rate is also 2.0 percent.
**Update: as of May 4th, they have now done this!
Just today, the Reserve Bank of Australia joined the fray by announcing a rate hike of 25 basis points to 0.35 percent, its first rate increase since November 2010.
Some notable holdouts thus far are the European Central Bank and the Bank of Japan. In late April, ECB director Christine Lagarde insisted that the bank would most likely refrain from raising its deposit rate (currently at -0.5 percent) throughout 2022, despite some expectations that a hike could come in July. Meanwhile, around the same time, BoJ governor Haruhiko Kuroda resolved to maintain short-term interest rates at -0.1 percent, which sent the yen plunging against the dollar to lows not seen since April 2002. Then again, Japan has been a curious holdout in the inflation trend in general.
Source: The Economist
The BoJ is also an exception among rich nations when it comes to asset purchases - it is the only central bank in the global north that does not seem be reversing the worldwide torrent of government bond purchases in which central banks engaged in response to the COVID crisis. These central banks have already begun to slow down the purchases, and there is the expectation that in the near future, they will begin winding down their balance sheets by simply allowing their holdings of bonds to mature. Bloomberg Economics predicts that for the remainder of 2022, G7 central banks could shrink their balance sheets by $410 billion, a sharp turnaround given that they have added a cumulative $8 trillion since the COVID crisis began.
The Bank of England initiated this process of "passive unwinding" - i.e., not actively selling bonds but not purchasing them - in February. However, back in August 2021, it decided that it might consider an active-selling policy should rates increase to 1.0 percent, an outcome that is now highly likely.
Source: Financial Times
We are going through times of enormous transition, and it surely impossible to predict where we are going next. What seems possible at this stage is a large-scale re-alignment of the global economy as trade relations are transformed; however, this is dependent on a multitude of factors for which we will not know the outcome until it has happened. Will the war in Ukraine end soon? If so, will the Europeans conduct business as usual with Russian energy as they did before the invasion? How will markets react to the abrupt end of an era of easy money? Will this be enough to tamp down on inflation? Who knows...