Daily Comment (December 5, 2022)

by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EST] | PDF

Our Comment today opens with a long discussion of several key developments today in the global energy markets, including the implementation of several sanctions against Russia’s oil and natural gas due to its invasion of Ukraine.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today.

Global Energy Market:  This week could be momentous for global energy markets, with the European Union and U.K. set to implement a ban on Russian oil imports, the broader group of industrialized countries set to impose a price cap on Russian oil exports, and Chinese President Xi set to visit Saudi Arabia.  These developments illustrate how the increased friction between the evolving U.S. and China-led geopolitical blocs has sparked a new era of intense economic warfare around the world, creating both headwinds and opportunities for investors.

  • As previewed in our Comment on Friday, the Group of Seven (G7) countries and their allies, representing much of the world’s richest and most advanced democracies, approved a plan to cap the price of Russian oil exports beginning today. To cut the revenues available to Russia for its war against Ukraine, the cap will ban Western companies from insuring, financing, or shipping Russian oil unless it is sold for less than $60 per barrel.
    • Russian officials have said they will not send any oil to countries that implement the price cap.
    • There are differences of opinion regarding the impact of the price cap on global oil prices. Oil prices are up so far this morning, but that could primarily be because of looser COVID-19 restrictions in China (see below).
  • Separately, today the EU and the U.K. will implement its ban on importing Russian oil, which was approved earlier this year. They will also implement a ban on Russian refined products beginning in early February.
  • Yesterday, the Organization of the Petroleum Exporting Countries and its Russia-led partners said that they will stand by their October decision to cut oil production by two million barrels per day, rather than the proposals last month ranging from an output cut to an output increase. The decision will give the OPEC+ group more time to assess the impact of the EU ban on Russian imports and the broader price cap on Russian oil exports.
  • Of course, oil isn’t the only front in the energy war. Data from commodity analytics firm ICIS shows that the EU’s demand for natural gas in October and November was 24% lower than its five-year average.  The figures suggest that the EU has made significant progress in finding energy efficiencies and implementing conservation measures, although they were also helped by the relatively warm weather in early autumn.
  • Spooked by the energy supply disruptions from the war in Ukraine, the Japanese government has launched a plan to develop a strategic reserve of liquified natural gas. The program would require importing an additional 840,000 tons of LNG per year, consistent with our view that the geopolitical fracturing of the world will not only threaten energy supplies, but will also encourage hoarding behavior, all of which will tend to buoy commodity prices.

Russia-Ukraine War:  As heavy fighting continues primarily in the Donbas region of northeastern Ukraine, and Russian forces continue to launch air, missile, and kamikaze drone attacks against Ukrainian infrastructure, explosions were reported at two air bases deep inside Russia.  The explosions reportedly damaged or destroyed several Russian military aircraft.  They are also consistent with a number of other explosions in Russian territory throughout the war that were likely carried out by Ukraine, although the Ukrainian authorities have not formally acknowledged any role in the attacks.

China:  Following the previous week’s big protests against the government’s Zero-COVID policies and repressions of freedom, we are seeing increasing reports that local government officials are gradually ratcheting back some pandemic restrictions.  The rollbacks include lifting some curbs on residents’ movements, such as by ending mandatory COVID testing for people who want to use public transport, enter parks, or visit other public spaces.  The authorities are also stepping up their efforts to vaccinate vulnerable citizens, especially the elderly, probably in an attempt to shield the population and healthcare system in case looser pandemic rules lead to higher infection rates.

  • The modest loosening of COVID restrictions may have helped eliminate the recent protests, but a heavy police presence and surveillance around potential protest sites probably played the bigger role.
  • The apparent easing in COVID rules have given a big boost to Chinese stocks and the CNY so far this morning. However, we continue to think the government’s COVID policies will weigh on the economy.  Much of China’s economy is still on lockdown, and even if the pandemic rules are loosened, the lack of herd immunity and weaknesses in the healthcare system mean big new outbreaks of infection will likely hold back activity.  That will also continue to create headwinds for the broader global economy and financial markets.

Iran:  After weeks of anti-government protests touched off by anger at the country’s Islamic “morality police,” the Iranian government said it is dismantling the organization and may roll back some rules such as the requirement that women wear the hijab in public.  However, protests continued over the weekend, signaling that the small grant of freedom may not be enough to relieve the political pressure on the government.  Instability in Iran, a major oil producer, may therefore continue in the near term.

Eurozone:  October retail sales fell by a seasonally adjusted 1.8%, even worse than expected and the biggest drop since last December.  Sales in October were also down 2.7% from the same month one year earlier.  The data supports the view that the Eurozone economy is now falling into recession.

United States-European Union:  In the latest sign that new U.S. subsidies and “buy-American” rules will prompt Europe to respond in kind, European Commission President von der Leyen said that the EU must “simplify and adapt” its rules on state aid to allow similar protectionist policies.  U.S. and EU officials are due to meet today to discuss the issue.

  • The Biden administration has not strongly pushed back against insinuations that the EU could respond with its own protectionist policies. Indeed, U.S. Trade Representative Tai recently proposed that the EU adopt similar policies, probably aimed at a reduction in EU trade with China.
  • In his meeting with French President Macron last week, Biden also suggested that the U.S. could adjust its rules to address European concerns.
  • The Europeans remain quite irritated and concerned about the new U.S. industrial support, which is focused largely on green technology, but President Biden’s conciliatory stance suggests that a trade war is not necessarily set in stone.

United States:  Two electrical substations in rural North Carolina were attacked by gunfire on Saturday evening, leading to power outages that could last for days for over 33,000 customers.  Although the outage is relatively small, the apparently deliberate attack has raised concern about follow-on attacks and the overall vulnerability of the nation’s electrical supply.

View PDF