The invasion of Ukraine by Russian forces has driven a major rally across commodities in the last few weeks, in particular in crude oil and grains.

Since early February, when the prospects of an invasion became increasingly mainstream and evident to some, WTI crude has rallied 28% and wheat is up an impressive 38% with markets being limit up, trading halted due to reaching the daily price increase limit, the last two days.

While these rallies seem impressive coming on the heels of a commodity cycle that started nearly a year and half ago, in our view should the Ukrainian situation last, or unfortunately worsen (the most probable scenario in our view), then the rally we have seen might be just a small teaser of the massive spike higher which would be ahead of us. In our view, the markets are so far not considering the risk of a “super spike” scenario which will likely shock many investors and has tremendous implications on food and goods prices.

Source: Bloomberg

A 30-40% rally in one month might seem extreme, but commodities are notoriously different to financial assets (stocks and bonds) with supply and demand dynamics making most extreme moves possible. Recall crude oil trading at less than negative 30 dollars in April 2020?

To provide some historical context, WTI crude rallied as much as 120% in a 2-month period in 1990, while wheat rallied in the same order in a 2-month period during 1973. So, higher from here is not a challenge by any stretch of imagination if there is real disruption to either actual supply or the supply networks.

Why a “super spike” is possible

In our view, this risk is particularly relevant for wheat as well as some base metals.

Let us remember that Russia produces:

  • 40% of world palladium;
  • 17% of world wheat exports (and another 12% exports are produced by Ukraine bringing together to nearly 30% of world exports);
  • 7% of world aluminum;
  • 6% of world nickel supplies;
  • about 10% of daily crude oil production (which is so far not targeted directly by sanction);
  • and most importantly, Russia is the top exporter of fertilizer.

The sheer magnitude of these numbers is impressive and if a material part of this supply is cut off, this can have a significant effect on world markets, many of which cannot clearly be predicted by anyone right now given the very interconnected web of international commerce and industrials chains.

In fact, in addition to commodity supply disruption, there is also:

a) Industrial supply chain disruptions and knock-on effects that will only exhibit themselves in weeks and months ahead – even if the fighting stops.

Recall how it took months before the reality of supply chain disruptions became apparent to everyone, because the way in which these chains were interconnected made it simply unforeseeable?

A hoard of sanctions was announced in only a few days and it is all but certain that none of the decision makers had enough time to gauge all of their corollary effects. For instance, while Russian oil and gas are not sanctioned, there seems to be no buyers, most probably because of fears of violating other sanctions (financial, etc.). This means a de facto indirect sanction on oil and gas; an example of unintended consequences with important effects on the energy markets.

b) The case of wheat is special and quite concerning. Nearly 1/3 of world exports originate from Russia and Ukraine. The operational effects of an invasion/war on the ground can on the one hand prevent farmers from properly proceeding with the care of the crop and/or harvest season while many ports also can be effected.

If the military confrontation was to intensify and in particular to drag on, then there is massive risk to the crop and world supply. While some of it is reflected in market prices, an extreme scenario on the ground can be a driver of a “super spike”.

c) Commodities as a strategic weapon. So far, markets are trying to find the right price for commodities assuming that Russia would want ideally to continue exporting “as usual”, but it will be deprived of its capacity to do so.

However, it is very important to think of the scenario where Russia, already having taken a massive economic hit and hardship – and with little downside left – would decide to use its commodities as a weapon and actually voluntarily decide to starve the world markets knowing that it will hurt the West by steering economic hardship and fostering public discontent in order to undermine social cohesion and order.

For instance, by making one of the most affordable sources of calories (bread) much more expensive for all or by putting a break on industrial activity by depriving them of base metals.

Or simply, by cutting off the supply of fertilizer, thus affecting global agriculture.

Once again, we feel that this scenario is not properly considered by the markets and can lead to a situation where many awaken to scramble and rush to secure commodities and potentially cause a positive feedback loop or a “super spike”.

The weeks and months to come will be froth with uncertainty and it wise to be ready for such a scenario which is far from being a tail scenario, as one might think, given the present context.