This article was first published by Lykeion and is reprinted here with permission.
IN THIS PUBLICATION
- Moscow has an imperative to pursue strategic depth in Europe given its geography.
- Russia does not want to fight a war, but in order to force political and security concessions, it must convince the West that it’s prepared to fight.
- The implications of a full-scale Russian invasion would impact oil, natural gas, fertilizer, nickel, and wheat prices.
What’s Going On?
Russia has deployed over 100,000 soldiers to its border with Ukraine. According to the US Department of Defense, Russia is ready to invade Ukraine with the goal of conquering the entire country. According to Reuters, Russia has even shipped blood and medical supplies to the frontlines.
To counter the threat, the US has placed 8,500 troops on “heightened alert” (That’s less than 10% of Russia’s deployed strength… Putin must be terrified). The US is also promising its European allies it can provide enough oil and natural gas to meet demand if Russia cuts the EU off.
Meanwhile, Russian Foreign Minister Sergey Lavrov has consistently repeated what several Russian officials have insisted for months: that Russia does not want war, but is prepared to respond to provocations from the US and Ukraine.
As for Kyiv – it has been telling everyone to chill out. In the words of Defense Minister Oleksii Reznikov: “Don’t worry, sleep well” as Russian and Ukrainian officials hold talks in Paris and promise to maintain a ceasefire in Eastern Ukraine “unconditionally.”
Don’t feel bad if you’re confused. On the surface, very little of this makes sense. Geopolitics, however, can light our way – and can also help zero in on exactly how and why this should matter to global investors as well.
The Need for Strategic Depth
Why does Russia care so much about Ukraine? To answer that question, let’s consider two maps.
The above is a simple population density map of Russia. The data is from 2000 but don’t worry – Russia’s population density hasn’t changed that much since then. On paper, Russia looks like a huge country. Indeed, it is the largest country in the world in terms of total area, a whopping 17 million square kilometres. Russia is almost twice as big as the next largest country – Canada.
In this case, however, size doesn’t matter. Or at least, not the way you might think it does. Most of Russia’s citizens live around two key population centers: Moscow in the north, and the fertile strip of land between the Black Sea and extending to Kazakhstan, often called “Black Earth” in Russia. Most of eastern Russia is essentially unpopulated - this unforgiving, freezing tundra is unfit for much more than drinking lots of vodka - but that’s also where most of Russia’s oil and natural gas is located.
The key takeaway from the above map is simple: Russia, however much it purports to be a “Eurasian” country, and despite holding extensive territory in Asia, is fundamentally and will always be a European country. Think of Moscow as the eastern extremity of Europe. Russia has far more in common with Europe than it does with its Asian neighbors, like Japan, China, and Mongolia. Europe’s geopolitics matter to Russia because the vast majority of Russia’s population lives in Europe.
The second map is a simple topographic map of Europe.
Please note where the map is green. Those are areas of low elevation, largely bereft of geographic barriers. Note that a large strip of green on that map extends all the way from the beaches of Normandy, through several of Europe’s great historic capitals – Paris, Brussels, Amsterdam, Berlin, Warsaw, and Minsk – all the way to Moscow. Except for some minor hills around Moscow, a tank can drive the length of this stretch practically to the Ural Mountains, deep in Russian territory.
- This is the invasion superhighway of Europe. (Its real name is the “Northern European Plain.”) For as long as any of you reading this has been alive, the geopolitics of Europe has functioned such that powers to the west of Moscow have feared Russia projecting power outwards – and rolling its troops and tanks through it.
- For most of Russia’s history, however, Moscow had just as much to fear from the West as the West had to fear from Russia. During the 1609-1618 Polish-Muscovite War, soldiers from the Polish-Lithuanian Commonwealth – once the largest country in Europe – occupied Moscow. 200 years later, Napoleon and his Grand Armée fought their way to Moscow, only to find the city abandoned and largely burned. The Nazi war machine tried to pick up where Napoleon left off, but like Napoleon, got caught in the Russian winter, and was eventually defeated.
- Whether the US promised not to add any Eastern European countries to NATO after the Soviet Union collapsed – which Russia continues to whine about as a pretext for its aggressive moves – is immaterial. Russia would find another justification for its moves in Eastern Europe if NATO didn’t exist – not because President Vladimir Putin is evil, and not because Russia wants to conquer the world – but because geographically speaking, Russia exists in a weak position.
Over the centuries, Russia’s approach to correcting this weakness has been simple: achieve strategic depth (i.e. increase its national borders or, at least, its political power). As you can see on the map, the Northern European Plain widens considerably in Poland before hitting the Baltics, Belarus, and Ukraine – all of which lie on a wide-open, flat area. When Russia is strong, it tries to increase strategic depth as far West as it can. Ukraine is a key country for Russia to control, not just because it is home to some of the most fertile land in Europe, but because Ukraine’s natural border terminates with the Carpathian Mountains. This is a far more defensible border than Russia’s current borders.
- This strategic worldview is very hard for the average American to sympathize with. Europeans can understand it better because they understand the pitfalls of having historical rivals so close to your borders. China also shares a certain empathy with this worldview – for most of its history, China has always been a land power, and in the same way that Russia pushes West, China pushes West, even building Great Walls to try and keep out barbarian invaders.
- The United States, by contrast, lives in an alternate reality. For over a century, the US has not had anything to fear from Canada or Mexico – neither has been strong enough to pose an existential threat to US national security. The US does not have to conquer strategic depth: the US enjoys strategic depth merely by existing. The Atlantic and Pacific Oceans isolate the US from the rest of the world’s problems. Once the US took Texas and California from Mexico after the Mexican-American War in 1848, the US did not have to conquer any additional territory to feel safe.
When Russian President Vladimir Putin says things like, “The collapse of the Soviet Union was the biggest geopolitical catastrophe of the [previous] century,” he is not bemoaning the fate of the global proletariat (much to Lenin’s dismay). He is lamenting Russia’s loss of its strategic depth – a loss Putin has spent his entire rule attempting to correct. No matter who is President of Russia, no matter what his or her ideology is, Russia has an imperative to expand to the Carpathians either politically, or with military force, to ensure the defensibility of its territory. It always has, and it always will.
The Maidan Revolution
And herein lies the last bit of context you need to understand what is happening in Ukraine. In 2014, Ukraine had the Maidan Revolution. The result of the revolution was a pro-Russian president being expelled from office, a pro-Western government was set up in Kyiv, and Russia conquered Crimea while fomenting an ongoing insurgency in Eastern Ukraine, specifically, in pro-Russian areas called Donetsk and Luhansk, which now claim independence from Ukraine.
Maidan was an unmitigated disaster for Russia and a supreme intelligence failure. Russia was unaware of the insurgence until it was too late to do anything to secure Russia’s interests there. Russia’s seizure of Crimea wasn’t an example of Russian strength – it was the bare minimum Russia felt forced to do to ensure its security. To add insult to injury, in an unrelated development immediately after Maidan, the price of oil plummeted, dropping from $108 a barrel in June 2014 to $44 a barrel by January 2015. Russia was weak and poor and the czar had no clothes.
Putin has been trying to fix the 2014 Ukraine mistake ever since. Russia does not prefer to annex portions of Eastern Ukraine – on the contrary, that would take valuable pro-Russian populations in Ukraine out of the Ukrainian electorate, all but guaranteeing pro-Western governments in Kyiv in perpetuity. So Russia has stoked a low-level insurgency in Donetsk and Luhansk for years while negotiating in circles with Ukraine, France, and Germany. Russia has also spent the last 7 years replenishing its foreign reserves and trying to develop other aspects of its economy, so it isn’t so dependent on oil (with mixed results, but we won’t digress). Finally, energy prices have recently started to close in on their 2014 levels, and with it, Russia is enjoying leverage over Europe it hasn’t enjoyed in almost a decade.
Plus, Putin seems to think he can make a deal with US President Joe Biden. Some Russian analysts speculate this is because the Kremlin thinks Biden will only last one term. I am more convinced by the argument that Russia thinks Biden has room to make a deal because of how tough Biden has been with Russia rhetorically. Remember – former US President Richard Nixon was the most anti-communist China hawk around until he became president and made a deal to give up recognition of Taiwan and embrace China. In the same way that Nixon made nice with China to combat Russia, Putin may be hoping the US will make nice with Russia to combat China.
Whatever the case may be, the key to remember is this: Russia is playing a weak hand in Ukraine. It is playing that hand skillfully, all things considered – but it is still a weak hand. Russia’s moves are aggressive, but they aren’t offensive – they are primarily defensive. Russia is in pursuit of strategic depth, and attempting a risky invasion of a country larger in size than France and with a hostile population of over 40 million people (aka Ukraine) is a recipe for defeat.
Remember what Lavrov said – Russia will act if it feels threatened. We think Lavrov means it when he says Russia doesn’t want war - not because we believe Lavrov, but because war would be bad for Russia. Russia’s ideal resolution, however, would be some kind of political arrangement that formalizes its security concerns about NATO expansion and cements its influence in Ukraine. In other words, if geopolitics is right, then Putin doesn’t want to conquer Ukraine. He is bluffing conquest to get what he really wants (strategic depth by increasing Russia’s sphere of influence to the Carpathians) at a lower cost. That imperative will inform all of Russia’s future moves.
Why It Matters for Investors
Now that we can understand Russia’s point of view better, let’s try to extrapolate and highlight why the Russia-Ukraine conflicts matter not just for government officials and geopolitical analysts, but specifically for investors.
The most obvious reason is that Russia is the second-largest oil exporter in the world and the most important provider of both oil and natural gas for the European Union. In Q1 2021, the EU imported 47% of its natural gasfrom Russia, increasing from 44% in 2020. Additionally, the EU’s dependence on Russian natural gas is set to grow in the short-term largely due to aging nuclear infrastructure, even as the EU prioritizes renewables in the long-term.
The picture is a little better for oil – Russia only accounted for 25% of EU oil imports in Q1 2021. That is still a large figure, however, and would be very difficult for the US and its allies to replace this in the event of short-term disruptions, especially as weather models show Europe winter’s coldest temperatures are still ahead. In the EU’s most recent report, inflation was up 5% – due largely to the fact that energy prices were up 26% year-on-year.
Russia, however, is not a one-trick economic pony. The worst-case scenario for a full-on Russia-Ukraine War isn’t a replica of the 1973 OPEC oil embargo because Russia is a more diversified economy than Saudi Arabia has ever been.
Consider this:
- Russia is, for example, the top global exporter of fertilizer in the world. Higher natural gas prices have already driven fertilizer prices to new highs – natural gas is critical to producing ammonia, and ammonia makes up 80% of the cost to produce nitrogen fertilizer, the most commonly used fertilizer in Europe for a range of crops. Add in a Russia-Ukraine War and the sanctions on Russia that would result, and suddenly the entire food supply chain starts looking tenuous. And that’s with food prices already higher than they’ve been in a decade.
- Russia is also the top global exporter of nickel, accounting for over 12% of global exports. Nickel is a versatile metal: its high melting point, natural resistance to corruption, and the ease with which it can be combined with other elements make it critical to manufacturing alloys, the most important of which is stainless steel. Nickel is also critical to cutting edge lithium-ion battery technologies. According to IEA estimates, clean energy technologies’ demand for nickel will grow between 30% and 60% in the next two decades. A Russia-Ukraine War would then increase the costs of everything from that new dishwasher you were hoping to put in your kitchen to that new Tesla Elon wants you to buy (which is why Tesla has been desperately securing its nickel supply).
- Russia is the largest exporter of wheat (over 17% of the global share) and the third-largest exporter of barley (12%) in the world. Ukraine is the fourth largest exporter of corn and barley (over 13% and 11%, respectively) and the fifth largest exporter of wheat (8%). In recent months, Russia has sent the price of wheat upwards by implementing a floating grain export tax in recent months. The stated reason is a disappointing 2021-2022 harvest forecast, but the conspiracy theorist in me can’t help but wonder if Moscow wants everyone to think they are preparing to be cut off from global markets and are ensuring domestic supply.
Understandably, the Russian ruble has come under considerable pressure since Putin began upping the ante on Ukraine. The Bank of Russia suspended purchases of foreign currency on January 24th to “reducefinancial markets volatility.” Not surprisingly, the Russian stock market has seen intense volatility, with Russian investors selling due to fears that state banks or oil companies will face the crippling sanctions Biden keeps warning about.
I also can’t help but wonder if it is a coincidence that the Bank of Russia chose now, of all times, to publish a 37-page report on cryptocurrencies characterizing them as a ”financial pyramid scheme” and urging the Russian government to ban issuing, trading, and holding cryptocurrency on Russian territory, to ban financial organizations from investing in any instruments with cryptocurrencies, and to enforce legal prohibitions on cryptocurrencies currently in place. With the ruble under so much pressure, the volume of cryptocurrency trading in Russia has gone up. It’d be a shame for Russia to have spent so much time and energy de-dollarizing only to find itself exposed to an even more fickle mistress.
Ultimately, the investment impact of the Russia-Ukraine crisis will come down to how serious Russia is. If I am wrong about Russia’s intentions – if Russia really is preparing for a full-scale invasion of Ukraine – the West will react with sanctions against Russia that will reverberate throughout the global economy as energy prices and food prices surge upwards. If this happens, you ain’t seen nothing yet with inflation. It’s precisely because of this that I rate the probability of full-blown invasion as fairly low – it’s mutually assured destruction.
If things continue as they have been – continued dialogue leading to some kind of resolution, or at minimum a stalemate – expect more of the same, i.e., in the short-term, higher energy prices, a weaker ruble, downward pressure on Russian equities, and upward pressure on key Russian commodities, like wheat, fertilizer, and nickel, in the coming months – all of which present interesting opportunities for the brave of heart if, as geopolitics suggests, this situation resolves itself without a full-scale war.
