Week 8: Doing business with Saruman

In this issue: ▸ Saruman is acting ▸ Let’s starts with the basics ▸ Who we are ▸ Investing for Saruman ▸ What now? ▸ And much more...

Dear all,

War. End of Line, Daft Punk. A couple of days ago, in year 2022, not 1938, a Saruman army descended over the lands of Ukraine. A mighty army of steel and blindness.

Missiles spiral overhead, their now dull explosions integrating with the patterned clicks of guns, and the insidious crackle of hidden landmines enfolding in a column of death and smoke its petrified prize. The symphony of sounds seamlessly morphing into a ridiculous melody, one of laments and agony. Its harsh sounds imbuing the shredded landscape with a nightmarish quality. Their cries of indignation lost. Amidst the clamour of soldiers, rigid in place, their minds and bodies slowly succumbing to the inevitability of death. War. 

War in Europe or Europe at war? I dwell on the first part of that sentence. Ukraine was attacked long before this (Crimea, 2014). Humiliated, its sovereign territory violated, annexed, taken. The world’s response? Limited sanctions, a couple of statements, and then business with Saruman went on. Investments went on, deals went on. Crimea is not Corsica or the Maldives.

Ukraine is a part of Europe, and will remain a part of Europe. But the Western response over the last 8 years has been rather toothless. The core of these sanctions has apparently not made any significant harm to Saruman. Saruman and the Eastern Empire of Sauron of China got closer and their appetites bigger, or shall we say more deliberate. Is history repeating itself, or do we in the West not really care with all the material wealth corrupting our senses and directions? Our ability to look for things is improving day by day while our ability to see is decreasing by the zillions.

Europe has always been divided over its identity. The EU project has not really delivered any answer in that respect. The US is too preoccupied with its own internal challenges, and Saruman and Sauron are no longer plotting, rather acting. 

The question here is also if the current ESG investments have a role to play in responding to the war brought to an independent and sovereign country by Saruman. It’s an important question and needs to be answered.

The question is… do investors care? 

Let’s starts with the basics

About 25% of the EU’s energy consumption comes from natural gas, according to the Directorate-General for Energy for the EU. Oil and petroleum (32%), renewable energy and biofuels (18%), and solid fossil fuels (11%) make up the rest.

That dependence on natural gas means a dependence on Russia. Today, the EU is the largest importer of natural gas in the world, with the largest share of its gas coming from Russia (41%), Norway (24%) and Algeria (11%).

In terms of foreign suppliers, Russian gas was just the cheapest. Rather than diversifying suppliers, routes to import Russian gas were diversified…

Here’s a rather unique document from The Energy Research Institute of the Russian Academy of Sciences and the Analytical Centre of the Government of the Russian Federation with a Russian energy outlook all the way to year 2040.

Who we are 

In the 24 hours after Vladimir Putin signed a decree recognizing two breakaway Ukrainian territories, the EU, the UK, and the US bought a combined 3.5 million barrels of Russian oil and refined products, worth more than $350 million at current prices. On top of that, the West probably bought another $250 million worth of Russian natural gas, plus tens of millions dollars of aluminium, coal, nickel, titanium, gold and other commodities. In total, the bill likely topped $700 million.

The US and its European allies will continue buying Russian natural resources and Moscow will continue shipping them, despite the biggest political crisis between the former Cold War warriors since the collapse of the Soviet Union in 1991.

Both sides are aware of the contradictions. The West knows that the commodities are a cash cow for Saruman, fuelling his imperial ambitions thanks, in great part, to ultra-high oil and gas prices. But the allies are also aware of the economic self-harm of cutting imports to zero.

For its part, the Kremlin may be tempted to weaponize its natural resources, which could trigger blackouts in Europe. But it also knows commodity exports are its own economic lifeline.

At this point, neither Moscow nor the US and its allies have an economic, political or military interest in weaponizing oil, gas and other natural resources. The initial round of Western sanctions, and the reaction from the Kremlin, was a reflection of that very posture.

The European Union and the UK targeted five medium-sized Russian banks, accusing them of helping the Kremlin’s campaign. But they left untouched the three state-owned giant lenders that are key for the commodities trade: VTB Bank PJSC, Sberbank of Russia PJSC and Gazprombank JSC.

Saruman did the same, telling an industry conference, the day after recognizing the breakaway republics, that Russia was planning “uninterrupted supplies” of natural gas to world markets.

The biggest casualty has been NordStream 2, the Kremlin-backed gas pipeline connecting Russia directly with Germany under the Baltic Sea. Berlin halted the administrative approval process for the pipeline, in effect putting the project on ice.

Tellingly, however, it did not impose sanctions on the pipeline itself. In any event, NS2, which hasn’t started operations, was unlikely to be approved before the summer. Berlin did not take any action on NS2’s sister pipeline, NordStream 1, which follows exactly the same route, and has been pumping gas for several years. 

Why not? NS2 is empty. NS1 is full.

For Berlin, halting the project sends a signal to the Kremlin without affecting current German natural gas supply. For its part, Moscow doesn’t need NS2 if its sister is at full capacity. Indeed, Gazprom, the Russian state-owned gas giant, hasn’t sent a single molecule of gas through its other pipeline the Yamal-Europe, which traverses Belarus and Poland, since late December.

We may soon see Gazprom boosting its gas supplies to Germany and the rest of Europe. Current spot gas prices are higher than the average of February-to-date, a situation that may prompt European utilities to maximize their Gazprom supply contracts from March 1st.

If that’s the case, Europe may see an ironic situation: simultaneously war waged by Saruman and higher flows of Russian gas.

Investing for Saruman 

Russia ranked 11th among Europe’s top 20 investment destinations. Germany, China and the US topped the list of major investors in the Russian economy in 2020.

Manufacturing and agri-food remained the most attractive activity for foreign investors in Russia. Moscow and Moscow Region are the top destinations for foreign investment in Russia. Half of the German funds were invested in agri-food, reflecting the sector’s growing attractiveness and profitability. Germany has always been among the leading countries investing in Russia.

Like in the case of German investors, over half of the US businesses invested in the agri-food sector. US companies working here highlight the continued importance of Russia for their business: Russia is a leading emerging market, and having a presence here is a strategic decision for many international players.

China remained focused on high-tech, with electronics taking over the lead from software and IT services as the most attractive sector for Chinese investments in 2020.

Italy moved up from seventh to third place, having doubled the number of projects in Russia from 6 to 13, and is now winning back its title as a leading investor in the Russian economy after slashing its project portfolio in 2019. Machinery and equipment attracted over half of Italian investments.

India and Sweden joined the top ten investors in Russia for the first time in the past decade.

Now imagine that a public sector worker in a US state or a UK county council, Sweden, France, Germany, whose funds are being invested in Russia. Are they comfortable that their pensions are invested in a country that wages war and occupies sovereign countries?

There is perhaps a natural tendency for such investors to detach themselves from challenging ESG stories in emerging market countries because they are being acted out abroad and have no obvious direct impact on their own countries. But such detachment does not seem possible given Russia’s malign actions and intent with respect to the West.

Investors have a fiduciary duty to secure the best returns for their investors, unless some specific ESG component is attached to any mandate. Index inclusion almost forces them to funnel funds to Russia.

I guess it will need an increased ESG focus on Russia and sanctions, or a more active move by the US Treasury et al to question Russian index inclusion and bring a more fundamental re-assessment of Russian holdings from an ESG and reputational risk perspective.

How does the conflict affect firms’ investment decisions? Well, the past results are mixed: a third of studies reviewed here report null or mixed correlations; some suggest conflict increases investments.

Firms operating at conflict sites dramatically reduce investments. By contrast, firms operating in territory surrounding conflict, but at a remove from fighting, actually increase investment. Firms far from violence see a small negative effect.

What now? 

Imagine that Biden and Johnson were to get up on a podium tomorrow and announce that they were going to cleanse the Western financial system of Russia’s dirty money. Instantaneously, our financial system would collapse.

A chain reaction would set off, something like this: Half the hedge funds and private equity funds on Wall St would go into liquidation, instantly, their capital depleted. That would break the banks they bank at. Unfortunately, those are the very banks the average person keeps their money at, too. Then we’d need another bank bailout, a huge one. In approximately three days after such an announcement. Anyone in particular want to step up to that plate? Nobody does.

The system is awash with dirty money. Our system. Our financial system. There is so much of it that without it, the economy as we know it would come to a grinding, near instantaneous halt. Withdraw, freeze, liquidate all those Russian funds – and bang, a chain reaction reaching down into runs on banks from the average person in America and Britain and Germany would be set off, in record time.

That is why Putin isn’t afraid of the sanctions. He knows that the West can’t go far enough to really hurt him and his cronies. It just isn’t really possible, at least not without pushing the self-destruct button on our own economies, and plunging ourselves into a financial crisis of epic proportions. Putin knows that he has the West over a barrel, a huge one made of dirty money.

If the West really tries to cleanse itself of dirty Russian money, then its financial markets, stock markets, and property markets will all crater. It’ll have an economic crisis that makes 2008 look like a picnic. Putin knows all that. Anyone, in fact, who understand modern finance well knows all that. That is why he appears totally… undeterred. 

Read more here.

Most likely there are a number of Russian stocks, bonds, credits in many portfolios around the world, some of them classified as article 8 products and sold to mortal people as sustainable investments. 

All of these products classified as article 8 according to SFDR, use various types of “integration” of ESG in their investment process and have certain, albeit vague, ESG credentials. Sanctions imposed by EU and US would most likely hit banking and financial sector in Russia. That means direct holdings in these banks. Some of them are listed and will be subject to sanctions and as such investors will need to get rid of them, i.e., divest. The same implies to Russian state bonds. 

However, some of these banks have shareholders that are other banks, or funds which means that “no harm principle” in this case encompasses even them. Russian companies aside of banks, listed ones, have some tangible shareholders from Western countries doing business and investing in them.  

Here are the biggest Russian listed equities. If you click on the link you can also see their rather challenging performance. 

Now if you want to know who owns substantial shares in the biggest listed Russian company here is the list, and yes, Western capital is heavily, let’s say deployed in Gazprom. 

So, in principle it is not so simple to just “divest” from Russian stocks, bonds and credits. Russia is a member of the global financial and economic fabric. Interconnected on so many levels with Europe and the rest of the world. As in this case as with the gas above, yes, we are going to continue buying it from Saruman, we are most likely going to continue investing, one way or another, in companies that directly or indirectly operate in Saruman’s world. 

When we opened Pandora’s box of the globalised market economy that have provided us with unforeseen prosperity, we also accepted the small print and even shook hands with the various forms and shapes of Sarumen and Saurons around the world.

And no, we don’t like to talk about it. It’s just business. 

Kind regards,
Sasja