HORACIA NAIDOO-MCCARTHY: The price of Putin’s invasion

Oil markets were tight before Russia’s invasion of Ukraine: major producers had fallen behind their production quotas, there was  limited spare capacity within Opec, and the sector has seen chronic underinvestment over the past few years. The situation has been worsened by investors shunning listed oil companies and their traditional “dirty” assets as the world pushes for the transition to cleaner energy. Now, there is a real risk that global oil supply will be further constrained due to the Russia-Ukraine war.

As the world learns to live with Covid and oil demand recovers to pre-pandemic levels, Russia — the third-largest oil producer — has, with its war, raised the pressure on Opec and the US to make up any looming oil deficit. Over the short term, higher oil prices are likely to result in further inflationary pressure, which will weigh on economic growth.

Brent crude has risen  from $59.60 a barrel prior to the pandemic to $106.65 currently. Should the war  drag on, a real risk is that a significant portion of Russian oil and gas could be offline for years — Russian oil storage facilities are limited and once they are full, the wells may need to be shut. Redrilling wells and rebuilding pipes, which deteriorate during a shutdown, takes time and will be more difficult given the loss of expertise from large Western oil service companies, which have withdrawn from the country.

There is a disconnect between how the world is powered and how we wish to power it in the future; despite efforts to transition to clean energy, most economies remain heavily reliant on fossil fuels. China and Western Europe, in particular, depend on Russian fossil fuels for energy. But given the exigencies emanating from the war, Germany recently reneged on its commitment to shut down nuclear power plants by 2022 and phase out coal-fired power by 2038.

While Germany’s commitment to transition to clean energy sources is commendable from an environmental perspective, the social ramifications of not having a sustainable energy supply have taken precedence. This  serves as a striking example of the trade-offs that need to be made between transitioning to cleaner energy and ensuring demand can be managed. While increasingly unpopular, fossil fuels are still required, given the pace of the transition to clean energy.

Another concerning consequence of the Russia-Ukraine crisis is the impact on food inflation and global food supply. Ukraine is the largest exporter of sunflower seeds and the second-largest supplier of cereals (maize, barley and wheat). Russia is the world’s largest exporter of wheat and together with Ukraine is responsible for almost a third of global wheat supplies.

While the potential constraint in the supply of agricultural staples is a threat to food security, on a global scale farmers have also been affected at virtually every stage from seed to table. Russia is a major exporter of potash, ammonia, urea and other soil nutrients as well as herbicides, oil, gas and diesel, which are needed to run farm machinery and to make propane to dry grains.

Poor harvests ensuing from these shortages may have a ripple effect for years to come, which has implications for food prices over the long term. It also means that in the face of a threat to global food security, sustainable farming practices, particularly the utilisation of renewable energy resources, may be indefinitely delayed.

Even as these ructions in food and energy markets play out, shareholders continue to prioritise environmental, social and governance considerations.  Climate change has become a key consideration for investors, but while many would prefer to shun investments into fossil fuels, the reality is that the transition will take time: both thanks to geopolitical events, and as the world moves to create the infrastructure required for cleaner energy.

As such, at Allan Gray we prefer to focus on the efforts of individual companies to reduce their adverse environmental impacts and explore sustainable opportunities, rather than choosing blanket disinvestment. We do not believe that the complete exclusion of fossil fuel companies is the most effective approach. We prefer engaging with boards and management teams,  encouraging them to conduct their businesses sustainably, before opting for disinvestment.

Over the short to medium term, we expect continued volatility in the oil price and rising food inflation pressure. Ironically, a higher oil price may just provide oil and gas companies with the opportunity to invest their super profits into clean energy technologies and pursue net-zero goals with more vigour.

* Naidoo-McCarthy is a business analyst with Allan Gray