MARKETS:
Dark risk from the Black Sea
An intensifying Russia-Ukraine War means it’s time for a refresh on the impact of export disruptions.
SUMMARY
- An intensifying Russia-Ukraine War raises the risk of export disruption.
- Wheat’s neutral supply context has created a short-biased market.
- The two are an uneasy combination.
- Disruption consequences remain high.
- Disruption probability, despite being higher, remains low.
- Thus, prices have little or no disruption premium.
- So, JIC, it is timely to map out the contingencies.
- Like 2022, a disruption event remains likely to generate a large initial price spike.
- Unlike 2022, the supply context means prices likely return to pre-disruption levels faster.
Dark risk from the Black Sea
Wheat prices remain at low levels. Market comfort that prices will remain low tends to generate positions that are, somehow, short. That bias creates a vulnerability to supply disruptions. The main ‘known unknown’ for wheat supply is the Ukraine-Russia War and its potential to disrupt exports from the region. The conflict is intensifying again. In our view, that does not make export disruption likely, but it is more likely than before. And export disruption remains a high-consequence event. As the ever-wise they say, forewarned is forearmed. So, we examine the potential impact of Black Sea export disruptions on wheat prices.
Creeping event risk
The Russia-Ukraine war is now a greater spike risk for wheat (and other crops). The war had been stuck in an ugly stalemate, but was also ‘contained’. But no longer. The war’s intensity has already increased. The US President is, belatedly, realising that Russia has little interest in peace. And that remains, despite his attempts to raise the stakes via a stronger, faster squeeze on Russia’s oil golden goose. The US is already preparing to resume some funding for the war. And, more importantly, the US will provide more weapons (but charge them to Europe’s tab). Thus, the war’s intensity will likely further increase. In that context, the chances of disruption to crop exports are greater. Importantly, we are not suggesting that disruption is imminent. Nor that Russia or Ukraine would specifically target the crop supply chain. Disruptions via unintended consequences and collateral damage, however, are more likely.
Current prices are unlikely to have any premium for this risk. While more likely, these events are still too low in probability and high in specificity for markets to maintain a premium on prices. So, in the event of disruption, prices are very likely to spike. A related possibility is a ‘scare’ that suggests disruption sensitises the market to this risk. Either possibility would prompt changes to the market’s positioning and boost prices.
2022 Review
Russia invaded Ukraine on 24 February 2022. Wheat prices jumped instantly, closing 5% higher that day. The full impact took about a fortnight to accumulate. Chicago May ’22 peaked more than 400¢ above its pre-invasion level, a 46% rise. Spreads also reacted violently. Chicago May ’22-July ’22, pre-invasion, was at about 6¢. Not quite a fortnight later, that spread was over 90¢. The price and spread gains both indicate the intensity of the market’s scramble for wheat. The eventual resolution had two phases.
The initial, or replacement, phase is traders chasing prompt wheat. A massive price reaction is not uncommon in this phase. Physical traders’ overriding need is to replace the missing wheat. And, in the interim, buy anything that correlates with it, like wheat futures. So, trading is no longer a balanced price-quantity interaction. Instead, it becomes overwhelmingly about quantity. And continues to be quantity-driven until replacement is completed throughout the supply chain. This replacement phase saw Chicago May ’22 peak just below 13US$/bl in early March.
The next (resolution) phase dealt with the uncertainty about how much Black Sea wheat would be available. For much of this period, Chicago Sep ’22 traded a 10-11US$/bl range. During this time, negotiations were conducted to create what would become the Black Sea Corridor. The negotiations were far from smooth, leaving the corridor in serious doubt at times. A pessimistic sentiment swing in mid-May 2022 generated a secondary price spike that neared the earlier highs. Russia and Ukraine, eventually, agreed to create a safe corridor for grain shipping. The Black Sea Corridor allowed exports to flow again (and remains in place). And prices fell in response. By early July, or about 5 months later, prices were back down to pre-invasion levels.
Now vs 2022
That history helps assess the potential impact of another Black Sea export disruption. 2022, though, is a single data point. A one-from-one. Therefore, care is required because the context will not be the same. Indeed, the market context now is substantially different to February 2022.
Unlike 2022, prices are now low. SRW Wheat, now, is a bit over 5US$/bl (193US$/mt). In February 2022, it was about 8US$/bl (294US$/mt). And, also unlike now, prices had been trending higher for almost a year and a half before February 2022.
The SnD context, by the numbers, between early 2022 and now looks little different. The perceived SnD, though, in early 2022 was a lot different to now. Back then, the market feared that supply was on a tightening path. That fear was why prices had been trending higher for 18 months. That early 2022 perception contrasts sharply with the current perception. Supply is seen as roughly neutral. Zooming in a little, exporters also have more inventory now than in 2022. And, much of that extra inventory is in the US, and would be available to for export. Timing mitigates that comfort. August is arguably the worst time for an export disruption; February is closer to the best. Northern winter wheat is arriving on the market now. So, much of this season’s exports are still at their origin, even if committed for export. And, this season’s Russia and Ukraine harvests have flowed unusually slowly to the market. Thus, any disruption will likely apply to more Black Sea exports. In summary, the macro SnD context has a little more comfort than in early 2022, but the micro mitigates that comfort.
The market’s positioning differs substantially from 2022. Investor positions have a greater short bias. And, the differences are much greater for Kansas than for Chicago. Investors have large short positions in both markets. And those short positions are also larger than in February ’22. 1.5x larger for Chicago. And a whopping 7x larger for Kansas. Investors also have hefty spread positions that, most likely, are predominantly short-near/long-far contracts. More speculatively, investors might also have material long-Chicago/short-Kansas positions. However, verifying that conjecture, and its size, is difficult. All of these positions are the wrong way around for Black Sea export disruption. The likely price response to disruption would quickly generate losses. So, because most of these positions are discretionary, many investors would likely exit those positions. Closing those positions would compound the scramble for prompt wheat, likely amplifying price rises. The positioning is a bigger problem now than in 2022.
2025 ‘preview’
So, what might a disruption in 2025 look like for prices? The impact has two dimensions. One, how much prices rise. And, two, how long the rise persists.
On the second, the duration is highly dependent on the exact nature of the disruption. And the number of potential disruptions is large. The two make it very difficult to usefully generalise about the likely duration. Most importantly, a disruption needs to be long enough for a sharp price rise to be triggered.
The price rises would likely have two phases, replacement and resolution, as in 2022. The replacement phase is most likely to generate large to very large price rises (up to 3-4US$/bl, 100-150US$/mt). Our judgment is that, during the replacement phase, the short positioning will trump neutral supply in setting prices. So, the initial response is likely similar to 2022. The resolution phase though is likely to be different. The neutral supply context will be the dominant factor governing prices. That context suggests the price plateau after the initial flurry will be lower. So the fall from the peak prices set in the replacement phase is likely greater, and may even eliminate all the price rises.
