2022 Theme: War In Ukraine - The Butterfly Effect of Deglobalization

We don't need to wait for the long term consequences of Russia's war in Ukraine to find problems however.

The chaos in the markets is already starting to break things. Real things. Not just derivative contracts or paper fortunes but the proper functioning of the global economy.

Many of these consequences have been hard to predict. Which is perhaps not surprisingly in an incredibly complex, large and highly levered and interdependent global economy.

Very few investors, financiers, farmers, business owners or industrialists had "major land war in Europe" on their bingo card at the start of the year. But even if we had been certain of Vladimir Putin's actions, it is unlikely that we would have been able to predict all of the serious consequences.

The idea of the butterfly effect is long standing but perhaps still under appreciated argument about the unpredictability of complex systems.

The idea is pretty simple: a single flap of a butterfly's wings could change conditions sufficiently that, eventually, it could cause a storm on the other side of the world. The scientist in Jurassic Park gave a memorable disquisition on it.

The terrible conflict in Ukraine might be about as unlike a butterfly as you can possible get and yet it is proving to be a great case study for chaos theory in economic action.

This week's most memorable example occurred in a small room in London called "the Ring."


The perfect case of the law of unintended consequences caused by tit-for-tat sanctions occurred in the market for industrials metals. Luckily but perhaps unsurprisingly, it happened in the lightly traded and obscure but industrially important commodity of nickel.

Now, for context, one the themes we should have perhaps pushed harder in the last 6 months is that the market for many industrial metals (aluminium, copper, nickel etc) has been nearly as tight as oil.

  • As with a lot of other metals, there is a lot of demand and very little new supply after years of underinvestment.

We held back from this topic because a) miners and industrial metals are a bit more esoteric b) metal prices are hard to express directly for retail investors and c) there are likely real limits to the appetite for our commodity gloom and doom!

When we did discuss metals we typically did so from the point of view that the energy transition will require huge quantities.

  • Here is an article from November on this theme.

  • Here is a previous newsletter where we discuss the energy transition angle and introduce the idea of "greenflation" where this transition will almost certainly lead to higher prices for electricity and other basic goods.

This past week, however, we were as stunned as anyone when the normally quiet and even sleepy nickel market suddenly exploded with controversy and drama.

The reason?

Here is the stunning price chart: from under $30,000 a ton to over $100,000:

This was a 30 standard deviation move, for those inclined to think in those terms.

Why did this happen?

Well, even before any specific policy or export embargo was implemented, people were understandably nervous about Russia's significant nickel production . The concern was it would be either sanctioned by the West or withheld by the Putin regime. This caused the price to start rising steadily and, then all of a sudden, all hell broke loose.

The details are a bit technical and not overly important but large numbers of physical nickel producers were "short" or betting against the price of the commodity.

That sounds nonsensical but people who produce commodities often do this intentionally to protect themselves against the sudden collapse in price because they are naturally "long" or in favor of the price rising.

In other words, someone who produces nickel for a living is already protected if the price rises but is very concerned about the opposite. They therefore hedge their position by shorting the price to a certain extent. This is like buying insurance, you lose some of your profits but you limit the risk of disaster,.

Now, when the price started to rise very quickly after the Russian invasion this caught a lot of producers (or speculators) by surprise and also under pressure to remove or "unwind" their shorts which only caused the price to rise higher and faster.

This was obviously great if you were net long and very bad if you were net short.

But wait, it gets better:

The sudden rise in price was so swift and caused such disruption in a normally sleepy and illiquid market that the chief exchange of nickel and other ores, the London Metals Exchange (LME), had to amazingly suspend trading activity.

The reason was that a somewhat notorious Chinese entrepreneur Xiang Guangda - nicknamed “Big Shot” - has for months held a large short position on the LME through his company, Tsingshan Holding Group Co., the world’s largest nickel and stainless steel producer.

When the price of nickel skyrocketed suddenly this large producer (along with many others) owed more money to cover their positions. In his case, Mr Xiang owed more money than he had. "Big Shot" was big time levered.

Rather than letting his holding company fail which, yes, would have caused other metal brokers to also take large losses and perhaps declare bankruptcy the LME instead decided to do two things:

  1. "Temporarily" suspend the whole market.

  2. And cancel the trades.

We are going to say that again: the LME cancelled the trades!

Rather than let the gambling and extreme leverage be punished and the market clear they have done the exact opposite. They have rewarded greed and recklessness of Big Shot Xiang and taken away legitimate profits from traders who acted responsibly and adroitly.

We have written about the concept of "moral hazard" before. But this is like moral hazard gone berserk. It is enough to make even veteran cynics of financial speculation gasp.

This is anti-capitalism capitalism.

If brokers know they will be rescued by the exchange if they act foolishly, then they have far less incentive to worry about large leveraged positions taken by their clients. Brazen greed will be the order of the day.

Incidentally, the LME have also made their market a far less attractive place to operate. Who wants to trade in a venue where being large and leveraged means far more than being right and responsible?

This will have also profound longer term consequences. Including, eventually, far more regulation of the LME, greater prices for raw ore and less liquidity in the global metals market.

Anyway, as of the time of writing, the nickel exchange is amazingly still suspended. In an incredible example of "doubling down," Mr Xiang is also refusing to abandon his short position which neatly reinforces the moral hazard he has created. Now that his gambling has been rewarded why would he do anything else? You can file these facts under the many other unprecedented events from 2022 so far. It is also not a great situation.

It is amusing - there will hopefully be a great Big Short-type movie in a few years about "Big Shot" and his big problems - but it also underlines some of the real vulnerabilities that are being exposed. And the real consequences of fact that the Ukrainian invasion has begun to create very wide ranging ripples with uncertain outcomes.

A month ago if you said Russia invaded Ukraine many informed observers might have suggested the price of nickel would rise. But how many would say that the chief metal financial exchange would be forced to cancel trades of those who bet on that price direction, reward moral hazard and then simply shut down the market?!?!

Quite the butterfly effect.

The LME's nickel market may be the first winged marvel. We suspect it is unlikely to be the last.


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    Russian Nickel: Fine It Is Expensive, Is It Important Though?


    2022 Theme: Ukraine - Coke & A Big Mac No Longer Possible, Have We Thought Sanctions Through?