War Hedges
Image credits: Wikipedia via Google Images
March 7th, 2022
Matthieu Papahagi
Russia invaded Ukraine on Thursday, the 24th of February 2022. Contra Alpha condemns this breach of sovereignty and territorial integrity and deplores the loss of human life and the destruction of livelihoods resulting from this aggression.
While these tragic events unfold, fund managers around the world still have the obligation to manage their investors’ capital to the best of their ability, and so the subject of hedging cannot be avoided. Below, I provide a retrospective view of the performance of hedges over the last two weeks and discuss which hedges could continue working.
On the 24th, before the start of Russia’s so-called “special military operation” in Ukraine, Brent crude oil was trading at $95 per barrel; by the end of last week it closed at $118 and this morning it reached nearly $140, before settling around $125, on fears of an embargo on Russian oil exports, which account for 10% of the world’s supply. European gas and wheat futures spiked even more on fears of supply tightness (Ukraine and Russia collectively account for 29% of global wheat exports and Russia produces 15% of the global gas), resulting in next winter’s gas futures doubling, while the wheat price is now up more than 70%. Corn, oilseed, and industrial metals have also rallied. Russian stocks tanked, and the ruble turned into rubble. The coordinated international sanctions with immediate effect and the swift financial isolation of Russia, which culminated with an effective paralysis of its central bank, have made hedges based on shorting Russian assets profitable and viable only very briefly, before the market structure for these assets collapsed and the liquidity evaporated.
Waking up to the news on the morning of the 24th, I remember spending the entire morning trying to hedge the Iosses in my equity portfolio, while compiling a list of potential bargains to buy later. In particular, I was looking at defence stocks that morning – European firms such as Thales, Rheinmetall, or Leonardo Finmeccanica were up around 5%, and among the large US contractors, Northrop Grumman was up around 2%, Lockheed up only 1%, and Raytheon was even down 2%. While this was arguably good performance in an equity market that was all in the red on both sides of the Atlantic, I thought that compared to the move in commodities, it was still not pricing enough the risk of higher escalations and what would amount to a near-certain increase in Western governments’ defence spending.
The problem with hedging post factum in a fast-moving market is that one is quickly left behind, as most assets that have high appreciation potential are very obvious and react immediately to the news – it does not take a genius to realise that war in one of the largest wheat producing countries and sanctions on one of the largest energy exporters will push wheat, oil, and gas higher. An investor or speculator is then left with the dilemma of choosing between hedges which have suddenly become expensive, and thus bet on continued disruption, or leave the portfolio vulnerable to further losses. Here, the contrarian response would be to not panic and start shopping for bargains among the assets that have sold off, but this only increases the risk exposure in the short-term instead of hedging it. Therefore, the logical answer is to look for assets which have reacted less, but have similar appreciation potential. On the morning of the 24th, defence stocks fit this bill impeccably.
In hindsight, the obvious trades were in fact the most profitable, but it is always so in market panics, as it is in market rallies. However, one should bear in mind that it is not the risks that the entire market is focused on that move prices the most, but rather unforeseen developments. The invasion on the 24th was a shock and prices moved accordingly, and momentum continued as the situation deteriorated. Defence stocks only truly jumped on Monday, following the German chancellor’s announcement of increased defence spending over the weekend.
Thinking about hedging ahead, one should therefore consider the hedges with the least downside risk – after all, there is nothing worse than one’s hedges turning against oneself just as the rest of the portfolio rebounds. In particular, I believe that oil has non-negligible downside, especially as it feeds through to broad inflation, which has become a political issue. Should the US and its allies announce measures to counter the price increase, such as strategic reserve releases, pressure on the shale industry to increase production, or easing sanctions on Iran or Venezuela, the rally in oil could be curtailed, or even reversed to some extent. So far, current measures have fallen short of expectations, with only 60m barrels to be released globally versus a daily consumption of 91m, which sent the signal that there is little firepower to fight high energy prices, and in fact, pushed oil higher. Yet, one should not forget about the other possible measures, of which I think US shale increasing production would have the greatest impact longer-term, while easing the oil sanctions on Iran or Venezuela (which Russia is trying to undermine) would more effectively alleviate short-term supply pressures. One should also not underestimate the consumer, who is increasingly likely to respond to high gas prices by reducing consumption, although this would take some time to impact prices. However, this factor could be very significant (remember the pandemic), especially since, following Covid-19, the world is more capable to operate with reduced travel. Finally, while an outright ban on Russian oil remains very much on the table, it should be noted that many large energy companies such as BP and Exxon have already ceased refining Russian crude, and so effectively Russian oil exports are already impaired. My conclusion on oil is therefore that it may be safer to bet on further backwardation of the oil curve instead of assuming a general long-term increase. Another possible trade would be long the Brent/WTI spread, since a total ban on Russian oil would have less impact on the US, which only imports 3% of its oil from Russia, than it would have on Europe and the more international Brent benchmark. However, these trades are highly speculative, and I would recommend caution and patience.
On the other hand, I believe that defence stocks remain a one-way bet – reasonably valued, they have little downside if the war ceases soon (which we all hope), but great upside if it is prolonged. In fact, following the €100bn defence spending announcement by Germany, and as of yet no similar commitments in France, Italy, or the US, and given the historic nature of this war, we are likely to see years of increased defence spending. Moreover, even in Europe, stocks such as Thales have only just recovered their pandemic losses and are priced not too far from the peaks of recent years, despite this amounting to a long-lasting regime change.
Finally, for those who missed the move in wheat or corn, I would like to draw the attention to an alternative hedge, whose price has appreciated far less, namely rice. While high energy prices can be corrected through demand destruction (e.g. people travelling less, industrial activity slowing down), addressing high prices induced by shortages in staples such as wheat is much harder. Therefore, with the prospect of wheat production in Ukraine being severely impaired by the displacement of the population, the answer to wheat shortages is not demand reduction, but rather substitution. When faced with empty shelves of flour and bread, consumers will be forced turn to alternatives such as rice, which is why I see reasonable upside in rice, but with less downside than in wheat or corn, should the situation deteriorate further. Food giants may also consider using alternatives to wheat in their products in a bid to minimise input costs.
While in this post I focused on defence stocks and commodities, there are, of course other possible hedges, such as credit shorts on highly-indebted companies with large energy costs, or the classic energy-currency proxy trades – going long the currency of an energy-exporting country and short the currency of an importing one, such as long CAD versus INR. However, my competency is limited in these areas, and thus I refrain from giving any particular suggestions.
One last word – I would encourage any investor who gains from hedges such as the ones discussed above to strongly consider donating to charities helping Ukraine and the displaced Ukrainian families. Personally, I have donated the entirety of my gains to date from defence stocks to the British Red Cross’s Ukraine Crisis Appeal.
