In today’s Exponential Investor:

  • Russia shuts down the pipe
  • EU stops making metals
  • Smelting equals defence 

Tuesday morning, Europeans woke up to news they knew was coming, but were dreading nonetheless: Russia was keeping the Nord Stream 1 pipeline closed indefinitely.

Russia’s state-owned Gazprom says it’s because of a faulty turbine. However, the Kremlin has hinted that pesky Western sanctions may have something to do with the closure.

Russia’s President Vladimir Putin began making noises about weaponising energy as early as April, when he threatened to suspend gas and oil sales to anyone who wouldn’t pay up in rubles. While closing the pipeline wasn’t a surprise, it is unprecedented. Russia didn’t cut gas off during the Cold War.

The problem with the mostly US-led sanctions on Russia is that those in the US will suffer very little compared to Europe and the UK, who will be hard hit.  

Don’t get me wrong, I’m sure those people who put the sanctions in place thought they were being very clever going for Russia’s fossil-fuel exports, which make up around 60% of the country’s gross domestic product.

It’s simple on paper, yet stupid in practice. The reality is that Russia has had no problems offloading its oil to India and China at a discount.

Actually, I’d wager that our friends in the East aren’t getting fire-sale prices, either. The Brent crude price is still 22% higher than the day Russia marched into Ukraine. Natural-gas prices are 66% higher than at the start of March.

Also, the excess oil has been mopped up as India and China now account for 50% of Russia’s seaborne oil.

Yet with this latest round of energy warfare, another problem has arisen.

And the impact of this one won’t be felt until next year…

The machines have been turned off

Part of the problem of a just-in-time supply chain is that you can’t see most of it.

Logically, we know that there are millions of interchangeable parts being moulded, assembled and shipped every second of every day. But mere mortals like you and I don’t often see or hear about the middlemen. The third, fourth and fifth party, as they’re called.

So much price chatter starts with commodities and ends with consumer prices. Partly because the latter are most visible to the consumer and the former are most visible to traders.

But now one of the most visible parts of the supply chain – energy prices – is putting a stop on the invisible ones.

High energy prices are forcing Europe’s smelting capabilities to be either reduced or shut down completely. Aluminium is the most energy intensive metal to produce. With energy prices so high, it’s uneconomic to manufacturer the metal.

Europe accounts for 40% of total global smelting capacity. The union’s ability to morph metals into alloys is what feeds Europe’s factories.

Over August, two major European smelters have reduced output to the bare minimum: Slovenia’s Talum is running at one-fifth of capacity. Alcoa’s Lista plant in Norway is dropping to just one line of production. That’s one million tonnes of aluminium offline.

Then there’s the Budel zinc smelter in the Netherlands, which accounts for 2% of total global zinc output. As of 1 September it has been placed into care and maintenance until further notice.

Then you have the second-largest steel producer in the world shutting down two of its blast furnaces in Germany. Citing “outrageously” high energy prices, ArcelorMittal has closed two plants indefinitely as of September.

Base-metal smelting critical for defence

Granted, market demand for these products is low right now. But the high energy prices act as a disincentive for companies to stockpile base metals to sell at a later date.

The impact of these indefinite closures will take months and months to filter through to the consumer. A shortage of metals isn’t likely just yet. However, as we witnessed in the early days of Covid, demand can increase suddenly and send the price of things screaming higher in a short space of time.

But, in addition, we might not have factored in a more serious outcome.

Smelters are strategically important because they allow a country to have a strong manufacturing base and also support its military abilities. Alloys of zinc, nickel and aluminium are absolutely critical for building defence equipment.

A metals trader bluntly pointed out to Bloomberg that we have an incentive to keep smelters running:

“History has proven, once aluminum smelters go away, they don’t come back,” said Mark Hansen, chief executive of metals trading house Concord Resources Ltd. “There is an argument which extends beyond employment: this is an important base metal commodity, it goes into aircraft, weapons, transport and machinery.”

Tolerating the gas pipeline being turned off is one thing. But will governments step in to subsidise smelters to keep them open just in case things get even worse?

Until next time,

Shae Russell
Co-editor, Exponential Investor

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