Lighthouse Investment Management

Geopolitical Game of Power in Ukraine

Russia has annexed Crimea and is in the process (directly or indirectly via "rebels") of occupying eastern
parts of mainland Ukraine. Here is what I wrote in my Market Comment "Ukraine: Disaster in the
making" (December 10, 2013):
"Russia tried to prevent Ukraine from signing a treaty of association with the EU
(triggering local unrest). All it needs are staged attacks on the Russian minority
(mainly east of Dnjepr river) in order for Russia to intervene to protect those
minorities. If you provoke the bear, it will attack (see Georgia).
CONCLUSION: This is a disaster waiting to happen. Best case: bailout by the IMF.
Worst case: default and partial occupation by Russia including military force."
Later (Market Comment, March 4, 2014), I described the Russian motivation and strategy behind their
move:
Crimea given to Ukraine in 1954 assuming it would remain in USSR
Strait of Kerch, less than 3 miles wide, controls access to ice-free waters (Black
Sea, Sea of Azov, Mediterranean and Atlantic, Don and Volga)
Crimea houses Russia's Black Sea fleet in Sevastopol
Ukraine harbors and maintains Russia's R-36M2 (ICMB10)
Once "pro-Russian" troops started fighthing the Ukrainian army, the US pressured Europe into agreeing
to sanctions.
Russia had warned it would not take attempts to integrate Ukraine into NATO lightly. Nevertheless,
Hillary Clinton said the following11:
"I enthusiastically welcome the Janury 11 [2008] letter from Ukrainian President
Viktor Yushchenko, Prime Minister Yuliya Tymoshenko, and Verkhovna Rada
Chairman Arsenii Yatsenyuk to NATO Secretary General Jaap de Hoop Scheffer,
which outlines Ukraine's desire for a closer relationship with NATO, including a
Membership Action Plan. I applaud the fact that Ukraine aspires to anchor itself
firmly in the trans-Atlantic community though membership in NATO and look
forward to working with Ukrainians and Ukrainian-Americans to reach that goal."
10
11

ICBM = Inter-Continental Ballistic Missiles

"Statement from Senator Hillary Clinton on Ukrainian Membership in NATO", January 28, 2008

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The US knew Ukraine was a "hot topic" for Russia. In a cable12 dated February 1st, 2008, US Ambassador
Burns warned everyone with name and rank:
Following a muted first reaction to Ukraine's intent to seek a NATO Membership
Action Plan (MAP) at the Bucharest summit, Foreign Minister Lavrov and other
senior officials have reiterated strong opposition, stressing that Russia would
view further eastward expansion as a potential military threat. NATO
enlargement, particularly to Ukraine, remains "an emotional and neuralgic" issue
for Russia, but strategic policy considerations also underlie strong opposition to
NATO membership for Ukraine and Georgia. In Ukraine, these include fears that
the issue could potentially split the country in two, leading to violence or even,
some claim, civil war, which would force Russia to decide whether to intervene.
Additionally, the GOR and experts continue to claim that Ukrainian NATO
membership would have a major impact on Russia's defense industry, RussianUkrainian family connections, and bilateral relations generally.
So what on earth were US Senators McCain and Murphy doing in Kiev in late 2013, speaking to a crowd
of demonstrators:
"The destiny you seek lies in Europe. People of Ukraine, this is your moment! The
free world is with you, America is with you, I am with you! If you are successful,
the US Senate will stand with you all the way!"
President Yanukovych, under pressure from Moscow, refused to sign a EU Association Agreement (talks
"suspended" on November 21, refusal to sign November 26, 2013). This infuriated demonstrators and
led to his flight from Ukraine (February 21, 2014). Beginning on February 26, "pro-Russian" forces began
to swiftly occupy strategic positions and infrastructure across the Crimean peninsula. On March 16, a
referendum was held to join Russia. The following day, the Crimean Parliament declared independence
from Ukraine and asked to join the Russian Federation.
By now, Putin was on a roll. Supported by high approval ratings at home, he felt emboldened to go for
parts of Eastern Ukraine (important defense and coal industries, mostly Russian-speaking population).
Controlling the shoreline of the Black Sea from Mariupol all the way to Moldova would be a plus.
The Russian's accused the CIA to be actively involved in Ukraine. The US denied. However, confronted
with pictures of the head of the CIA, the US had to admit:
"The White House confirmed Monday that CIA Director John Brennan travelled to
Kiev, Ukraine, in recent days as part of a longer trip to Europe."13

12

"08MOSCOW265_a", Confidential cable from Ambassador William Burns to Joint Chief of Staffs, NATO EU Cooperative,
National Security Council, Secretary of Defense, Secretary of State. Source: WikiLeaks

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I am not defending Putin's actions in any way. All I am saying is that you have to understand the
motivations behind each player in order to be able to understand the game being played. The US is not a
saint, either. And not very clever at hinding that fact:
"Vice President Biden's son Hunter is joining the board of a gas company [Burisma
Holdings, Ukraine's largest private gas producer] that operates in Ukraine
Ukraine."
."14
Why would you do that? As the president's son, would you like to sit in a country which is at war with
Russia and meddle in a local gas business? Of course not. More likely, this was a "thank you" from
Ukraine to the Biden family. Hunter will get paid handsomely, and maybe join a conference call once a
quarter from a safe distance. Since he is being paid for his "work", it's not corruption.
Of course, the US pretends to be gravely concerned by Russia's moves
moves.. A lot of finger wagging. Some
financial
inancial help for Ukraine (via IMF, but that went straight to Gazprom to pay for gas delivery arreas). And
then you look at a map of the location of US aircraft carriers. The closest one to Ukraine,
Ukraine USS Bush, just
left the Mediterranean via the Strait of Gibraltar (coming from Marseille, France).

Wouldn't the first thing to do include moving some military assets close
closer to the conflict zone (Black
Sea)? This does not make sense. Unless...
13
14

"White House: Brennan was in Kiev this weekend", USA Today, April 14, 2014
"Biden's son joins board of Ukraine gas company", USA Today, May 13, 2014

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Unless the US is as paranoid about the preservation of its power as Russia. The enormity of the NSA's
spying operations, even on its allies, speaks volumes.
Despite spending more on defense than the next ten countries (China, Russia, UK, Japan, France, Saudi
Arabia, India, Germany, Italy and
Brazil) combined, the US is
somehow worried about its
security.
The US has by far the most
aircraft carriers on earth.
Developing and maintaining
those swimming fortresses is
extremely costly. The US has
budgeted $12-14.5bn for the
replacement of its current
Nimitz-class carriers (not
counting $12bn for
development and research). Hence cost is a barrier to entry, and size of economy (and ability to absorb
those costs) a strategic asset.
The importance of controlling the seas of this earth cannot be overestimated. Here is The Policy Tensor15
on the subject:
"The United States, alone among the major powers, has the tremendous strategic advantage of having two of the
worlds great oceans as moats. The stopping power of water is such that no state in the international arena can
threaten the US homeland. The oceans offer not just protection but also access to world markets. People, ideas, goods,
and technologies are transmitted smoothly and rapidly over sea-lanes protected by US naval primacy.
Sea power is different from land-based military power. Threats by land travel weakly over distances. Although a seaborne invasion of a territory well-defended by a great power is well-nigh impossible, sea power can be easily projected
far from home. Moreover, unlike on land, where a rough balance of forces can persist for long periods of time, the
blue-water security market is a natural monopoly. Jean D. Bloch, the turn of the century Russian railroad baron and
prominent banker who predicted the course of the First World War, argued in 1902 that there was no point in building a
blue-water navy that is not supreme, since a fleet that is not supreme is just a hostage in the hands of the power whose
fleet is supreme."

The US is fine, as long as the dollar remains the world's reserve currency and Japan, it's last major ally in
the Western Pacific, doesn't collapse under its debt. The US has two choices: let Japan collapse under its
debt or help finance the government by purchasing Japanese government bonds. The latter would
probably drag the dollar into the abyss, too. A collapsing Japan would leave large parts of the area to the
Chinese (having just built their first aircraft carrier).

15

"The Third World War", by: The Policy Sensor, May 21, 2013

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Which brings us to Europe. Two thirds of world currency
reserves are currently in US dollar. A quarter in Euros. 4%
British Pounds, 3% Yen, and 2% all the rest (including Swiss
Francs). So the only currency that would be able to
dethrone the US dollar is the Euro.
Europe and Russia make one huge land mass. Western
Europe gets relatively inexpensive and (until recently)
reliable energy from Russia. Russia builds its foreign
currency reserves and is part of the BRICs trying to break
the dominance of the dollar. The Chinese are working on
making the Yuan convertible and investible, but they lack deep markets to invest in.
Here's my theory: US willingly provoked Russia by enbracing Ukraine, therefore exposing one of Russia's
achilles heel, the narrow Strait of Kerch. Putin had no choice but to act, and he acted swiftly. The US
pressured the EU to enact sanctions. Vice-President Biden admitted16 that "it was America's leadership
and the president of the United States insisting, oft times almost having to embarrass Europe to stand
up and take economic hits to impose costs". The EU grudgingly approved sanctions. However, on the
day the sanctions were announced, Siemens CEO Kaeser met with Putin as well as the head of Gazprom.
By far greater damage, however, was inflicted on Russia by falling oil (and gas) prices. Oil demand and
supply are very price inelastic, meaning that consumers and producers do not quickly change their
quantities based on price changes. You simply don't drive more miles because the oil price declined.
Similarly, it is very costly to shut down an oil well or rig. So you keep it flowing. Oil is toxic and relatively
cheap (it's cheaper than beer, for example). So storage is a problem. Once all available storage is full,
producers need to sell - at
any price. Hence a few
100,000's of barrels a day
in oversupply can really
wreck havoc with the oil
price. Traditionally, the
world's largest producer,
Saudi Arabia, has played
the "valve", reducing
output in times of
oversupply and vice-versa.
But what if the US told
Saudi Arabia to keep it
flowing no matter what?
Hurt Putin where it hurts
16

RT, October 4, 2014

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most. Oil & gas. Crude oil prices, both North Sea Brent and West Texas Intermediate, are down about
30% since mid-June. Oil and natural gas sales accounted for 68% of Russia's total exports in 2013. The
fiscal break-even price for Russia is around $100/bl (see next page).
Falling oil and gas revenues caused the Russian Ruble to tumble (see chart previous page), losing roughly
a quarter since the middle of the year. Apart from the Ukrainian Hryvnia it is among the worst
performing emerging market currencies. The Russian Central Bank has already spent $70bn intervening
(selling dollars, buying Rubles) in the foreign exchange market. This leads to a contraction in the local
monetary base, adding to the negative effect of rising interest rates.
Over the past three years the Euro has risen from 40:1 to 60:1 to the Ruble, making imports from the
Euro-zone 50% more expensive and hurting Euro-zone exports to Russia. Inflation has risen to 8%.
Russia's population peaked at 148m in the early 1990's (today: 143m). Under the assumption no nuclear
weapons will ever be used, Russia, in the long run, poses no threat to the US. However, Western Europe
combined with cheap Russian energy might be able to mount a challenge.

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What are the consequences of those geopolitical games? At first sight, lower oil prices might be good for
consumers (less money spent at the pump = more discretionary spending). However, tapped-out
consumers might prefer to pay down debt instead. Oil exploring / producing and service companies, on
the other hand, are quite prominent in the US high yield ("junk") corporate bond market. More
importantly, Russia has been an important export market, especially for German companies. The conflict
in Eastern Ukraine will weigh on Russian-European relations for some time to come, dampening trade.
In the end, the conflict serves as a wake-up call to Western Europe, accelerating the move towards
renewable energy sources and reducing Russia's potential oil & gas revenues.
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