Sunday, March 16, 2014

Deep State Financial Order Of Battle Between Russia And The West

Mike Lofgren's "Anatomy of the Deep State" for Bill Moyers sheds new light on the elite actors shaping national and global policies.  This analytical framework allows consideration of both state actors and non-state actors shaping the confrontation between Russia and the West over Ukraine.  Military analysts discuss "orders of battle" when nation-states face off in a military confrontation.  Financial analysts may compile a financial order of battle in parallel for a conflict's non-violent dimension.  Ukraine Crisis' excellent infographic depicts the financial battlefield.  Here is the Alfidi Capital contribution to the global dialogue.


Radio Free Europe / Radio Liberty identified some of Russia's deep state players in 2012.  The Carnegie Endowment recognized in 2011 that Russia's deep state security operatives periodically emerge to harm the Putin regime's opponents.  Anywhere from a few dozen to a few hundred people close to Vladimir Putin control a blend of public and private mechanisms that apportion wealth in Russia.  They have large but not unlimited financial resources.

Russian billionaires have lost significant wealth since the crisis began.  The advance warning that allowed them to escape forced bank recapitalizations in Cyprus is present in this crisis, but the escape routes to more hospitable climes may not be available this time.  Repatriating personal assets to Russia will make them subject to the kinds of political schemes they sought to avoid by relocating abroad.

Gazprom is Russia's state-connected private energy behemoth.  It presents "Gazprom Ukraine Facts" (do a Google search for that term) telling its side of the Russia-Ukraine gas dispute.  Reuters notes that Rosneft is interested in buying an Odessa oil refinery if Russia's state bank VTB forecloses on its unpaid debts.  The tension between Russia and Ukraine over Ukraine's unpaid gas subsidies was one of the triggers for this crisis.  Alfidi Capital believes that any Gazprom and Rosneft financial interests in Ukraine provide both a pretext for further Russian military provocations and pain points the West can target with financial restrictions.

The Financial Times reports that Russian companies have moved large amounts of cash out of Western banks in anticipation of sanctions.  Where those assets end up is anyone's guess but there aren't many places they can go to avoid SWIFT transfer restrictions.  The record drop in Treasuries held in custody at the Fed has Bloomberg and other media wondering whether Russia's central bank is moving its holdings beyond the reach of US sanctions.  It is too early to tell whether Russia intends to sell some or all of its Treasuries.  The ruble's value against the dollar has severely weakened in recent weeks, so the longer Russia waits to sell, the less local cash they will receive.

Putin's Palace is an impressive redoubt that sanctions cannot reach, but the oligarchs who helped build it may not have the patience for a protracted conflict that hurts their fortunes.  There is no evidence in public media  that Russia has the financial equivalent of a Tsar Bomba it can drop on financial markets.  No one would expect a financial WMD that will show Kuzma's mother to the world.  Then again, Dr. Strangelove ended with the detonation of a Soviet cobalt bomb after several Americans were admonished not to fight in the War Room.


Alfidi Capital has already assessed Ukraine's financial condition.  Many Western commentators have missed how things got so bad.  Ukraine was the third largest recipient of US development aid during much of the 1990s.  Much of that aid appears to have been wasted or looted.  Yulia Tymoshenko, a key leader of Ukraine's nationalist political coalition, is by some accounts an oligarch.  Ukraine's oligarchs are divided against themselves; Dmytro Firtash, a Tymoshenko opponent, has been arrested for allegedly gouging Ukraine to help Gazprom.

Ukraine's dire financial straits and rich physical assets define the country more in the role of prize than combatant.  This East European Gas Analysis map of Ukraine's gas pipelines depicts two very important characteristics that other maps ignore:  compressor stations and gas fields.  Russia cannot cut off gas supplies to Ukraine without cutting off its European customers as well.  Russian forces would have to control all of those stations throughout the entire country to apportion gas flows as rewards or punishments.  Chevron agreed in 2013 to develop the Olesska shale gas field in Ukraine's west.  Shell agreed in 2013 to develop the Yuzivska field in Ukraine's east.  It should go without saying that infrastructure and fields in Ukraine's east are in more immediate danger of falling under Russian control than those in the west.  Control of the Ukraine pipeline network and untapped oil/gas fields is a major strategic prize at stake in Ukraine.

DEEP STATE United States

The White House published an Executive Order on March 6, 2014 authorizing the government to act against anyone who facilitates Russian armed intrusions into Ukraine.  The term "United States person" is defined to include corporate entities, and this includes the foreign branches of US banks and corporations.  This EO is clearly targeted against a handful of Russian citizens and Ukrainian collaborators who have directly interfered in Ukraine's internal politics.  It is not intended to silence any foreign policy debates here in America.  Paranoiacs can relax.  The Magnitsky Act provides further US leverage against specific Russian officials who commit human rights violations.  It is unclear at this time whether American sanctions will prohibit American ownership of Russian-derived securities (ETFs, mutual funds, ADRs of Russian companies, etc.) traded on US exchanges.  That is another shoe waiting to drop, depending on which Russian companies appear on the US Treasury's Office of Foreign Assets Control (OFAC) lists and how the SEC interprets its role in sanctions.

A potential Russian sale of all of its central bank's Treasuries would liquidate about 1% of the US government's outstanding marketable debt securities.  The Federal Reserve has reduced its commitment to quantitative easing but this is an easily reversible decision in an emergency.  The Fed could buy all of Russia's liquidated Treasuries once they were released to the world market, although the difficulty of getting around sanctions barriers would delay the transactions.  I don't think Janet Yellen wants to run afoul of OFAC.  The US Treasury would probably have to authorize the Fed to deal with non-US financial institutions that aren't on the NY Fed's primary dealers list in such an emergency.

US companies may not be very farsighted; it is not clear whether they have considered moving cash out of Russia to avoid retaliatory sanctions from that country.  Indeed, Exxon still appears fully committed to its JV with Rosneft to develop multiple energy projects.  That may now be an untenable arrangement.  A new regime in Crimea will imperil offshore oil and gas leases granted to Western supermajors.  A lot of high-priced MBAs didn't see this one coming.  US-based multinationals that do not have contingency plans for non-Russian cash transfers remain exposed to any Russian financial countermoves.  

Implications for financial markets

The conflict between Russia and the West over Ukraine has a military dimension that is fortunately confined to small areas.  Alfidi Capital's Third Eye OSINT has already assessed Russia's likely military moves.  The remainder of this conflict will take place largely in financial markets and trade relations.  The deep states of the US and its allies have an overwhelming advantage in financial capabilities and will likely inflict more pain on Russia's deep state than the converse.  This is a likelihood, not a certainty.  Investors watching the crossfire can avoid getting trapped on a financial battlefield.

Full disclosure:  This author does not own any positions in any securities of Ukrainian or Russian companies.