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Russian Investment Opportunities: The Drivers and the Hidden Gems

From the world’s best performing index in the first three months of this year, to a laggard this quarter, the Russian index has offered dramatic returns as well as downside risk. What has driven investor sentiment and what are many investors missing?

The World Leader Slips to World Laggard

Russia’s RTS Index was the world’s best performing index in the first three months of this year but has now fallen by around 11% in value so far this quarter (Source: Bloomberg). Moves in this market are often attributed to sentiment over the oil price due to the significant revenues generated by the country exporting this commodity. Therefore speculation over economic growth (read: oil demand) is highly influential. This year has been no different. Turmoil in the Middle East can be attributed as one of the main drivers of a strong rally in oil in the first quarter and concerns over economic growth has caused a reversal since that time. However, is this too simplistic a view and aren’t there other factors to which an investor in Russia should be paying attention?

Source: Bloomberg. Russian RTS Index (white) vs. MSCI World Index (orange) - all $.

Beyond Oil

It is clear to see why investors play so much emphasis on the oil price as a dictator of Russia’s financial health. Supplying some 11.4% of the world’s oil supply last year, Russia is the “biggest single source outside the opec cartel”. Although official figures calculate its contribution to Russia’s GDP at 9%, it is important to be aware that speculation over tax avoidance suggests the value may be nearer to 25%. Nevertheless, what is often overlooked is the specific oil price factored into their budget. For this year, a price above $75/barrel will produce a deficit reduction. With Brent currently standing at $115/barrel, a fall in the Russian Index in reaction to a fall in the oil price to anything above $75/barrel may be missing the point.

Boosting Ties with Iraq

With Russian oil fields maturing and production growth resting heavily on foreign investment, the country is looking externally for new sources. Iraq offers potential opportunities and TNK-BP, Russia’s 3rd largest oil producer and BP Plc’s 50-50 joint venture, isn’t holding back. The relationship between the two countries dates back many years and in 2008 Russia wrote off most of their $12.9bn debt mainly generated pre-gulf war from the Saddam Hussein government purchases of Soviet weapons. Interestingly, last October the Russian President, Dmitry Medvedev announced his country was ready to strengthen co-operation with Iraq, the same month TNK-BP gained the right to bid for 3 natural gas areas in the region.

Mediating the Exit of Qaddafi

Within the political arena, Russia has been just as active. In addition to fighting for a stronger developing market influence at the IMF, Russia has offered its services to facilitate the exit of Qaddafi from rule in Libya. This is the first time it has shown support for the NATO-led military campaign after abstaining from UN Security council vote in March which authorised the intervention and accusing NATO of violating the resolution by backing anti-Qaddafi rebels and causing civilian casualties from air raids. Due to the belief that Qaddafi has “forfeited legitimacy”, they are willing to negotiate his fate with members of his entourage. Evidence of the country’s powerful network, the value of their political clout has been highlighted.

Driving the Agriculture Market

Back to commodities but from a different angle, the Russian weather is an influencer to watch for investing in the agriculture markets. Fine weather has prompted an upward revision of Russian grain production with the Federal Hydrometerological Center reporting the warmer weather has improved the prospect for crops. This has led to speculation that Russia’s ban on grain exports may be lifted on 1 July. Wheat future prices saw double digit losses.

The Chinese Buyer

One particular potential buyer of Russia’s resources is China, state media reported last Monday. China Investment Corp (CIC), the country’s $300bn sovereign wealth fund, was set up in 2007 to invest some of the country’s massive foreign exchange reserves. With the world’s largest foreign capital resource, at $3.0tn, they are keen to find better sources of return and commodities to fuel their rapid economic growth.

G-8 Bullishness Boosting Appetite for Risk

Despite these many factors which may influence Russia’s outlook, financially, economically and politically; its index continues to exhibit a strong correlation to the oil price. This week we’ve seen oil (and Russian equities) respond positively to the declaration by the Group of Eight that the global recovery is strengthening.

Investment Insight

Nevertheless, to differentiate between short-term over-reaction and more logical fundamental moves, being aware of all the issues will equip you with the insight to navigate this volatile but potentially profitable market.

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Libya – Oil, Water, Gold – The Real Issues

The oil price has sky rocketed over the past few months. The finger has been pointed at the troubles in Libya and claims of supply disruptions have dominated the press. However, are these claims grounded in fact or are we watching yet another sentiment driven bubble? What are the issues we should be aware of and how should we best invest in the face of such turmoil?

Expectations are often more damaging than reality

Libya’s contribution to global oil production is in stark contrast to the column inches it has been awarded in the press. As quoted by the National Journal, the country produces around 2% of the world’s oil. OPEC (Organization of the Petroleum Exporting Countries) has claimed that they have managed to “accommodate most of the shortfall” and instead attribute the rise in the oil price to fears of a shortage rather than any genuine supply issues. Oil reached a 2.5 year high last Friday. This is against a flattish demand side dynamic. Paris-based International Energy Agency and the U.S. government’s Energy Information Administration left fuel demand growth for this year unchanged and OPEC only raised their forecast by a relatively small amount (to 87.9m b/d from 87.8m b/d).

Note - this chart also highlights the Crude vs. Brent trade with the discount at record levels. Source: http://www.tradingnrg.com/crude-oil-price-forecast-recap-for-march-and-outlook-for-april-2011/

EU Sanction: A further boost for the oil bulls

On Tuesday, the EU extended sanctions against Libya to include energy companies, freezing assets in an attempt to force leader Muammar Gaddafi to relinquish power. Phrased another way, by the German Foreign Minister, this is a “de facto embargo on oil and gas”. Approximately 85% of exports are for delivery to Europe and importers will now have the task of finding potentially more distant and/or expensive alternative sources.

The pent-up downside risk

Nevertheless, many are not paying attention to the downside risk to the oil price as we move forward. Libya has Africa’s largest proven oil reserves but 75% of the country’s petrol needs are met with imports because of limited refinery capacity. Any improvement on this front, if a regime change is eventually secured, could significantly reduce imports and boost global supplies.

 Is water the next oil?

In addition to oil reserves, one asset belonging to the Libyan government which is rarely mentioned is an ability to bring water to the desert. With the largest and most expensive irrigation project in history, the $33bn GMMR (Great Man-Made River) project, Libya is able to provide 70% of the population with water for drinking and irrigation. The United Nations estimates that by 2050 more than two billion people in 48 countries will lack sufficient water, making this an enviable asset indeed.

How can the US pay for the Libya intervention?

It is interesting to note, with all the claims being made that the intervention is oil motivated that, Libya has another form of ‘liquidity’.  According to the International Monetary Fund (IMF), the country’s central bank has nearly 144 tonnes of gold in its vaults…

How to best invest: Retain context

The tide is starting to turn, Goldman Sachs has called the top for commodities in the near-term and oil fell by 4.5% on Monday and Tuesday alone (Source Bloomberg) . With this amount of volatility, short term noise can sometimes overwhelm. For a long term investor, looking for steady and stable returns, an ability to cut through the sentiment (whilst acknowledging it’s importance in driving returns in the shorter term) is valuable. Often many factors are at play and it will ‘pay dividends’ to be well-informed as they become wider known and priced in by the markets. Knowledge may be king but preparation will come up trumps.