Tag: russia

Notes on Russia and Oil & Gas

“My problem is that my imagination won’t turn off. I wake up so excited I can’t eat breakfast. I’ve never run out of energy. It’s not like OPEC oil; I don’t worry about a premium going on my energy. It’s just always been there. I got it from my mom.” — Steven Spielberg

“Russia is tough. The history, the land, the people — brutal.” — Henry Rollins

We recently met with the management team at Rosneft — the third largest company in Russia and one of the top 25 oil & gas exploration companies in the world by revenue —  for a wide ranging discussion on oil & gas, Russian macro, the deal with Saudi Arabia and OPEC, shale oil and geopolitics. In this week’s piece we share our notes from the meeting.

On Russian macro:

  • Russian budget balances at an oil price of around US dollar 47 per barrel.
  • Government and corporate external debt has declined from around US dollars 730 billion in 2014 to approximately US dollars 450 billion by the end of 2018.
  • 50 per cent of crude oil production is exported unrefined, 50 per cent of production is utilised for refined products of which 50 per cent are exported. Directly and indirectly, approximately 75 per cent of oil produced is exported.
  • The government is actively running a weak ruble policy, which is benefiting exporters at the cost of lower domestic economic growth and lower purchasing power for the Russian consumer. This is translating into Russian economic growth being investment-led as opposed to consumption-led.
  • Moreover, the policy is resulting in weaker than potential economic growth. Real GDP growth is around 2 per cent while the economy has the potential to grow between 3 to 5 per cent annually.
  • To counter the below potential growth, the government is trying to attract foreign direct investment into the economy — Russia moved up to 31st in the World’ Bank’s ‘Doing Business’ rankings in 2018, up from 120th in 2011. The spectre of further economic sanctions, however, has thus far deterred foreign capital.
  • To implement the weak ruble policy, the Central Bank of Russia sterilises all oil revenues above US dollars 40 per barrel. At current oil prices, the central bank purchases between US dollars 200 to 300 million from the open market on a daily basis
  • Russia is able to implement its weak ruble policy as the majority of costs, even for oil & gas exploration companies, are priced in rubles. For example, Schlumberger and Haliburton price onshore oil rigs lease rates in rubles, not US dollars. Oil & gas companies are only impacted if they are engaged in offshore drilling as offshore drills are not available in Russia. At present none of the Russian oil & gas majors are engaged in offshore drilling.
  • Pension reforms implemented in 2018 raised the retirement age from 60 to 65 years for men and 55 to 60 years for women.  The reforms were deeply unpopular  amongst the populace and instigated protests across the former Soviet Union. Eventually only a watered down version of the originally proposed reforms were implemented.

On the deal with OPEC / Saudi Arabia:

  • The production quotas / deal between Russia and OPEC holds far greater significance for Saudi Arabia than for Russia given Russia’s lower budget break even price, free floating currency and ruble based cost structure.
  • Russian oil production peaked in October 2018 at 11.4 million barrels per day. It has been cutting daily production levels by 65,000 barrels each month starting January 2019 and will reach the agreed upon production level in May 2019, which should be between 220,000 to 230,000 barrels per day lower than levels recorded in October.
  • Saudi Arabia has already cut production by more than the levels they had committed to as part of the deal with Russia and they expect the Kingdom to enact further cuts in the coming months.
  • Subsequent to our meeting, Bloomberg reported that “Saudi Arabia will supply its clients with significantly less oil than they requested in April, extending deeper-than-agreed production cuts into a second month”.
  • Although Rosneft is opposed to the production quotas, they expect the deal between Russia and OPEC to be extended beyond June 2019.
  • Rosneft, which accounts for 41 per cent of Russian oil production, could have increased its output by 5 per cent in 2019 but will limit growth to 2 per cent. In return, they have submitted a request for tax breaks to the Russian Ministry of Finance to compensate for the lost revenue.
  • One of the unintended consequences of the production cuts has been heavy, high-sulphur (or “sour”) crude trading at a premium to Brent crude in parts of North West Europe and the United States despite its lower grade. This has occurred as the majority of OPEC producers, predominantly Saudi Arabia, have focused their production cuts on high-sulphur crude and at the same time sanctions have been enacted on Venezuela, a major producer of high-sulphur crude. Demand from US refiners, which are configured to operate only with high-sulphur crude, and China’s preference for it as well — a byproduct of refining heavy crude is bitumen, which is used in the construction of roads  — has caused the squeeze.

On demand:

  • Demand erosion from electric vehicles has not been evident and it will take a much higher adoption rate for it to have a meaningful impact. Whatever adoption that is taking place is being more than compensated for by first time automobile buyers in emerging markets, particularly India and China.
  • Global demand is robust and should remain so as long as the US can avoid a recession in 2019.

On shale oil:

  • Full cycle, operating and capital expenditures cash break even for the Permian basin is between US dollar 40 to 50 per barrel versus the widely touted US dollars 35 to 40 dollars. This excludes the cost of land, which can push break even levels to as high as US dollars 55 to 60 per barrel.
  • There are signs of high cost inflation in the shale patch, particularly in the Permian, which may push up break even levels.
  • Listed shale oil companies returning capital to shareholders are being rewarded and those increasing capital expenditures have been punished. This suggests that the capital expenditure cycle for US shale may have peaked and that an increasing number of companies will choose to return capital as opposed to increasing production. If this happens, US production growth is likely to disappoint to the downside.

On natural gas and geopolitics:

  • Nord Stream is an offshore natural gas pipeline between Russia and Germany that is owned and operated by Nord Stream AG, whose majority shareholder is the Russian state company Gazprom. It has an annual capacity of 55 billion cubic metres.
  • Gazprom has a monopoly on all Russian natural gas exports.
  • Nord Stream 2 is a project to lay two additional lines and double annual capacity to 110 billion cubic metres and due for completion in 2019 . The project was backed by Chancellor Angela Merkel and the German government despite objections from some EU and NATO member states and from the European Commission
  • Since November 25, 2015, Ukraine has no longer imported Russian gas; instead, all supplies that enter Ukraine’s gas network from Russia are transferred to Europe. The gas transit agreement with Ukraine expires in December 2019. Nord Stream 2 is incidentally due for completion in December 2019. The completion of the project would allow all Russian gas to flow directly into Germany without transiting through Ukraine.
  • The cost of liquefaction, transportation and gasification of natural gas from alternate sources means that Russian gas remains the most economically viable source for Europe. Given Germany’s reliance on natural gas, especially after Chancellor Merkel outlawed nuclear power in Germany, it is difficult to see Europe turning away from Russian gas. German dependence on Russian gas has, however, caused a rift between France and Germany in the recent past.
  • Russia is confident that it can find alternative buyers for its supplies should Europe decide to stop buying from them.
  • In 2017, Rosneft sold a 20 per cent stake in Verkhnechonskneftegaz — one of the largest-producing fields in eastern Siberia that connects Russia with China, Japan and South Korea — to Beijing Gas. This is a sign of growing collaboration between the two states and a possible step towards de-dollarization.  With the added benefit for Rosneft and Beijing Gas of undermining the domestic monopolies of Gazprom and China National Petroleum Corporation.

Some data points:

  • Organic reserve replacement costs in Russia are approximately US dollar 0.20 per barrel of oil equivalent vs. US dollars 1.10 for BP, 1.00 for Chevron, 2.90 for Royal Dutch Shell and 5.70 for PetroChina
  • Lifting costs (the cost of producing oil and gas after drilling is complete) is US dollar 2.50 in Saudi Arabia and US dollars 3.10 in Russia vs. US dollars 5.60 for Total, 7.30 for BP, 10.60 for Royal Dutch Shell, 11.40 for Chevron, 11.50 for PetroChina and 12.30 for ExxonMobil.

This post should not be considered as investment advice or a recommendation to purchase any particular security, strategy or investment product. References to specific securities and issuers are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.

Russia: Tailwinds, Not Geopolitics

 

“Russia is a riddle wrapped in a mystery inside an enigma.” – Winston Churchill

 

 “The secret of politics? Make a good treaty with Russia.” – Otto von Bismarck, founder and first chancellor (1871–90) of the German Empire

  

“Sometimes it is necessary to be lonely in order to prove that you are right.” – Vladimir Putin

 

In 1985, members of Hezbollah, the Sh’ia political party and military group based in Lebanon, kidnapped four Russian diplomats in West Beirut. The terrorists “warned that the four Soviet captives would be executed, one by one, unless Moscow pressured pro-Syrian militiamen to cease shelling positions held by the pro-Iranian fundamentalist militia in Lebanon’s northern port city of Tripoli.” The militants ended up killing Arkady Katkov, a consular attaché and one of the four kidnapped diplomats.

Moscow, upon hearing the news of Mr Latkov’s death, dispatched Spetsgruppa “A” – also known as the Alpha Group.

The Alpha Group was formed in 1974 by Yuri Andropov, the chairman of the KGB at the time, in response to the Black September attacks at the Munich Olympics in 1972. Although founded under the KGB, the unit survived the collapse of the Soviet Union and operates today as a stand-alone counter-terrorism and counterintelligence unit under the auspices of Russia’s Special Forces.

The Alpha Group successfully rescued the three remaining diplomats after being dispatched to Lebanon. How they achieved this feat though is a chilling tale of brutality and effectiveness.

According to one version of how events transpired, the Alpha Group kidnapped twelve Shi’a, one of whom was the relative of a Hezbollah leader. The kidnapped relative was castrated and shot in the head, his testicles stuffed in his mouth, and his body shipped to Hezbollah with a letter promising a similar fate for the eleven other captives if the Russian diplomats were not released. In an alternate retelling of events, the unit is said to have abducted one of the kidnapper’s brothers, and sent two of his fingers home to his family in separate envelopes.

Russia allegedly has a longstanding policy of targeting family members of terrorists. The reports of Alpha Group’s rumoured operation in Lebanon are in keeping with this tradition.

Hezbollah has long since heeded Otto von Bismarck’s advice and made a ‘good treaty’ with Russia. Today, Russia and Hezbollah operate closely as allies in the Syrian civil war and in their support for Bashar Al Assad in the conflict

The recent poisoning of former Russian spy Sergei Skripal in the UK has set-off a wave of diplomatic expulsions. The United Kingdom, accusing Russia as being behind the poisoning, made the first move by expelling twenty three Russian diplomats. In a show of solidarity, twenty six other nations, including the US, followed Britain’s lead and expelled Russian diplomats. Moscow, rejecting the accusations, has announced the closure of the British Council and US consulate in St. Petersburg and the expulsion of British and American diplomats.

While the saga continues to make the headlines, we believe neither the British nor the Americans have the wherewithal to sustain a diplomatic dogfight with the Russians. Britain still has the not-so-small matter of Brexit negotiations to deal with and its economy cannot afford to close itself off from Russian capital or Russian consumers. The Trump Administration, on the other hand, is fighting too many battles on too many fronts and a diplomatic standoff with Russia, as it appears at least, is way down the list of priorities.

While geopolitics will always be a concern when one invests in Russia, we think the political risks are no greater today than they have been in the past. We think both the US and the UK will either make good with Russia over time or there will be little development in solving the murder and the issue will be demoted to background noise. We certainly do not see Russia backing down – Putin after all remains ready to exploit the ‘us against them’ siege mentality to the benefit of his popularity amongst Russians.

For now, we prefer to focus on cyclical tailwinds that Russia is enjoying today and not the geopolitics.

 

 

Investment Perspective

 

The sharp drop in the oil price in late 2014 forced Russia to move the ruble to a floating exchange rate. The move led to a sharp drop in the ruble as the artificially overvalued currency adjusted to the new regime. The inflation that followed was painful and the Central Bank of the Russian Federation responded by hiking interest rates. The combination crippled economic activity.

No sector suffered more in the economic slump than the consumer sector. As inflation ravaged the Russian consumer in 2015 and 2016, consumer spending dropped off a cliff – leading to high levels of consolidation across consumer facing companies. Only the largest were able to withstand the challenging environment. And even then, they too had to adapt and become leaner and more efficient.

The rebound in oil prices last year has lifted the economy out of recession, supported the ruble and allowed the central bank to aggressively cut interest rates – cumulatively the central bank has cut the policy rate by 9.75 per cent since January 2015. The policy rate now stands at 7.25 per cent, well above the central bank’s target inflation rate of 4 per cent.

In response to the economic upturn, we expect Russian consumer demand to recover as increased economic activity translates into higher employment rates and higher wages. This recovery in consumer spending in turn should fuel further improvements in economic activity. The combination of increasing economic activity and significantly lower interest rates will encourage, we think, Russian corporates to increase capital investment.

Based on the Levy-Kalecki profit formula:

Profits – Tax = Gross Investment + Government Deficit + Net Exports – Workers’ Saving

Increasing capital investment and higher consumer spending (lower workers’ savings) both contribute to higher profitability. If Russian consumer spending and capital investment do increase as we suspect they will in 2018, the profitability of Russian companies, too, should be much higher. Specifically, consumer companies that have come out of the slump much leaner and with much larger market shares are well placed to benefit from the cyclical upturn in the Russian economy.

For those of you that have frequented Bond Street in London or Dubai Mall in the United Arab Emirates will be all too aware that Russian consumers have a taste for the finer things in life. Demand for luxury handbags, expensive automobiles, and beachfront properties all goes up when the Russian consumer is spending. For this reason we think that some of the leading European fashion houses will also be amongst the primary beneficiaries of the improvements in the Russian economy.

We have been long Russia since the start of the year and remain long. Next week, we will be adding a number of European fashion houses as long trade ideas as means to play the Russia theme, especially for those of you that cannot directly invest in Russian assets.

 

 

 

This post should not be considered as investment advice or a recommendation to purchase any particular security, strategy or investment product. References to specific securities and issuers are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.