Positions in Europe: Long Germany (EWG); Short Spain (EWP)
Sizing up Russia is never an easy task. Political risk runs high, its banking industry is largely opaque, and the country’s outsized leverage to the price of commodities makes its economy sensitive to price cycles.
Of the fundamental risks to the economy, below we highlight rising inflation, mixed fundamentals, a downside price target on oil, declining oil production, rising tariffs that shun foreign investment, and over the longer term TAIL a declining population, judicial challenges, and the struggle to transform the economy beyond its leverage to commodities. In the past, we’ve recommended playing Russia via the etf RSX, which is overweight Energy (40%), Basic Materials (27%) and Financial Services (13%).
Our models suggest that Russia’s equity index (the RTSI) is broken on immediate term TRADE and intermediate term TREND durations (see chart below).
Based on the IMF, Russia has a growth profile of 4.8% this year and 4.5% next year and a budget deficit of 1% of GDP this year. However, stripping out oil and gas revenues, the deficit would be as high as 11% of GDP, which owes to Russia’s reliance on oil revenues to balance its budget and therefore increases its vulnerability to external shocks, namely the price of oil. It’s worth noting that the IMF forecasts are based on an average price for Russia’s crude blend Urals, the country’s main export blend, at $104 per barrel in 2011 and $103 in 2012. Given our bullish stance on the USD and our longer term downside level on oil (WTI) to $89, a sustained pullback in oil could bring Russia short of its forecasts.
The real pressing threat in Russia remains its exceptionally high inflation rate. Inflation, as measured by the CPI, recorded 9.6% in MAY Y/Y, with food stuffs and other agricultural goods leading the upward charge. These prices, particularly on a year-over-year basis, have been significantly influenced by the severe drought in Russia last summer that affected the harvest of key food staples, like potatoes and grains. Domestic food price inflation coupled with the spill-over of global price inflation from its import partners to make up for lost yields have only further stoked prices. Also, given that the consumer weight of foodstuffs in Russia’s CPI basket (similar to the other BRICs) is higher than for developed economies, like the US, inflation figures appear even loftier in comparison.
Producer Prices, the input costs that typically drive up Consumer Prices, have remained elevated, at 19.2% in MAY Y/Y, off slightly from 20.2% in the previous month.
While Russia is poised to lift its grain export ban July 1st and the Central Bank has stated that it does not expect rising prices as more producers export more grain than they sell at the local market, it’s another risk worth considering.
The Russian Central Bank has hiked the main refinancing rate twice year-to-date (in February and May), currently at 8.25%, to stave off inflation. The Bank continues to state that as the year progresses inflation should fall to the Bank’s official target of 6% to 7%, but it has shown little indication on the timing of a hike.
Of the positive releases in recent high frequency data, MAY showed that the Unemployment Rate fell to 6.4% versus 7.2% in APR. and Retail Sales gained a healthy 5.5% Y/Y. Domestic investment in Russian business surged 7.4% in MAY Y/Y versus 2.2% in APR yet disposable income fell -7% and real wages increased only 2.6%, a signal that inflation is squeezing the consumer and wage inflation is not keeping up with the headline figures.
The most forward-looking indicators of PMI Services and Manufacturing showed that Services have held up well each month year-to-date, with the most current reading at 57.6 in MAY vs 55.8 in APR. In contrast to Manufacturing, we expect the more domestic-oriented Services to hold up in the coming months. Manufacturing, on the other hand, may continue to tail off as the important export market of Europe remains mired in sovereign debt contagion. PMI Manufacturing fell to 50.7 in MAY vs 52.1 in APR and has trended down ytd, teetering just above the 50 line, separating expansion (above 50) from contraction (below).
The Mighty Petrodollar and the “One-Trick Pony”
One major concern to monitor in Russia is the so-called oil curse of oil-rich countries. While Russia should have learned its lesson from 2008-9, governments of oil-rich countries have a disposition to issue unjustified government expenditures (and therefore lower budget discipline) when oil prices are elevated due to optimism over the additional revenues from oil profits. Russia’s Finance Minister Alexei Kudrin has said that the “government expects the budget to remain in deficit through 2014 based on an average price for Urals crude oil of $75 this year and $78 in 2012. Russia may balance its budget this year if oil averages about $115 a barrel, or more than 50 percent above the government’s target price.”
As a point of reference, oil and gas exports accounted for roughly two-thirds of all Russian exports by value, with oil and gas revenue contributing ~1/3 of general government revenue. Further, reviewing estimates on the marginal tax rate on petroleum, the government pulls in an average of 90 cents on every dollar of exported crude selling above $25/barrel. [Note: under $25 the government also receives its share, albeit a proportionally smaller one on a tiered basis].
It’s Russia’s leverage to energy in particular that has lent our naming of the country a “one-trick pony.” In short, the chart below shows the tight correlations between the price of a barrel of oil, foreign direct investment in Russia, the RUB-USD, and GDP over the last 10 years. Over one year we see a correlation between RTSI and Urals Crude of 0.95 and between RUB-USD and Urals Crude of 0.91! So watch out as the USD strengthens against the RUB and oil falls!
Given that we’re making a bullish call on the USD over the intermediate term, which should cool oil price appreciation, we’d expect to see even less foreign direct investment, and decreased oil revenues, and lower growth—all cause for concern on Russia’s economic outlook.
Oil Constraints and Government Intervention
Over the last 12 months there has been much talk from President Dmitry Medvedev about diversifying the country away from its sole leverage to energy. Implicit with the goal is his understanding that the country is 1.) bumping against its outer bound of oil production, and 2.) that being solely reliant on energy leaves the country in a vulnerable position to external disruptions.
To the first point, it’s worth noting that Russia A.) doesn’t have spare oil production capacity, and B.) the government has announced that it expects Russian domestic oil production to remain flat at roughly 10 MM bbl per year through 2020. Attaining production levels will be challenging as higher crude prices trigger higher oil export tariff rates which discourage foreign investment in Russia’s oil and gas sector that is essential for the country’s future exploration projects. Additionally, state limitations on foreign ownership rights in Russia’s oil and gas sector, lack of financial transparency and minority shareholder rights make investment in Russia a high risk venture.
Other Key Points To Consider, from our Energy Team:
- Export Tax: Russia has a punitive export tax levy upon domestic producers that seriously impairs operating cash flow to fund development investment.
- Significant Spending: Flat production at 10 MMb/d will require capital spending of roughly $280 billion from 2010 to 2020.
- Mature Fields High Depletion Rate: Traditional production areas, such as Western Siberia, are nearly 60% depleted, with high decline rates and high water cuts, requiring significant investment for secondary recovery efforts to maintain current production levels.
- Capital Constrained: Russian companies relative to western peers have low dividend yields and low internal cash flow generation.
Recent Headlines on additional Energy levies
- Russian government plans to increase tax burden on the country’s gas sector over the next three years, impacting Gazprom in particular. The tax burden on the industry will increase by 150 Billion Ruble ($5.4 billion) in 2012, by another 170 Billion RUB in 2013, and by another 185 Billion RUB by 2014 (from Platts, June 3, 2011).
To the second point, there’s little evidence that private consumption can offset the loss of foreign investment. On a slight tangent, we’d also question grouping Russia in with the rest of the BRICs, for unlike the others, Russia shows no clear prospects for a domestic growth story, especially considering its declining population (more below) and lesser growth profile over the next couple of years so long as energy costs retreat from abnormal highs witnessed in the earlier part of the year.
Longer Term Headwinds
As mentioned above, Medvedev has called for the country to transition away from its sole reliance on energy to grow the economy, however it’s important to stress that this will neither be an easy nor quick process. In late March of this year Medvedev unveiled a 10-point program to make the nation more attractive to investors. The measures included removing senior officials from the boards of state companies they oversee, approving a state-asset sale program for the next three years and proposing a law on minority shareholders’ right to information.
In mid June Medvedev further unveiled at the St. Petersburg annual economic forum a $10 billion sovereign fund to stimulate domestic private equity and indicated plans for a $30 billion asset sale program to help lure investors and revive investment interest in the country. One asset considered for this program is OAO Sberbank, the country’s largest lender, in a transaction worth as much as $7 billion, while the government also asked Morgan Stanley, JPMorgan and Deutsche Bank to manage an IPO of OAO Sovcomflot, Russia’s biggest shipper.
At the core is Medvedev’s understanding that foreign capital is fleeing Russia based on the country’s reputation for government and business corruption. Russia is estimated to have total net outflows of $30 billion to $35 billion for 2011, roughly equal to the $35.3 billion of capital that left last year, according to the Central Bank. Countering this force is obviously critical, however our position is that short of oil reaching levels seen over the summer of 2008, we won’t see investors barreling into Russian investments.
A further consideration when sizing up Russia on the tail are the headwinds facing the country based on its grim demographic outlook. The World Bank reported that by the end of 2009, 17.4% of the population (24.6 Million) will live beneath the subsistence level of $185 per month, about 5% more than before the global recession. The Economy Ministry said Russia’s working population will annually decrease by ~1 Million every year over the next three years, and the population has been in decline over the last 14 years, falling to 141.0 Million in 2010.
As inflation remains elevated, and the price of oil is squeezed with a rising US Dollar, we’re cautious on Russia’s investment outlook as the country is highly dependent on oil prices to generate revenue (and therefore balance the budget) and grow the economy. Longer term, the country will attempt to diversify economic growth, but this process will take many years and frankly we have our doubts on its success—changing a culture of corruption is after all a long road.
One of the largest threats is the flight of foreign investment over recent years. The biggest impediment to foreign investment in Russia is its lack of a strong “judicial” system of judicial recourse not just for Russian domestics, but critically for foreign rights – shareholders providing foreign capital inflows. On this front we’re unlikely to see much (if any) near term change.
Further, Russia is in direct competition with other BRIC nations for foreign investment, so what is its competitive edge – the advantage that will prompt foreign investors to choose Russia over say China or Brazil that have more upside potential due to their more diversified economies.
Finally, demographic headwinds, forces not facing the other BRICs, play against Russia, and will force the need for more foreign investment and stronger ties with China, factors which Russia may not easily or directly be able to control.
In aggregate, these factors leave us cautious on Russia.