My Trip to Russia: Energy Resources Look Appealing

Highlighted by meetings with executives of buy-recommendations Gazprom (OGZPY.PK) and Lukoil (LUKOY.PK), I had a memorable first visit to Russia last week (see pictures below). I also glimpsed first-hand the cultural legacy of the country while touring its current and former capital cities, Moscow and St. Petersburg. I traveled alone while trusting two excellent local guides, one in each city, both provided by an American travel agent with long experience in Russia. It was an adventure to explore new places safely and it was rewarding to meet warm and friendly people who work hard for a better life. Adventure may also describe investment in Russian stocks as demonstrated by last year’s stock price volatility. My thesis for including Russian investments in a diversified portfolio is a motivated government will seek long-term growth in a global economy that enriches Russia and by necessity must also reward international investors. Success will be measured by higher stock prices. Stock prices will be higher only if investors see appropriate reward.

Russian Pride
Like people everywhere, Russians take pride in their achievements. Despite communism’s antipathy to the monarchy, the government directed support to restoring historic palaces. After communism, cathedrals were restored. The accumulation of wealth in the form of gold, precious stones, and fine craftsmanship in glorious structures is startling.
There are many smart and talented Russians, of course. One of my favorites is the 19th century chemist, Dmitri Mendeleev, the inventor of the Periodic Table of Elements. Another is a current national hero, Irina Rodnina, the all-time great pairs figure skater.
The Kremlin, a symbol of a controlling government, also showcases history. I once pictured the Kremlin as a building that looked like what turns out to be Lubyanka, the former KGB headquarters. Instead the Kremlin, or ancient fortress, surrounds cathedrals and museums along with an office building for President Medvedev. The Assumption Cathedral in which all the tsars were crowned is practically gold clad, it seems to have so much of the precious metal. The Armory Museum does have ancient armor that Russians used to repel the Mongols who dominated the country in its early history. Otherwise the Armory is better known for its collection of Faberge eggs. The tsar’s coaches are also on display looking just as I envisioned in fairy tales.
Steeped in the knowledge that Communism was atheist, I was surprised to see churches and cathedrals seemingly everywhere. The government supports the Russian Orthodox religion again and likely controls it. Apparently there are also choices for those seeking solace away from the government religion.

Government Control
In the Putin years, the government has reasserted its control over the economy. As a result, Russians have respect for order. No graffiti in public places and no trash on the streets. The air above central Moscow was mostly clear during my visit and seemed clean.
Journalistic expression is controlled by government ownership of the media. Illustrating that, the tallest structure in Moscow appears to be a communications tower standing over the downtown skyline. As it looks like a needle, some of the locals apparently refer to it as the “ideological injection”.

Russia Rising with Resources to Export
I am optimistic about Russia with the hope that well-publicized problems and challenges can be overcome. The daily facts are on the side of hope as evidenced by the price of the ruble, the Russian currency, above its 200-day average relative to the dollar and stock prices of Gazprom and Lukoil also above their 200-day average. Of course, that still doesn’t guarantee tomorrow when trends could change without notice. Investors need to be vigilant.
Russia’s appeal to me lies in its natural resources, particularly natural gas and oil. Other Arctic and near-Arctic countries and states, including Norway, Canada and Alaska have similar appeal.
Investors have a history of making money in the latter, subject to setbacks from time to time. Changes in the rules of the game as occurred in Alaska and Alberta are discouraging. Norway has the highest tax rate, but at least it hasn’t changed much in 30 years and companies can invest accordingly. Russia has only a short history as a market oriented country and there have been large disappointments for international investors along with better experience recently.

Opportunity in the International Capital Markets
What’s missing in the resource picture is financing for development. Historically, a strong government just took what it needed. Peter the Great, the founder of St. Petersburg in 1703, built the city from scratch with military labor, we understand. Catherine the Great, whose art collection formed the core of the Hermitage Museum, apparently financed her monarchy in part with the labor of serfs and the spoils of conquest. Coincidentally, Tsar Alexander II freed Russian serfs beginning in 1861, the same year President Abraham Lincoln began freeing U.S. slaves. Joseph Stalin apparently built the magnificent, museum quality, underground subway stations in the 1930s with the labor of political prisoners.
Today, the international financial markets are well-suited to provide the capital to develop Russian energy resources, either through Russian companies or international companies. Companies with high stock prices can raise capital on the most efficient terms. Stock prices go up when companies make money. The most important factor influencing profitability in Russia is government policy. By relaxing excise taxes and price controls, the government can make the companies more profitable.
The same week I was in the two cities, Prime Minister Putin was entertaining international oil executives at a conference in the Arctic on the Yamal Peninsula, the location of the country’s largest undeveloped natural gas resources. It is welcome news that international companies are being invited again to invest alongside Russian companies. As long as a country needs new investment, existing companies should do well. Though conditions can change and there is a long way to go, the trends appear better for now.

Weekly Six-Year Natural Gas Price above 40-Week Average
Last, the industry backdrop looks positive with an upward price trend for both oil and natural gas. Latest settlement prices for the average of futures for the next six years at $77 a barrel are above the 40-week average of $72. The current quote of $6.82 for six-year natural gas exceeds the 40-week average of $6.73, perhaps the beginning of the long-awaited break to the upside.

Gazprom HQ:

Lukoil HQ:

Originally published on September 29, 2009.

Comments

[davidbdc]

No graffiti in public places and no trash on the streets.
----------------------...

That statement made me smile.....On your second trip to Russia you should visit places like Samara, Kazan, Perm, Magnitogorsk, Ufa, Chelybinsk, Omsk, and many more....I think you'll revise that statement.

Russia is two countries. Moscow is an major international city, open 24 hours. St Petersburg is a cultural attraction and also a somewhat international city. But you have to go outside these two cities to really see Russia, just like you can't visit NYC and say you've seen America.

The big challenge for any investment in Russia is the sheer amount of bureaucracy that you have to navigate. And frankly, a large part or that bureaucracy thinks that "gifts" to get things done are quite normal and acceptable......and thats before the outright corruption. Need a building permit....sure as long as my brother-in-law gets a 100K USD contract to do some of the building (ie he probably won't even show up but you better pay him).....and on it goes.

There is vast opportunity for those that can navigate the system. And to be clear the bureaucracy has improved over the years, but its still enough to leave you with no alternative but to smile at times. But you better make sure your doing your investment with a Russian partner that has a seat at the table of power......because if you don't you can see it all vanish tomorrow.

Good luck.

2009 Oct 26 06:43 AM

[Ferdinand E. Banks]

I'm optimistic about Russia too. It is a fantastically rich country in terms of geology and agriculture, and if they go easy with the vodka the people can be rich too. They also need some decent leaders, and as far as I am concerned they now have them.

I'm not optimistic however about the morons that are attempting to start the Cold War anew. We need Russian gas in Europe, and thanks to those ____witted critics of Russia in Europe and North America, much of that gas will be going to China.

2009 Oct 26 08:01 AM

[john s. gordon]

serfdom in russia - abolished over 100 yrs ago as you say.
we have serfdom in the u.s.a today - it's called mexican field labor (undocumented of course).
alcohol abuse remains rampant in russia - cold dark winters very depressing.
> jack

2009 Oct 26 08:39 AM

[John Galt]

"My thesis for including Russian investments in a diversified portfolio is a motivated government will seek long-term growth in a global economy that enriches Russia and by necessity must also reward international investors. ".

The key part of that phrase is "rewarding international investors" and I'm not so sure that will happen. Also, Russian is highly dependent on commodities, and that's an asset class that everybody seems to love right now. What happens if the world's thirst for building (growth) is subdued in a "New Normal" for 10 or 20 years.

2009 Oct 26 10:19 AM

[Mad Hedge Fund Trader]

oon Last January I was extremely positive about building long equity exposure in Russia, one of the two BRICKS that is a big energy exporter (click here for the call ). I predicted that the Market Vectors Russia ETF (RSX) would deliver double the upside of the S&P 500 in the imminent bull market. Well I lied. It actually tripled, while the Dow eked out a measly 70%. It even would have worked as a market neutral pairs trade, long Russia, short the US. This was an oil play on steroids, and with crude then trading in the $30s, how hard of a call was that? A recovery in the ruble also gave you a nice hockey stick effect in the dollar traded ETF. The bounce in the Russian currency stopped the country’s reserve outflow dead in its tracks, and enabled the Russian Central Bank to start slashing interest rates from the nosebleed territory of 13%. There is plenty of room for further cuts. But Russia is not out of the woods yet. Some 30% of the $780 billion in corporate debt is due for rollover this year, and the unemployment rate is at 9.5% and climbing. It also doesn’t help that they lock up oligarchs on bogus tax charges, and will expropriate foreign assets at the drop of a hat, as they did from Shell and British Petroleum. But none of my investors told me I could only do business with nice people who gave me a warm and fuzzy feeling. A rising oil price atone for all sins, as any Middle Eastern sheik can attest. You might want to take a shower after you write the trade ticket, buy hey; sometimes you just have to follow the money. Just watch out for the volatility.

2009 Oct 26 11:05 AM

[Old Trader]

I'd agree that Russia is full of long term potential, but until they develop (and stick to) some reasonable "rule of law", I'd give the country a wide berth (at least in a core portfolio).

2009 Oct 26 07:56 PM

[TradingHelpDesk]

Good article thanks. I think Russia is unique in the BRIC basket.

There are geo-political influences that pushed down Russian stocks (Georgia, etc), but I think we will not visit the lows of later 2008, early 2009.

Here's a tidy piece by Elliott Wave that analyses the technicals of the market as well:

www.elliottwave.com/a....

2009 Nov 03 08:13 AM