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Summary

  • The sudden turmoil in Iraq places a strategic premium on the safety and stability of Russian Oil & Gas exports to Europe, South Asia, and the Far East.
  • Russia has much to gain ($) by softening its Ukraine policy and actively promoting peace along its western borders with Europe.
  • Domestic and foreign capital flight from Russia has diminished, but a lack of trust is now prevalent among potential investors and former political allies.
  • Current valuations of the energy-laden Russian Stock Market do not reflect the recent 8% rise in Brent Crude (Spring, 2014).

On June 12, 2014, news broke that Iraq was on the verge of an all-out civil war: Sunnis in the West, Kurds in the North, and Shias in the East. Since early June, activities on the ground there have been proceeding at a breath-taking pace.

The oil fields are surrounded by competing armies of insurgents; supply roads from the north (Turkey) to the Gulf states have been effectively cut off by a war zone. It is likely that the country's largest oil refinery has been captured by militants (See: Did ISIS capture Iraq's biggest refinery? by CBS Interactive, June 24, 2014).

How Important is Iraq in the world's oil markets?

  • Iraq has the fifth largest proven crude oil reserves in the world, and it passed Iran as the second largest producer of crude oil in OPEC at the end of 2012.
  • Iraq was the sixth largest net exporter of petroleum liquids in the world in 2012, with the majority of its oil exports going to the United States and to refineries in Asia. (See: U.S. Energy Information Administration, Iraq)

(click here to link map with countries' oil production)

As you can see from this chart, Russia's borders touch Europe to the West, the Middle East to the South, and China and Japan to the Far East. The vast geographical spread of Russia's oil and gas exports across the Eastern Hemisphere now has a unique position in the wake of Iraq's instability.

How Important is Russia to the world's petroleum markets?

  • Russia is the second-largest producer of dry natural gas and third-largest liquid fuels producer in the world.
  • Russia's economy is highly dependent on its hydrocarbons, and oil and gas revenues account for more than 50% of the federal budget revenues.
  • Russia was the third-largest producer of liquid fuels in 2012, following the United States and Saudi Arabia. During that year, liquid fuels production averaged 10.4 million bbl/d.
  • Russia's Transneft holds a near-monopoly over Russia's pipeline network, and pipeline exports account for the vast majority of Russia's crude oil exports.
  • Russia holds the largest natural gas reserves in the world, and is the second-largest producer of dry natural gas.
  • Russia is one of the top producers and consumers of electric power in the world, with more than 220 gigawatts of installed generation capacity. In 2011, electric power generation totaled approximately 996 billion kilowatt hours, and Russia consumed about 861 billion kilowatt hours. (U.S. Energy Information Administration, Russia).
  • President Putin recently signed a gas deal with China that "will directly link Russia's huge gas fields to Asia's booming market for the first time - via thousands of miles of new pipeline across Siberia." (See: As Putin looks east, China and Russia sign $400-billion gas deal, by Alexei Druzhinin, Ria Novosti/Kremlin {for Reuters}, May 24, 2014).

The important economic and political point of Russia's strategic position is their transport of crude oil and gas: its pipelines. They control the entire transfer process from their oil and gas fields to adjoining nations. Russia's simple and scalable economic model employs little use of oil tankers, and requires only sufficient investment capital to expand and maintain the necessary infrastructure to export oil and gas for decades.

Thus, it has everything to gain by establishing itself as a reliable, trustworthy business partner to markets in Europe, South Asia, and the Far East; and a lot to lose by approaching its neighbors with aggression.

The nostalgic ideal of Novorossiya - and re-assertion of Russian military and political power as it was during Soviet times - has driven the recent annexation of Crimea and inspired armed Russian insurgents in Eastern Ukraine, but it has also pushed brinkmanship with the West towards new economic sanctions against Russia's energy industry, and in Europe, likely sanctions on Russia's banking sector.

The legacy of Soviet domination in Eastern Europe is recent, and it is not a sanguine one. Just a generation ago, there was an iron curtain stretching from the Baltic states in Scandinavia to the Bosporus. East Germany, Romania, and Belarus were police states. There was very little economic opportunity outside of Communist Party memberships. With the first inklings of perestroika, massive waves of emigration left Russia for Israel, Europe, the US, and Latin America. Eastern European countries shed Soviet control as soon as they were able to. Almost no one living in those Eastern European countries today wants to go back to "the way it was". The nostalgia is in the mindset of the former conquerors, not the conquered.

There could hardly be a more stark comparison between economic opportunity and re-alignment banging at the door (via Iraq), and an inability to seize it because of a desire to create a buffer state around its western borders, re-acquire lost territory from Soviet times, and recover Russian Diaspora from neighboring countries.

This comparison chart between the price of Brent Crude (red line) and the RUSL (Direxion Daily Russia Bull 3x Shares) shows the undervaluation of the Russian stock market vis-a-vis its energy industry. The RUSL is currently somewhere between -30% to -50% below its previous price during spikes in Brent Crude (see blue arrows).

The gradual drop in the stock market also coincides with a recent surge in government military spending (See: Russia spends more of its wealth on arms than US in 2013 by Richard Norton-Taylor, The Guardian, Sunday 13 April 2014). Federal budget expenditures on Russian military spending are now the largest in Europe.

This is occurring against a backdrop of capital flight inspired by the Ukraine crisis. (See: Lord Mandelson sees 'looming nightmare' for Russian economy despite gas deal, by Ambrose Evans-Pritchard, The Telegraph, May 22, 2014). Much of this capital flight has been from Russian citizens, destined for the London stock market. Domestic outflows were 2.5x that of foreign outflows during the panic of March and April, 2014.

"Never since the Second World War have we seen a financial crisis of this kind caused by political events in a very large country that is fully integrated into the world financial system. There are things happening beyond our control," said Irackly Mtibelishvily, Citigroup's chairman in Russia.

Mr Mtibelishvily said the ultimate test is whether Russia can deter its own people from funneling money out of the country. "It is domestic capital that will determine the success or failure of the Russian economy. People don't feel comfortable about keeping their money here. It is a long sad story that we ignored for years," he said.

(See: Russia's central bank chief deems crisis over as capital flight is halted, by Ambrose Evans-Pritchard, The Telegraph, May 23, 2014)

Peace would be bullish - very bullish - for the Russian stock market - and whenever news of peace talks or negotiations in Ukraine crosses the wires - the stocks in the Micex immediately respond. The Russian market is clearly signaling where it thinks the path of least resistance lies.

The recent insurgent mortar attack - just 24 hours into the peace process - highlights the fragile stalemate. After a vigorous rally on the news of the mutual cease fire, the Micex index quickly dropped 3% on the news of the downed helicopter attack (9 deaths), wiping out its recent gains.

With the sudden onset of the Iraq crisis and the resulting instability in OPEC's Middle East, Russia has a unique opportunity to create a rapprochement with the West, to take advantage of both its geographical position and political stability to be a purveyor of oil to Europe and the East. If it did so, Russia could quickly emerge as the single most-politically stable and reliable oil producer in the Eastern Hemisphere.

The trade here is to remain long Russian equity ETFs (RUSL, RSX, RSXJ, ERUS), while keeping an eye on leveraged oil (NYSEARCA:UCO) for sustainable short-term oil prices, hoping that cooler heads will prevail in the Ukraine situation; and that Russia's foreign policy will come into alignment with the emerging economic opportunity in oil and gas sales - one that could re-assert Russia's power in business and trade, not just militarily.

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For further information on the unfolding Iraq war and its economic impact, see also: Militants on March in Iraq Undo What U.S. Sought, by Nicole Gaouette, June 12, 2014, Bloomberg News; and Iraq burns again: What has sparked the fire? by Catherine Boyle, June 12, 2014 Yahoo/CNBC); and Obama's Disastrous Iraq Policy: An Autopsy, by Peter Beinartjun, June 23, 2014, The Atlantic)

Source: In The Wake Of Iraq, Parsing Putin's Next Move