Russia: No Money, No Problem?

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Includes: OGZPY, RSX
by: Craig Pirrong

I asked a Russian friend how the financial and economic crisis had affected the regional art center in the Urals where she works. She said that she and her colleagues were coping with typical Russian resignation, and had made “нет дениг, нет проблем” (”No money, no problem”) their motto.

The “нет дениг” part may fit the country as a whole, but the “нет проблем” part doesn’t, quite. The Sayano-Shushenskaya dam disaster is widely considered to be a harbinger of potential problems. The direct economic consequences are severe, reducing Russian electrical generating capacity by 2 percent; this in fact understates the impact because the dam was an inframarginal (i.e., relatively cheap) source of power. The costs of repair are very high. Estimates run to $1.25 billion, but being estimates, being early, and being Russia, it is likely that the final bill will be much higher than that. (Just ask the Indians about how the estimates for the repair bill to the Admiral Gorshkov compared to the actual cost.) That in itself represents about 3 percent of total Russian infrastructure spending in 2008.

But as bad as the direct cost of repairing this one dam is, the prospect that Russia is just waiting for many additional shoes to drop is even worse. And all at a time when there is no slack whatsoever in the budget; the state investment funds are being depleted rapidly, the budget deficits are forecast to be at the very upper limit that the country can run without risking grave risks to the currency, and Russia plans to return to the debt markets soon to cover its existing shortfalls. Nor can the country rely on foreign investors to step into the breach. The combination of poor economic prospects and a history of mistreatment has exacted its toll.

Even the big cash cows are running dry. Case in point: Gazprom (OTCPK:OGZPY).

Gazprom’s profits were battered by plunging gas sales to the European Union and Ukraine in the first three months of the year, it has reported in its latest resultsunder international accounting standards.

A 62 per cent drop in profits to Rbs110bn (about $3.5bn, at today’s exchange rate), reflects steep falls in gas export volumes, which were down 31 per cent to the EU, and 61 per cent to the former Soviet Union countries, including Ukraine. The economic downturn, which has hit demand for gas, particularly from industrial users, in Europe and around the world, was part of the reason; supply disruptions caused by the interruption of flows to Ukraine during the pricing dispute in January were another.

. . . .

The company’s debts are continuing to rise. Borrowings were up 17 per cent by the end of March from the end of 2008 to Rbs1,191bn (about $38bn at today’s exchange rate), mostly because of the fall in the value of the ruble, which pushed up the ruble value of Gazprom’s foreign currency debts. Since then, it has made significant further expenditures, including $4.1bn buying a 20 per cent stake in its oil subsidiary Gazprom Neft from Eni of Italy, and $1.67bn buying 55 per cent of London-listed Sibir Energy.

Amazingly, some, like Sanford Bernstein analyst Oswald Clint are trying to gussy up this corpse:

Capital expenditures have been cut 15% in 2009, the 2008 proposed dividend was cut 86%, and capex hungry projects in the Yamal peninsula have been delayed. Combined, we now expect much improved balance sheet flexibility, and expect the company to generate positive free cashflow this year, which provides plenty of scope to re-grow the dividend. With added tailwinds of favorable government moves to boost domestic pricing tariffs by 15% in 2010, 2011 and 2012, the company is also likely to start generating profit for the first time from 292Bcm of gas sales (50% of total) sold in the domestic market.

So. Let me get this. The company is in such deep financial straits that it all but eliminates its dividend, sharply reduces its capital expenditure, and delays its big investments in new production. And this is good news because this creates “balance sheet flexibility”? I guess. But flexibility to do what?

Talk about looking on the bright side. ”Other than that, how was the play, Mrs. Lincoln?” ”Well, there’s now one less mouth to feed.”

Even There’s-a-Pony-in-There-Somewhere Clint recognizes that Gazprom’s production, which fell sharply in 2009, will not reach 2008 levels until “late in the next decade.” Which means 8-10 years. And with the sharp drop in capital expenditure, the delays at Yamal, and the accelerating declines in its mature western Siberian giant fields, that may be very optimistic. Which means that, even given additional domestic revenue, the company’s prospects for generating the kind of positive cash flow that will (a) keep certain people living in the style to which they have become accustomed, and (b) more importantly, it will not be able to generate revenues for the Russian state to address its already pressing fiscal problems, let alone provide funds to shore up a collapsing infrastructure.

And in the aftermath of Sayano-Shushenskaya even the higher domestic revenues may be in doubt. Putin and Medvedev have already pledged that the state will prevent power prices from rising excessively due to the loss of capacity. Which means that the on-again, off-again electricity tariff reforms are probably off again for a long time. Moreover, given that the loss of hydro capacity will increase the demands placed on gas fired power plants, the imperative to keep power prices low will surely induce the power plant operators to pressure the government from keeping gas prices low. Furthermore, it is likely that the government will attempt to palliate consumers who end up paying higher electricity prices with the sop of lower gas prices, and will therefore delay full implementation of the scheduled gas price increases.

In brief, Russia faces a yawning capital gap. The country has lived, after a fashion, on the Soviet inheritance, from huge hydro stations to massive gas fields. ”Deferred maintenance” became a modus operandi. The Sayano-Shushenskaya disaster is just a vivid illustration of the consequences of this. It makes me wonder what the true rate of Russian growth in recent years would be, if the true depreciation/consumption of capital were taken into account. The country has consumed much of its seed corn.

The country’s major source of cash–the energy business–has lived off the Soviet inheritance as well, so Russia can’t look to that for succor; indeed, that sector needs a massive infusion of capital too. Foreign investors won’t step up. Compared to other countries, Russia invested relative little as fraction of its GDP even during the seven fat years.

So, no money: big problems.

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