Is Putin Winning The Oil War?

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Includes: BIK, BKF, EEB, EMDD
by: Shareholders Unite

Summary

Admiration for Putin's decisiveness has largely subsided in the West, but not totally. There are still people arguing Russia will come out the other end reinforced.

While low oil prices will also produce problems in the US shale sector, it's strange to close one's eyes to the problems these cause in Russia's energy sector.

The fall in the ruble could, long-time provide a boost to non-energy production and exports from Russia, but not without serious reforms.

And Russia first has to survive a rather acute crisis.

Only if oil recovers and Russia embarks on reforms would it be a good place to invest.

Putin was, until recently, regarded by some as an excellent chess player, running rings around the West. That view was rather at odds with the reality even at the time, and one would argue that Russia is in a spot of bother:

  • Oil prices have nearly halved in less than a year
  • The ruble has nearly halved in a year
  • The economy is stagnating
  • Capital is fleeing the country
  • Foreign direct investment is drying up
  • Interest rates have been hiked to 17%
  • Inflation is high and rising above 10%
  • Russian companies have $700B+ in foreign debt
  • These companies have little, if any access to foreign capital, as a result of the sanctions
  • The Russian budget breaks even at $100 oil and half of the budget comes from energy

While it's one thing to assume that Putin will roll-over and withdraw from the Ukraine (or, even more improbable, Crimea), it's another thing altogether to assume that he's actually winning the battle with the West. Yet there are people who actually argue just that:

Not really says Marin Katusa, author of "The Colder War," and chief energy investment strategist at Casey Research. Katusa believes that falling oil prices will eventually give Russia the upper hand and deeply injure the U.S. energy industry. The falling ruble makes Russian oil less expensive and more desirable to other countries-Russia also produces oil quite cheaply while the American shale industry has a larger cost of operation. Russia is more than able to weather the current storm, Katusa says. "They have a $200 billion a year trade surplus. They have over $400 billion in reserve currency. They've increased their gold reserve. They have much lower debt to their GDP than America. So yes there's pain in the economy… [but] it's far from terminal."

This is an odd comment. Yes, the low oil prices might very well dent, or even damage US shale prospects. Opinions are really divided on how much though. For instance, Citygroup argues:

"Production is going to continue to grow. Could we see another million barrels a day of growth next year over this year? We happen to think so," said Edward Morse, global head of commodities research at Citigroup. Morse expects an average Brent crude price of $80 per barrel next year, but if it's lower, he says U.S. oil production could still add 800,000 barrels per day.

But a more pessimistic assessment comes from Bank of America:

The bank said in its year-end report that at least 15% of US shale producers are losing money at current prices, and more than half will be under water if US crude falls below $55 (€44.4, £35.1). The high-cost producers in the Permian basin will be the first to "feel the pain" and they would have to cut back on production soon.

Many players are hedged against falling oil, providing something of a cushion. On the other hand, much of the expansion is based on leveraged finance and with cash flows rapidly decreasing, quite a few players might go under. In the greater scheme of things that won't matter all that much, as their licenses and assets will quickly move to more capitalized companies.

There are odder parts in the comment from Marin Katusa. Oil is priced in dollars, nobody from abroad is buying in rubles, so for export purposes, Russian oil isn't cheaper. The $200B trade surplus is also rapidly disappearing and is testifying to that.

According to US Energy Information Administration (NYSEMKT:EIA) figures, oil and gas shipments accounted for 68pc of Russia's total $527bn of gross exports in 2013, when Brent crude - comparable to Russian Urals - traded at an average of $108 per barrel. Should the current price of Brent, at around $60 per barrel, be sustained over the next 12 months, that would result in Russia's export income from crude dropping to $95bn, from $174bn in 2013. However, these losses will be amplified by the total loss of revenue accrued from lower prices for refined petroleum products and domestic sales of crude, which totalled $122bn in 2013, according to the EIA. [Andrew Critchlaw]

Yes, we realize that over time, China might buy more oil and gas from Russia and payments might be partly settled with currency swaps enabling Russia to pay its imports from China bypassing hard currencies altogether. But this is a slow movement, and Russia and China aren't exactly buddies.

The Kremlin is counting on acquiescence from the BRICS quintet as it confronts the West, and counting on capital from China to offset the loss of Western money. This is a pipedream. China's Xi Jinping drove a brutal bargain in May on a future Gazprom pipeline, securing a price near $350 per 1,000 cubic metres that is barely above Russia's production costs. [The Telegraph]

But to suggest that the fall in oil will in time be a blessing in disguise is, well:

Every $10 fall in the price of oil cuts export revenues by 2pc of GDP. The "financing gap" will soon be 10pc of GDP.

Let's see how they get out at the other end of this first. We're also not convinced (to put it mildly) that Russia's energy sector is thriving without Western capital and technology. According to the International Energy Agency, it needs $100B investment a year for two decades to stop its oil and gas output from declining.

Russia's reserves of cheap crude in West Siberian fields are declining, yet the Western know-how and vast investment needed to crack new regions have been blocked. Exxon Mobil has been ordered to suspend a joint venture in the Arctic. Fracking in the Bazhenov Basin is not viable without the latest 3D seismic imaging and computer technology from the US. China cannot plug the gap. Andrey Kuzyaev, head of Lukoil Overseas, said it costs $3.5m to drill a 1.5 km horizontal well-bore in the US, and $15m or even $20m to drill the same length in Russia. "We're lagging by 10 years. Our traditional reserves are being exhausted. This is the reality for our country," he said. Lukoil warns that Russia could ultimately lose a quarter of its oil output if the sanctions drag for another two or three years. [The Telegraph]

Then there are serious problems in the banking system:

the combination of economic contraction, a liquidity crunch and the falling exchange rate is likely to lead to the failure of a number of banks. Russia has more than 800 banks, many them with low capitalisation, weak finances and weak corporate oversight. As of December, the RCB had withdrawn licenses from more than 80 banks in 2014 alone. While the sector is in need of consolidation, however, the disorderly failure of a large number of banks could cause significant economic disruption, deepening the recession and further undermining public confidence in the financial sector. [The Economist]

What would be the way forward for Russia? Well, they should embark on something they've promised for years, reform their economy:

Russia ranks 136 for road quality, 133 for property rights, 126 for the ability of firms to absorb technology, 124 for availability of the latest technology, 120 for the burden of government regulation, 119 for judicial independence, 113 for the quality of management schools, 107 for prevalence of HIV, 105 for product sophistication, 101 for life expectancy and 56 for quality of maths and science education. This is the profile of decline. [The Telegraph]

And they should diversify their economy away from energy and commodities, which are cyclical, highly capital intensive sectors that lock the economy in a boom-bust cycle generating little employment. Now they have to make that transition largely without the help of the West. It could have been so much easier after the end of the Cold War..

We have already argued that Russian stocks, no matter how cheap, are a dubious bet at the minimum. We haven't seen much to change our minds. Only an oil recovery would do the trick. But bigger tasks remain, getting Russia of the energy and commodity trap would be one.

But there is a simple gauge to assess which way Russia will turn, the oil price. Should the price of oil recover the next year, then things might turn out less dire. Some (but only some) comfort can be taken from the fact that Saudi Arabia itself seems to predict $80 next year.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.