Russia Experiences A Double Whammy As It Heads For A Recession

Summary

• Russia is facing the twin challenges of Western sanctions and lower crude prices.
• The country’s currency, which closely tracks Brent crude prices, is still significantly weak, despite the recent rally.
• Financial and energy sectors will face the brunt of the weak market.

This has been a tough year for the Russian economy which had to deal with the US and EU's sanctions related to Russia's conflict with Ukraine as well as plunging oil prices. And it seems that the challenging times are here to stay.

Recession Ahead

Alexei Kudrin, the country's former Finance Minister, has recently warned in an interview that Russia, the biggest global exporter of energy, is moving towards a "full-fledged" economic crisis while Finance Minister Anton Siluanov has also given a grim forecast.

The Western sanctions have restricted access to foreign capital for Russian corporations and led to a flight of capital from the country. To exacerbate, the European benchmark Brent crude oil prices have dropped by 48.7% during the last 6 months to its lowest level in 5 years, hovering around $58 on December 29. A prolonged weakness in oil prices to less than $60 a barrel in 2015, could cause the country's GDP to shrink by 4% next year while its budget deficit could exceed 3%, Russia's current finance minister warned last week. That's because the country gets more than 50% of its budget revenues from oil prices. The prices of the country's blend of exported crude are benchmarked against international Brent prices.

Brent prices have remained over $100 a barrel throughout the first nine months of 2014, but their future isn't looking bright due to supply glut and sluggish demand. This is due, in part, to the sluggish growth of China's economy, is set to expand at its slowest pace in 10 years in 2015. China plays a crucial role in driving the global energy demand since it is the world's largest energy consumer.

Ruble vs. Brent

With the Western sanctions and a gloomy forecast for oil prices, it's not surprising that ruble, which closely tracks Brent prices, was the worst performing currency in the world for the previous month when compared against 170 other countries. In November, ruble dropped by 16% against the dollar. Interestingly, in the same period, Brent futures also dropped by 16.8%. For the year-to-date, ruble has dropped by 42.5% against the dollar while Brent oil has fallen by nearly 49% in the same period.

This close relationship between the price of Brent crude and ruble is shown in the picture below. I have used United States Brent Oil Fund (BNO), which tracks the movements of Brent crude oil, as a proxy for Brent crude.

Image Source: Google Finance

In its attempt to recover the ruble, the Bank of Russia created a cash crunch via the money market by increasing its interest rate from 10.5% to 17% earlier this month. This was the single biggest increase in about 16 years. In 2014, the central bank has raised interest rates five times. The four previous attempts failed to halt ruble's collapse. However, in December, ruble recovered 45% from its record lows, as shown in the picture above (red circle).

So far this year, the Russia's central bank has spent more than $80 billion to support the declining currency. Moreover, the government has also implemented other capital control measures to shore-up the ruble. For instance, the government has asked the state-controlled oil and gas giants Rosneft (OTC:RNFTF) and Gazprom (OTCPK:OGZPY) to sell some of their dollar reserves in a bid to prop up the ruble.

Nonetheless, a single ruble is now worth 1.72 cents, down from more than 3 cents in January. This weakness will eventually lead to higher inflation in 2015, just as it happened twice in the 1990s. The country's Economy Minister Alexei Ulyukayev has already predicted double-digit inflation throughout 2015, touching 10% by the end of the year. Kudrin, the ex-finance minister, has forecast inflation growth rate of between 12% and 15% for 2015. Either way, it's bad news for Russia which has been recovering since the global financial crisis of 2008 and hasn't seen double-digit inflation rates over the last five years.

Russian companies

Several Russian companies have been brutally hit by the downturn. Trust Bank, a midsized lender, was the first victim of the crisis and is being bailed out by the government. Meanwhile, the government has moved in to boost the capital of state-owned financial institutions, which includes VTB Bank, the country's second biggest lender, and Gazprombank, the third largest bank.

While Russia's financial sector braces for weak ruble, the country's oil sector is going to bear the brunt of lower crude prices as well. Moreover, Western companies have started scaling back their Russian oil and gas operations on concerns related to sanctions. Consequently, the future prospects of Russian oil and gas giants could take a hit.

For instance, Rosneft's bid to expand by acquiring the oil trading arm of Morgan Stanley has been recently thwarted by the US. Earlier this month, Exxon Mobil (XOM) moved away from its venture with Rosneft for the development of the massive one billion barrels of oil reserves beneath Kara Sea. Similarly, North Atlantic Drilling (NADL) has delayed its $4.2 billion deal with Rosneft while the German chemicals company BASF (OTCQX:BASFY) has also halted its exchange of assets with Gazprom.

On top of a worsening economy, the Russian companies have limited access to international capital due to the sanctions.

On the other hand, US companies with significant exposure to Russia could also face major headwinds in the form of foreign exchange losses due to the strengthening dollar and weakening ruble. Among such companies is BP (BP). No other oil major has greater exposure to Russia's energy sector than the British oil producer, thanks to its 19.75% stake in Rosneft. As Russia plunges into recession, the value of BP's stake in Rosneft could be reduced, the company's earnings will take a hit while it faces a threat of deteriorating cash flows next year.

Analysts are expecting around 70% sequential drop in fourth-quarter profits when BP reports its results on February 3, 2015, due to the anticipated $630 million loss from Rosneft. Moreover, the Russian oil giant could suspend dividend payments next year, analysts have predicted. BP gets around 2.7% of its annual cash flows from Rosneft through dividends. Meanwhile, the $13.7 billion value of the British company's interest in Rosneft, calculated last year, could be reduced.

Conclusion

With recession, persistent weakness in ruble, double-digit inflation due to the Western sanctions and plunging crude prices, 2015 is going to be a tough year for Russia. The country's oil sector, the backbone of its economy, as well as the financial sector could be the hardest hit. This is going to be reflected in the performance of the $1.6 billion Market Vectors Russia ETF (RSX).

The fund, which has fallen by 46% this year, is composed entirely of stocks of 49 leading Russian companies, or those companies that generate a majority of their revenues from Russia. Ten of its largest holdings include oil and gas companies Lukoil, Gazprom, Novatek and Rosneft, as well as financial institutions, such as the VTB Bank. Not surprisingly, the ETF is heavily weighted towards energy (43.5%) and financial sectors (11.6%). Due to the aforementioned concerns and the fund's exposure to the two sectors, I believe investors are better off staying on the sidelines.

Disclosure: This article was written by Sarfaraz A. Khan, with valuable contribution from Iffat Zehra, research assistant at Half Bridge Business Review. Neither Sarfaraz A. Khan, nor Iffat Zehra have any positions in the stock(s) and fund(s) mentioned in this article.

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