Amid Protests, Novatek May Be Losing The Putin Shine

Includes: OGZPY, RNFTF
by: Emerging Money

By Jett Coltrane

There has been one Russian energy name to own over the past few years: Novatek. While it is difficult for U.S. retail traders to buy or sell, its changing fortunes can rock the entire Moscow market.

This independent gas and condensate producer with very humble beginnings in Siberia in the 1990s has grown with lightning speed into the world’s fifth-largest gas company by proven reserves, now about 10 million barrels of oil equivalent.

That has helped catapult its market capitalization from $4 billion to $45 billion in seven years. That makes it $7 billion bigger than a company like Apache Corp. (NYSE:APA), which was a player in the energy business 40 years before Novatek got moving.

The company’s star achieved new heights in 2011 when Russian Prime Minister Putin’s government approved tax breaks for Novatek’s world class greenfield project on the Yamal peninsula in the Arctic. The estimated $25 billion project may begin shipping LNG in 2016.

Novatek brought that LNG project a step closer to reality by selling a 20% stake in the Yamal field last year to France’s Total (NYSE:TOT), which has the expertise to develop such complicated projects.

Novatek’s owners further cemented that key relationship with Total by giving the French the option to buy up to a 20% stake in the company. Despite the turbulence on global markets that sent Russia’s RTS index falling 22% in 2011, Novatek ended the year in the green on the back of those deals and shifting tax breaks.

With the help of the Yamal LNG project, Novatek plans to more than double natural gas output to 110 billion cubic feet by 2020 and triple liquids production, its most profitable business.

Throw into that mix constantly rising Russian domestic gas prices — which may rise by as much as 65% by 2015 — and Novatek’s net income is headed for orbit.

According to investment banks, Novatek profit is forecast to jump 75% to $3.3 billion over the next two years. Not only is Novatek set to leave Apache in the dust, it could creep up on Occidental’s (NYSE:OXY) market capitalization of $83 billion in a few years-- assuming the company continues to deliver.

But just as Novatek’s production outlook brightens, the shine may be wearing off this star of the Russian equity market. Putin’s sky-high popularity is sinking back to earth as protesters take to the streets, and that has investors questioning whether Novatek will continue to receive special tax treatment and access to reserves.

Continued outperformance versus state-owned Gazprom (OTCPK:OGZPY) and Rosneft (OTC:RNFTF) this year will be difficult if political uncertainty continues.

Political Connections

Political connections are the magical keys to unlocking the forbidding gates guarding Russia’s enormous natural resources base. In fact, scratch the Cyprus offshore holding of any private Russian oil or gas company and you are likely to find a current or former government official (or family member) among the real beneficiaries.

Russia in that sense is probably not different from other resource-rich emerging nations. What separates Novatek from other Russian private oil and gas companies is that it got its hands on the most important key: Putin himself.

in October 2008, as the global economy was edging toward a 1930s-style depression, Gennady Timchenko acquired a 5% stake in Novatek, turning heads in Moscow.

What did this businessmen with reported ties to Putin and current owner of Gunvor, Russia’s dominant oil trader, plan to do with the small gas producer? Was it just an equity investment? The answer would come in early 2009.

Little did anyone know that Timchenko owned a license to the South Tambeiskoe field, one of three major gas and condensate fields on resource-rich Yamal. In May 2009, Timchenko agreed to sell a 51% stake in South Tambeiskoe to Novatek in exchange for new shares. Novatek also bought an option to the remaining 49%.

By the end of 2009, a year in which Novatek raised gas production at state-controlled Gazprom’s expense, Timchenko owned about 23.5% of the company.

Investors and bankers started to whisper that perhaps Novatek was Putin’s new project, a sort of personal pension plan managed by his old acquaintance from St. Petersburg — speculation vehemently denied by the Kremlin and Timchenko.

The denials did little to cool passions, pushing investors to snap up the shares, which have doubled since 2009.

Novatek shares trade at P/E and EV/EBITDA multiples that are double the average of international and Russian peers and 4 times that of Gazprom, the state-owned Russian gas giant. Novatek’s 2012 P/E hovers now around 17x vs about 4x for Gazprom.

Since Timchenko’s initial purchase in October 2008, Novatek’s proven and 2P reserves have doubled, mainly driven by dirt-cheap acquisitions. Novatek has promised more acquisitions inside Russia. With Timchenko-backed Novatek successfully snatching choice Russian gas assets that some time ago would have only been the domain of Gazprom, investors began to question whether Novatek could get its hands on Gazprom’s golden chalice: Gas export licenses.

Currently, Novatek sells its natural gas only inside Russia and at regulated prices, which are about four times below the price in Europe, the main export destination for Russian gas. Those low domestic prices haven’t stopped Novatek though from posting higher than 40% EBITDA margins. These could rise to near 60% if it sends a portion of its output to Europe. The return on capital has been an outstanding 30%.

Historically a fierce defender of Gazprom and its assets, Putin hinted in September at the possibility of ending Gazprom’s export monopoly in coming years, without giving any concrete dates. But the mere fact that Putin, who fought off oligarch attempts to break up Gazprom in the early 2000s, even mentioned that possibility had the Novatek bulls roaring.

But then something unexpected happened that has shaken confidence in the ballooning “pension plan.” Members of the growing Moscow middle class stood up in December for the first time as a group to publicly say they had enough of Russia’s Czar and his corrupt regime. The protesters — about 40,000 to 50,000 — have come out on two more occasions, the most recent this past Saturday.

When protestors organized the largest demonstration since the collapse of the Soviet Union, Russia followers started to question whether Novatek could lose its privileges. And Novatek shares did something it hadn’t done in years: It underperformed other Russian oil and gas stocks in the month following the first protests.

Though Putin looks set to win the presidential election in March and reign for another six years, his star has fallen, with his popularity rating at historic lows.

With the middle class less fearful to voice their opinion and demonstrate against state abuse, Putin’s government may need to think twice before letting more choice pieces of Russia’s gas pie fall on Novatek’s plate. And without new, sizable assets on the cheap or export licenses, Novatek’s heavenly multiples will likely return to earth, setting it up for its first underperformance in at least three years.

This, in turn, should weigh on Russia funds like RSX which are heavily invested in Novatek. RSX, for example, has 6% of its overall assets in this company’s stock — a full 15% of its allocation to the energy sector.

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