Russia Still Attractive, Despite The Risks

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Includes: LUKOY, OGZPY, RSX
by: David Urban

The Russian RTS Index in down approximately 10 from its high made earlier this year. Russia has been one of the hot emerging markets in the past few years as rising commodity prices and the firm hand of Vladimir Putin guided the country out of the mess they created in 1998 when they redefined the word 'risk.'

This correction is nothing more than the standard correction investors have come to expect over the years during the second quarter setting the stage for a second half rally leading into the Presidential and Duma elections later this year.

In the past few years investors in Russia were rewarded with exceptional returns and the Russian government began to flex its newfound political strength overseas. Holding one of the worlds largest reserves in oil and natural gas the Russian government keenly offered stakes in projects and negotiated shrewd deals with governments and foreign firms looking to invest. Rather than being taken advantage of as many emerging economies are in negotiations with foreign firms Russia looked to turn the tables. But the flexing of muscles may have gone too far as the 27 members of the European Union have decided to unite and push back against Russia's increasing show of strength.

Two events in particular seemed to have united the Europeans. The protests and Internet attacks which laid siege to the Estonia over the moving of a Russian monument and the political stalemate over the handling of Andrei Lugovoy, the man accused of poisoning former KGB spy Alexander Litvinenko.

While the British may be prodding the Russians to turn over Lugovoy, it should be noted that the British have provided shelter to Boris Berezovsky; a former oligarch who stole billions of dollars from Avtovaz and Aeroflot in the 90's and created a new meaning for the term 'destroying shareholder value.' Berezovsky has openly called for a revolution in Russia. One should think how the US government would respond if similar tactics were employed against them.

As always with Russia the events and reasoning behind the scenes are typically different than what is shown in the press. In this case, it appears as though Putin is attempting to show the world that he is not a lame duck president and the Russia will remain strong through the handover of power early next year. By being firm he gives the next leader of Russia some wiggle room to immediately make a good impression on the world stage and show a softer side and that he represents a 'new Russia.'

Western press often does not understand the political positions Russia make take on the global stage and is looked at as the villain when the opposite may be true. For example, during the gas dispute with the Ukraine where gas was cut off to Europe a few years ago, Russia's position was that they wanted the Ukrainian government to own up and pay for the gas which they had stolen from the pipelines going through their country. Gazprom owns the pipelines entering and leaving the Ukraine and it is well known that the Ukraine takes great liberties with their usage of gas for local industry and residential consumption while claiming to use much less while paying a rate far below market.

With regard to Kosovo, Russia has had a long standing relationship with the Serbs and that relationship is the reason behind their stance with the Serbian government.

The stripping of assets and licenses from foreign oil companies can be looked at as notice that prior behavior in the country will not be tolerated. In the past, oil company's negotiated deals with a former president whose affinity for alcohol was well known and contracts would be heavily negotiated in their favor. In the end, the oil companies would take the bulk of the profits while providing very little, if anything, to the countries coffers. Nigeria is a perfect example of what happens when one sided contracts become the norm. Russia put an end to this practice and used its massive reserves to instead negotiate the best deals for the country rather than foreign firms.

Like all investments, one needs to consider perspective and look at a situation from all sides before coming to a final conclusion.

With all of these risks, is Russia still an attractive investment? Yes, commodity stocks, such as Lukoil (OTCPK:LUKOY), Severstal, Gazprom, and Norilsk Mining (OTCPK:NILSY) have major positions within their respective industries and are expanding globally. There will be some additional downside from here but look for a summer rally after a basing pattern forms and attractive returns leading up the Duma and Presidential elections.

Disclosure: The author owns shares in Norilsk Mining.