On July 20, 2015, the normalization of relations between Cuba and the United States had captured investors' interest as both nations struck a deal which officially resumed diplomatic relations and saw the United States reopen its embassy in Cuba's capital city of Havana. Several months have passed since that historic moment and with President Obama visiting Cuba for the first time last month, investors are realizing that the thaw in tensions between the two nations signals a new era of investment for the country. With such positive progress, it is an appropriate time to begin looking at the investment opportunities that exist in Cuba and begin speculating as to how this improved relationship will impact the economy. This article will focus on identifying the fundamentals that exist in the Cuban economy and will aim to help investors understand how to establish exposure in order to benefit from any positive developments in the country. The current correction in emerging markets offers favorable long-term investment opportunities in many markets and for those with additional capital, it is now time to begin considering the potential Cuba has from an investment perspective.
There have been many key developments in the past year between the United States and Cuba, however, from a political perspective, Cuba continues to operate under a democratic centralist system. Constitutionally, Cuba is identified as a socialist state that ascribes the role of the Communist Party of Cuba to be a leading force of society and state. During 2006, the Chief of State for over 50 years, Fidel Castro, stepped down due to poor health and appointed his brother Raul Castro to become the new President with executive power over the country. Fidel, who is currently 90 years of age, released a letter in February outlining his overall perspective on the recent developments between the US and Cuba. He initially came into power in 1959 when he led a guerilla war against then US-backed Fulgencio Batista forces and overthrew the administration. His recent comments supported Raul Castro's agreement with the United States but also shared his distrust towards the US and their intentions in signing the deal. While his caution is expected, Fidel's general acceptance of the progress between the two countries is rather surprising and signals a change in perspective which has further improved investor sentiment. Conversely, current President and Commander in Chief, Raul Castro, has approached US relations in a much more cautious way as he recognizes that to help the economy grow, accessing global markets is essential. Last month, Raul visited France to speak with French President Francois Hollande in order to discuss Cuba's foreign debt in addition to boosting trade between the two countries and improving tourism opportunities. Raul Castro has been much more transparent regarding the human rights accusations made against his country during last year's talks with the United States but it remains a key topic that both nations disagree upon. While many investors may feel uneasy about the stability of negotiations, from Cuba's perspective, the country is acting out of necessity to reestablish economic ties, thus, both countries have an interest in seeing through a possible long-term agreement.
These small steps towards normalizing relations will require time and patience from both governments which can be challenging as both nations will undergo leadership changes in the following years. For the United States, 2016 is election year and the incoming President may have different opinions regarding this issue, however, President Obama has spoken to these fears and predicts that congress will lift the embargo under the next President. Conversely, Raul Castro has set 2018 to be the transition year when he steps down and cedes power to an incoming successor, who many believe to be Miguel Diaz-Canel. The 56-year-old has been seen as the possible successor but no information is available regarding his political views on Cuba's current position in the global economy and the nation's relations with the United States. At the moment, the central risk from the United States' perspective is whether the incoming leader of Cuba will follow in the steps of Raul Castro and continue negotiations or adopt the nationalistic behavior previously seen in Fidel Castro.
While it is important to consider Cuban leadership, investors should also analyze the current political environment from the United States' perspective, as they will be the deciding force as to whether or not sanctions will be fully lifted. The central issue for the US is whether lifting sanctions continues to meet their political goals of influencing Cuban politics to move towards more democratic ideologies. The US find themselves in a delicate situation where the impact of lifting sanctions on the government and country's population remains unforeseeable in the future. There needs to be a balance where the government can continue to put pressure on communist ideologies while also supporting the Cuban population by improving their standard of living and enforcing human rights. Under current restrictions, the communist party has continued to see its financial and social resources depleted and it is important for the US to negotiate in a manner that directs this improved flow of resources towards the general population rather than the party's leadership. President Obama spoke about the possible political repercussions that exist with helping the Cuban economy recover in a recent interview. He said;
"There are going to be certain sectors of the economy where we think, if there's some modification of the application of the embargo, the Cuban people will benefit directly, but there are going to be some areas where it could prop up, you know, certain cronies of the regime, but not necessarily have widespread impact."
It is important for investors to understand that while an initial deal may have been struck, the process of lifting sanctions will require a lot of political effort in order to cautiously focus on helping Cuban citizens rather than funding a communist regime. For this reason, when considering the political risks involved in the current environment, negotiations have been successful, however, this can quickly change if the United States begins to disapprove of the way reduced sanctions are impacting the Cuban economy. It is impossible to predict how relations will develop, but it is important to recognize that the difficult part of negotiations is far from over. In addition to the risk of changing direction, the political reform required to significantly change Cuba's economy will take years to implement. There will be initial resistance from Cuban leaders as any political changes will require large reforms in the current administration which could turn into a lengthy process. Thus, even if the United States agrees to fully remove sanctions in the following decade, it will take many more years to fully see the country change its political system to meet US expectations and implement the free market principles that global investors' desire.
One of the more unique challenges that Cuba faces is its dual currency system that has been in place for over 20 years. The system originated in 1993, following the collapse of the Soviet Union which was known as the "special period" in Cuba for the dramatic shift in trade strategy. Before the collapse, majority of Cuba's trade was done with the Soviet Union and its oil-rich economy, however, with the collapse occurring, these trade deals fell through and the country saw trade decline by 80%. With almost no foreign trade, the Cuban economy experienced a shortage of currency as the nation's old currency, the Cuban Peso (CUP), was being hoarded by consumers in an effort to protect savings. In response to the economic environment, Fidel Castro made the US dollar legal tender to encourage more valuable currency to enter the economy. This complicated matters with regards to businesses pricing services and goods so the country implemented the Convertible Peso (CUC) which would be paid to citizens and was on par with the US Dollar. By 2004, the country removed the USD from the economy in retaliation to US sanctions which left the currency system in a rather unique situation; the country had two different domestic currencies. Since Raul Castro's transition into power, there has been talk of improving the country's economic transparency and among these tasks involves changing the currency situation in Cuba. The problem arises at the consumer and business level as there is a tiered service structure in which consumers paying in one currency or the other are offered different levels of service and goods. For the wealthier class, mostly those who work in tourism, the use of the CUC provides great purchasing power in the Cuban economy with a 25 CUP to 1 CUC exchange rate. Conversely, the consumers who receive salaries in CUP suffer in this system, as they lose purchasing power and are exposed to the possible devaluation of their savings during the unification process. The Cuban government find themselves in a difficult situation where the current system inhibits them from developing their economy, while unifying these currencies would devalue the CUP and destroy the middle classes' savings.
Delving further into the currency unification process, the system masks a much larger problem which would change the overall purchasing power of the Cuban economy and related consumers. For state-owned enterprises and government accounts, the exchange rate of one CUP to the dollar, in effect, has been the same rate since 1959 and has not changed since. Once the currency is influenced by supply/demand fundamentals, the valuation will dramatically fall in reaction to Cuba's current economic state. Pavel Vidal, Cuban economist and monetary specialist, says
"A real monetary reform implies a significant devaluation of the CUP exchange rate. This would change the financial situation of state companies - some of which would fold - improve competitiveness of the sectors operating within the global economy and promote more transparency in financial accounts."
For investors, these currencies cannot be traded in the FX markets so the potential arbitrage opportunity does not provide any investment potential. However, because the currency does not trade outside of Cuba, the overall valuation of the CUC is not dictated by normal supply and demand fundamentals. Usually, when an economy wants to peg its currency to another, the central bank needs to react to price movements in the market by either buying or selling its own currency to keep up with market movements. Cuba isn't forced to use its foreign reserves because it dictates its own CUC to the USD exchange rate, creating another difficult challenge for the Cuban economy and its transition over to a one currency system traded on global markets. Even more challenging is the overall transition and how Cuba will be able to remove the CUC from circulation after two decades of providing strength in the economy. For state-owned enterprises and other government accounts, managing the current system involves handling both currencies in its reserves (no reserve information available) which complicates their balances sheets. The Economist covered this accounting issue in a recent piece, the article writes;
"Unifying the currencies would also end a bizarre anomaly in Cuban accounting, whereby state companies pretend in their balance sheets and domestic trading books that one CUP equals one CUC. The practice has prevented CUP inflation. But it has made imports seem artificially cheap and exports unprofitable. It also obfuscated inefficiencies that plague Cuba's predominantly state-owned businesses. Ending the charade could have dire consequences for many firms."
To make matters worse, for commercial businesses and general consumers, the exchange rate is 25 CUP for 1 CUC, a rather confusing structure that undervalues assets bought by state enterprises while overvaluing that same sale from the commercial side. Therefore, when considering the overall system and the ease at which the Cuban government will have during this transition, it seems very unlikely that the economy will react to a one currency system in a positive manner. While the current currency situation is not expected to change for several years, investors need to clearly understand this major hurdle that the Cuban economy will need to face in order to implement more free-market oriented principles.
Looking at the economic strengths of Cuba, it is the largest country in the Caribbean region and also one with a tremendous amount of potential as majority of the country's resources remain unexplored. The country has been struggling due to its underdeveloped capital markets and infrastructure, however even with such limitations, Cuba has the potential to absorb and allocate foreign investment. To put things into perspective, Cuba's recent GDP per capita was $6,051 USD while Mexico, among the more popular emerging markets, recorded a slightly larger $9,802 per capita. Looking at GDP annual growth in 2015, the country reported a positive increase of 4%, an enviable growth rate in a global economy where many emerging markets have been beaten down by lower commodity prices. While the Cuban economy was also affected by lower commodity prices, the lack of dependence on the US economy has created a sort of resilience against these global headwinds. Looking back at the country's historical GDP growth rate, in 2009, when the United States reported a -2.8% decline in GDP, Cuba was largely unaffected and reported a positive 1.4% growth during the global recession. Therefore, from a volatility perspective, the economic growth in Cuba has been largely positive with the country last reporting negative GDP figures in 1994.
Looking at the longer-term performance of the economy, it remains evident that the relationship between the US and Cuba is largely influential on the country's economic performance, as the 1990s were more volatile due to conflict between the two countries while the 2000s, were much stronger due to initial progress made in trade and economic liberalization by Raul Castro. Currently, Cuba has been forced to depend on more distant trading partners and the country has turned to entrepreneurs from China, Italy, Spain, and Venezuela for assistance. For China, Cuba provides the key to the gulf region given the country's geographical region while for Venezuela and Spain, the country's Spanish roots provide a great economic foundation for future investment. It is expected that as the country improves its relations with the US, more distant countries like China and Spain will see declines in trade volumes as Cuba begins to work more closely with partners in the Gulf region. Overall when considering the economic growth rate in Cuba, the resumption of diplomatic relations between the two countries should only benefit the economy as its trade strategy shifts and foreign investment increases.
^Sourced from Trading Economics
Looking at Cuba's inflation rate provides a different illustration of where the economy is relative to the growth in the Gulf region. While there is limited pricing information due to the large disparity between the public and black markets in the country, in 2014, Cuba reported an inflation rate of 5.3% which declined by 12% compared to 2013 numbers. The high inflation rate is more of a weakness for the economy as business savings are quickly eroded, forcing many owners to redeploy capital into more unprofitable projects in order to protect their savings. The origin of this inflation comes from the country's two currency system which forces businesses to sell products through two currencies while reporting them in one. In the long-term, it is expected that as the country switches off this dual currency system, inflation will become more manageable, as all consumers will operate on the same pricing level.
^Sourced from Trading Economics
Speaking to the long-term economic potential in Cuba, Texas A&M University released a report in 2015 which modeled the potential economic benefits that will be seen if the United States lifts the Cuban embargo. It is important for readers to understand that the United States has attempted to trade with Cuba before in the early 2000s through the Texas-Cuba Trade Alliance (TCTA). The TCTA, which was signed on February 12, 2003, focused on testing the trade potential between the two nations as state selected Texas farmers exported their agricultural products to Cuba resulting in over 1,500 new jobs. The agricultural sector in Cuba is among the nation's strongest industries and trade with Texas reached a high of $96.2 million in 2008. Unfortunately, with negotiations progressing and economic conditions worsening in Cuba, exports through the TCTA were down to $131,327 in 2014, a dramatic 98% decline in just 6 years as both nations were focused on signing a much larger deal. While the decline was dramatic for both parties, the TCTA proved that there is potential for trade between the two countries. Sheryl Jean of the Dallas News reported on this potential;
"Businesses in the state [Texas] stand to generate jobs and millions of dollars in trade with Cuba as the United States takes steps to open relations with the communist country for the first time since 1961. Texas could see $43 billion in total economic impact and 214 new jobs from increased exports and other trade with Cuba."
Under no-restriction conditions, the potential $43 billion in total economic impact is a large influence for both the United States and Cuba. The figure itself covers the relative demand for current US agricultural as many Cuban cities have increased the demand for imported food. Current trade agreements are focused on supplying the tourist resorts throughout the country however if restrictions are lifted and the economy sees an inflow of capital, the trade potential in the agricultural sector alone will create billions of dollars in business for both countries. In addition to the country's agricultural sector, recent findings in the Gulf of Mexico have indicated that the country has discovered billions of barrels of oil which would significantly change its energy dependence upon Venezuela. It was confirmed that Cuba will begin drilling for oil by the end of 2016 in these respective regions in order to produce its own oil and focus on shifting its energy strategy towards oil generated energy. Overall, when considering the economic potential in Cuba, future investment in the agricultural sector and oil space should be the leading sectors in the country's long-term growth strategy. From a fundamental perspective, the geographical location of Cuba provides numerous trade benefits with the United States and as relations normalize, foreign investment in these undervalued sectors will largely drive future economic growth.
When considering the current trade environment in Cuba and its main trading partners, US sanctions have created rather unique economic inefficiencies for Cuba's trade profile. Political allies in the Gulf and Central America have avoided trading with Cuba once the United States introduced the embargo which forced Cuba to import and export to countries that are geographically further away and less removed from these tensions. This directly impacts the cost of trade as transportation expenses increase and Cuba foregoes its relative geographical advantage in order to trade with more distant partners. Looking at the current portfolio, Cuba's top 5 exports are Raw Sugar (17%), Refined Petroleum (15%), Rolled Tobacco (13%), Packaged Medications (9.4%), and Nickel (7.4%). When considering the relative size of these accounts, the raw sugar and refined petroleum accounts provide significant exposure to volatile spot prices which have punished the country's trade balance in current markets. In the past two years, both sugar and oil have performed poorly and the combined 32% weighting was impactful on Cuba's trade balance. The country currently has a trade deficit of $4.29 billion USD which has increased as the country continues to grow its imports to meet a growing population's demand. Looking at the country's exported goods, Cuba has emerged as a possible leader in the pharmaceutical field for its developed medical field, a possible area of export growth in the following decade.
^Sourced from the Observation of Economic Complexity Database
When analyzing Cuba's export destinations, the country's top 5 trading partners are; China (20%), Venezuela (14%), Spain (10%), Netherlands (7.3%), and the United Kingdom (6.8%). The more developed economies like Spain, Netherlands, and the UK heavily purchase rolled Tobacco products and sugar exports while developing regions like Venezuela and China have taken advantage of Cuba's trade sanctions and have signed cheap agreements for the export of oil and nickel. The current trade strategy has seen exports decline in the face of increased global competition, which further drives down the value of Cuba's trade. Therefore, with the lifting of sanctions and Cuba's shift towards increasing trade with the US, the value of exports should see a significant shift while also changing the composition of trade partners. It is expected that current trade volumes with China, Spain, and Venezuela will see declines as Cuba takes advantage of its geographical location and begins exporting to the US. This change in strategy should also see the demand of exports change as tobacco and oil exports will move towards the US while sugar exports will continue to be sent to faster growing economies.
One of the key developments seen in the past decade in Cuba has been the country's declining birth rate. As Cuba continued to develop at a slower rate due to economic restrictions, the country saw its birth rate decline which hindered population growth. In 2015, Cuba reported yearly population growth of only 0.14%, a slight increase in the past 5 years but a serious decline compared to previous historical highs. With a current population of 11.2 million people, demographic factors remain unfavorable as the population is not expected to reach 12 million within the following decade. Looking at the country's median age of 39.9 years, the working class (ages 25-54) make up majority of the population with around 47.1% of the total population while the younger generation (0-14) were the second largest group with 16.3%. One of the arguments against Cuban labor in recent years is that the country has lost its highly-skilled workers as they migrate to more developed economies in search of better opportunities. While a portion of this skilled labor class does leave the country, with such high education attainment levels, the large working class in the country disproves any theories that Cuba has seen a depletion in skilled labor. Therefore, when considering the potential the country has from a population and median age perspective, while population growth may seem limited, the current generation provides the necessary skill-set needed to help modernize the Cuban economy.
^Sourced from Index Mundi
In addition to Cuba's population, another major consideration is the nation's education system as it provides the necessary foundation to help Cuba work alongside foreign investors to develop the economy and modernize industrial practices. Surprisingly, the country's literacy rate is incredibly high at 99.8%, which ranked Cuba 10th in the world in educational rankings above Canada (36th) and the United States (45th). In 2014, the World Bank reported that Cuba had the best education system in Latin America and the Caribbean as majority of the population are able to attain a university degree due to the government's subsidies. This strong literary foundation should be extremely helpful for a nation which will undergo significant developments in technical fields like medicine and the industrial sector. Cuba currently allocates the highest percentage of its state budget to education (13%), however, the disadvantages of the current economic system originate from its undeveloped economy rather than available skill set. For many, the training gained in the education system is not utilized once out of school as many workers have a desire to enter the tourism sector for its higher wages and increased stability. Cuba finds itself in a unique situation where it has the technical skills to produce and become competitive in the global economy but lacks the proper infrastructure and facilities to employ this technical labor.
Building off the previous section, Cuba's high literacy rate and government controlled economy has created a labor environment where the unemployment rate in 2014 was 2.7%, a yoy decline of -18%. Looking at the labor composition; 19.7% of workers are engaged in the agricultural sector while 17.1% and 63.2% of the workforce are engaged in the industrial and services sectors. The heavy weighting in the services space is primarily led by the country's large tourism industry which reported a record 3.52 million visitors in 2015, up 17.4% from 2014. With US travel restrictions being reduced and the tourism outlook improving, a growing dependence on the service sector should see more labor market participants enter the travel industry. Looking at the longer term unemployment chart (see below), it seems that there is an inverse correlation between the performance of the country's tourism sector and Cuba's unemployment rate. Looking at the illustration, due to the nation's heavy dependence on the tourism sector, lower tourist numbers during periods of economic recessions has a direct impact on unemployment. There seems to be a lag in the market reaction as the tourism sector saw a decline in 2007 while unemployment began moving upwards in 2009. This lag could be due to the labor market's underdeveloped infrastructure as the hiring and firing process in the country is much slower due to the government approval process. The Cuban government holds ownership in all tourist resorts throughout the country and under current law, hiring must go through the state and require approval, a tedious process that explains the delayed increase in unemployment following the decline in the tourism sector.
^ Data sourced from The World Bank
In addition to the general unemployment rate, youth unemployment (Ages 15-25) was at 3.1%, slightly higher than the overall market primarily due to the large middle class discussed in the previous section. It is expected that the youth unemployment rate will remain within this range for the medium term. However as FDI begins to enter the economy, Cuba will see an increase in both youth and general unemployment as labor participation increases. In the current market, the incentive to work has declined significantly over the past decade as wage growth has been minimal and the number of state jobs has declined. With the recent developments between the US and Cuba, wage growth is expected to resume as the economy benefits from increased foreign investment. As average wages increase, labour participation is expected to increase from its current 72% range as Cubans reenter the market to capture the rewards of lifted US sanctions. Overall, while the current unemployment rates for both the general market and youth groups illustrate strength in the labor market, frozen wage growth has driven many upper-middle class workers out of the public sector and lowered the labour force participation rate since the 2008 recession. However with expected changes in the Cuban economy as US sanctions are lifted, labor participation is expected to increase which should negatively impact unemployment numbers in the long-term.
^ Sourced from the Association for the Study of the Cuban Economy (ASCE)
Herzfeld Caribbean Basin Fund
When considering the investment opportunities in the country, the nation's underdeveloped economy does not provide any direct opportunities for foreign investors. In a nation where the tourism industry is run by the government and income taxes do not exist, the nation will need decades of development and leadership in privatization efforts to see any real movement in developing its capital markets sector. However, while it may not be possible to invest directly, the closed-end mutual fund Herzfeld Caribbean Basin Fund (CUBA) provides an indirect way of following the economy's progression. The fund's objective is to benefit from economic developments in the Caribbean Basin which is made up of Cuba, Jamaica, Trinidad and Tobago, the Bahamas, the Dominican Republic, Barbados, Aruba, Haiti, the Netherlands Antilles, the Commonwealth of Puerto Rico, Mexico, Honduras, Guatemala, Belize, Costa Rica, Panama, Colombia and Venezuela. While the fund focuses on exposure to these countries, 58.36% of its holdings are of US-based assets which engage in trade with or derive substantial revenue from operations in this region. When considering the influence that the Cuban economy has on the fund's performance, on July 20 th when the US and Cuba struck the initial deal, the fund's share price saw a 67.91% jump in a single day. Many investors reacted to this jump negatively as media outlets bashed the fund's lack of direct exposure to the country, however majority of its holdings operate in the Caribbean and in the long-term, will benefit from normalized relations in the region.
^Sourced from Google Finance
Another important consideration is the current leadership and their overall strategy for the fund. Erik Herzfeld, the current Portfolio Manager and President, Thomas Herzfeld, have consistently updated investors on their current position regarding the developments seen in Cuba, as presented in their recent semi-annual report. The following is an excerpt regarding the current progress seen and how the fund will be positioned;
"With the support of the majority of Americans, we believe lifting the embargo is inevitable and should provide new economic opportunities for the region as the largest Caribbean island by area, almost the size of all the other islands in the Caribbean combined, continues to be welcomed back into the global economy... but, with only one year left in his presidency, it appears the next president will determine whether the U.S. pursues lifting the embargo or walks back some of the progress made under the Obama administration."
Being that the Herzfeld Caribbean Basin Fund is the only investment product which focuses on exposure to this region, management will be among the first to invest in any opportunities related to the Cuban economy over the next decade. Thomas Herzfeld is one of the premier investors in the Caribbean and his familiarity with the region should provide valuable investment management experience as Cuba opens its economy. In a space where products providing exposure to Cuba are limited, from a management perspective, the fund does offer value for its service and in the long-term should provide the necessary experience and exposure to benefit from long-term developments in the Cuban economy.
^Author's own work
In addition to the current investment strategy and outlook, looking at the fund's holdings, it remains clear that its current US-based holdings will benefit from any exposure to the underdeveloped Cuban economy. Around 25% of the fund is invested in cruise line companies which travel in the region and as travel restrictions normalize between the two countries, cruises to Cuba should draw in short-term revenue growth for these organizations. Construction and infrastructure companies also make up a large percentage of the fund and will benefit as the country sees increased foreign investment focus on Cuba's underdeveloped infrastructure. Thus, in the following decade, the companies with exposure to the Caribbean region should see increased business growth as Cuba begins to develop its economy and necessary infrastructure. Looking at the fund's performance in the past few years, the 5-year results remain flat, while its 1-year performance was -23.88%. With the correction seen in the market, majority of the fund's decline was seen in the past three months as investors continue to watch developments between Cuba and the United States. Overall when considering the fund's exposure, these large cap companies with diversified holdings should benefit from direct growth within Cuba and also see increased opportunities as political relations in the region develop. The fund is relatively small with a market cap of only $41.96 million USD and as seen in 2015, large capital inflows greatly influence the volatility of the fund as investors consider using the product to gain Cuban exposure.
One of the more unknown investment options which provides exposure to the Cuban economy is Sherritt International Corp. (OTCPK:SHERF), a mining and refining nickel company with operations in Canada, Cuba, and Madagascar. The company has seen its share price decline significantly in the face of lower nickel prices as the company has a strong correlation coefficient of +0.8 to the commodity price. With nickel prices declining in the past 5 years by over 80%, the base metal's decline has hurt Sherritt's earnings as the stock dropped by 55.02% in the last year. The company remains a more leveraged and long-term play as it has operated in Cuba for over 20 years and has the necessary experience to benefit from longer-term developments in the region.
^Sourced from google finance
When considering the strengths of the company, Sherritt International offers large investment exposure to Cuba as about 75% of its revenue comes from its energy and mining operations in the nation. Sherritt has been mining nickel in Cuba for two decades and being the only foreign company in the country's mining sector provides considerable advantages once the nation begins to benefit from more open markets. As previously mentioned, the country is extremely underdeveloped from an infrastructure perspective and once FDI begins to fund new projects, Sherritt will be among the first and most direct benefactors from this political change in relations. In addition to current exposure, the company has worked together with the current Cuban government in a joint venture project which sees the company produce nickel at the Mao plant in Cuba and refine it at the Fort Saskatchewan refinery in Canada. This partnership has been in effect since December of 1994 and provides valuable political capital for the company as they work closely with the government and in the current economy. This partnership has proven to investors that it is possible to work alongside Cuban officials as long as FDI deals and projects are in the interest of both parties rather than taking advantage of current sanctions.
^Author's own work
In addition to Sherritt's nickel operations in the country, the company currently owns and operates 5 oil fields across Cuba which produce oil and energy for the country. Being the largest independent oil producer in the country, Sherritt has taken advantage of existing cheap labor and has grown production to 17,045 barrels of oil per day in addition to over 226 MWh of energy annually. From a production perspective, the company's oil division made up 33.4% of the country's total oil production, while energy made up around 1.66% of the nation's yearly energy consumption. With such large contributions to both fields, the potential for growth in these divisions is evident and any growth in the economy will see direct production and development growth across the company's oil reserves. In the current environment, Sherritt operates under restrictions from Cuba's current administration but in the following decade, if relations normalize, we can see the company use closer oil refineries that provide higher cost efficiencies in addition to newer drilling equipment for coastal reserves. When looking at the 2015 annual results for the company, the current oil and energy environment have been very unprofitable for the company, while the decline in the price of nickel also impacted FCF from nickel operations. The 55% decline in the share price over the past year is primarily why investors have undervalued the company's assets. In the short to medium term, the nickel, oil, and energy environments do not provide any considerable upside, thus, the equity should only be considered for a long-term hold in expectation of normalized relations (+10 years).
When speaking to the potential of Sherritt's oil and energy operations, the reserves are highlighted on the Cuban map below. In the current market, infrastructure for oil and energy production are subpar which increases the costs per barrel and cost per MWh produced. However as Cuba develops its infrastructure and economy with the lifting of US sanctions, Sherritt should see a direct reduction in production costs and further efficiencies in the sales market. In addition to production potential, the company owns large exploration blocks around the Cardenas and Matanzas regions. With heavy import restrictions enforced by the US, the cost of drilling and related equipment is significantly higher as it needs to be shipped from Canada. With trade opening up between the US and Cuba, Sherritt will see its exploration costs decline as importing materials becomes significantly more convenient with access to the US markets. Overall, when considering the energy and oil operations throughout Cuba, Sherritt owns blocks of land close to large coastal cities like Cardenas and Matanzas, a benefit to importing and exporting its production.
^Sourced from Sherritt.com/oil-and-gas/
While the company has worked alongside the current Cuban administration to produce nickel and energy for the country, the normalization of relations between the US and Cuba will see the company benefit greatly from the economy having access to cheaper and higher quality goods. During this transition, Sherritt might be at risk of seeing short-term changes to current agreements, however, there is no considerable risk in the long-term as operations will greatly benefit from lifted restrictions. Having the operational experience in the region and established facilities provides a first mover advantage which should provide incredible value as the economy grows. In the current market, the equity looks unfavorable as developments in Cuba will take several years before any significant growth is seen. Thus, the company will be primarily pegged to the performance of the price of nickel, it is recommended that this equity be considered only once sanctions are fully lifted and the economy has made significant progress from a development perspective.
Risks to Current Investment Proposition
While there are countless risks to be considered in any investment decision, the current situation in Cuba requires a lot of patience and risk acceptance in order to generate any significant returns. When considering the information presented above, investors need to be aware of two central risks which could impact their overall exposure. Firstly, the progress made in the relationship between the United States and Cuba has been led by leadership changes in both countries, as Fidel Castro ceded power to Raul Castro in 2004 and the US elected Barrack Obama in 2008. These changes improved political relations, however, with 2016 being an election year, the incoming President and his/her administration may shift efforts towards other endeavors which could either slow down the normalization process or stop it. Thus, it is recommended that investors have patience and await the new administration before considering any exposure to the region. Secondly, while many of the companies that currently have exposure to the Caribbean region provide the necessary exposure to benefit from the lifting of US sanctions, it is important to consider the relative impact of such an event. Many articles covering the investment opportunities available in Cuba suggest companies like Netflix (NASDAQ:NFLX), Delta Air Lines (NYSE:DAL), or Copa Holdings, S.A. (NYSE:CPA) as potential investments to benefit from normalized US relations. Investors need to be aware that although the Cuban economy is undergoing a significant change, the relative size of its market will not impact such large companies. Thus, when considering investments, investors need to consider the relative size of the Cuban market and its impact upon the respective company.
After considering the different strengths and weaknesses in the Cuban economy and the possible investment opportunities, Cuba remains a rather challenging and risky place to invest. The overall investment strategy when approaching emerging markets primarily depends on the respective investor's holding period and this consideration is no different for Cuba. From a long-term perspective, the nation remains an undervalued opportunity with underdeveloped infrastructure and industries that will contribute positively to economic growth. With access to global markets and lifted US restrictions, Cuba has the potential to become a large contributor in the Gulf region and chief among these opportunities is the potential trade efficiencies with the United States. However, all of these opportunities remain a distant thought as the nation currently faces decades of negotiations with international partners and domestic leaders in order to shift the economy towards a more democratically oriented system. In addition, the communist party has expressed it overall desire to remain in power throughout this process which should complicate the overall transition into the new economy. The state-controlled model has never worked in the long-term and it seems that Cuba will be faced with a difficult dilemma where the government can trade off political authority for economic performance. In the short-term, the situation remains challenging and any positive movement seen in equities related to the region are more momentum-based rather than fundamentally driven. For many investors, the diplomatic deal between the US and Cuba signaled a possible investment opportunity and while there has been increased interest, the real investment potential remains a distant thought. It will take decades for the country to implement the right measures to improve the domestic economy and because of this uncertainty in time, I am unable to grade the country on a buy/hold/sell level. For those who are connected to the economy and are able to invest early, the opportunities are there, but for the average investor, Cuba is a wait and see play.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.