From Russia with Love?

Thanks to some reader suggested input, I will now place the thesis of each post at the very top. Thesis: Long Russia/Long LNG.

For those of you who have read my prior posts you might have realized that I am relatively bullish on certain foreign economies, with Russia being one of them. The Russian thesis in a nutshell is: they have an immense amount of natural resources which should drive their domestic economy allowing the government (via heavy export levies) to invest substantial amount of domestic infrastructure which should help spur development in non-natural resource based industries, this coupled with the fact that I believe their currency is currently undervalued should provide a U.S. investor an interesting return spectrum. The risks to this thesis are obvious: inflation, Dutch Disease, government risk (think recent events with Mechel or Yukos), and most recently war with Georgia.

As you probably have heard Russian tanks crossed into South Ossetia Friday after Georgia launched a major military offensive to recapture control of the separatist province on Thursday night. In Moscow, Russian equities tumbled, as investors turned nervous following news of the escalating situation. The benchmark RTS stock index fell 6.5%. The index has declined 24.8% this year (this decline is due to three things: 1. Putin’s recent move against Mechel, 2. Falling natural resource price and 3. Conflict with Georgia. The Russian currency, the ruble, fell more than 1% against its dual currency basket Friday. South Ossetia has a population of 70,000, most of whom are not ethnically Georgian, but close to the Ossetians in Russia's province of North Ossetia. A destitute region, South Ossetia has received two-thirds of its $30 million budget from Russia and the majority of its population holds Russian passports, according to Global Insight. Russian state-controlled gas giant Gazprom is building a pipeline to the region as well as infrastructure. For Russia, South Ossetia is a useful means to undermine and cause inconvenience to the unfriendly Georgian government, which sees itself as the U.S. outpost in the post-Soviet space and seeks to join NATO, which is very annoying to Russia. Politics aside one can’t help but wonder what could be the end result financially speaking. The likely result is that the fighting will continue until Russia is allowed to either remove the people or claim the territory; I view the former as the most likely scenario. Although Georgia does control reasonably important pipeline territory Russia has already been finding ways to build around it. I think the recent sell-off in both the equities and currency is overdone.

Demographically speaking Russia does face certain challenges. Russia stands out for its high levels of educational and scientific achievement. But the fiscal crisis of the 1990s caused a ‘brain drain’ of many of its top researchers and difficulties in recruiting new teachers. The country still needs to go some way to restoring the quality of its schools and universities, while adapting them to the demands of a knowledge-based economy. Demographics pose one of the most serious challenges to Russia’s long-run growth potential, and have a direct, negative impact on the future size of the economy. The US census bureau forecasts that Russia’s population will shrink from the current 142mn to under 110mn by 2050, with the workforce contracting after 2009. So far, the government has offered incentives to mothers to have more children, has begun to invest more in health care, and has promised to promote a healthier lifestyle. As the government begins to invest more domestic infrastructure that will drive job growth which will spur immigration from surrounding countries. Just as in the other BRIC nations, Russia needs to improve its infrastructure significantly. Because Russia is already reasonably urbanized, its need is not in the same league as China’s or India’s. Nonetheless, Russia has plenty of scope to improve its transport systems, linked to the rapidly rising wealth of Russians. The airline/airport infrastructure need appears to be especially strong, and it represents both a challenge and a significant business opportunity.

The question then remains will commodities remain high enough to fund the backbone of the Russian economy? The conflict in Georgia might act to disrupt Russian oil & gas supplies to Europe (they could also tighten the spigot as a form of political pressure for EU neutrality or support). Speaking on a more macro level, there has been a substantially negative shift in sentiment owing largely to concerns about commodity “demand destruction” in the context of both slowing global economic growth and substantial commodity price increases this year. Concerns about increased supply availability owing to OPEC production increases and substantial improvement in US crop conditions and development post the slow start to the U.S. planting/growing season and the Midwest flooding have also contributed to recent sharp price declines. Although US and broader OECD demand for oil has weakened substantially over the prior six months in response to rising prices, this weakness has been necessitated by extremely disappointing non-OPEC crude oil supply growth –down 650 thousand b/d year over year in June – in the context of still strong emerging market demand. The US in particular has borne the brunt of the demand declines relative to the rest of the world because lower taxes, a weaker economic environment and tighter credit conditions have left US consumers most sensitive to rising prices. Despite substantial US demand weakness, US total product inventories have failed to build meaningfully and US crude oil inventories actually remain at critically low levels, providing further evidence that any supplies made available by US demand weakness are being consumed by emerging economies. This lack of an inventory build also underscores that recent increases in OPEC production have only served to offset substantially larger-than-expected production declines in places such as Mexico, Venezuela, Russia and the North Sea. As the rise in prices earlier this year is very consistent with the magnitude of the resulting demand weakness based on historical relationships, it is likely that the demand weakness has simply been induced by the rising prices and is therefore temporary rather than more permanent demand destruction.

I will now spend some time focusing in on a few key commodities.

Black Gold:
Oil prices declined by almost 15% in July and another 4% so far in August primarily as concerns over global economic growth and weakening oil demand have triggered a sharp financial liquidation. WTI crude oil open interest has plummeted to the lowest levels since the beginning of 2007 and speculative length has declined to lows reached at the beginning of the year when oil prices declined by 13% - similar to the recent sell-off. As a result, prices have declined to levels where large open interest in put options is concentrated, underscoring the risk of further selling pressure as financial traders who sold the puts need to sell further contracts to delta hedge their portfolio – traders call this the “negative gamma effect”. Recently, the U.S. consumer has borne the brunt of the necessary demand adjustment because lower taxes, the weak U.S. dollar, a soft economic environment and tighter credit conditions relative to the rest of the world have left the U.S. consumer most sensitive to price. Accordingly, U.S. oil demand has been exceptionally weak. However, the magnitude of weakness has been consistent with the rise in price, suggesting that this weakness is likely transient rather than more permanent demand destruction and could reverse on stabilization or decline in prices. Importantly, this demand weakness on top of recent increases in OPEC production is not leading to meaningful inventory builds as emerging markets are consuming the available supplies, and as OPEC production increases have largely served to offset non-OPEC production disappointments. Since the beginning of May, total US and OECD oil inventories have built less than seasonal norms and have declined below 10-year-average levels while US crude oil inventories remain at critically low levels. A strong rise in Chinese refinery runs - up 7.2 % year over year in June despite the 20% increase in controlled domestic prices announced on June 20 – underscores the emerging market demand strength. Overall, while spare oil production capacity is extremely low, inventories remain below 10-year average levels, underscoring that global demand for oil is not falling significantly below supply. Goldman Sachs recently reaffirmed their year-end price target of $149 which is a full 29% above Friday’s close. In my opinion I think this forecast might be slightly high, given the negative demand dynamics associated with EU and US consumers I am leaning more towards a year-end price target of around $130 which is about 13% higher than today’s prices.

Natural Gas:
NYMEX Natural Gas closed at $8.248 with WTI Crude closing at $115.20. Historically, crude oil has traded at about a 6-8 multiple to natural gas, currently the ratio is 13.96x. Natural gas was the worst performing commodity in July, as prices declined 46% in the period (vs. a 15% decline in Oil), disconnecting from international natural gas prices and widening their discount to the oil complex, largely on the back of economic concerns that have generated downward pressure across the commodities complex as well as a meaningful softening of the US natural gas balance. Specifically, despite modestly hotter-than-normal weather in July, natural gas inventory builds over the last few weeks have been substantially above average, leaving inventory levels only 6 Bcf below 5-year average levels from a peak deficit of -78 Bcf in the week of July 4, 2008. On the supply side, US pipeline imports from Canada, although still down year-on-year, have reduced their differential to 2007 levels by more than 400 mmcf/d or 38% in July relative to June. Going forward, expect no meaningful recovery from Canadian exports to the United
States due to still low Canadian gas rig counts and no significant displacements of natural gas-fired generation, now that the excess water supply has been depleted and natural gas/coal differentials are at near record-low levels. Goldman Sachs recently came out with an October price target of $13 which is 57% above current levels. I think this forecast is a little overly bullish. It relies significantly on a strong hurricane season and a large amount of cold weather in both September and October. I think a fairer price estimate would be in the $11.50 range which is still 39% higher than current prices.

On the equity side, even after accounting for the pull back in commodities, the consumer and energy shifts look extreme. The equity damage in the energy sector has outpaced the commodities themselves. In fact, the recent disconnect between equities and commodities are on the high end of their historical relationship. Part of the equity drag has been a reflection of the underperformance of large cap refiners, with margins under extreme pressure. In fact, refiners look more like industrial oil users than parts of the energy sector. But even when looking at an equal-weighted version of the energy sector, the gap to commodities is at the top end of the range.

Given the recent pull back in commodity prices the risk/return dynamics have been favorably skewed. It would be wise to re-adjust your portfolio allocation to this specific sector. Given that Russia is the largest producer and exporter of LNG it might also be wise to take a look at it. The short-term risks with Russia are over blown; the real worries lie in inflation and long-term growth (i.e. bulking up non-natural resource dependent sectors of the economy).