Thursday, October 06, 2005

Mailbag: The Russian Front: Oil, Putin and Prosperity

Why I don't Follow Russia
Hi Vitaliy, I'm just curious as to why you don't follow Russian market? Is this a choice (it is for me, and I missed the best stock market in the world for the last 6 years), or just "so happened"?
Thanks, Alex MA-
There are several reasons why I don’t follow the Russian market:
  • I was educated in the United States and though I do speak and read Russian, my Russian business vocabulary is very limited. Speaking in Russian on a business topic is a very painful experience as I keep looking for the appropriate translation for investment / business words.
  • I don’t know Russian GAAP, nor do I trust the numbers put out by Russian companies. That being said (to be fair), the Enron and WorldCom disasters did not happen in Russia. But Russia is still riddled with corruption. Bribery is widespread, though it is not an official expense line on the income statement – it should be - as it is a cost of doing business in Russia. I resented bribery all my life, it is opposite of taxation (not that I am big fan of taxes) – economic resources are shifted from the poor to the rich. The majority of us never encountered bribery that is instilled into the economical and political system. I remember when we were leaving Russia for the United States, on the way to the airport (a forty mile stretch), our car got pulled over three times by the police for no reason at all and every time the policemen wanted a bribe to let us go. We obliged. These types of incidents don’t cultivate fondness about the country and put it at a significant competitive disadvantage. Maybe that is in part the reason why Singapore has such a successful economy – the most uncorrupt country in the world (albeit without any bubble gum).
  • The US stock market is much more fun to follow; it has a lot more breadth and width than the Russian market. The Russian stock market is dominated by three industries: energy, industrials and banks – very limiting in terms of constructing a diversified portfolio. I suspect that high oil prices are the reason why the Russian stock market (and economy) has done well lately. I would not want to have my future tied to only one single commodity.
  • I left Russia and never looked back. It honestly still puzzles me why I write about it. I have mentioned several times before, and I’ll do it again – I am a capitalistic pig (and I think like one). In the 1980’s Brezhnev came up with a slogan: “The economy has to be economical” – I am still not sure what that means.

Personal Note: My memories from living in Russia are mixed. All of my fondest memories come from my family; all the bad ones came from the external environment – secondary school and college etc. I was not a good fit within a culture that encouraged uniformity and discouraged creative and descending thinking. Vitaliy,

Thanks for your terrific message. I am a bit perplexed however as even the Russians acknowledge their exports of crude oil have peaked and will decline soon yet you say: “Political stability in Russia will insure a stable flow of energy resources out of Russia. “ Where are these extra “energy resources?" The KGB has always lied yet even they say their energy exports have peaked. What do you know that the rest of us do not? They have been stripping assets rather than investing in new productive capacity [as you point out] so how does this lead to more energy rather than a decline as even the KGB acknowledges?


Russia and Oil

J, I think you are making an excellent point. You are right about Russian production - it has peaked. Privatization in large was responsible for oil production growth in Russia, as economic (free market) incentives that were put in place stimulated production growth (production grew from 6 million barrels a day in 1998 to 9 in 2004). On another hand, de-privatization of oil companies is likely to do the opposite. Gazprom going on an acquisition spree and becoming one of the largest oil companies (if not the largest) affirms that fear, as it will be run to maximize cash flows for the short run (you said it: thus stripping assets rather than investing in new production). I cannot argue with that logic as it makes total sense.

This paragraph also confirms your point: “Press reports from January 2005 are already attributing late 2004 production decreases to the Yukos 'affair.'" Also, a recent report from the Siberian branch of the Russian Academy of Sciences says that nearly 60% of all proven reserves in Western Siberia are near depletion.” As I mentioned I really don’t follow Russian markets very closely, I spend most of my time analyzing U.S. and lately European companies (our play on a belief that dollar will weaken). However, talking to my relatives (especially my father who follows Russia very closely), I gather that there is a lot of pressure on Putin to please retirees.

It is very likely that Gazprom’s oil/gas revenue will be diverted from capital expenditures on improving existing production and looking for more oil/gas to raise or probably just maintain pension benefits to retirees - an enormous liability for Russia. However, a very sad reality--relatively low life expectancy (61 years (men), 73 years (women) Source: UN) is working in Mr. Putin’s favor.

In my article I was making a general point, that the flow of oil out of Russia will be less predictable and lower in case of political unrest. So in other words, the bleak picture of peaking production (that you and I agree on) is likely to get bleaker in case of political unrest. And lower oil prices (not a prediction, though I do believe in mean reversion) are likely to create that political unrest. -Vitaliy

Did I just comment on Russia again?

My friend John Ray pointed out an excellent Business Week article that describes surging Russian government spending. Budget expenditures surged from $34 billion in 2000 to $129.5 billion this year, where tax revenue grew even faster, from $40 billion (in 2000), to $153 billion today. My limited knowledge of government spending tells me that it is a lot easier to raise spending than to cut it, thus this increase in spending is likely to stick while oil revenues may not. Note though that Russia did use oil revenues to payoff a very large chunk of its foreign debt.

Vitaliy N. Katsenelson, CFA



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