Kingsmill Bond of Citigroup Capital Markets -

-- A rentier state is a term used to classify those that derive all or a substantial portion of their national revenues from the rent of indigenous resources to external clients. And the distribution of rents is key to the Russian market. In our inaugural strategy piece, we look at how $500bn in annual rent from commodities moves through the economy. In broad terms, we believe oil rents flow via the government to voters, gas rents go directly to the economy, and metals rents are captured by oligarchs. Of the rent, 58% goes to taxation, 18% to subsidy, 16% to capex and 8% to shareholders.

--How to invest. We believe investors should buy suppliers of domestic goods and services as the rent ends up with them, stick with oligarchs who are successful at accessing rental flows, trade the shifts in rental allocation for government companies, and watch the commodity cycle, as the system depends on this.

--MSCI Russia Index target of 1,100. Two key factors determine our index target - the oil price and Western perception of reform. At present, we expect the former to drift down and a slight improvement in the latter, giving a year-end target of 1,100, with most money made on sector rotation.

--Buy domestics and Gazprom. In a flat commodity price environment, domestics tend to outperform as they have superior growth and can resist inflationary pressures better. Gazprom should benefit from a marginal shift of rent in its favour, as well as improving global gas pricing and better use of capex.

--Top picks. Among domestics we prefer Sberbank, Nomos, MTS, X5, Synergy, Integra and Globaltrans. Among exporters we prefer Gazprom, Rosneft, Severstal, Raspadsya, Uralkali and Norilsk Nickel.

Why use a rentier framework?

We believe that it is instructive to look at the Russian system from the perspective of a rentier framework, as this can throw a light on how to invest in the market and steer a middle path between Russia's detractors, who argue that the market is uninvestable, and Russia's believers, who see no fragility in the current set-up.

It is worth saying up front that Russia is not yet a pure rentier economy, but as Willem Buiter points out in "Global Growth Generators - Moving beyond 'Emerging Markets' and 'BRIC'," on February 21, it is in danger of becoming one, with some of the less appealing aspects of rentier economies. Commodity taxation makes up over half of federal revenue, rents to the level of over a quarter of GDP are generated by the commodity sector, the economy is highly vulnerable to external price shocks, as we saw in 2008, rent is transferred from the government to the people, and so on. The fiscal break-even level of the Russian budget gives some indication of the degree to which the system has become ever-more dependent on oil.

Rentier economies typically split into three parts - the natural resource (usually commodities and usually oil); the intermediary (usually the government); and the beneficiary (sometimes foreign bank accounts, sometimes the people). In simple terms, the rent is derived from the natural resources sector, taken by the government and passed on to the people. Rentier economies have several key characteristics: the elite fight over the division of spoils rather than seeking to improve the system; the population remains quiescent provided enough of the rent is passed down to them; property rights are relatively weak, the currency rises; the industrial sector stagnates; the elite indulge in white elephant projects; and so on. The paradigm for rentier economies is of course Opec countries in the 20th century, although the Spanish economy of the 16th century is a frequently cited example.

Who provides the rent?

If we define rent as the gap between world prices and extraction costs, then, in broad terms, there are three providers of rent in the Russian system: oil, gas and metals (ferrous and other). On top of this, it is also worth mentioning the infrastructure sector, which has been providing an effective subsidy to the economy as prices have been set at less than replacement cost for many years.

We estimate that at world market prices, the value of Russian production of oil, gas and metals is some $650bn, and extraction costs are $150bn, leaving a total level of rent generation of $500bn.

We lay out below an approximate calculation of the level of rent in the system, based on the current level of prices (oil at $100 per barrel, gas at $400/'000 cubic metres (cm), and steel at $600 per tonne) and Citi analysts' perspective on cost and tax structures that will be in place by the end of 2011. We seek where possible to tie these numbers back to our actual sector forecasts, although of course they will not tally perfectly, as not all commodities are produced by listed companies, and certain companies (such as Gazprom) have additional product lines passing through their accounts. While of necessity we simplify some fairly complex issues, we believe that the conclusion accurately reflects the nature of rent generation and distribution.

--Oil: The size of the oil rent is relatively easy to calculate. Russia produces around 10m barrels of oil a day, and the extraction cost plus transport is less than $15. If we take the world market price of $100 a barrel, then that implies some $310bn of rent from the oil sector, in theory, and a little less when adjusted for the fact that some is turned into oil products and sold in Russia.

--Gas: Russia produces around 600bn cm a year of gas. The all-in extraction and transportation cost, based on Novatek's accounts, is no more than $65/'000 cm, while the rule of thumb for the European price is that it is 4 times the oil price, or $400 in this analysis. For the sake of argument, we remove the $70/'000 cm cost to transit Ukraine, and this implies a total rent of around $160bn.

--Ferrous metals: Russia produces around 70m tonnes of steel at an operating cost of the integrated iron ore, coal and steel plants of around $300 per tonne when the global price is around $600. This gives a rent of over $20bn.

--Other metals and mining: There are other sources of rent (in gold, potash, or Norilsk Nickel) where one can simply take the difference between sales and operating costs to get a sense of the size of the rent. We estimate that this is around another $20bn.

There are two other areas which we have not included in our totals as the situation is changing so rapidly and the subsidy is being removed, but we also comment on them below as the situation is fluid.

--Utilities: It might appear odd to include utilities in a list of rent providers in the Russian economy, as this is not a sector which is traditionally thought of as a provider of rent. However, we would argue that it has been a provider of subsidy to the rest of the economy, as the government deliberately underinvested in the sector and exploited the Soviet legacy. For example if the true cost of producing electricity is say 10 cents per KWh and an electricity company is selling it for say 4 cents, then this is a subsidy of 6 cents per KWh to the economy. This subsidy traditionally came from two areas - cheap gas (which we have already accounted for above) and the failure to invest in new power stations, which is why the sector has such old equipment. We estimate that in the past the underinvestment has been in the order of $30bn a year.

--Transport: The same argument applies to the transport sector, where for years the government failed to invest enough to maintain the infrastructure. We estimate the total at around the same level as in the utility sector.

Who are the intermediaries?

It is when we look at the intermediaries that this exercise starts to get rather more interesting. For in Russia, unlike in a normal rentier economy, it is not the government that is the sole intermediary. We believe that there are four principal uses for the rent: taxation paid to the government; subsidy arising from selling raw materials to the economy at less than the global price; capital expenditure; and returns to shareholders.

In a nutshell it is the government that takes the rents from the oil sector and passes it on to the voters, the economy and capex benefit from the gas sector, oligarchs from the metals sector, and the economy and oligarchs from the infrastructure sector.

Overall, we calculate that 58% of the rent is taken in taxation, 18% is subsidy to the economy, 16% is spent in capex, and just 8% is available for shareholders. We lay out below our estimate of the distribution of the total rent.

Who are the end beneficiaries?

It is possible to identify a number of key end beneficiaries of the system:

--Providers of consumer goods: As we have seen, much of the money amassed by the government through commodity taxation is passed back to the people though social transfers and low taxation rates. Moreover, individuals benefit from cheap electricity and gas, as well as the impact of high commodity revenues trickling through the economy. This is one of the reasons that despite relatively low wages, Russian consumers have tremendous spending capacity and are able to buy such large amounts of consumer goods.

--The banking sector: The impact of a rentier environment on the banking sector is mixed. On the one hand, high rents encourage demand for financial services, but on the other it enables companies to borrow directly abroad. On balance we believe that the sector should be seen as a beneficiary in the same way as other providers of consumer services.

--Providers of goods and services for industry: As much of the money is spent on capex, so it is that companies servicing industry (such as oil services, IT services, pipes or logistics) are able to benefit.

--Companies able to capture the rent for themselves: If companies are able to buy cheap commodities in Russia and sell them aboard with no tax at global prices, then they are in a strong position. Examples include Rusal (cheap electricity) or the nitrogen fertiliser (cheap gas) sector. Other examples of companies that have been able to capture the rent are those in the metals and mining sector that have been able to resist the high taxation levels prevalent in the hydrocarbon sector, or Novatek which has been able to combine low production costs with low domestic taxation on gas and success in being chosen for lucrative projects.

--Government companies: With so much rent available, the government is able to distribute some of it to some companies, usually those it controls. Examples include the recent payment to VTB to help it with the Bank of Moscow purchase, the payment to Aeroflot of overflight revenues, or the awarding of oil and gas licenses at low cost to Gazprom or Rosneft.

--Providers of high-end services: The high-end service sector is booming, with Moscow widely known to be home to more billionaires than New York.

--Foreign bank accounts, a certain proportion of the rent (we estimate capital flight of around $50bn a year based on the capital account data) is taken abroad.