COMMENT: Russia talks modernisation, but still prioritises energy

By bne IntelliNews January 21, 2011

Chris Weafer of Uralsib -

@@%% /pics/1/2468_chris_weafer.jpg ::: ::: Chris Weafer %%@@

The most prominent buzzword in Russian politics today is "modernisation." Everybody understands this is something that must happen or the country will face a declining growth rate and increasing social instability. In practice, the more significant actions continue to be in the energy sector.

Establishing Russia as the world's biggest energy provider was critical in returning the country to a position of importance in geopolitics and in restoring the strong sense of national pride and confidence that, as much as improving living standards, underpins majority public support for Vladimir Putin. For that reason, maintaining average daily oil production at 10m barrels per day (b/d) and connecting additional gas pipes to Europe and Asia are by far the greatest priorities in Russia.

Since the start of the Putin administration on January 1 2000, Russia's average daily oil production has grown from 6.2m b/d (1999) to 10.15m b/d (2010). More importantly, Russia's average daily exports of both crude and refined oil products grew from an average 2.6m b/d to 7.3m b/d in the same period. Today, Russia is the world's largest oil producer and the largest exporter. In that same period, Russia earned approximately $1.5 trillion from exporting oil and gas.

When Putin became president in 2000, his most important economic/industrial policy was to push the oil companies to stop playing corporate politics and to invest in the industry, ie. to restore production. The tax reforms put in place during Putin's first term as president were as much about stopping capital flight in the oil sector - eg. via such mechanisms as transfer pricing - as they were to stimulate investment in the broader economy.

Raising oil production had two important objectives: to increase oil revenues for the budget and to make Russia too important to be left out of geopolitics. Those are still the key objectives today.

Juggling act

Keeping oil production at the current rate over the next 10 years - the declared objective of government - while keeping tax revenue high enough to fund planned budget expenditures, is going to be a difficult juggling act. Nobody doubts that there will have to be changes to the current tax oil and gas sector structures and that capital investment in the industry will have to be increased. Otherwise, average daily production will inevitably decline. The evidence points to the fact that remaining the world's most important oil producer is a greater priority than, for example, domestic projects like the Skolkovo business school, for both domestic and geopolitical reasons. The debate over how this may be achieved will likely dictate investor approach to the sector, and the debate over government fiscal priorities, later this year and post election.

From a strategic viewpoint, the most likely outcome is that tax breaks will be applied to greenfield projects in East Siberia, Sakhalin, the Caspian and in other offshore areas. Energy Minister Shmatko recently said that Russia is considering creating new Production Sharing Agreements (PSAs) to involve international oil majors in new projects. That way, the Finance Ministry can keep a high tax take from existing, albeit maturing, oil fields, while the 10m b/d oil target might be achieved with new investments in greenfield projects and using a lot of foreign investor capital.

Russian PSAs have become are a bad word in the oil industry because of Sakhalin II, where Shell was forced to cede control to Gazprom. It is, however, important to bear in mind that Putin's government did not like the PSAs that it inherited because of what it considered to be unfair terms agreed under the previous administration. However, over the past eight years new "rules of the game" have been established and PSAs concluded under these rules will be safer. That is entirely consistent with the oil majors' experiences in other oil regions over the past 100 years. The National Oil Companies of countries such as China, India, Malaysia and Gulf Arab states are already eager participants and several oil majors already active in Russia, eg. Shell, BP, Total, ENI, are also expected to have active roles.

For investors that doesn't mean that Russia should only be considered an energy, or materials, theme within global markets. Far from it. The trickle-down effect of oil and gas tax revenues via budget distribution and the confidence factor generated by the country's energy strength provide a very strong foundation for the investment case. The fast pace of growth in consumer spending and services is very evident for all to see. But what it does mean is those investment opportunities in the most attractive industries for stock market investors are far fewer than in the highly regulated industries.

Russian listed stocks can be split into distinct categories; state-controlled energy producers/distributors; state regulated utilities; metals and miners; commercial sector; infrastructure. Breaking down the current $1-trillion market capitalisation of all Russian listed equities into those broad categories shows:

Oil & Gas: 45% of total stock market*

Metals & Miners: 20%

Utilities: Electricity & Telecoms** 16%

Consumer: Banks, Retail, Pharma, Housing, Media*** 17.5%

Infrastructure: Transport, IT, Manufacturing 1.5%

* as of December 31

** assumes a greater role for Rostelecom

*** includes

The most attractive long-term growth categories only account for less than 20% of the total stock market capitalisation.

New direction

As 2010 gave way to 2011 on Russia's Far East border with China, the first direct oil pipeline connecting both countries was officially inaugurated. This is Russia's first eastern oil export pipeline and China's second direct oil import pipeline (the first was from Kazakhstan). Over the next six months, it is expected that Russia and China will finally bring to an end the long-drawn-out negotiations to build a gas pipeline between both countries.

In 2011, Russia also wants to wrap up talks to build the South Stream gas pipeline, to push ahead with plans to co-ordinate gas exports from North Africa to Europe, to conclude talks to build two Bosphorus bypass oil pipelines, and to push its claim for greater sovereignty in the potentially energy-rich Arctic.

Contrast the near frenetic activity, and real progress, in the energy sector with the much more modest advances in the modernisation agenda. Most of the hype about Russia's future, and the core of investor expectations, is based on the assumption that the country is accelerating efforts to make the country more attractive for strategic investors outside of extractive industries and that the country will continue to diversify both in terms of economic growth drivers and budget revenues. That is also the base case assumption that I recently set out in a note, "Economic Glasnost" - ie. that there is today simply no choice but to make the changes/reforms required to advance that goal.

Aggressively pushing ahead with energy projects of course does not exclude progress with the modernisation agenda. But what it does mean is that progress in the latter will remain slow and project specific, so long as the government priority is focused on the former. We have seen time and time again that even as the president and prime minister talk about wide-ranging reforms and investment priorities, the only real progress is in those areas where the most senior members of government are personally active. Last year, those efforts were mainly directed towards rebuilding the auto sector; this year, the signs are that the pharmaceutical, housing and agriculture sectors will be prioritised.

Bottom line is that so long as energy projects remain the key priority, as they clearly are today, progress elsewhere will be slow and selective.

Chris Weafer is chief strategist at Uralsib

Related Articles

Drum rolls in the great disappearing act of Russia's banks

Jason Corcoran in Moscow - Russian banks are disappearing at the fastest rate ever as the country's deepening recession makes it easier for the central bank to expose money laundering, dodgy lending ... more

Kremlin: No evidence in Olympic doping allegations against Russia

bne IntelliNews - The Kremlin supported by national sports authorities has brushed aside "groundless" allegations of a mass doping scam involving Russian athletes after the World Anti-Doping Agency ... more

PROFILE: Day of reckoning comes for eccentric owner of Russian bank Uralsib

Jason Corcoran in Moscow - Revelations and mysticism may have been the stock-in-trade of Nikolai Tsvetkov’s management style, but ultimately they didn’t help him to hold on to his ... more

Register here to continue reading this article and 2 more for free or 12 months full access inc. Magazine and Weekly Newspaper for just $119/year.

If you have already registered, enter the information below with the same email you used previously and you will be granted immediate access.

IntelliNews Pro subscribers click here

Thank you. Please complete your registration by confirming your email address. A confirmation email has been sent to the email address you provided.

Thank you for purchasing a bne IntelliNews subscription. We look forward to serving you as one of our paid subscribers. An email confirmation will be sent to the email address you have provided.

To continue viewing our content you need to complete the registration process.

Please look for an email that was sent to with the subject line "Confirmation bne IntelliNews access". This email will have instructions on how to complete registration process. Please check in your "Junk" folder in case this communication was misdirected in your email system.

If you have any questions please contact us at

Subscribe to bne IntelliNews website and magazine

Subscribe to bne IntelliNews website and monthly magazine, the leading source of business, economic and financial news and commentary in emerging markets.

Your subscription includes:
  • Full access to the bne content daily news and features on the website
  • Newsletters direct to your mailbox
  • Print and digital subscription to the monthly bne magazine
  • Digital subscription to the weekly bne newspaper

IntelliNews Pro subscribers click here

bne IntelliNews
$119 per year

All prices are in US dollars net of applicable taxes.

If you have any questions please contact us at

Register for free to read bne IntelliNews Magazine. You'll receive a free digital subscription.

If you have already registered, enter the information below with the same email you used previously and you will be granted immediate access.

Thank you. Please complete your registration by confirming your email address. The confirmation email has been sent to the email address you provided.

IntelliNews Pro offers daily news updates delivered to your inbox and in-depth data reports.
Get the emerging markets newswire that financial professionals trust.

"No day starts for my team without IntelliNews Pro" — UBS

Thank-you for requesting an IntelliNews Pro trial. Our team will be in contact with you shortly.