MOSCOW BLOG: $100 oil and Russia's coming boom

By bne IntelliNews October 29, 2007

bne -

There is a clear sense of nervous excitement in Moscow as the year draws to a close. Businessmen and bankers are becoming increasingly sure next year is going to be a spectacular success, unlike anything seen so far, but remain nervous enough about Russia's short-term prospects that they are trying hard not to crow.

It reminds me very much of the summer of 1996, just before former president Boris Yeltsin was re-elected. Or more importantly, defeated the Communists and ensure there'd be no return to the USSR - the issue that really concerned investors.

Although the ailing president disappeared from view between the first and second round of the elections, his victory in the polls sparked a huge revaluing of Russia. The RTS soared and by the spring of 1998 Moscow was packed with foreign businessmen as everyone was making money hand over fist. You could barely recognise a single foreign face in the Hungry Duck on a Friday night. That came to an end in the summer and the Duck was full of regulars again.

Once again investors seem to be poised on fence, looking in and ready to jump over. Several things are contributing to this building up of interest.

Oil at $100 a barrel

The first and most obvious is the strength of the economy and $100 oil. Russia has been hit by a string of nasty external shocks since America's Federal Reserve started raising interest rates, leading to the first big sell-off in May 2005.

The shocks have come one after another: the Ukraine gas debacle, the Shanghai sell-off in May 2006, and most recently the rout caused by the meltdown of the US subprime debt market. These events have been sufficiently close together to keep investors unsettled and prevent any momentum from building up. It also means that most investors have taken their eye off the fundamentals.

But not all. Foreign investors continue to flock in and Russia is on course to have another record foreign direct investment (FDI) year. At the same time the RTS is at a record high.

Like a bit of steak in stuck in your teeth, no matter how worried investors are by the effect of a possible financial train wreck in the West, they can't forget about the high oil prices and its effect on the Russian economy.

In 2005 Peter Westin, then chief economist at Aton Capital, wrote a speculative paper ruminating on what Russia would like with $100-a-barrel oil. At the time, oil had already risen to $50 a barrel from the long-term average of $25 - the start of the sustained price increases - and even Westin said the consequences of a quadrupling in the price of Brent Russia "starts to border on the surreal."

Now $100 oil doesn't look strange at all. Indeed, with Brent at $93 on October 29, it looks like an almost certainty oil will break into triple digits before the end of the year. One oil trader said in his widely read blog this week: "$100 oil. Get used it. It's coming." So what happens in this case? Westin predicted that President Vladimir Putin's goal of doubling GDP would be met by 2011 - not 2030 as the Ministry of Economic Development and Trade predicts - while GDP per capita would exceed that of Portugal's by 2012 (Russia has already overtaken Portugal and is close on the heels of Italy since 2005). And the RTS index would rise to 8,650 by 2015.

However, for Russia to benefit from this rosy scenario, Westin said the government must contain the ill effects of the so-called Dutch disease, the sickness that has hit most natural resource-based economies in times of high oil prices, leading to reform paralysis and inflationary spirals that debilitate growth. This is done by keeping tight control on spending. The falling inflation over the first half of this year led the government to announce at least $1 trillion of spending over the next decade and just this year the state plans to spend RUB2 trillion on infrastructure. Then inflation spiked in September, largely because of rising food prices. More worryingly Finance Minister Alexei Kudrin said over the weekend that inflation would be rising even if food prices - which make up 40% of the consumer price index - were counted out of the index.

The game has clearly changed in the last couple of months. Still, if the government is careful - and a little less ambitious - then it could still pull off stunning growth in the next few years. Just that the job of fixing infrastructure is going to take a bit longer than the Kremlin believed at the start of this year.

What liquidity crisis?

In the meantime, investors have now shrugged off most of August's liquidity crisis concerns. Analysts have spoken with one voice to say that Russia is not only well protected from drying up of liquidity on the international capital markets, but that it has emerged as a "safe haven." The Central Bank of Russia has over $400bn in reserves and Russian banks are the least exposed to international borrowing of the all the bank sectors in Eastern Europe.

If there was any doubt, then IPO of fertilizer-maker Uralkali in the middle of October should have put an end any speculation. The company raised $950m with an offer that was a massive 24-times oversubscribed. "A pretty convincing vote of confidence," says Roland Nash, head of research at Renaissance Capital.

At the same time, Russia's blue chips are back in the market with big Eurobond issues. Last week VTB Bank placed two tranches of a $2bn Eurobond and Gazprom also just placed a €1.2bn Eurobond. Bankers also report there has been a raft of smaller issues, although they admit that the market is still closed for the risky issuers.

Admittedly, these bonds are costing more to place than pre-liquidity crisis - the Gazprom was priced at 187 basis points over LIBOR - but as the volumes build and (if) the financial train wreck that everyone is terrified of (continues to) fails to appear, then the spreads will narrow again.

The RTS is also defying gravity continues to break all-time highs on a daily basis. The RTS is on course to hit the 2,300 target most analysts were predicting at the start of the year - although most of them are modest enough to admit they didn't expect to get to their target by the route taken. But this in itself is telling. Given the brouhaha of this year it is amazing that the RTS is on course to hit target. What would have happened if Russia hadn't been hit by all these shocks?

And even the 2,300 result is an understatement of where the "true" market level should be. Like the bonds, companies are queuing up again to start IPOs. bne:stocks tracks IPOs on a weekly basis, but since the summer we have had barely anything to write about. That changed with the Uralkali IPO. Since then approximate $3.8bn of new equity issuance has been announced for the last months of this year and the first commercial banks are lining up to start a raft of IPOs in the second half of 2008. I count four already - Zenit bank (which will be the first to go), MDM Bank, Bank St Petersburg and KIT Finance - and more are surely in the wings.

Banks are the hottest sector in the Russian economy and they all desperately need more capital if they are to continue their fast growth. IPOs are the obvious way to get is those that were going to go down the route of selling to a strategic have already done that over the last two years. So the banking sector is entering a second phase where aggressive banks will float on exchanges to finance more expansion. However, the volume of issues has already depressed stock valuations. For most of this year the RTS has failed to perform because of the massive oversupply of fresh stock after Sberbank and VTB both pumped over $21bn worth of shares into the market when only $5bn of fresh money came in from the outside - in other words Russia investors had to sell some $17bn of stocks in order to buy into the two issues.

Ditherers take the plunge

And there's the rub. If Russia really is going to boom, then it needs more cash to come in from outside. The key will be if the ditherers who have been watching Russia for years now decide to take the plunge. And this is where the analysts are getting excited, as they believe the fence-sitters are also on the way.

And not just the analysts. Presidential Advisor Igor Shuvalov said on Wednesday, October 24, at a session of the US-Russia Business Council, that GDP growth would be 7.7% in 2007, compared with 6.7% in 2006. He noted that foreign investment accounted for $40bn in the first nine months of this year, up from $30bn in 2006, and added that he expected an investment boom after the upcoming parliamentary and presidential elections.

Why will there be a boom? Two reasons: word is getting out that Russia is a great investment opportunity and there is no where else to go.

The most obvious reason driving the RTS is that Russian stocks are cheap with price/earning ratios of about 9 whereas after the phenomenal gains of the last two years stocks in China and India - Russia's main competitors for funds - are closer to 20.

Investors already working in Russia are extremely happy with their deal. A recent survey found that 90% of foreign companies invested into Russia are happy with their decision and plan to increase their investments. Kudrin reported at the weekend that capital flight has stopped and Russia received $10bn this year. The country saw record high capital inflows of $70bn in the first half of 2007 as companies went on a borrowing spree abroad while foreign investors bet on the appreciating ruble. At the same time he reported that fixed capital investment growth was 25% of GDP in the first half of 2007, which is an Asia Tiger-level of growth.

Spectacular growth has always pulled investors into the Russian market, but what will change next year is that for the first time they may be pushed into the market as well. With China's economy running white hot and its shares riding sky high, the Chinese market is looking decidedly toppy. At the same time because the Indian market is in the same position the government recently started to make it harder to invest in an effort to cool the growth and pre-empt a crash. At the same time, with the US on its knees and ready to fall on its face, the traditional "safe haven" of US Treasuries don't look anything like as safe as they used to. Investors are looking for new destinations with high growth and rock solid public finances - Russia excels in both.

If China and India do close to investors, then a general process of "switching out" of the two leading BRIC markets will start and it would be Russia's turn to receive this "switching in" money. If it starts - and all the conditions for it to start seem to be in place - then it could quickly snowball. The idea is clearly already in the air, but if people actually start investing money - and the rise of the RTS plus the FDI numbers suggests this has already started - then Russia's boom becomes a self-fulfilling prophecy.

"If it starts this year or next year and the really big institutional investors arrive - investors that have traditionally shunned Russia - then the volume of money we will see arriving will unlike anything we have ever seen before," says Chris Weafer, head of strategy at UralSib. "Of course, as the global conditions for growth have changed Russia could then fall off a very big cliff in 2009 as well."

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MOSCOW BLOG: $100 oil and Russia's coming boom

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