$100 Oil and Russia. Sinking or Swimming in a Sea of Cash

By Chris Weafer, Chief Strategist at Uralsib Financial Corp.

$100 dollar milestone in sight. The price of a barrel of oil recently hit a
record high of over $99/bbl, and although the medium-term outlook appears
weaker, traders are clearly intent on marking a $100/bbl price in the short
term. With the value of the US dollar continuing to decline and the approach
of winter, heating oil demand may provide that excuse. While the run-up in
the price has not helped the stock market so far, the economy is a clear
beneficiary of the current high oil price by virtue of the increased value of
exports and higher tax revenue. Should the price hit $100/bbl, Russia will
earn about $800 mln each day from oil and gas exports - about $250 mln
per day more than it earned this time last year. If oil was to average
$100/bbl over a full year, with the usual gas price catch-up, that would mean
an extra $90 bln in total revenue, and about $70 bln extra for the budget.
Over the past seven and a half years of Putin’s presidency, Russia has
earned $900 bln from oil and gas exports, and by the time the next president
is sworn into office, the total is likely to have swelled to $1 tln.

Higher budget surplus. At the current oil price, the government will run a
substantially higher budget surplus than that envisaged by the current threeyear
budget. This will allow for less reliance on foreign participation in the
planned investment programs, and will also allow for greater flexibility in
social spending. High oil revenue also encourages stability within the
government by reducing the need to fight over scarce resources, and add to
Russia’s competitive advantage in negotiations with the EU, China and
others in “energy-for-trade” barter deals. The South Stream gas pipeline
deal signed last week is a good example of that.

Higher inflation and a stronger ruble. But high average oil prices also
bring problems that, if not handled properly, have the potential to negate the
benefits of higher revenues. As the government now moves from a period of
sanitizing oil revenues (via the stabilization fund) to a more active spending
phase, the pressure on an already-rising inflation base will increase. Higher
revenues that translate into higher spending levels will push the inflation rate
much higher. That could kill off, or severely reduce, the growth trend, as the
economy becomes increasingly less competitive. Higher oil prices will make
the government’s plan to allow ruble appreciation in 2008 easier, but will
also make the ruble even more attractive to speculative investors. A rising
volume of speculative capital inflows can provide a short-term boost to the
economy, and some asset types, but ultimately it will severely destabilize
the economy. This is what happened in South East Asia in the mid-1990s.
High oil revenue that make spending programs easier to fund have
historically slowed the pace of reform in oil-producing countries. While high
oil revenue can fund growth in other sectors, the real danger is that the
budget and economy actually increase reliance on these high revenue flows,
which increase the vulnerability of an economy to future oil price shocks

Optimum price is lower. For Russia’s investment case, the optimum oil
price per barrel is around $75/bbl, or about $10/bbl higher than the price
average assumed in government investment plans.

Uncertainty over oil price direction. Despite the sharp rise in the price of
oil since the late spring, there is considerable uncertainty as to where the
price will head in 2008. A slide of the US economy into recession, dragging
the rest of the world with it, is the biggest downside threat, while a supply cut
over Iran is the biggest on the upside. But there are other clear and
contradictory drivers that will affect the price. One of those is the fact that
Russia’s oil production looks set to plateau sometime over the next five
years, while export volumes will inevitably fall. The almost zero growth in
production is due to the low level of capital expenditure in the industry and a
deliberate Kremlin policy of not making available any new hydrocarbon
deposits for development. At the same time, domestic demand for oil
products, particularly gasoline, has been rising steadily, because of the
expanding economy and the more than 2 mln new cars sold in Russia
annually. Until recently, the growth in demand for fuel has been matched by
efficiency gains. But that is now over. It is estimated that in the next 4 to 5
years, Russia will reduce the volume of oil exports by an annualized
250,000 bbl/day. By 2012, therefore, Russia’s export volume of crude and
oil products will be between 1.0 and 1.3 million barrels per day lower than
current export volumes.

Higher for longer oil raises option of tax cut. Should the current high oil
price environment persist, or even level off at an average above $75/bbl, a
cut in the high oil tax charge during the 1H08 is probable. More likely,
however, the state will retain a cautious approach, with initial tax cuts
applied to new projects – onshore, offshore and downstream – and will
mainly benefit the state companies (Rosneft, Gazprom and Gazprom Neft).
Only after a prolonged period of high oil prices will the government move to
alleviate the tax burden across the sector by, for example, raising the
current $27/bbl threshold for the windfall tax rate. But it will want to be much
more confident of a “higher for longer” oil price before making such a
sweeping move. The likelihood of preferential treatment for the state
companies further enhances the investment case for investing “with the
state” in 2008.

GAZPROM
The “Kremlin Proxy”. A high oil price and an uncertain energy environment
create an ideal backdrop for Gazprom in its role as the “Kremlin proxy” on
the stock market. The investment case for Gazprom is both an earnings
enhancement and a re-rating story. The company is set to benefit this winter
from the higher gas export prices induced by high oil prices. It is a re-rating
story, because most of the energy deals that are expected between the
Kremlin and the EU, China, and other countries are gas-based, and will add
to the future development of Gazprom’s business. With such a high oil price
(in nominal terms) and considerable uncertainty in the global energy market,
this is the ideal time for the government to press ahead with energy trade
deals. Gazprom will be the Russian partner in deals such as Shtokman,
Kovykta, the development of the Yamal Peninsula, as well as LNG plant
projects. This is also one of the reasons why Gazprom is a top stock pick in
Russia for 2008. The risk is that these deals will continue to stall, as they
have over the past two years, because of politics and a possible future lower
oil price environment. Such a scenario could undermine the Kremlin’s ability
to conclude favourable deals for the state and for Gazprom.

INVESTMENT THEMES
Some clear winners from high oil prices. The main winners from higher
for longer oil include:
State oil & gas majors: Gazprom, Gazprom Neft and Rosneft
Refiners: Ufa Refinery, Ufaneftekhim, Bashneft and Sistema
(Bashkir holdings)
Second- Tier E&P Urals Energy and Imperial Energy.
Economy: Sberbank
Ruble Bonds Strong ruble and relatively high yields.
Real Estate Always a target for speculative capital flows
Steel: Infrastructure spending in “downstream” and
infrastructure
Pipes: Chelyabinsk Pipes and TMK
Oil Services: Capex in oil fields is expected to increase

BUDGET REVENUES
Less reliance on outside investment. There are some obvious positives
and negatives coming from higher oil and gas tax revenues accruing to the
federal budget. It means that the government’s planned investment
spending in infrastructure and the strategic sectors is much less dependent
on FDI and external financing. The Finance Minister has declared that the
state plans to contribute about 25% of the planned investment spending,
with the rest coming from strategic partners, local (mainly state or “state
friendly”) partners and generated cash flows. It is not expected that the
government will expand the number of industries that it intends to support
with financial incentives over the next few years, even if substantially more
money is made available. That is because (a) it is very focused on control of
project spending and (b) it recognizes that many projects lack the required
support from bureaucrats and state agencies.

Money to buy its way out of problems. Another benefit of higher revenue
is that the government can afford to fund the planned programmes and also
have cash available to boost social spending, such as pensions and state
salaries. If revenues totalled less than expected, the risk is that choices
might have to be made between investment projects and social spending. In
that case, the choice would be between slowing industrial reforms or
increased risk of social instability.

Better prospect of Kremlin stability. There are different groups within the
government that support different long-term objectives for state spending.
One group sees the state’s role in strategic industries as necessary – but
transitional only. The other group sees this intervention as more permanent
and in more ideological terms. The former group views the stabilization fund
as windfall taxes to be positioned as a fund for future generations, while the
other sees the money as being available to spend on the development of
strategic industries. There have been a few publicized disagreements on the
approach in the past (e.g. over the issue of reducing the VAT rate) but to
date, higher oil revenues have always smoothed the issue. Now that the
new spending phase is starting, there will likely be more frequent
competition and conflicting demands; if there is not enough tax revenue to
satisfy both, then we could see greater friction and instability within the
government.

Slower pace of reforms. The negative side of higher revenue is that the
pace of reforms slows. Within OPEC countries, high levels of cash available
internally mean lower incentives to carry out reforms. The classic “curse of
high oil” scenario that has played out in various economies in the past
usually takes the following path. The government has a detailed plan of what
it wants to achieve when budget revenues rise, and that plan is pursued in
the early days of the oil boom. But as the coffers swell, the plan is followed
less stringently as it becomes easier to achieve goals by increasing budget
spending, such as in social projects. Plans to make structural changes are
abandoned. Panic usually sets in when the oil price dips. The response is to
initially increase social spending even further to stave off public criticism.
The final stage is to return to fiscal prudence as the revenue-starved budget
shrinks.

Increased reliance on oil revenues. In oil-producing countries, state
budgets usually become increasingly dependent on oil revenues. Even
though the rate of growth in the economy (GDP) becomes less dependant
on oil revenue, as spending elsewhere increases, the financial dependency
on oil flows increases over the medium term. If effectively spent, then over
time the value of budget revenue from other areas increases and creates a
better balance. In Russia, the stabilization fund tax regime has sanitized the
oil effect out of economic growth, but no new major sources of budget
revenue have emerged. Currently, the federal budget depends on oil and
gas taxes for over 60% of revenues. That will increase over the next few
years before it can be expected to fall.

INFLATION
Inflation already above 10%. The big risk is of higher and accelerating
inflation. This year, the inflation rate will again be in double digits, and
planned increases in state spending will put that figure under even more
pressure in 2008. The inflation rate did not benefit from the usual seasonal
summer deflation in 2007, partly because of the government’s spring
offensive against illegal immigration that reduced the availability of cheap
food produce in markets and partly because of a lifestyle change that is
encouraging more people to shop in modern supermarkets at higher prices.
Sanitizing benefits done. The state has been effective in bringing the
inflation rate down in recent years by sanitizing oil revenue via the
stabilization fund. But this year, it used some of the oil revenues to boost
spending ahead of the election season. This has also boosted inflation. The
trend will worsen next year, when spending programmes are further
increased and directed towards infrastructure projects and strategic
industries. The result will be higher inflation in the economy in 2008.

Speculative capital inflows. Inflows from portfolio investors riding the ruble
appreciation wave are likely to form another driver of inflation in 2008.

STRONGER RUBLE
Ruble is rising partly on higher oil. A higher long-term oil price will also
cause the ruble to appreciate against the US dollar. While the last currency
controls were removed in the summer of 2006, it was not until the 1st Qtr of
this year that international banks could settle their ruble trades in the
Euroclear system. Since then, the ruble has become something of a “petrocurrency” rising and falling against the US dollar in correlation with oil prices (figure 4). As that trend continues, it is accompanied by a rise in capital
inflows from speculators taking advantage of the relatively higher yields in
Russia. It is also attractive to those looking for naked ruble exposure.

Higher inflows push inflation higher. On the negative side of the equation,
higher capital inflows are inflationary and add to the problem in asset
classes such as real estate. While these inflows are good for the stock
market in the short term, they are very destabilizing over the longer term.
Moving to open market mechanisms. The Finance Ministry is planning to
change the way it converts oil taxes, as a way of controlling inflation. By
using open banking mechanisms, the Ministry hopes to raise and stabilize
the level of liquidity in the banking system, and also to push the value of the
ruble higher. The objective is to raise the value of the ruble relative to the
Euro, as most of Russia’s imported consumer goods are priced in Euros,
and as the Euro has strengthened against the ruble, that has added to
inflationary pressures. Russia Inc has suffered a margin squeeze in that
revenues (mainly dollar based) have fallen in translated rubles while costs
have been rising.

ECB leaning towards higher rates. Getting the ruble to appreciate against
the Euro will be a difficult task, given that the ECB is moving into a phase of
tightening interest rates. However, this policy may be tempered in order to
prevent a loss of competitiveness relative to US industries.
Loss of competitiveness. Apart from inflation, the other major negative of
a strengthening ruble is the loss of competitiveness of Russia’s
manufacturing industries and non-commodity exporters. On balance, this is
a negative that the government is expected to tolerate over the medium
term, since its priorities are inflation control and infrastructure spending.

GEO-POLITICS
The Kremlin has a competitive advantage. Higher oil gives the Kremlin a
competitive advantage in its trade talks with the EU and other potential
partners, such as China. The prospect of high and continuing oil prices and
considerable uncertainty over the future of energy encourages energydependent
economies towards prudent actions and conservation of
resources. But those measures take time, and in the meantime, the priority
is to ensure energy security. As the owner of the world’s biggest gas
reserves, this plays into Russia’s hands. The likelihood is that current
reserves will be increased in the Arctic region and in the water off Sakhalin.
Offering access to those reserves and to the products extracted gives the
Kremlin considerable leverage in its trade, investment and political
negotiations with neighbouring energy-hungry countries.
More deals expected. In recent months, progress has been made in
restructuring the Shtokman JV, in reaching a price agreement with China for
gas exports, and with Italy on the South Stream pipeline. Further deals
covering Kovykta and the Yamal Peninsula developments are expected over
the next few months. Russia expects reciprocal favourable trade and
investment deals as part of the barter.

But only so long as oil is high. Those favourable deals will be possible
only so long as the price of oil and the general uncertainty about energy
security remain high. If oil prices fall, then Russia’s leverage in these barter
deals will also be lower.

WHERE NEXT FOR OIL?
Both higher and lower scenarios are possible. There are a number of
different and often contradictory factors that will influence the direction of oil
prices through 2008. It is convenient to look at the factors that drive oil in
five separate categories;

Demand Outlook
Demand is expected to fall as growth slows. The I.E.A. has reduced its
forecast for oil demand in the current quarter, and has cut the previous
forecast for oil use through 2008. This is due to the uncertain outlook for the
US economy and the effects of higher prices on consumption. The US is the
biggest consumer of oil and oil products, and the US Fed has recently cut its
guidance for 4th quarter growth to less than 2.0%. The continuing housing
market and credit crisis has raised fears of a recession in 2008. Hence,
OPEC is concerned about a substantial decline in demand for oil in 2008,
and is therefore reluctant to add additional supplies at this time. OPEC does
not want to repeat the scenario of 1997, when high oil prices resulted in calls
for the organisation to increase production. The organization yielded to
these demands just as global economic growth began to decline, and a
“double-whammy” effect resulted in the low oil price of 1998.
But long-term demand rising. But the counter argument is the fact that
demand in developing economies, such as China, India and Russia, is
growing, and even if that growth slows in 2008, the trend is clearly rising.
Hence, the argument is that even if demand falls in the US next year, this
will not detract from the generally rising trend globally. Any price pull-back
will therefore be temporary.

Increased Spending on Exploration
Oil companies spending more. Once oil companies become convinced
that the price of oil will remain higher for longer, they usually increase
exploration budgets and go looking for oil in places that are either expensive
to explore or expensive to produce from. This includes deep-water areas,
the Arctic and the various pockets of oil sands. This usually results in growth
in production from these areas that then adds to supply, particularly from
non- OPEC countries. This is another reason why OPEC is not keen to see
the oil price stay so high (its declared “comfort zone” is around $70/bbl) as
very high oil prices encourage exploration and can result in a loss of market
share over time.

Peak-Oil arguments. According to the peak oil theory, the world is already
at, or near, peak oil production, meaning rising demand in the future will not
be able to be met with increases in supply. The argument is that the world
does not have any more giant oil fields and that any additional discoveries
will be much smaller in scale than the older fields that are now approaching
the twilight of their production lives. The point about Peak Oil is that nobody
knows with absolute certainty. What we do know is that many of the world’s
major oil deposits are closer to the end of their production lives than they are
to the beginning, but we have no idea of whether there are replacement
wells to be found in new areas, such as the Arctic or Sakhalin. Proponents
of peak oil assume not.

Increased Focus on Alternatives and Conservation
Environmental issues are a big factors. The current peak oil debate has
coincided with the debate on global warming. The two have combined to
give unprecedented impetus to alternative energy plans. Governments
across the globe are reviewing and planning major programmes in nuclear
power and renewable energy projects. Some have made the argument that
this is the beginning of the end for the age of hydrocarbon energy sources,
and over time, the demand will shrink, as will prices.

But any shift will be slow. There is a major push away from fossil fuels at
present. But even if this trend is sustained and financially well-supported
(not a given if the price of oil were to drop sharply) the substitution process
would still take a very long time – long enough for one or two more price
cycles, or for the advocates of peak oil to be proven right or wrong.

Supply Threats
Iran and Mid East remain major threats. The uncertainty over Iran is a
major factor in the current high oil price. Countries and oil companies have
been increasing oil stocks in case of further oil supply shocks. The major
identified issue is the threat against Iran and the possible consequence of a
disruption of supply from that country, and even a broader disruption of oil
exports from the Gulf region. In more general terms, the continuing threat
posed by the instability in the Middle East and in production regions such as
Nigeria is helping to sustain a price premium.

But they will end. The counter-argument is that the specific threat against
Iran will end, one way or another. Either there will be an attack and some
brief oil flow disruption (the country needs the oil revenue) or the problem
will be resolved by internal changes. This week, the newspaper aligned with
the country’s religious leaders launched an unprecedented attack against
the president and his policies. This could easily develop into a more serious
conflict, and the emergence of a dominant political influence that then drives
to an end-game.

Financial Factors
Oil producers need higher price with weak $. The weakness in the value
of the US dollar has a very direct influence on the price of oil. As the value of
the dollar weakens, than oil producers look to preserve their purchasing
power by raising the price per barrel (see graph below). Right now, the trend
in the dollar looks to be heading even lower, as pressure grows on the US
Fed to raise rates at its next meeting and as the Administration favours a
period of weak currency to try and stimulate domestic growth and shrink the
trade deficit. That trend of a weaker dollar looks like continuing through
2008, and that will provide a strong prop for higher oil. That also creates a
favourable backdrop for financial speculators, such as hedge funds, that
trade on the correlation between the two.

Longer-term shift to currency basket. Over the long term, the pressure to
shift away from an exclusive US dollar price regime is increasing. But given
the vulnerability of oil producers to the dollar, in terms of financial reserves,
that is not likely to happen anytime soon. In theory, it may occur when the
US dollar recovers and is better able to withstand a shift. That appears to be
two or three years off at least.

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