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Minyan Mailbag: Oil and Russia

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J,

I usually stay away from commenting on Russia for the reasons I explain in the following article, but I still have an urge to comment on Russia once in awhile. I wrote this article for Minyanville.com, I hope you find it interesting.

Vitaliy N. Katsenelson, CFA


The Russian Front: Oil, Putin and Prosperity

Putin's time ends in 2008. Will Russia's begin?

I don't follow Russian markets and recently I discovered that I don't understand the psyche of Russian people (that discovery was made after talking to my high school buddies that still reside in Russia and my capitalistic dialect is not understood well there). I don't even have a decent inventory of hard liquor at home, a disgrace by any Russian standard (or so I've been told). And please don't be misguided by my Russian first name and "sophisticated" Russian accent when I talk about the country.

However, I want to point out a very important but lost headline: Putin will not be running for re-election in 2008. The Russian Constitution allows the president to serve only two terms and Mr. Putin's second term ends in 2008.

Mr. Putin's consolidation of power over the last several years--which has left the country less of a democracy and more akin to a pre-Gorbachev Russia--had convinced many that he'd seek an amendment to the Constitution to allow a third term. His decision not to amend the Constitution increased my respect for Mr. Putin exponentially--considering he is close to possessing absolute power. And as we know absolute power corrupts absolutely.

The outcome of the 2008 election scares me a little. It'll scare me even more if oil prices return to their long-term average. The devil we know now is better than devil we don't (though I'm not calling Mr. Putin a devil, just an expression, Mr. Russian President). Though from a western perspective, Mr. Putin's actions were very questionable to say the least. To a certain degree we know where he stands.

Russia's recent prosperity, funded primarily by the western world, has been driven by high energy prices. According to the CIA World Factbook, oil, natural gas, metals, and timber account for more than 80% of Russia's exports, thus leaving the country vulnerable to swings in world energy prices.

A turn away from this prosperity could prove to be dangerous and create an even more volatile economic situation. Hungry people are not famous for making rational decisions. Arguably that is how Hitler came to power in Germany. Though on the surface this statement appears eye catching, it is a reality of Russia. I remember the time when Zherinovskiy (not much different from Hitler on many levels) ran for president opposing Yeltsin in early 90s, and he received a very large vote count, considering how extreme his positions were on political and ethnic issues.

Russia has a chance that a country gets every 30 years or so to reinvent itself. If it captures this opportunity and reinvests huge inflows of funds from oil exports into developing other industries (and Russia has plenty of engineering talent to do so), it may come out stronger at the end.

Maybe this is my Russian skepticism talking, but Mr. Putin still has two years to change his mind, as he is only 52 years old - an infant in political years (ask Senator Byrd). A large terrorist event (god forbid) happening between now and the 2008 election would certainly provide justification for him to change his mind and amend the Russian Constitution.

Why do US investors care what happens in Russia? A fair question. Political stability in Russia will insure a stable flow of energy resources out of Russia. Russia is still among the largest nuclear powers. Russia engulfed in political unrest will be a feeding ground for terrorists looking to get their hands on nuclear weapons.


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?

-J


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." (Source:http://www.eia.doe.gov/emeu/cabs/russia.html )

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 (http://www.globalaging.org/pension/world/2005/cutbacks.htm).

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

No positions in stocks mentioned.

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