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A Deeper Look at Russia's Commodity Industry

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Russia is the world's largest producer of chromium, nickel, and palladium.

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Russia may be the ninth largest economy in the world by nominal gross domestic product, but its abundance of natural resources in the Ural Mountains, Siberia and the Russian Far East makes it much more important in the world of commodities. The emerging market has long been known for its vast production of some of the most vital commodities in the world. Below, we dissect Russia's commodity industry to give investors an in-depth look at this BRIC nation.

Mining

Russia is consistently ranked among the leading world producers of minerals ranging from aluminum to vanadium. According to InfoMine, the country is the world's largest producer of chromium (30%), nickel (19%), and palladium (43.3%), and it is also the world's second largest producer of aluminum (10.3%), platinum (11.6%) and zirconium (18.7%). These activities contribute to approximately 20% of the country's industrial output, with minerals representing about 15% of its total exports with ferrous and non-ferrous metals representing the majority.

Unfortunately, Russia's mining industry suffers from a number of problems. The country's regulatory framework has made it difficult for many international companies to participate in mining activities, with a number of state-sponsored giants in control, while its depleting reserves and low discovery rate for new reserves paints a very bearish long-term picture. However, some changes to the country's regulatory framework were made in 2005, including removal of certain state secrecy laws and easier access to capital in Western marketplaces.

Energy

Russia is perhaps best known among investors for its energy industry, where it controls the world's largest supply of natural gas, second-largest supply of coal and the eighth-largest supply of crude oil. In 2010, the country was the largest oil producer, the largest producer and exporter of natural gas and the fourth-largest energy consumer after China, the United States and India, according to the International Energy Administration ("IEA"). And with its land near the Arctic, the country could also have access to billions of tons of additional reserves.

Despite these enormous reserves, the corporate landscape is dominated by state-owned monopolies rather than private enterprises. Gazprom (MCX:GAZP) is the largest gas exploration and production company in the world, Lukoil (MCX:LKOH) controls the country's crude oil production, Rosneft (MCX:ROSN) controls exploration, and Transneft (MCX:TRNFP) holds a monopoly on the country's network of pipelines. According to the World Energy Outlook 2011, the country's inefficiencies contributed to some 200 million tons of oil equivalent of waste, or 30% of its consumption that year.

Agriculture

Russia's agricultural industry primarily produces wheat and barley, but sunflower oil remains its most consistently profitable crop. The majority of these farms are made up of state-owned or collective farms that tend to be a large 5,000 hectares, while smaller 50-hectare farms make up the rest of the market. Notably, private household plots that are only a few hectares produce a high percentage of the country's potatoes and vegetables for both personal consumption and sale at local markets.

Not surprisingly, the country's agricultural industry was the most severely affected industry following the transformation from a command economy to a market-driven economy in the 1990s. The sudden loss of funding caused a significant contraction in livestock inventories and a significant drop in grain production and demand. But after nearly 10 years in decline, the industry has started to show some signs of improvement in the 2010s, with increasing efficiency and a production skew towards smaller farmers over large corporate farms.

Stocks/Funds to Play Russia's Strengths

Russia's influence on the global commodities market has a significant effect on a large number of stocks and funds, but the country's closed economy somewhat limits investor participation.

The iShares MSCI Russia Capped ETF (NYSEARCA:ERUS) offers a great way to participate in the country's energy and material sector, with a combined 63.45% weighting in these sectors. With a 51.42% weighting in energy, the ETF counts Gazprom as its largest holding (18.2%) and Lukoil as its third largest holding (12.49%). Materials companies like MMC Morilsk Nickel OJSC also represent an aggregate 12.03% of the ETF's overall holdings. And in total, the fund has $253.57 million in assets with a modest expense ratio of 0.61%, providing liquidity at a reasonable price.

Those looking for a more direct approach may also want to consider ADRs or stocks traded on European stock exchanges. For instance, investors can purchase energy giants like OAO Gazprom (PINK:OGZPY), OAO Lukoil (PINK:LUKOY) and OJSC Rosneft Oil Company (PINK:RNFTF) as ADRs on US exchanges. Meanwhile, fertilizer company Uralkali (PINK: URALL) offers exposure to the agricultural industry, while mining stocks like MMC Norilsk Nickel JSC (ETR:NNIA) can be purchased on European stock exchanges.

Trends/Developments to Watch

There are several trends towards privatization and increased efficiency to watch in Russia that could pave the way to better investor returns. For instance, in 2008, President Medvedev announced new initiatives designed to reduce the country's energy intensity by 40% by 2020, which could have significant implications for energy use, according to the IEA. At the same time, Russian stocks remain cheaply priced relative to many other similarly developed countries, trading at just five-times forward earnings.

Despite these positive developments, the country still appears to be run by a large centralized government that maintains a lot of control over the private sector. So-called "loans-for-shares" programs turned many formerly state-owned firms into politically connected oligarchs and left equity ownership highly concentrated among Moscow's billionaires.

The Bottom Line

Looking ahead, it's clear that Russia has enormous potential, as its relatively inefficient economy has tremendous room for growth, particularly in natural resource sectors. But while the economy has been opening up since 2010, politicians and oligarchs still exhibit a high amount of control over the country's commodity industry, making it a risky place for many investors. As a result, those looking for exposure may want to seek out diversified ETFs like ERUS instead of pursuing individual companies trading as ADRs or foreign stocks.

Follow us on Twitter @CommodityHQ

Editor's note: This article by Justin Kuepper was originally published on Commodity HQ.

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