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How to profit from the scramble for resources in central Asia

The 'Stans' of central Asia are awash with natural resources. And that spells opportunity for the adventurous investor. James McKeigue explains how to play one of the world's most remote regions.

Life in central Asia's former Soviet republics has never been easy. The larger states Kazakhstan, Uzbekistan and Turkmenistan are dominated by tree-less steppes and arid, sprawling deserts. The terrain of the smaller countries, Kyrgyzstan and Tajikistan, consists of little more than mountains. Throw in the fact that the whole region is landlocked, and has no navigable rivers and little decent agricultural land, and it's no surprise that the five Stans' are among the most sparsely populated countries on earth. On average, there are only five people for every square mile in the region. Or to put it another way, a population roughly the size of Britain's is spread out over a region 17 times as large.

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Yet despite the harsh geography and sparse population, some of the region's economies are booming. Why? One reason is the demand-fuelled surge in commodity prices over the last decade. The Stans are host to vast amounts of natural resources, many of which were underexploited during the years of Soviet rule. As a result, the last ten years have seen a horde of Russian, Chinese and Western firms pile into central Asia in a dash to secure the best assets.

But it's not just about the hunt for resources. Thanks to the growing power of China and India, and the war in Afghanistan, the Stans have also gained in geopolitical importance. As a result, the US and Chinese governments are desperately trying to expand their political and military influence in the region.

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This renewed interest is critical to the development of the Stans, says geopolitical analyst and publisher Stratfor. The vast, barren landscape of the Stans means that, "with the exception of commodities, central Asia is endemically impoverished and will always have massive infrastructure demands. The central Asian states can therefore only be remotely functional if they can tap the capital supplies of a larger state outside the region. Without outside assistance, they will continue struggling to maintain the capital necessary to maintain existing infrastructure, and developing new infrastructure will pose an even greater challenge." Indeed, in the 1990s, neglected by Russia, the Stans largely stagnated. Now, however, the region is tapping the capital of three larger states, which are all jockeying for influence and that spells opportunity for bold investors.

Central Asia's treasure trove

So just how large are the region's commodity reserves? It differs from country to country, but the short answer is enormous'. Take Kazakhstan. It is home to 3% of the world's oil, 4% of the world's coal and 15% of its uranium. It has the world's largest reserves of zinc, lead and chromite, and it is in the top ten for supplies of copper, iron ore, gold and manganese. This may seem surprising until you realise that Kazakhstan is the world's ninth-largest country: it's five times the size of France. The only resource Kazakhstan doesn't have much of is people. With only 16 million citizens, little of these precious commodities are needed at home, leaving more for exports.

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Turkmenistan is also rich in energy, with almost 4.5% of the world's natural gas. Again, it uses little, freeing up most of the gas for export. It also has 500 million barrels of oil. Uzbekistan has significant natural gas reserves, about 0.8% of the world's total about the same amount as Libya and sizeable gold, copper, lead and uranium reserves. It's also the most populous Stan', with 26 million people.

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That's more than enough to get less resource-rich nations envious. But geologists believe there is a lot more commodity wealth yet to be discovered in the Stans. Dr David Robson, chief executive of Tethys Petroleum, a small London-listed firm operating in central Asia, believes the region's Soviet past has left some areas underexplored. "We have just made a find in Tajikistan. In Soviet times Tajikistan was a rural part of the economy and not thought of as a source of oil and gas, but we believe it has similar geological traits to other hydrocarbon-rich parts of the region."

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Location, location, location

The Stans are also well-positioned geographically to benefit from this resource wealth. Since before the time of Christ, trade between Asia and Europe has travelled through central Asia along the Silk Route. Today that positioning means that Kazakhstan is in the perfect position to satisfy demand both from Europe, and the growing economies of Asia.

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However, until recently, it has been difficult for miners and oil firms to take advantage of central Asia's great location. Miners need good road or rail networks to get their goods to international markets. These already exist in established resource areas, but large swathes of central Asia are underserviced.

Another problem is that much of the transport infrastructure that does exist was built in the Soviet era and, as a result, is aimed towards servicing Russia. Oil and gas travels by pipeline to Russia, which pays a low price for it. "We sell gas to the local market but effectively the price is dominated by what the Russians pay for the exported gas," says Robson. Meanwhile, minerals must travel through a Russian-controlled river and canal network if they are to leave landlocked Kazakhstan and reach the Black Sea.

Infrastructure is expanding

But since independence, governments in the area have pushed ahead with new infrastructure projects designed to increase their access to new markets. In 2009, the first gas pipeline to be built without Russian involvement came into operation, linking Turkmenistan, Kazakhstan and Uzbekistan to China. Qiang Xiaoyun from Shanghai Business School Journal estimates that Chinese gas imports will double between 2010 and 2020, most of which will come from central Asia. This will help to reduce China's reliance on liquefied natural gas (LNG) imports, which travel by sea and are therefore more vulnerable to terrorism and piracy.

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China is also making heavy investments in Kazakhstan's oil fields and mineral projects. Economic cooperation between China and the five Stans has grown steadily. Over the past few years, the volume of trade has increased by 40% a year, reaching around $20bn in 2010, and this growth shows no sign of stopping.

China isn't the only one with an eye on the region's gas. India and Pakistan are both struggling to meet demand amid rising gas usage. On 11 December last year, Turkmenistan, Afghanistan, Pakistan and India signed an inter-governmental agreement on the TAPI gas pipeline. This agreement provides for the construction of a 1,735 km gas pipeline at a cost of $8bn. When completed in 2013-2014, the pipeline should enable Turkmenistan to export 33 billion cubic metres of gas in total, with five billion cubic metres going to Afghanistan and 14 billion cubic metres to Pakistan and India.

Western oil firms are also well established in the region. American firms dominate, controlling 75% of new oil fields. Their overall investment of $30bn represents around 40% of foreign investment in Kazakhstan and Azerbaijan. But energy companies from Britain, France, Italy, Iran, and Japan are also present. For example, British firm BG Group leads a consortium in Kazakhstan's massive Karachaganak oil and gas field.

The great game revisited

Central Asia also forms an important plank of US foreign policy. America is keen that the region continues to provide support for Afghanistan, especially when American troops leave. America's New Silk Route' strategy focuses on bolstering north-south trade linking India and Pakistan via Afghanistan to the Stans. Notably if unsurprisingly Iran, an important post on the original Silk Route, has been left out of the plan.

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Perhaps feeling that he needed to regain the initiative, Russian prime minister Vladimir Putin has in turn proposed investing $500m in a joint project with China that would transmit electricity from central Asia to India and Pakistan. The Stans have always been Russia's backyard. The country still has a network of military bases, infrastructure and political alliances in the region that give it clout for now, and it certainly doesn't want other powers gaining the upper hand in its sphere of influence.

"The central Asian countries are benefiting from competition between the powers," says Xie Wenxin in China Economist. "They have maintained close relations with Moscow, since much of their oil and gas exports continues to transit via Russia. But for technical and financial reasons, they are in the process of re-examining their cooperation with Western oil companies." Rivalry between the great powers should help central Asia fund the infrastructure it needs to exploit its resources, and in turn open up more lucrative markets to sell to. Where there's reward, there's risk

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Of course, while central Asia may be full of commodities, it is also full of risk for investors. First, there are the internal politics. In all five countries, former Soviet strongmen seized power when the region gained independence in the early 1990s. One such leader has been forced out by death (Tajikistan), another by revolution (Kyrgyzstan), but the rest stay in power. Indeed, despite what their well-paid Western PR agencies might try to tell you, all apart from Kyrgyzstan are dictatorships.

The most politically stable of the Stans is Kazakhstan. It is ruled by Nursultan Nazarbayev, the former first secretary of the Kazakh Communist Party, who became president when the country gained independence in 1991. Despite maintaining close links with Russia and keeping most of the Soviet-era bureaucracy, Nazarbayev has opened the economy up to foreign investors. The autocrat didn't have an easy ride in the 1990s. "Like most Commonwealth of Independent States (CIS) countries, Kazakhstan's economy collapsed in the 1990s in the wake of the break-up of the USSR," says Baillie Gifford's Andrew Stobart in the firm's Trust magazine. The economy almost halved in size, between 1989 and 1998. "Inflation peaked at nearly 3,000% in 1994."

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Yet eventually Nazarbayev's focus on opening the economy up began to pay off as production of oil, minerals, metals agriculture and heavy industry increased. The economy grew at around 10% a year between 2000 and 2007. But the boom drove a debt-fuelled property bubble that burst in 2007 when cash-strapped European banks started calling in loans (sound familiar?). The crisis tested Kazakhstan's young financial institutions, and the nation's sovereign wealth fund had to buy stakes in two listed banks to prop up the sector. But, unlike in the West, growth has returned, and Stobart reckons it can be maintained at "high-single digits" for the next few years.

This year, Nazarbayev was re-elected president with 95% of the vote. These elections were neither free nor fair, but most analysts think Nazarbayev who is well liked for raising living standards would win even if they were. Kazakhstan is also the best bet for investing in central Asia. It has the most resources, the largest economy and welcomes foreign investors. We look at the best ways to play the region below.

The best ways to play Kazakhstan

The Kazakhstani stockmarket (KASE) has had a terrible year. It's down 36% so far. It's not down to any specific problem with the country investors have abandoned riskier markets in general as fears grow about Europe and America's debt problems. That may continue, but in the long run, stocks exposed to the central Asian growth story should do well.

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So how do you invest in the region? You could buy directly into the Kazakhstani stockmarket through a specialist broker such as Visor Capital, but it's not cheap. As for retail funds, none offer significant exposure to the Stans, although Sturgeon Capital is planning to bring one out next year we'll keep you posted.

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Fortunately, many Kazakhstani stocks are listed in London and Canada. Now, it's fair to say that just because a stock is listed in London doesn't mean that it is safe from corruption and governance issues. The controversy earlier this year at Kazakhstani miner Eurasian Natural Resources Corporation (ENRC) when the controlling oligarchs kicked out the independent board of directors was a high-profile example. ENRC's stock fell 25% on the debacle and has struggled to recover.

However, there are some good stocks out there. The first is copper miner Kazakhmys (LSE: KAZ). That might seem an odd choice, given that Kazakhmys owns a 26% stake in ENRC. But any concerns about the ENRC stake are already in the price, says David Radclyffe at BMO Capital Markets. With China's urbanisation still ongoing, demand for copper for manufacturing and construction in the region should continue, despite the recent slowdown. Indeed, China Development Bank has lent Kazakhmys more than $4bn since 2009. Kazakhmys also looks cheap, trading at a heavy discount to peers: it's on a forward p/e of 4.2, compared to Chilean rival Antofagasta's p/e of nine. Even without selling its ENRC stake (which would clearly boost the shares), the business looks a good long-term investment.

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Another option is oil and gas producer Zhaikmunai (London International: ZKM). It already has a London International listing and is seeking a place in the FTSE UK index. ING rates it as one of "the most exciting investment opportunities" in the oil sector in Russia and Kazakhstan. FT Alphaville's Alistair Marsh notes that it's cheap (due to the Kazakhstan discount', it trades on a forward p/e of 5.4), "and has the potential to double its output in a relatively short space of time". Another plus is that, "in contrast to a number of the other Russia/CIS firms looking at premium listings, Zhaikmunai is not owned by oligarchs". Its major shareholders include Prudential, Franklin Resources, JP Morgan Asset Management and Henderson Global.

A smaller play is Kazakhstan-based gold producer Hambledon Mining (LON: HMB). It's made a habit of disappointing the market by undershooting production targets. As a result its share price has tanked. But Hambledon still has a lot going for it. It produces 22,000 ounces of gold a year. New chief executive, Tim Daffern, plans to raise that to 100,000 ounces a year by 2017 and recently raised £9m to invest in new production facilities.

Hambledon-chart

The gold miner plans to start mining underground at present it has an open-pit operation where grades should improve from 1.2 grams of gold per tonne to four. Its main Sekisovskoye mine has 1.93 million ounces of gold reserves, and it has bought two smaller mines with an extra 440,000 ounces of gold. With no debt, and a steady stream of cash coming from existing production, Hambledon should be able to realise its potential.

This article was originally published in MoneyWeek magazine issue number 568 on 16 December 2011, and was available exclusively to magazine subscribers. To read all our subscriber-only articles right away, subscribe to MoneyWeek magazine.

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