Profit from Russia as Putin’s boom rolls on

published 12 March 2008

Former lawyer Dmitry Medvedev knows his predecessor's leadership will be a tough act to follow, but the boom times roll on in Russia, says Eoin Gleeson

As Vladimir Putin takes leave of office, the image that will stick in many people's minds is that of the Russian leader on holiday last year: bare-chested, rifle in hand and aiming a thousand-yard stare over the Siberian wasteland.

Investors sizing up Russia have every right to be cynical about the handover. But what we shouldn't ignore is the reason for Putin's popularity. Because the undeniable truth is that during his premiership, Russia has undergone one of the most remarkable economic recoveries in recent history. Having folded in on itself completely in the early nineties, the Russian economy has been growing at a pace of 8% a year as it draws on massive reserves of oil, gas and precious metals to feed rampant growth in China and India. That success has created a thriving middle class that is spending its way into the comfort of Western domesticity buying cars, mobiles, then splashing the change on trips to Europe and the Far East.

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But it's the job facing Putin's successor that makes Russia such a compelling case for investment. Medvedev is faced with a mammoth task to maintain the stability his mentor achieved. Under him, the Kremlin must radically overhaul its dangerously decrepit infrastructure and wean the economy off its heavy reliance on energy. As Medvedev presides over a $1trn plan to reinvent the Russian economy, the opportunities for foreign investors may just be to good to pass up.

The case for investing in Russia has to start with energy. Russia is fired by the wells that draw from the vast oil reserves in its western heartlands. Fully one-third of the world's gas reserves sit in the giant Siberian gas fields, making Russia by far the largest global gas producer and exporter. In the time that Putin has been in office, Russia's neighbours have come to rely heavily on those reserves. The European Union has increased its dependence on Russian oil from 9% to 25% over the past decade, and 25% of its natural gas comes from Russia.

The energy boom has left the Kremlin in an enviable position. When the price of oil was relatively high in 1995-1996, the government squandered its natural wealth, allowing oligarchs to hoard vast sums in offshore accounts, while ordinary Russians starved. Regardless of what you think of his methods, Putin has done everything in his power to reverse that mistake, wresting control of Russian behemoths such as Gazprom and Rosneft from the oligarchs who prospered during the Yeltsin years.

The Kremlin rakes in a fortune as it taxes oil and gas producers to the hilt. At current oil price levels, for every dollar that the price of a barrel goes up, the Kremlin takes 85 cents, most of which goes straight into its rainy-day Stabilisation Fund. The fund has grown 60% in the past year alone, swelling to $150bn. Exporting oil has left the Russian government with the third-largest foreign exchange reserves in the world and the luxury of a budget surplus tipping 6% of its GDP.

But state ownership has a downside. Publicly-owned companies the world over are less efficient than private ones, and Russia is no exception. As the oil fields in Siberia age and investment has slowed, growth in oil production has dropped from 9% a year in 1999 to 1% last year. High levels of taxation are taking their toll, leading some analysts to the conclusion that playing the Russian oil story has had its day.

Before leaving office, Putin managed to cajole hydrocarbon-rich Turkmenistan and Kazakhstan to enter a supply contract that allows Russia to tap their considerable reserves for a fraction of the price they'll charge the EU and China. The deal reinstates Moscow's control over the remote Caspian region and will go some way towards helping Russia's gas groups to continue supplying both Asia and Europe in the coming years, notes Thomas Orszag-Land in CNBC European Business.

At home, domestic demand for gas is rising as the economy develops. Electricity in Russia is produced mostly by gas, with domestic demand set to take up 479 billion cubic meters (bcm) of an estimated 665bcm capacity by 2010. In the past, gas groups have been hampered by the fact that they have been forced to supply domestic markets cheaply, generating very little profit. But domestic tariffs are to be lifted, allowing the likes of Gazprom and private gas firm Novatek to charge higher rates to industry in its home market. Russia's Federal Tariff Service approved a 25% increase in Gazprom's price to Russian consumers for the year ahead.

If there's one thing that could trip up the Kremlin's energy ambitions, it's Russia's decrepit infrastructure, which has been allowed to fall into decline since the collapse of the Soviet Union. Russia can pose as an energy superpower, but with pipelines 25 years out of date and a railroad network so underdeveloped that it cannot transport goods to its main customers, the good times won't last long.

The task facing Medvedev is formidable. Russia's roads are a nightmare, collapsing under the weight of transport trucks and the new traffic on urban routes. Even big cities often depend on single-lane roads. Russia's road system is only one tenth as long as America's, but only 5% or so is good quality, notes Chris Mayer for the Daily Reckoning and in Russia, good quality means little more than having "more than one lane and a surface that doesn't buckle under the weight of a car". While China has built 25,000 miles of highways since 1988, Russia has only laid the tarmac on a few hundred.

Russia's famed railroad system is also suffering. The rails stretching across the central plains are crumbling with rust and the supply lines to the gas fields are cut off as rails are cracked by the Arctic winds. Freight cars crawl at average speeds of no more than 25 miles per hour. It's difficult to square the image of a thriving energy industry with the wasteland it operates in. There were 1,300 working airports in the 1990s, but with only 250 in use today, the country is blighted by relics of the Soviet Era. Railways alone will need $440bn of investment to 2030, according to finance minister Alexei Kudrin.

And that's exactly what it's doing. The Russian government plans to throw $1trn at the problem. Around $200bn will come from the Kremlin, while the private sector will stump up the rest. The key aim is to update the energy distribution network the pipelines, roads, electric power plants and transmission lines. Grand projects are already in full swing with work under way on the St Petersburg "High Speed Diameter" highway, and the $3bn Helsinki Expressway. A total of 2,600 miles of road are planned each year, while national champion Russian Railways will spend $16.6bn laying railways in 2008 alone.

It's not just transport that's booming. Investment in the electricity sector is set to exceed $28bn in each of the next three years, while Russia plans to build more than 60 atomic power plants abroad. All this comes at a time when the construction industry is already thriving, with bridge, road and rail builders struggling with a backlog of projects. Output rose 18% in 2006 to $129bn, and the pace of growth is escalating, rising by 26% last year alone.

While many Russians still live in the Spartan blocks that sprang up under communism, they at least have the money to furnish their homes with the trappings of a Western lifestyle. Russia now ranks fourth in the world in terms of making new millionaires. And Russia's "fashion-conscious youth are helping close the country's gap with the rest of the world in penetration rates for mobile phones, PCs and broadband", Carina Baranova of Kazimir Partners tells the International Herald Tribune. Retail sales are growing at around 13% a year in real terms.

One very noticeable sign of Russia's prosperity is the number of cars on the road. Ten years ago you could sit and have a picnic on the main road into Moscow, says Ambrose Evans-Pritchard in The Daily Telegraph. But now St Petersburg and Moscow are teeming with Renaults and Audis imported from Europe. Car sales rose 67% last year to $53bn, yet there are still only about 200 cars per 1,000 people in Russia, against 1,000 in Europe. Analysts at Troika Dialog, Russia's oldest financial bank, believe the number of cars is set to double in Russia by 2015.

Spending aside, the emerging middle class, possibly stung by the memory of having to queue hours for bread and milk, have proved careful savers. And that means there is plenty of room for Russia's immature banking sector to grow. The sector is already doing good business in credit cards and traditional banking services, but total mortgages still amount to a mere 0.4% of GDP, against 65% in the US and nearly 50% in the EU.

Russia is also cheaper than its Bric (Brazil, Russia, India and China) rivals, trading on a p/e of 13.5 against India's rating of 30, and China's 50. That's partly because Russian equities lagged 15% behind the MSCI Emerging Market index last year, due to uncertainty over the changeover in the Kremlin, says Roger Bootle of Capital Economics. But with Medvedev seen as a continuation of Putin's reign, "there are good reasons to believe that the Russian equity market is on the cusp of a boom".

So what's the best way to buy into Russia's ongoing success story? An obvious play is gas giant Gazprom (LSE:OGZD). With its former chairman Dmitry Medvedev becoming Russian's new president, Russian analysts expect the group to get pretty favourable treatment. It will also reap the rewards of the 25% rise in domestic tariffs, is attractively priced on a forward p/e of 9.9, and will benefit from Putin and Medvedev's efforts to secure cheap hydrocarbons from Central Asia.

Another of Russia's big exports to China is fertiliser. Leading Russian potash outfit Uralkali (LSE:URKA) is an attractive play on China's efforts to get the most out of its dwindling farmland reserves. Profits jumped 48% last year and the group is one of only two potash firms that can add significant capacity, accounting for 50% of planned global expansion. The stock trades on a forward p/e of 13.

One of best ways to play Russia's infrastructure boom is through the steel firms supplying the construction industry. As Russia's monopoly producer of rails, steelmaker Evraz Group (LSE:EVR) has to be singled out. Steel consumption in the country has grown by 14% each year for the past three, and Evraz accounts for about 20% of national steel output. It trades on a forward p/e of just 9.3, say analysts at Centreinvest.

Another good infrastructure play, says Troika analyst Kirill Kazanli, is commercial port operator Novorossiysk Commercial Seaport (LSE:NCSP), whose global depositary receipts you can pick up in London. The group gives good exposure to Russia's crude, timber, grain and metals exports. With a forward p/e of 14.7, Novorossiysk is trading at a discount to the sector average of 17.7, despite its prime position in the export chain.

For broader exposure to the Russian economy in general you might consider Neptune's Russia and Greater Russia fund. Manager Robin Geffen has turned in a stellar 201% return over the past three years and is confident that Russia will be well-cushioned from a global slowdown. Elena Shaftan's Jupiter Eastern European opportunities fund has been another strong performer, with a three-year return of 120%.

Russia may have undergone what Liam Halligan in The Daily Telegraph calls the "most incredible economic turnaround in human history", but despite the progress the country has made, life for many Russians remains grim. The country has the lowest life expectancy of any developed nation, with poverty, alcoholism and one of the world's highest HIV rates all of which means that the average Russian man only lives to the age of 59. And the country's massive social problems are only the tip of the iceberg.

Governance risk: The biggest risk in Russia as Yukos, BP and Shell have found out to their cost is that the Kremlin will simply snatch assets from companies if it sees fit. Foreign investors lost $6bn when Putin attacked Yukos. In Medvedev's own words: "Russia is a country of legal nihilism." It's promising that the country's leader recognises this, but that doesn't mean the situation is going to change. The key thing is to select domestic companies over foreign investors, and keep an eye on the political mood music as long as a company is in favour with the Kremlin it should be reasonably safe.

Energy risk: Russia's turnaround has largely been fuelled by oil and gas. As The Economist points out, if the price of oil takes a dive as the global economy falls, the Kremlin may find that its best-laid plans never materialise. Russia's strong-arming of oil and gas groups has already hurt production, with oil capacity in bad need of investment to tap reserves. But oil would have to fall below $65 a barrel to trouble the Russian growth story, Mark Atherton of Morley Fund Management tells the Wall Street Journal. Even in a severe slump, this seems fairly unlikely.

Recession risk: The big blot on Russia's story is inflation. With oil wealth swilling around the economy, inflation could hit the mid-teens next year, pushing up borrowing costs. While the government is virtually debt-free, big business is hugely backed by foreign loans, with Gazprom borrowing $13.1bn from a consortium of Western banks to buy oil group Sibneft. But as the Nikitsky letter points out, these borrowings are covered several times and Russian firms haven't engaged in US or European-style leverage, which makes them less vulnerable to any downturn.

There can be little doubt about the reason Dmitry Medvedev has found his way to top office in the Kremlin he has been fiercely loyal to Vladimir Putin since the former lawyer came under the wing of the former secret service agent 17 years ago. Medvedev has even been remade in Putin's image undergoing a style change in the run up to office to match the "hard man" image of his mentor, going so far as to declare his weakness in interviews for 1970s rock groups Deep Purple and Led Zepplin.

While Medvedev has stated his commitment to carrying out Putin's legacy, there are stirrings in the Kremlin that Medvedev may be a far more liberal animal than Putin. Backed by his gregarious wife Svetlana, who is credited with being the driving force behind his ambitions, and whose glamour has earned her comparisons to Raisa Gorbacheva, some commentators are not ruling out that Medvedev will be seduced by the power of being Tsar, and butt heads with the man who has installed him in the Kremlin.

Eoin came to MoneyWeek in 2006 having graduated with a MLitt in economics from Trinity College, Dublin. He taught economic history for two years at Trinity, while researching a thesis on how herd behaviour destroys financial markets.