- By Holly LaFon
Enormous amounts of money have flowed in and out of Russia over the past several months as oil prices and U.S. policies turned from favorable to seemingly unfavorable, though some investors see a compelling market based on a more complex economic picture.
From the Nov. 8 U.S. election through the end of the year, Russia stocks rallied 35%. Lifting the market primarily were expectations that newly elected President Donald Trump would easy heavy sanctions put in place by former president Barack Obama in response to the country's annexation of Crimea and rising oil prices. Sanctions have targeted its state banks and corporations as well as energy firms, which produce the most crude oil of any country at 10.25 billion barrels per day as of 2015.
The intrinsic value of RTD:GZAV
Sanctions also hit Russia particularly hard as the oil sector accounted for about 50% of its budget revenue over the past decade. For the oil industry, they prohibit providing goods, services or technology to the country's exploration or production of deepwater or shale oil or gas, and it gets roughly half of its technology for it petroleum activities from the West.
As Trump's warm relationship with Russian Prime Minister Vladmir Putin fueled hopes of economic relief, a rebound in oil prices further lifted Russia's market. Crude oil WTI rose as high as $56 per barrel in December from lows under $30 per barrel one year previously.
In the buoyant market, investors poured $1 billion into the VanEck Vectors Russia ETF, the best-performing country ETF of 2016, according to Bloomberg.
Good fortune extended to the energy sector. In 2016, a basket of Russian oil stocks, such as Gazprom (RTD:GZAV) and Lukoil (MIC:LKOH) would have returned 51.7% for the year. By comparison, U.S. large cap oil companies gained only 21.9% in 2016, versus a 9.6% rise in the S&P 500 index.
But a reversal in Russia's positive trends started in late January. Markets began to doubt the certainty that Trump would shift policy on Russia and President Obama in January extended sanctions, set to expire in March, until March 2018. The European Council had already extended its economic sanctions against Russia until July 31.
In March, the oil rally also ended with a plunge to below $48 per barrel, near its lowest price since November, when OPEC struck a deal to reduce production. Driving the cutback was a 400,000 barrels per day increase in U.S. crude oil production since September and leftover excess from OPEC before their cutback agreement.
"The market needs time for the full impact of the big supply cuts under the output reduction agreements to be felt, the International Energy Agency said in its Oil Market Report on March 15. "We do not predict OPEC production per se, but if current production levels were maintained to June when the output deal expires, there is an implied market deficit of 0.5 mb/d for 1H17, assuming, of course, nothing changes elsewhere in supply and demand. For those looking for a re-balancing of the oil market the message is that they should be patient, and hold their nerve. In the meantime, the volatility that suddenly broke out last week will probably recur, as the IEA has regularly warned."
The combined factors pulled the floor from under Russia's market, which fell 9.8% year to date, making its MICEX Index the worst performing index in the world.
Beyond the equity market's strong reaction to energy and sanction woes, Russia has exhibited several other compelling economic aspects. The Central Bank of Russia, for one, has provided some support for Russia equities after changing its approach after the market's crash of 74% in the MSCI Russia Index in 2008.
The bank implemented reforms such as "improving the financial infrastructure to make Russian domestically denominated bonds easier for foreign investors to trade, aggressively cleaning up the banking system, and increasing the role of domestic pension funds in domestic financial markets," as well as introducing an inflation mandate, according to James Syme, senior fund manager of emerging markets opportunities at JOHCM Funds.
Syme is has a sizable position in Russia and increased his weighting in the past two weeks, he said in a March "Emerging Markets Spotlight."
"Russia faces some very serious structural growth issues (including corruption, the rule of law, demographics, capital flight and resource dependence), but enjoys a strong cyclical outlook at present, created partly by the CBR's embrace of orthodox policies, which we believe the market has overlooked," he said.
Syme also cited growth in real wages, recovering retail sales and improving industrial production as positive signs for the economy, as well as good positioning to benefit from a recovery in oil prices.
Russia continued to have record high oil output through December, despite sanctions against help from U.S. corporations, at 11.21 million barrels per day. The country has pledged to follow its OPEC agreement to reduce output by 300,000 barrels per day in the first half of 2017, and has "consistently said that its cut would be gradual," according to the IEA.
So far in 2017, the same portfolio of Russian oil stocks that jumped in 2016 have slid 5.04% in price. The group contains Rosneft Oil Co. (MIC:ROSN), PJSC Lukoil, Gasprom Neft PJSC, Tatneft PJSC (MIC:TATNP) and Surgutneftegas OJSC (MIC:SNGS).
Growth is also expected in its economy after a deep recession that began in 2014. The World Bank projects its economy to grow at 1.5% in 2017 and 1.7% in 2018, as oil prices reach an expected $55.20 per barrel in 2017 and $59.90 per barrel in 2018.
GuruFocus data projects an annualized market return of 32.9% for Russia in future years, an unusually high number for several reasons. The return is calculated with contributions from economic growth, dividend yield and valuation reversion to the mean. Economic growth is defined as the ratio of total market cap over GDP, which stands at 20%, near a historical low of 16%. If the ratio returns to the historical mean of 65% in the next eight years, it would contribute 19.25%. Russia's GDP has has seen tremendous growth over the past decade, roughly tripling in the past eight years. Eight-year GDP growth gives a contribution of 11.9% to the calculation, and dividend yield 1.8%.
Emerging market projections also tend to overestimate future returns and are far more uncertain than those for developed markets as high rates of past growth cannot continue indefinitely into the future.
This article first appeared on GuruFocus.
The intrinsic value of RTD:GZAV