Monday, 12 May 2008

Investors in Russia miss out as oil price gush passes them by

Financial News

Jason Corcoran in Moscow

12 May 2008

Falling production of crude and domestic issues have dampened the effect of global price rises

Crude oil rose to a record $123.9 a barrel last week following threats to supply in Nigeria and Iraq and growing Asian consumption. Yet fund managers investing in Russia’s oil majors have seen little upside over the past year as a result of declining oil production, high taxation and disputes involving shareholders and the state.

Only Lukoil (7.%), Tatneft (6%) and Gazprom Neft (5.2%), the oil arm of gas producer Gazprom, have outperformed the Russian market over the past year. TNK-BP, the Anglo-Russian joint venture, has fallen 12% and Surgutneftegaz is down 18% while Novatek and Rosneft are flat.

Alexander Kotchoubey, managing director of Renaissance Investment Management, which has more than $6bn (€3.9bn) in assets under management, believes the speculative bubble in oil prices is not applicable to Russia. He said: “The direction of oil price has not impacted our strategy. Domestic oil production is falling, Russia is facing a huge headwind in capital spending and the taxation policy looks confusing.”

Kotchoubey said the price of crude could rise to $130-$140 over the next six months before the bubble is pricked. Many Russia fund managers prefer gas to oil because of the liberalisation of domestic gas prices and the perceived undervaluation of state-controlled Gazprom.

The Energy Ministry last week reported operating data for Russian oil and gas companies, which showed crude oil output down 0.9% year-on-year in the first four months of 2008. Production data for Surgutneftegaz, Lukoil, Gazprom Neft and TNK-BP showed their production had fallen by more than 2%.

However, gas output was up 2.3% over the same period and Gazprom’s production rose 1.4%.

It was the fourth month in a row that Russian oil production had fallen. Commentators said it was this that provoked a change of heart in Vladimir Putin, who stepped down as president last week in favour of Dmitry Medvedev. Putin, now Prime Minister, had ruled out a reduction in taxes on oil companies, but last week told the Duma, Russia’s Parliament, that 75% to 80% of oil company profits were going to the Government through taxes and this had made some oil wells unprofitable. He called for taxes to be lowered to stimulate investment.

James Fenkner, managing partner of Moscow-based Red Star Asset Management, saw his hedge fund punished in March for its short positions on oil. He said: “The concept of $120 oil is not there in the Russian equity market. You just have to compare share prices of Brazil’s Petrobras to Russia’s best performer Lukoil. Petrobras has been on the tear and Lukoil is up just a tick.”

Fenkner believes oil prices will remain just above $100 a barrel until the end of the year because of the thirst of emerging markets.
Stephen Cohen, chief executive of investment bank Troika Dialog’s hedge fund business, does not factor in a view on current oil prices into his firm’s investment strategy. He said: “We don’t have a view beyond what the futures market is telling us. I think there will be some compression from the current spike but prices won’t fall dramatically.”

Lukoil has been one of Troika’s biggest holdings but it now prefers Gazprom because of increasing global energy prices and growing domestic tariffs for natural gas.

The UFG Russia Select Fund was almost entirely invested in oil and gas assets at its launch five years ago because its managers found it impossible to have a diversified portfolio. Florian Fenner, managing partner of UFG Asset Management, said: “In the past, the rising tide lifted all boats. Since valuations were so low for almost all assets in Russia, stock selection was only of secondary importance as long as you had significant exposure.”

Over the past five years, the fund has gradually shed almost all its oil assets and today treats oil stocks as a proxy for the market.
Fenner said: “We also find that the much-discussed political risks seem to be concentrated in oil. Derivatives, which did not exist for all practical purposes a couple of years ago, have become an asset class in their own right and are now a staple of our investment decision process. Risk-reversals and bull spreads on Gazprom are quite common parts of our portfolio. Thus, we might not make more money, but there is a lessened degree of risk.”

The significant underperformance of Russia’s oil sector has spurred the hedge fund Diamond Age Capital Partners to reduce its exposure in Russian integrated oils close to a zero weighting.

Slava Rabinovich, managing partner, said: “A key missing ingredient for the Russia investment case has been a catalyst to ignite the market’s largest sector.

“The very significant underperformance of the Russian oil sector over the past year and a half or so has been a drag on performance. The RTS Oil and Gas index is up just 3% since the end of June 2006, while our fund is up 27% during the same period.”

Rabinovich said the fund had benefited from oil strength through long crude futures contracts, and exposure to Commonwealth of Independent States oil stocks.

The oil and gas sector remains one of most important components of the Russian economy. It makes up about 65% of the market capitalisation, according to federal statistics agency Goskomstat.

The state’s share of Russia’s oil production has risen to 44%, from 6% in 2000, after it took over most of Yukos and Sibneft, according to investment bank Uralsib. The gas industry is almost all in the hands of the state-controlled Gazprom. Faced with declining production, the Government threw the oil sector a lifeline in March when Finance Minister Alexei Kudrin announced a proposal to reduce the mineral extraction tax for oil companies by roughly $4bn next year as part of a first step to support investment in the industry.

Since 2004, when oil giant Yukos was bankrupted, the Kremlin has buried the industry under a mountain of taxes as a punishment for Mikhail Khodorkovsky’s perceived attempt to mount a political challenge to President Putin.

The resulting marginal oil tax rate of more than 90%, the highest in the world, has suppressed crude production growth. In the four years before the 2004 change, Russia’s oil production grew at 8% a year; in the four years afterwards, it slowed to 2% a year.

When prices climb above $27 a barrel, the oil tax rate kicks in and this has reduced incentives to increase output and explore developing oil fields in remote regions beyond the maturing fields of West Siberia.

Investors remain concerned about potential state expropriation of TNK-BP following the decision by the Shell-led consortium to cede a majority stake at Sakhalin-2, a vast oil and gas field.

Russian oil shares rallied briefly following the news on taxation but some fund managers believe the state will ultimately find other ways to maintain the tax burden on oil companies.

Kotchoubey said: “Taxation is one of the big obstacles preventing investors from jumping in with both feet. They might ease taxation on exploration but the industry is too far into a production slide and they will probably increase tax on the other side of the pipe anyway.”

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