FALLS CHURCH, Va.–The US Treasury’s plan to rescue Fannie Mae and Freddie Mac should instill confidence that the authorities will do whatever possible to avoid a total collapse, but it’s also a stark reminder that the situation is quite dire.
This is why the decision for action took place well ahead of the arrival of a new administration, and why the package is so large and so wide in scope. There will be more bad news to come out of US banks because many hold Fannie and Freddie paper and preferred stock.
The consequences of the current turmoil, particularly the loss of confidence in the system’s purported invincibility and superiority, will be long lasting. It’s a point I’ve made here repeatedly: The system’s checks and balances didn’t work because greed was the primary force and structural finance operated as the magic wand. Unfortunately, most would-be swans have turned into pigs.
True, the Treasury’s plan will allow the mortgage market to function, but this isn’t the same thing as reviving the wild spirits. Weakness in the economy will continue to discourage people from buying again in droves; the latest weak labor report is further indication that the consumer recovery is still far off.
Finally, keep in mind that the Treasury plan specifically states that the Fannie and Freddie debt isn’t guaranteed by the US government.
Markets have shown signs of attempts to rally, a logical consequence of such a dramatic intervention by US authorities. The jury’s still out, although there’s a lot of money sitting on the sidelines, and the mood is still negative.
Asian markets, the hardest hit during the global swoon, should outperform under a rally scenario. Part of the hit can be justified based on slower earnings growth and margin contractions as well as expectations of lower economic growth. But the fact remains that Asia is collateral damage in the context of the great credit unwinding of the Anglo-Saxon economies.
That said, almost every available indicator is undershooting dramatically in Asia and, barring a total catastrophe, the stage is being set for a massive long-term buying opportunity. Asian assets aren’t as cheap as houses in California, but, then again, the growth potential they offer can’t be found in the Governator’s state, either.
Russia Is Here to Stay
By Yiannis G. Mostrous and Elliott H. Gue
For the past seven years, the Russian market has outperformed the rest of the BRIC (Brazil, Russia, India and China) economies hands down. We anticipated 2008 would be another decent year, and it was for the first six months. But the market has been hit hard recently.
The main reasons for this underperformance are the oil-led breakdown of the commodity universe, the generally negative investor sentiment on emerging market growth and geopolitical developments in the Caucasus. Because the Russian market is dominated by resource companies, weakness will persist as long as investors continue to fear that slower growth in emerging markets will hurt demand for commodities. The majority’s inability to quantify the demand drop intensifies the uncertainty.
But Russia is still in a very good position. It’s a net oil exporter that’s forecast to post 2008 GDP growth of 7.6 percent. The country doesn’t depend on foreign capital flows. It’s rather politically stable, boasts reasonable market valuations and, above all, enjoys solid exposure to the biggest growth story of our time, Asia.
Russia’s fiscal position is quite strong; neither the corporate sector nor the consumer is overly indebted. At the same time, the Bank of Russia, the central bank of the Russian Federation (CBR), has accumulated enough foreign exchange reserves–around USD600 billion–to give itself some serious maneuvering space. Furthermore, the majority of economists agree that the budget will remain balanced as long as oil prices remain above USD50 per barrel.
As we noted earlier in the year, high inflation has been the economy’s main problem in 2008. The result of strong growth as well as higher commodity prices, inflation should subside later in the year as commodities correct.
Ruble appreciation has been on of the strong points for the economy, but, as the chart below indicates, the currency has been weakening of late. Expect the ruble to remain fairly strong and support domestic consumption, especially because the CBR has the financial muscle to make sure that this happens.
The Russian ruble is quoted as the number of rubles per US dollar. The descending line indicates the appreciation of the currency.
On the political front, the situation is improving and, in a year’s time, the Georgian incident will look much less significant.
Furthermore, Assistant Secretary of State Daniel Fried told the House Foreign Affairs Committee that the administration has questions regarding Georgia’s management of the conflict.
Although there’s still a lot of animosity in Washington toward Russia, there’s a consensus forming: The US-Russia relationship has been damaged for no serious reason.
In an article written for The International Herald Tribune a little over a month before the President of Georgia took his chances, Henry Kissinger noted:
The issue of relations with Ukraine goes to the heart of both sides’ perceptions of the nature of international affairs. Genuine independence for Ukraine is essential for a peaceful international system and must be unambiguously supported by the US. But the movement of the Western security system from the Elbe River to the approaches to Moscow brings home Russia’s decline in a way bound to generate a Russian emotion that will inhibit the solution of all other issues. It should be kept on the table without forcing the issue to determine the possibilities of making progress on other issues.
There are still plenty of risks, but the recent market selloff offers a good opportunity for gradually buying into the market.
Energy Is the Game
The mainstream media would have us believe that Russia is hostile to foreign investors and companies, particularly if those firms hail from the US. After all, the Russian government has renegotiated the terms of a handful of key oil and gas projects that were being pursued in partnership with foreigners. And those renegotiated contracts clearly weren’t as favorable to the foreign partners as the original deals.
But most investors spend far too much time thinking about Big Oil doing work in Russia under the traditional production sharing model of international contracts.
Traditionally, under production deals, a big international oil company would provide the expertise, technology and project management skills needed to handle a complex international oil or gas development project. In exchange, the big oil firm would receive a share of oil and gas produced from the fields.
That model has fallen out of favor and not just in Russia. With oil and gas prices still not far off record highs, most countries are no longer keen to give up control of their resource wealth to foreigners. Some have dubbed this problem resource nationalism.
But resource nationalism doesn’t mean that foreign firms don’t benefit from international contracts in countries like Russia. In fact, there are currently several prominent US energy firms that are doing business happily in Russia; in fact, several have identified the nation as among their most profitable and fastest-growing markets. However, Big Oil is no longer the big winner in such deals.
Houston-based Schlumberger (NYSE: SLB) is the largest oil services firm in the world. The term services is loosely defined and can refer to a large number of very different functions related to exploring, drilling and producing oil and gas fields.
For example, Schlumberger owns a fleet of advanced seismic ships used to explore for and delineate fields located in the deepwater. And the company also helps producers drill horizontal wells, uses specialized equipment to test a reservoir’s potential during drilling and prepares wells for production. Suffice it to say, you can’t drill and produce a well without help from an oil services firm, and the more complex the well, the more services you need.
Schlumberger operates in just about every imaginable segment of the services business and every energy-producing region of the world; therefore, management has an unparalleled view of key trends underway in the industry.
Schlumberger’s birds-eye view of the oil business is superior even to the major oil companies. That’s because the company works in regions where Big Oils don’t. Moreover, at one time or another, Schlumberger works on projects managed by all the Big Oil firms.
Back in July, Schlumberger hosted its quarterly conference call to report and discuss results from the second quarter. One of the most interesting points Schlumberger’s CEO made during the call concerned Russia. Consider the following quote from the analysts’ question and answer (Q&A) segment of the call:
Analyst: …How do you think the geographic markets rank in growth?
CEO Andrew Gould: Well, I think 2008 Latin America will be the star. And 2009, actually I think it’s going to be very much influenced by the arrival of a lot of the offshore rigs, which is North Sea, West Africa, Gulf of Mexico, and to some extent, Brazil. And then on land I actually think that Russia will be very strong again.
CEO Andrew Gould went on to say that demand in the lucrative Russian market looked ready to accelerate because Russia’s lowering the taxes it charges oil producers.
These taxes take away a large chunk of the benefit of rising oil prices from local producers. Because local producers don’t get the full benefit of rising prices, they’re not incentivized properly to undertake more drilling projects; oil production from Russia has actually been dropping recently for the first time in many years.
The Russian government knows this and is cutting taxes on producers to encourage more exploration and production (E&P) activity. When an analyst asked if the proposed tax cuts would be enough to support more activity, Gould responded with a simple, unequivocal “yes.” Because Russia’s a huge market for Schlumberger, this reacceleration in activity is an undeniable positive.
Schlumberger is no newcomer to the Russian market. At the end of 2007, the firm had a workforce of 14,000 skilled and unskilled workers, engineers and geologists in Russia. Many of its employees are Russian; Schlumberger has long followed a strategy of hiring, training and building up a local workforce. In this way, the services giant avoids the negative image of importing hundreds of workers from the US and Europe every time it wants to perform a project. In addition, by going local, Schlumberger actually reduces overall labor costs.
Schlumberger’s overall Russian revenues have more than tripled since the beginning of 2004. Much of its recent growth has come from a relatively new business line known as integrated project management (IPM). Gould stated that he remains astonished at the demand for this service.
In an IPM deal, a producer actually contracts with a service firm to handle a project. Depending upon how the deal is structured, the services firm may provide the rigs, contract with engineering companies or provide some of its own in-house service functions, as well as contract with third-party providers for other services.
In many ways, IPM deals are replacing production-sharing deals with major international integrated oil companies. Many state-owned national oil companies (NOC) prefer not to give up rights to some of the production from their fields; this was the norm under production-sharing deals. In an IPM, the NOCs can simply pay the services companies to handle the work.
IPM is also good for the services firms because these deals typically represent major contracts and can carry healthy profit margins. The growth in this market is exploding as producers switch from partnership deals to IPMs. Russia is one of the fastest-growing IPM markets in the world with arguably the best prospects for growth. A good deal of spending in this market will flow through IPM deals to services companies.
Bottom line: The “resource nationalism” that Big Oil often complains about is actually a boon to services firms. And if you still believe western firms can’t do business in Russia, consider that Schlumberger scored more than $1.5 billion in profits from the nation last year.
On the same business, Weatherford International (NYSE: WFT) is best known as a services firm specializing in mature oil and gas wells that have been in production for many years. Traditionally, the company has been heavily exposed to North America and, in particular, Canada where mature well developments are common.
But Weatherford has been able to take the services it perfected in Canada and apply them all over the world. In fact, Weatherford is one of the fastest growing oil services firms in the world. One of the key markets for Weatherford’s services: Russia. The nation also has a large number of mature wells that are perfect for Weatherford’s service offerings.
In fact, during the company’s first quarter conference call, Weatherford’s CEO noted:
…There is only a handful of countries that can compete with Russia in terms of growth rate, and I’m talking about important countries, not those countries that go from zero to a few million dollars where the growth rate is extravagant. I am talking about countries already sizable who also have a high growth rate. It’s hard to compete with Russia.
And like Schlumberger, Weatherford has also entered the IPM business. Given its mix of business, the company is well placed to win contracts.
Services giant Baker Hughes (NYSE: BHI) also has an impressive position in Russia. The company recently noted that it’s seeing an uptick in interest in new drilling activity in Russia rather than simply old field rehabilitation; lower export taxes do encourage new drilling activity.
The services firm also noted an uptick in well complexity. For example, Baker is seeing strong demand for long horizontal wells, which are dug down and sideways through oil bearing layers of rock. Drilling horizontal wells is more expensive and technically complex than vertical wells; however, such wells can be more effective in producing certain fields.
And Baker is also seeing increased interest in high sulphur wells and wells exposed to high pressures and high temperatures. With a strong reputation in key service functions such as directional drilling, Baker also stands well placed to benefit from increased E&P activity. In fact, with overall growth of close to 40 percent, Russia was one of Baker’s fastest-growing geographical markets in the most recent quarter.
Contract drillers are in the business of owning drilling rigs and leasing those rigs out to operators for a fee known as a day-date. Nabors Industries (NYSE: NBR) is one of the largest contract driller in the world that specializes in land rigs.
Historically, Nabors has operated almost exclusively in the US and Canada. But over the past three years, the driller has made a major push overseas.
In a few years’ time, its international business may even be larger than the traditional North American market thanks to high profit margins available overseas and strong growth. Nabors’ management team estimates international earnings will grow 40 to 50 percent for the foreseeable future.
Nabors has received some lucrative, major contracts in Russia. One of the largest was a deal it won in late 2007 to do work with Weatherford in Western Siberia for TNK-BP. Weatherford is providing some major services for the deal while Nabors is supplying the drilling rigs necessary to conduct the project.
Nabors presence and history in Russia gives it an inside track on new deals. In addition, Nabors builds some of the most powerful land rigs in the world, including some that were built with harsh Alaskan weather in mind. This is exactly the sort of cutting edge rig needed to handle Russian contracts.
Finally, there’s one international integrated oil firm that should be part of every discussion of Russia: ConocoPhillips (NYSE: COP). Conoco owns a minority stake in Russia’s Lukoil (OTC: LUKOY) and has partnered with the Russian oil giant on several major deals, including its ongoing efforts to develop the Timan-Pechora region. Much of this remote region in northeast Russia is actually semiautonomous, consisting of the Komi Republic and Nenets Autonomous region.
Lukoil is our favorite domestic oil company to own in Russia.
It’s Russia’s largest vertically integrated oil producer in terms of reserves, with 15.9 billion barrels of oil and 4.4 billion barrels of oil equivalent (boe) of gas reserves; it accounts for almost 20 percent of Russia’s total oil production.
The company has the largest international upstream portfolio among the Russian majors, with international projects accounting for almost 5 percent of proven oil and 37 percent of proven gas reserves. Lukoil operates 1,658 retail stations in Russia and 4,135 abroad.
Recently, Lukoil reported second quarter 2008 results and, although net income was up 31 percent quarter-over-quarter, the company took a hit of USD621 million on hedging losses. In addition, cost of operations was also elevated, growing at 11 percent quarter-over-quarter.
Management should be looking in its trading/ hedging operations in an effort to reduce the effect on the company’s results. Furthermore, more effort to suppress costs is necessary, especially as the price of oil remains weak.
Even so, the company doesn’t deserve to trade at such cheap valuations given that its growth potential around the world is one of the best in the industry.
Gazprom (OTC: OGZPY) is the long-term favorite here on Russia’s energy sector. The company is by far Russia’s largest company and controls close to 85 percent of the country’s total natural gas production.
In fact, given Russia’s dominance in the global gas market, it’s hard to talk about natural gas at all without mentioning Gazprom. The company alone accounts for nearly 20 percent of global gas production.
There are two major catalysts for Gazprom’s stock in the coming years: growing production and rising average selling prices. To the first point, Gazprom has a number of new projects scheduled to start up in the coming years.
The company’s long-term production plans are to increase gas production from 523 billion cubic meters in 2000 to 560 billion cubic meters by the end of 2010, 590 billion cubic meters by the end of 2020 and as much as 630 billion cubic meters by 2030. Rising prices are already making an impact: The company expects its revenues to surpass USD65 billion this year, which compares favorably to last year’s USD39.5 billion.
The company has big investment plans for expansion. Deputy
CEO Alexander Medvedev said recently, “In general terms, we are interested to have reserves which will allow us to create a vertically integrated chain to include all major products in our output–natural gas, crude oil, electricity.”
The Telecoms
On the domestic front, consumption should remain strong as nominal wages are still growing at around 28 percent year-over-year. Furthermore, the government’s plan is to spend money to improve infrastructure and the business environment, giving the economy a real chance to sustain its growth.
Wireless telecom operators have been our favorite way to gain exposure to the domestic story in Russia and the rest of the region as well.
After the recent selloff, both Silk picks offer strong value; their stocks trade at low price-to-earnings (P/E) multiples of around 10 and offer a decent yield. Our long-term holding Mobile TeleSystems (NYSE: MBT) has a 5 percent dividend yield.
The company is the largest cellular operator in Eastern Europe, with 50 million subscribers. The company has licenses in 87 Russian regions, Ukraine, Belarus, Uzbekistan and Turkmenistan, covering a population of more than 233 million people.
Long-term favorite Alternative Holding Vimpel-Communications (NYSE: VIP) is also a strong grower. It has 50 million active subscribers, and Russia accounts for more than 80 percent of group revenues. Kazakhstan is the next largest market. The company is also present in Ukraine, Uzbekistan, Tadjikistan, Armenia and Georgia.
The company is currently focusing on managing and integrating its assets, as it’s been expanding rapidly in the past couple years.
Specifically, it continues to incorporate recently acquired Golden Telecom into its structure acquisition and is settling into its new venture in Vietnam and Cambodia. It’s also been consolidating its interest in KarTel (Kazakhstan) and Sky Mobile (Kyrgyzstan), which KarTel has agreed to manage.
Short Recommendation
Stay with the short on HSBC Holdings (NYSE: HBC). It’s still an excellent short to hedge your long positions in the global markets, especially Asia.
HSBC remains the biggest camouflaged financial in the world because investors focus on the bank’s exposure to Asia while disregarding the fact that its bread-and-butter is, by far, the US and British consumer. Short HSBC at current prices; place your stop-loss at USD89.
Fresh Money Buys
The investment process is constant. If you’d like to add to your positions in portfolio recommendations or allocate new funds in a diversified way, focus on the following markets, in order (for both countries and sectors). Consult the Portfolio tables for details.
- Russia (energy, telecommunications)
- China (consumer, telecommunications, port, machinery, oil, e-commerce, coal)
- Hong Kong (banking, real estate, infrastructure)
- India (banking, pharmaceuticals)
- South Korea (banking)
- Japan (banking, insurance)
- Taiwan (ETF)
- Philippines (telecommunications, real estate)
- Singapore (banking, telecommunications, industrial)
- Vietnam (ETF)
- Cambodia (casino/hotels)
- Macau (casino/hotels)
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