Focus on Russia

The Russian Federation is the world’s second-largest producer and exporter of crude oil and one of only a handful of countries with the scope to meaningfully increase production over the next five years. And the nation is truly the Saudi Arabia of the natural gas market; without Russian natural gas, the European Union would go dark in a matter of days.

You can’t have a meaningful conversation about the global energy markets without discussing Russia. Roughly a fifth of the Russian economy is directly tied to the oil and gas industry, and two-thirds of all foreign direct investment (FDI) flows directly into the sector.

In The Energy Strategist, I’ve touched on this market on several occasions. And, of course, some long-time recommendations, such as Weatherford, have exposure to Russia and have been benefiting from a wave of growth in recent years.

But the growth prospects in Russia are important enough to devote an entire issue to the topic; investors willing to commit capital to Russian energy stocks have been amply rewarded over the past five years with returns as high as four times that of the S&P 500 Energy Index. And although the Russian energy market is a key part of the story, the industry isn’t the only way to play the nation’s growth.

To give a more complete picture of how to play Russia, today’s issue of TES will take the form of a lengthy, comprehensive report. I’ve fully covered the prospects for Russia’s energy sector and two key Russian oil and gas firms: Lukoil and Gazprom. Both stocks will be tracked in the How They Rate Table as buy recommendations.

In addition, I’ve enlisted the help of Yiannis Mostrous, editor of TES‘ sister publication The Silk Road Investor and co-editor of Vital Resource Investor, to cover the political and economic outlook for Russia and offer ways to play on burgeoning Russian consumerism. And Roger Conrad, also co-editor of Vital Resource Investor, rounds out the report with his take on the Russian metals and mining sector, offering up two additional stocks to play the growth.

The Re-Emergence of Russia

By Roger S. Conrad, Elliott H. Gue and Yiannis G. Mostrous

We’ve long favored Russia as a destination for investment, building our case primarily around its energy sector. But we’ve also highlighted the increase in domestic demand and the infrastructure boom taking place there.

Russia is currently in a sweet spot: It’s a net oil exporter, has good GDP growth, isn’t dependent on foreign capital flows, is relatively stable politically, boasts reasonable market valuations and, above all, enjoys solid exposure to the biggest growth story of our time–Asia.

President Vladimir Putin, whose party won another electoral victory a few days ago, is credited with making the changes necessary for Russia to advance. The Yeltsin years, by contrast, were essentially a lost decade; Russia had no direction and no clear vision of its future. A continuation of this situation could have ended extremely badly for Russia. 

Because of the changes Putin has pushed, Russians are confident and more open to doing business with and learning from the rest of the world. These factors were lacking in previous cycles. Note that this cooperation doesn’t include selling Russia’s natural assets to foreigners or their local representatives, as previous advisors had once counseled.

As a result, the Russian market has easily outperformed the rest of the BRIC (Brazil, Russia, India and China) countries since 2000, as demonstrated in the chart below.

  Source: Bloomberg

The above picture flies in the face of the rubbish eager politicians and their advisors have been feeding people about the beginning of a new Cold War. Heeding the expert opinions expressed during the past seven years in The Economist and other publications heralding an imminent Russia collapse would have cost you the huge returns the Russian stock market has generated for investors willing to look beyond smokescreens.

The economic interdependence between the growing Russian economy (now the eighth largest in the world) and the West is increasing rather than subsiding. Germany is a good example.

Chancellor Angela Merkel has been critical of President Putin’s methods of responding to what he views as threats to Russia’s security. But the two countries (as well as France and Italy) have become quite interdependent–a condition that should be expected only to intensify in the future.

The two main reasons are the importance Russia has gained economically (economic growth as well as domestic consumption) and Europe’s need for a reliable energy provider.

Europe–Germany, in particular–is also a big exporter and, therefore, has been benefiting tremendously from the growth in the emerging economies. Russia was the fourth-largest contributor to Eurozone export growth in 2006.

It won’t be a smooth ride, but cooler heads will prevail. Russian practices haven’t changed overnight–far from it. But things are looking much better, and the positive news should continue.

Political Uncertainty Is a Myth

A lot of analysis has taken place both in the US and Russia regarding a potential revival of the Cold War and the like. This kind of talk is expected during election years in both countries because it helps to keep voters in line. But it’s far from reality.

On Dec. 4, 2007, Army General Yuriy Baluyevskiy, chief of the Russian Armed Forces General Staff, flew to Washington for a meeting with Admiral Michael Mullen, chairman of the US Armed Forces Joint Chiefs of Staff. The trip also featured meetings with high-ranking White House officials, as well as a visit to a US naval base and a strategic nuclear submarine with Trident II missiles on board.

The US and Russia never really met on the battlefield except the Allied intervention in the Russian Civil War in 1918. Then-President Woodrow Wilson dispatched US troops to northern Russia and Siberia under British command. Early in 1919, President Wilson decided to withdraw the American forces, and by Aug. 5, 1919, all American forces had been withdrawn.

Even then the intervention wasn’t so much against Russia, but as reports, “[t]he British, French and Americans hesitantly and fitfully intervened with a fourfold goal: (1) prevent Japan from creating an empire in the East, (2) prevent massive Allied stores originally sent to the tsarist armies from falling into German and subsequently Bolshevik hands, (3) assist the White Armies in overthrowing the Bolshevik regime and bring Russia back into the war against Germany, (4) rescue the Czechoslovak Legion trapped in central Asia so that they could rejoin the war against Germany.”

Obviously, this was a real strategic plan rather than a hot-headed, anti-Russian expedition.

We’ve maintained all along that President Putin has been the stability factor for Russia, and the economic achievements under his leadership and his huge popularity–even the anti-Putin camp accepts the latter–prove that.

By indicating that First Deputy Prime Minister Dmitry Medvedev is the party’s candidate for next March’s presidential election, President Putin has made sure that Russia will most likely enjoy a smooth transition of power. The new power order will still involve Putin as the next Russian prime minister.

Medvedev is known for his significant interest in the broader economic issues (i.e., public health, education, housing and agriculture) that Russia faces, on which he’s likely to concentrate. Furthermore, Medvedev is a pro-market advocate; we expect he’ll accelerate the economic reforms Putin initiated.


The Russian economy surprised to the upside in the third quarter of 2007, with growth of 7.6 percent on a year-over-year basis. This growth is mainly driven by domestic sectors, especially the machine building sectors, which shouldn’t be too exposed to a sharp slowdown in global growth.

The Russian market is currently trading at a discount in most sectors to its emerging market peers. Given that the Russian economy is well insulated from outside economic shocks and its financial institutions have no exposure to subprime problems, this divergence remains a mystery to us.

The only serious economic problem that Russia will face entering 2008 is the recent inflation acceleration, which could rise into the mid-teens next year–a symptom of strong domestic demand.

  Source: Bloomberg

Such a development will permit the Russian Central Bank (CBR) to allow for a faster appreciation of the currently undervalued ruble, which will also help the economy’s domestic demand growth as its middle class continues to expand.

The Russian ruble is quoted as the number of rubles per US dollar. The descending line indicates the appreciation of the currency.

  Source: Bloomberg

As long as Russia continues to grow and modernize its economy and its middle class increases in size and influence, its political culture will also increasingly reflect more Western characteristics.

Until then, Russia remains open for business. Companies and investors that play by the local rules–as they must do in any other country they invest in–have not only profited handsomely but have also established strong foundations for the future.

Oil and Gas

No commodities are more important to Russia than oil and natural gas. The Energy Information Administration (EIA) estimates that every USD1 rise in oil boosts the Russian government’s receipts by some 0.35 percent of GDP. In addition, most estimates suggest that the oil and gas industries account for about 20 percent of the country’s GDP, generate nearly two-thirds of export revenues and comprise close to a third of foreign direct investment (FDI) inflows into Russia.

As you can imagine, the energy bull market has been outstanding news for the country. Russia has instituted an oil stabilization fund modeled on the one used by Norway. This fund collects taxes related to oil and gas production and currently has a balance of more than $100 billion.

But that’s not to say that Russian companies with exposure to oil and gas haven’t also benefited. The two prime Russian plays on the energy markets, Lukoil and Gazprom, are up 545 percent and 1,185 percent, respectively, in US dollar terms over the past five years. That totally dwarfs the 243 percent performance delivered by the S&P 500 Energy Index over the same time period.

In this section, we’ll take a look at current Russian crude oil and gas production and the prospects for growth in production in the coming years. And, of course, we’ll take a more complete look at the two primary Russian plays on energy noted above.


Russia is second only to Saudi Arabia in terms of total oil production. In 2006, the nation produced 9.8 million barrels of oil per day, compared to about 10.9 million barrels per day for Saudi Arabia.  
With domestic consumption of crude oil running at just 2.7 million barrels per day, Russia is also a huge net exporter of crude oil; the country had around 7 million barrels per day available for export in 2006. The chart below offers a closer look at Russia’s oil consumption and production over the past two decades.

Source: BP Statistical Review of World Energy 2007

Russian oil production over the past 20 years has exhibited an unusual U-shape. During the Soviet era, the government mandated that producers pump oil as quickly as possible. These surges in production meant that, in the early to mid-1980s, Russian production was as high as 12.5 million barrels per day. This is the left-hand side of the “U.”

But those surges came with a cost. Producing a field too quickly and aggressively can actually damage the reservoir and negatively affect the total amount of oil recoverable from a given field. Many analysts have speculated that Russian production surges in the ’80s did cause damage to key oilfields such as Samotlor, Russia’s most prolific field at the time. 

It’s also likely that, during the waning days of the Soviet era, Russian producers simply didn’t invest what was needed in oil-related infrastructure. Pipelines fell into disrepair, and producers didn’t perform necessary maintenance on wells.

This was compounded by the fact that oil prices collapsed after 1985 and remained depressed for most of the late ’80s. This both reduced the incentive to export crude and impacted revenues. There just wasn’t as much money to be reinvested in production-related infrastructure.

But since the late ’90s, Russia’s production growth has been impressive. A number of factors have conspired to bring about that shift.

One is simply that oil prices have risen sharply, increasing incentives to produce and generating capital to be reinvested in growing production. In addition, Russia has modernized its infrastructure notably, adopting more modern technologies imported from the West to squeeze more production out of existing, maturing fields.

Finally, although the Russian government continues to exercise considerable control over natural resources, oil and gas firms were privatized in the ’90s. Less-direct state intervention in and mandates for day-to-day production decisions has led to better decision-making.

A classic example is the country’s giant Samotlor field that accounted for about a quarter of Russia’s total oil output in the ’80s. At its peak production rate, Samotlor produced some 150 million tons of oil per year. But according to TNK-BP, BP’s Russian joint venture and current operator of Samotlor, the field’s production collapsed to 16.74 million tons in 1996, barely a tenth its peak rate.

But TNK-BP has taken several steps to stabilize Samotlor’s production rate. One of the most important is to implement hydraulic fracturing techniques that greatly improve the rate at which wells flow. Basically, oil and gas don’t exist underground in some giant cavern. Rather, hydrocarbons are trapped inside the tiny pores and crevices of rock. The oil- (or gas-) bearing rock in a given oilfield is known as reservoir rock.

The greater a reservoir’s porosity, the more pores there are in the rock that can potentially hold oil. When an operator spuds a well, the oil and/or gas–under geologic pressure–flows through the rock into the well and to the surface.

But if the pores in a rock aren’t well connected, there are few channels through which the hydrocarbons can travel. Although there may be plenty of oil and gas in the ground, those hydrocarbons are essentially locked in the pores of the rock and unrecoverable. The degree to which pores are connected is known as permeability.

But there are ways to produce such reservoirs. In fracturing, operators pump a liquid under tremendous pressure into the ground. That liquid or gel-like substance actually enters the reservoir and cracks the reservoir rock.

By cracking or fracturing the reservoir rock, the operator creates channels through which hydrocarbons can flow, improving the permeability of the reservoir. This makes it easier for oil to flow from the formation into the well.

Hydraulic fracturing has greatly helped Samotlor’s production. According to TNK-BP, production from the field grew from an average of 30 tons per day per well in 2000 to more than 117 tons per day per well in 2004.

TNK-BP has also been able to target smaller pockets of oil within the Samotlor field. The company estimates that there are still areas of the field where only around 4 to 5 percent of the reserves have been recovered.

This is significant when you consider that, according to the EIA, 71 percent of Samotlor’s total recoverable reserves have already been produced. TNK-BP is using more advanced techniques, such as directional wells and actually injecting water into wells, to help re-pressurize the reservoir. 

All told, TNK-BP believes it can stabilize production at Samotlor after 2010 at around 35 to 36 million metric tons annually, equivalent to about 700,000 barrels per day. The company believes it can maintain production in that region for a number of years. This is a fraction of the 3 million to 3.5 million barrels per day of oil production Samotlor once managed but represents considerable growth from the field’s mid-’90s nadir.

Of course, Russia’s oil industry isn’t just about revitalizing production from older, depleted fields such as Samotlor. Most of Russia’s oil production comes from western Siberia. See the map below for a closer look.

  Source: International Energy Agency, EIA, CIA

The areas highlighted in a shade of darker green represent the current oil production centers in Russia. It’s clear that most are located in the western half of the country.

This, of course, leaves relatively vast areas unexplored, lightly explored or underdeveloped in more-remote eastern Siberia. Some of Russia’s more promising oil and gas fields are located in this region.

One of the most important projects currently underway is the development of Sakhalin Island. You can see Sakhalin Island on the map of Russia above. It’s located in eastern Siberia to the north, northwest of Japan. The development currently consists of two phases.

The first phase is operated by Exxon Neftgas, a joint venture between ExxonMobil and a host of other companies, including India’s ONGC and Russia’s Sakhalinmorneftegas. Sakhalin-1 consists of three offshore fields called Chayvo, Odoptu and Arkutun Dagi; these three fields collectively offer potential recovery of 2.3 billion barrels of oil reserves and around 17.1 trillion cubic feet of gas reserves.

Production from Sakhalin-1 began in October 2005 and hit peak production of 250,000 barrels of oil per day in February 2007. The project is expected to retain production at that level for some time, and long-term plans show production at some economic level continuing for decades.

Sakhalin-2 is majority owned by Russia’s Gazprom; Royal Dutch Shell, Mitsui and Mitsubishi are also involved in this development. Shell and its Japanese partners had majority control in the project up until earlier this year when they sold the majority stake to Gazprom for $7.45 billion.

This move came after considerable pressure from the Russian state. The Kremlin has moved in recent years to step up its control and participation in natural resource developments.

However, since that deal, the project has moved ahead far more quickly and is finally nearing completion. In fact, the project has already been producing oil for years; oil production comes from a single offshore platform that can only operate during the warmer months of the year.

Its total existing operations consist of 80,000 barrels per day for six months of the year. By next year, however, Sakhalin-2 oil production is scheduled to jump to about 180,000 barrels per day. That production should be more or less year-round.

Of course, the big story with Sakhalin-2 isn’t oil but natural gas: It’s one of the world’s largest liquefied natural gas (LNG) projects. We’ll cover that aspect of the project in more depth later on in this report.

Finally, Sakahlin also has four additional phases under various stages of development containing more than 10 billion potentially recoverable reserves. Russia’s Rosneft has already completed some three-dimensional seismic shoots on Phases 4 and 5 and has drilled and tested a handful of successful wells. Clearly, these new projects could result in considerable additional oil production from the Sakhalin area.

Another key project to watch is Lukoil’s exploration and production activity in Timan-Pechora. Much of this remote region in northeast Russia is actually semiautonomous, consisting of the Komi Republic and Nenets Autonomous region. These regions are also underexplored, and Lukoil, mainly in partnership with ConocoPhillips, has undertaken significant exploration and testing work in this region.

In 2006, the Conoco/Lukoil joint venture, called Naryanmarneftegaz, produced some 10,000 barrels per day of oil. But one of Lukoil’s largest fields in the region is just starting up and will reach 150,000 barrels per day of total production capacity.

Of course, these aren’t the only projects of interest for oil production in Russia. The easy fruit of Russian oil production growth has likely already been picked; we’re unlikely to see those older fields ramp up production in the next five years at anything close to the pace witnessed in the past decade.

However, increases in oil production from new projects are expected to make up for a gradual decline in production from existing fields such as Samotlor. Check out the chart below for a closer look.

  Source: EIA

This chart shows the EIA’s estimates of total Russian liquids production out to 2030. Liquids would, of course, include both oil production and production of so-called natural gas liquids.

Although the EIA has often been overly optimistic in terms of its production estimates, it’s safe to say that Russia will remain a key global oil producer for years to come. In fact, it’s one of the only regions in the world with meaningful scope to increase oil production in the coming years.

Natural Gas

Russia is even more dominant in the natural gas business than it is in crude oil. The country has the world’s largest reserves of natural gas and is also the world’s largest producer. Check out the chart below for a closer look at global natural gas reserves.

  Source: BP Statistical Review of World Energy 2007

Clearly, three countries dominate the natural gas business: Russia, Iran and Qatar. In total, these three countries hold more than half of global gas reserves. And Russia is far and away the largest of these three in terms of reserves, with more than a quarter of global natural gas reserves.

Russia produced nearly 60 billion cubic feet (bcf) per day of natural gas last year, making it the world’s largest producer. The world’s second-largest gas producer is the US; US gas production totaled about 51 bcf in 2006. The chart below shows Russian natural gas production and consumption on a historical basis.

  Source: BP Statistical Review of World Energy 2007

In 2006, Russia’s consumption of natural gas totaled just less than 42 bcf per day; this leaves nearly 18 bcf per day available for export. That’s enough to make Russia by far the world’s largest natural gas exporter.

One major problem the Russian gas industry faces should be obvious from this chart: Consumption of gas domestically has actually been growing faster than production in recent years. Although it’s hard to discern from the net exports line in the chart above, Russian gas exports have actually dropped slightly in the past few years from 18.7 bcf per day in 2005 to barely 17.5 last year.

Natural gas is far and away the most important source of energy in the domestic Russian market. One reason for this reliance is that gas prices are subsidized by the Russian government.

Because oil, coal and other commodities aren’t subsidized, Russian consumers and businesses naturally chose to use more gas and less of these more expensive commodities. That’s why gas has actually increased its importance as a source of energy in Russia from about 42.4 percent in 1990 to around 55 percent by 2004, compared to just 19 percent for oil and 16 percent for coal.

To give you an idea of the extent of the subsidy, in 2006, Russian gas prices at the wholesale level were $40 to $50 per thousand cubic meters. The government allowed a 15 percent hike to those rates in 2007 and plans a further 25 percent jump in 2008.

However, when you consider that European countries pay closer to $150 per thousand cubic meters, the extent of the subsidy is obvious. And Europeans pay even more when you factor in transportation costs–closer to $250 per thousand cubic meters on that basis.

As you can imagine, this has been a problem for Gazprom and other major Russian gas producers. Domestic sales have been, at best, weakly profitable under this regime, and subsidies have artificially inflated domestic gas demand.

But as of late 2006, the Russian government unveiled a plan to gradually ameliorate this situation. The government will allow a step-up in pricing each year through 2013 that will gradually bring Russia’s domestic prices more in line with export prices when adjusted for transport costs.

To be specific, Russia will stop setting caps on prices for domestic industrial customers in 2011 and for residential customers in 2013. This should help alleviate the issue of excess domestic consumption of gas and actually boost Gazprom’s importance as an exporter.

And Russia has plans to greatly expand its domestic nuclear power capacity, too, building as many as 40 new large-scale reactors by 2030. This would allow the nation to replace some gas consumption for power generation with power from nuclear facilities. This move will also help free up more gas for Russia to export.

Another problem the Russian gas market has faced is simple geology. The nation is still dependent on only a handful of older fields for the vast majority of its gas production.

According to the EIA, three Russian gas fields—Urengoy, Yamburg and Medvezh’ye—account for 70 percent of Gazprom’s natural gas production. And, of course, Gazprom accounts for close to 85 percent of all Russian gas produced. The important point to note is that all three fields are ageing; the IEA estimates annual production declines from these fields at 700 bcf per year. 

And Gazprom itself really makes no secret of this fact. According to its 2006 annual report, Gazprom believes it saw production drop 25.2 billion cubic meters from its key older field; that’s about 4.5 percent of the 555 billion cubic meters the company produced in 2005.

Just as in the oil market, Russia will be able to offset some of these natural production declines through new exploration. Above we noted the importance of the Sakhalin Island project to Russian oil production; it’s even more important for natural gas.

Phase 2 of the Sakhalin project involves the construction of a huge LNG liquefaction facility. For those unfamiliar with LNG, it’s a technology for super cooling natural gas to around minus 260 degrees Fahrenheit. Once super-cooled, the gas liquefies and can be loaded onto specialized LNG tanker ships for shipment anywhere in the world with LNG import capacity.

The first actual shipments of LNG from Sakhalin-2 are scheduled for early 2008. All of the projected LNG production is already sold under long-term contracts covering the next 20 years. Japanese utilities have been big buyers under these deals.

Another big project is Shtokman, located in the Barents Sea. This field is scheduled for production as soon as 2010 and could produce as much as 71 billion cubic meters of gas per year. This gas could be exported via the so-called Nord Stream pipeline under the Baltic Sea to Europe or as LNG to markets such as North America.

Gazprom is also active in projects outside Russia. This would include working on deals with central Asian states such as Uzbekistan, Kazahkstan, Tajikistan and Kyrgystan to develop new gas and oil reserves. In some cases, Gazprom actually imports natural gas from these nations for re-export to Europe or Asia.  

Check out the chart below for a closer look at total gas production estimates from the EIA to 2030.

  Source: EIA

In 2004, Russia produced 22 trillion cubic feet of natural gas out of total global production of 99 trillion cubic feet. By 2030, the EIA estimates Russia will be able to boost total production by more than 68 percent to 37 trillion cubic feet.

Europe will be particularly reliant on Russian natural gas in coming years. The EU as a whole has always been a net importer of natural gas; however, the situation has become direr in recent years as demand has accelerated while production has begun to decline.

As of last year, the EU gas gap was approaching 20 bcf per day, despite the fact that an unusually warm start to the winter caused a slight fall in EU gas demand. Over time, Europe’s import dependence will only grow given the projected growth in EU demand in the next two decades.

Let’s put this massive gas gap into perspective. Consider that the US consumed 60 bcf of gas per day in 2006. That’s considerably more than in the EU.

But more important, US production totaled more than 50 bcf per day. The US only needs to import a touch under 10 bcf, roughly half of what Europe imports. And the vast majority of US imports come from neighboring Canada. That’s not to say that the US has no gas supply problem; it’s just less pressing than for the EU.

Another problem for the EU is that its gas demand is growing far faster than in the US. In 2004, the developed European markets, members of the Organization for Economic Cooperation and Development, consumed some 18.8 trillion cubic feet of gas. By 2030, that’s projected to be nearly 27 trillion cubic feet. See the chart below for a closer look.

  Source: EIA International Energy Outlook 2007

The primary reason for that growth disparity is that Europe’s carbon-dioxide legislation is pushing more gas demand. Natural gas plants emit about half as much carbon dioxide as coal plants, so gas is fast becoming the fuel of choice for electric generation in the EU. In fact, total EU electricity generation from natural gas will jump from 20 percent of the total in 2004 to around 30 percent by 2030. 
To make a long story short, overall Europe is currently dependent on Russia for about a third of total gas imports. Several key countries, including Germany and Italy, are far more dependent than that. By 2030, this dependence is set to grow to more than 50 percent.

Russia’s Energy Picks

The two most direct domestic plays on the Russian energy market are Gazprom and Lukoil. Both stocks should be considered core holdings for anyone interested in playing the bull market in energy commodities and related stocks. Here’s a review of the investment case for each:

Lukoil (OTC: LUKOY)

Lukoil is currently Russia’s largest oil producer, accounting for 19 percent of the nation’s total production volumes. In the most recent quarter, Lukoil produced 2.181 million barrels of oil equivalent per day, about 1.97 million blue barrels per day of which was crude oil. The company’s total proved reserves are around 20.4 billion barrels of oil equivalent.

To put these numbers into context, US integrated oil giant ExxonMobil’s total proved reserves are only slightly higher at 22.7 billion barrels of oil equivalent. Meanwhile, Exxon produces about 2.7 million barrels of crude oil per day.

However, the company produces more than 4 million barrels per day of oil equivalent. On that basis, Lukoil really isn’t much smaller than Exxon in terms of oil reserves and actual crude production.

For a comparison on a valuation basis, check out the chart below.

  Source: Bloomberg, company accounts

This chart compares some of the largest oil- and gas-producing companies in the world. The ratio depicted is simply the total value of the company compared with total oil equivalent reserves. The higher the ratio, the more you’re paying for reserves. As you can see, Lukoil is far and away the cheapest of the firms in my table on this valuation metric.

Lukoil doesn’t deserve to trade at such a cheap valuation relative to its peer group. The company has been consistently boosting its production of oil and natural gas in recent years; overall barrels of oil equivalent production are up more than 70 percent since 1999. From 1999 through 2006, the company’s total cumulative annualized growth in production was 5 percent compared to 2 percent for the global integrated oils.

In the general discussion above, we outlined some of the major projects Lukoil is involved in, including the Timan-Pechora project it’s co-developing with ConocoPhillips. That project will ramp up to around 150,000 barrels per day of oil production by sometime in 2009.

And Lukoil also has a number of projects in the Russian section of the Caspian Sea. The company is primarily working in six fields it’s discovered in this region.

In Lukoil’s third quarter conference call, the company announced total oil production from this area should be around 280,000 per day at peak levels; the field should reach that stage in the 2015-16 timeframe. And the company believes natural gas production could be an additional 250,000 barrels of oil equivalent per day.

The company also operates outside Russia. Recently, Lukoil started production from a project developed in Uzbekistan with the national oil company there. This is primarily a gas project that will see annual production as high as 15 billion cubic meters sometime in the first half of the coming decade.

In addition, Lukoil has operations or exploration work underway in Saudi Arabia, Columbia, Africa and Asia. These projects and others suggest that the company will be able to continue growing its production in the coming years organically by bringing new projects on stream.

Lukoil also has a major advantage over most global integrated oil companies–superior resource access. The problem faced by most international integrated oil companies is that traditional oil-producing basins such as the US and North Sea are mature and largely depleted; production is dropping. To find new sources of oil production, these companies are partnering with state-owned or partly state-owned national oil companies (NOC) in places such as Africa, South America and the Middle East.

Reserves controlled by these NOCs are less mature and more promising. However, NOCs understand the value of their resources. They’re demanding large takes of production developed in their countries.

Being a local Russian firm, Lukoil has far easier access to some of the most attractive reserves and exploration projects in the world. Therefore, the problem of resource access is less acute for Lukoil.

Finally, it’s worth mentioning that Lukoil has a large refining segment; the company owns a series of five refineries in Russia and three in the Eastern European markets of Bulgaria, Romania and the Ukraine.

Lukoil currently refines about a third of its oil at its own refineries. But the company is undertaking a series of major refinery upgrade projects that will expand that percentage in coming years. This will allow Lukoil additional flexibility to sell crude oil or various refined products, wherever the returns are highest.

Other potential catalyst for Lukoil is any change to the Russian oil and natural gas tax regime. In the first nine months of 2007, Gazprom paid around $88 in mineral extraction tax per metric ton of oil produced and $189 in export tariffs. A metric ton is roughly 7.2 barrels, so these two taxes are equal to around $39 per barrel–hefty by any measure.

Russia has already introduced special tax regimes for oil produced from certain regions, and there’s widespread talk of further reform after the March elections. Any such deal would increase Lukoil’s profitability, acting as an upside catalyst for the stock.

Lukoil trades as an American Depository Receipt (ADR) in the US and can be easily purchased through most US brokers.

Gazprom (OTC: OGZPY)

Gazprom is by far Russia’s largest company and controls close to 85 percent of the country’s total natural gas production. We discussed the company at some length in our general discussion of natural gas for the simple reason that it’s impossible to talk about the Russian natural gas market without discussing Gazprom.

For that matter, given Russia’s dominance of 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.

These production gains will be achieved by targeting smaller reserves within existing producing reservoirs and by adding production from projects such as Shtokman and Sakhalin Phase 2. (These are all projects outlined above.)

The Russian government owns more than 50 percent of Gazprom’s outstanding stock. The Kremlin has made no secret of the fact that Gazprom is likely to be part of any new gas projects that proceed inside Russia.

It’s also highly likely that Gazprom’s current chairman will be the next president of the Russian Federation, as noted earlier. Clearly, Gazprom has an advantage, as does Lukoil, in terms of resource access.

In addition to higher production, higher gas prices are also likely. With European import dependence rising rapidly, the region is becoming increasingly dependent on Russia to supply its needs. This hands Russia and Gazprom significant pricing power because the EU has few alternative gas sources.

And gas demand is also ratcheting up in the US and Asia-Pacific. Higher demand and relatively constrained, concentrated supplies spell higher prices for Gazprom’s export sales, whether these sales are in the form of pipeline gas to Europe or LNG to other parts of the world.

Also, as noted earlier, the Russian government is gradually phasing out price subsidies for natural gas. As a result, Russia’s domestic prices will approximate those charged in Europe minus transport costs by 2011 to 2013. Higher prices spell higher profits for Gazprom.

Domestic Demand

The Russian economy has changed dramatically in the past seven years, as it continues to reassert it’s self. Take a look at the table below.

Russia Economics
GDP (Billion) USD196 USD1,179
GDP Growth (Year-over-Year) 6.4% 7.5%
Budget Surplus (% of GDP) 2.2% 5.5%
Current Account Surplus (Billion) USD46 USD72
Foreign Reserves (Billion) USD28 USD489
Stabilization Fund (Billion) USD0 USD160
Sov. Foreign Debt (Billion) USD144 USD46
Inflation (Year-over-Year) 37.0% 10.8%
Unemployment Rate 11.0% 7.0%
GDP per Capita USD1,343 USD8,303

Source: Central Bank of Russia (2007 estimates), Bloomberg

We could write endlessly on the major economic changes that are taking place in Russia, but this table conveys the situation clearly. The important thing is what the Russian government has decided to do to improve the above picture. Improving the country’s domestic economy and social safe net seem to be priorities.

As the economy has drastically improved, the government has initiated a lot of infrastructure projects in an effort to improve the economy’s potential, while foreign direct investments (FDI) have been rising.

Last summer’s St. Petersburg International Economic Forum was a great reminder of that. High-level executives from companies around the world participated in the forum.

Some of the attendees included the CEOs of Royal Dutch Shell, BP Plc, Arcelor Mittal and Siemens, the chief operating officer of Coca-Cola and the vice chairman of PepsiCo. The biggest delegation was from China, with 168 executives.

On the business side, there was USD13.5 billion worth of deals signed–much more than initially expected. The majority were either FDI-related (e.g., Suzuki Motor of Japan agreed to build a car plant outside Moscow for USD135 million) or orders that Russian companies placed with foreign suppliers.

By far though, the contracts between US-based Boeing and several Russian companies were among the largest deals signed at the forum. For starters, Russian national carrier Aeroflot will buy 22 Boeing 787 Dreamliners. Boeing will also assist with global marketing and service for the Russian Sukhoi SuperJet and has a broad cooperation agreement with state-owned United Aircraft, which is expected to revive Russia’s aviation industry.

The better economic conditions, and the fact that Russians overall feel better about the future, have helped to improve retails sales, as the chart below demonstrates. Given the low starting levels, the growth potential is quite impressive, and we expect the uptrend to continue.

  Source: Bloomberg

Mobile TeleSystems (NYSE: MBT) 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.

Stronger spending by Russian consumers will help increase the average revenue per user (ARPU) for the cellular companies in Russia. Industry experts expect that the introduction of 3G services in Russia will significantly increase the demand for data and value-added services that MBT provides.

The company also expects the strong upward trend outlook in Russia to continue. It now estimates that minutes of usage (MoU) will reach 400 by 2012, compared with 163 MoU in the third quarter of 2007.

This growth is achievable; MoU per user in Russia are quite low when compared with other emerging markets, despite the increased penetration levels. All Russian operators have said they’ll concentrate on subscriber retention while stimulating growth in usage. Buy Mobile TeleSystems at current prices.

Wimm-Bill-Dann (NYSE: WBD) is Russia’s largest food company. Group operations are split into three key business lines: dairy (74 percent of sales), beverages (19 percent) and baby food (7 percent).

Wimm-Bill-Dann is the dairy market leader in Russia, with a 30 percent market share and the third-largest player in juices with a 20 percent market share. Tony Maher, a 30-year Coca-Cola veteran and previous CEO of Multon (a Coca-Cola subsidiary and the No. 2 juice producer in Russia), was appointed as the new CEO in April 2006 and brought an experienced management team with him.

  Source: Euromonitor International

With per-capita consumption of juices, fresh dairy products (shown in the chart above) and baby food at roughly a third of developed markets averages, the Russian market offers significant growth potential. Given Wimm-Bill-Dann’s leadership position in the industry (strong brands and good distribution network), the company is in a unique position to benefit from rising consumption of these products and be on center stage in the sector consolidation game that’s taking place in Russia.

Beyond Oil

The long-term bull market in metals and other commodities is only in its infancy.

The key is accelerating global growth. The US is slipping momentarily under the weight of an overheated housing market and a mountain of shaky mortgage debt. But fueled by emerging Asia and an increasingly vibrant Eastern and Central Europe and the Middle East, the world as a whole is in the midst of an unprecedented boom.

Metals and other vital resources are the critical fuel for the boom. Without them, everything grinds to a halt. And the world’s nations are increasingly competing to assure themselves of the scarce supplies they need to keep their growth going, from China’s overtures to Africa and Iran to Russia’s planting of its flag at the North Pole.

Ultimately, these increasingly scarce resources–as well as a score of other raw materials–will score gains that will dwarf their to-date totals. But any bull market has to pause from time to time. And it’s only natural that this one will, too, possibly in the near future.

One thing history shows us about commodities is that the dips in a bull market can be quite gut-wrenching, though they’re always resolved by a move to higher highs. Keep this in mind when you contemplate your portfolio decision making.
Even if we do wind up in something more substantial, it won’t end the long-term bull market in vital resources or in stocks of vital resource producers. In a worst case, we may give back some of the gains realized in the past couple years.

But recession alone won’t trigger the real demand destruction needed to swing the balance of market power back to the consumers. In fact, falling prices will delay the needed adjustments to get us there.

This bull market in vital resources is anchored in several deeply ingrained factors. The most important is the insatiable appetite in the developing world for metals, minerals, water and a host of other basic materials. The US isn’t the only engine of growth in the world anymore.

And fast-growing nations from China and India to the Middle East and Central and Eastern Europe desperately need vital resources to keep their economies going. Even if the US falters, the demand in these nations will continue to grow.

Then there’s the growing scarcity of supply in easy-to-access places, which is forcing users to seek vital resources in ever-more remote and dangerous locales. That’s made these commodities increasingly vulnerable to supply shocks for any number of reasons.

One is resource nationalism, which is on the rise globally as countries look to get a bigger cut from what’s produced within their borders. But natural disasters are also a growing threat. And although the world isn’t running out of mineral resources, the deposits that remain are more frequently smaller, deeper or more remote from infrastructure than those currently in production.

Finally, market power in the vital resource sector is rapidly consolidating. That’s in large part because only very large companies have the needed reach and financial power to function in an environment of soaring costs, scarce reserves and rising political and economic risks. But consolidation also creates larger, more-profitable companies.

Back in the ’70s, vital resource stocks occasionally tumbled as investors took profits and the climate temporarily changed. Each time, the pause refreshed the cycle, and prices moved on to new highs. Those who hung in there were well rewarded for their patience and risk tolerance.

How to Benefit

MMC Norilsk Nickel (OTC: NILSY) is the largest mining company in Russia. It produces four main metals–nickel, copper, palladium and platinum–and a variety of by-products, such as cobalt, rhodium, silver, gold, tellurium, selenium, iridium and ruthenium.

The group is involved in prospecting, exploration, extraction, refining and metallurgical processing of minerals, and producing, marketing and selling base and precious metals. The company is the world’s leading producer of nickel and palladium. It’s also the fourth-largest producer of platinum and one of the largest copper producers.

  Source: Norilsk Nickel

China is one of the fastest-growing nickel consumers. At the end of the ’90s, China used around 40,000 tonnes of nickel a year and accounted for less than 4 percent of global demand.

This year, it will use more than eight times that amount of nickel and account for 23 percent of global nickel demand. Over the same period, China has emerged at the world’s largest producer of stainless steel–the main end-use for nickel.

In mid-2006, Norilsk Nickel announced a modernization plan of $1 billion a year over 2007-10 to upgrade its core operations on the Taimyr and Kola peninsulas. The company is also focused on developing sites in other parts of Russia. It currently has more than 2,000 geologists working all over the country to identity the best potential projects.

The company has also been working in joint ventures with global giants Rio Tinto and BHP Billiton and has been active in the acquisition arena in the US, Europe, Australia and Africa. A long-term grower, MMC Norilsk Nickel is a buy at current prices.

  Source: Bloomberg

The steel sector is one of the most vibrant and exciting in the commodities universe because steel has become extremely important for economic growth around the world.

As the emerging economies continue to improve, investment in construction is booming. And steel construction is the biggest area; 58 percent of the steel in China is now used in construction. Furthermore, steel companies remain reasonably valued, particularly in comparison to other vital resource sectors.

The dynamics in the steel industry have changed markedly in the past 15 years. For one thing, China has become the world’s biggest consumer.

In the ’60s, the US accounted for around 40 percent of global demand. Today, that number is around 10 percent. In contrast, China is now the 40 percent player, up from a 10 percent share in 1990.

Infrastructure growth in the developing economies and energy construction are the main drivers of steel’s success. On the latter, strong oil prices will continue to support infrastructure spending for pipelines, windmills, oil rigs and other related steel-intensive uses. Shipbuilding and growth in auto production will also be big drivers.

  Source: International Iron and Steel Institute

Apart from the growth factor, Chinese steel exports will also play a huge role on the resource’s price. That’s being hugely affected by China’s internal demand.

As of this writing, and according to a preliminary report by the Chinese government, China’s steel export volume fell 22 percent from August to September 2007, and exports are now at their lowest levels since February.

One major reason for the export decline is the reduction in the tax rebate from 8 percent to 5 percent. Others include the higher production costs that many Chinese producers face, an extremely strong domestic market for steel and high shipping costs that make overseas markets relatively unappealing to Chinese companies.

As the competition from Chinese steel diminishes, opportunities for non-Chinese companies are increasing. And we’re starting to see the positive impact on their revenues.

  Source: Bloomberg

As for the big cycle for steel, it’s very much intact. The rest of Asia, the Middle East, Eastern Europe and Russia continue to grow and improve their respective infrastructure. The global economic outlook will affect the industry from quarter to quarter. But barring a full-scale global recession, economic growth will continue to support steel prices at robust levels.

Mechel (NSYE: MTL) is Russia’s second-largest producer of long steel products; it operates one major steel mill, with a capacity of close to 5 million tons of output per year. Mechel operates in Russia, Lithuania and other countries in Central and Eastern Europe.

The company’s ace in the hole is a mining business that focuses on raw materials used in making steel, primarily coking coal, iron ore, nickel and steam coal. The company’s steel business is 100 percent self-sufficient in coking coal, 80 percent in iron ore and 50 percent in electricity.

This aspect of Mechel (i.e., vertical integration) is critical in an environment where raw materials prices continue to rise. And it should support the stock because its performance this year has been nothing less but dazzling.

Mechel is a high-cost producer, and management has worked to cut costs while improving efficiency. Those efforts have been quietly successful up to now, and we expect this to be an ongoing positive theme.

And Russia’s strong domestic demand, as mentioned above, is an additional advantage for the company. Mechel is a buy at current prices.