Russia and Oil – The Tie That Binds

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While the macroeconomic links between Russia and oil are well known, I believe that it is useful to review how they work. Because Russia produces so much oil and gas, it is the oil price that determines export and government revenues. The ruble is used as a safety valve to control the impact of these factors on the economy, and that, in turn, determines the absolute level of dollar GDP.

THE IMPORTANCE OF HYDROCARBONS

Russia produces just under 10 mln bpd of oil, as Ill as 550 bln m3 of gas (also around 10 mln boepd) and large amounts of other commodities, which in recent years have broadly followed oil prices up and then down. The percentage of Russian GDP made up of oil and gas is a moot point, as much of the hydrocarbon production is sold cheaply on the domestic market, enabling other sectors to reap the benefits. One way around this is to look at the total value at world market prices of the oil and gas sold. In 2008, this was $ 590 bln, or 36% of 2008 GDP; this year, I forecast it to be $ 340 bln, or 27% of 2009 GDP.

EXPORTS

Russia exports around 5 mln bpd of oil, 2.5 mln bpd of oil products and 200 bln m³ of gas, generating export revenues of $ 280 bln from hydrocarbons in 2008, or 63% of total export revenues. Overall, commodities account for more than 90% of exports. As a result, it is the oil price that acts as the key determinant of the trade and current account balances.

KEY RELATIONSHIPS

ˆ Oil determines the reference RTS Index level. For much of its existence, a pretty good rule of thumb for the level of the RTS Index has been 22 times the oil price minus 200. This framework explains not only the 2,000 point fall in the index in 2008

ˆ Spreads are the main secondary factor. Although spreads are themselves determined by the oil price (if the oil price rises $ 10/bbl from current levels, they move by around 75 bps, and if it falls, they rise by twice this amount), the addition of spreads improves the R2 of an index model from 83% to 90%. A model including spreads gives the fair RTS Index level as 16 times the oil price

minus 250 plus 1,000 divided by the cash bond spread.

– To quantify the links;  I calculate that RTS profits move up by around 9% for every 10% increase in the oil price. This is because 78% of the index is made up of commodity stocks, while the domestic stocks comprising the rest of the index benefit from the rising ruble, which moves up by a round 3% f or e very 10% i ncrease in t he o il p rice. Moreover, a s spreads are oil price dependent, so too is the P/E ratio, as fair value moves 5% for every 10% move in oil.

– Take profit unless you are an oil bull. At an RTS Index level of 800, the market is already pricing in $ 50/bbl oil and cash bond spreads of 400 bps, which are fairly close to current levels. A fall in the oil price to under $ 40/bbl would drive the RTS Index down to below 600, while a break above $ 60/bbl would take it up to 1,000. Investors who think that the oil price is likely to fall back over

the summer should therefore look to take profit now.

– The macroeconomic framework will remain oil price dependent. At market prices, Russia’s hydrocarbon production makes up one third of its total level of GDP, as well as half of federal government revenues and 60% of exports. As we have already shown, this means that the ruble has to be used as the balancing factor between the oil price and the economy.

– What could break the link between Russia and oil. In the past, the link has been broken on the upside by geopolitics (the events of September 11, 2001) or a strong independent theme (global stability and the rise of the middle class in 2007) and on the downside by collapse (Russia’s default in 1998) or fear (the YUKOS case). While US President Barack Obama’s reset of relations between the

US and Russia provides a fair wind, it is unlikely to overwhelm the skepticism resulting from corporate governance scandals and low payout ratios, and the market is likely to struggle to escape from its oil price dependency for the time being.