Date: 4/26/2021
Author: Kent Moors, Ph.D.
Until COVID hit, I had spent much of the previous several years on an airplane. Time was my black card that could get me on any flight, anywhere, anytime. I am slowly moving back to that kind of schedule. But it is still premature to expect a return to what I was undergoing this time last year.
Then, over barely five days, I moved from meetings in New York on a Thursday to London over the weekend and on to the Continent by the beginning of the week.
This time around (last week), I also had meetings over five days. But this time, they all took place in the same spot – on a yacht in waters off the Florida Keys. Depending on who did the calculating, the waters were either international or still US. However, we were reasonably certain they were not Cuban!
Nonetheless, the participants were largely the same. The assembled were members of my network of large private investors and market figures. Interestingly, both the subject matter and the conclusions were similar to what these same folks had in mind the last time we met.
When the current market smoke clears, some major moves will be underway in what is a rapidly changing global investment picture, especially in energy. The bulk of this will now unfold over the next four to twelve months.
One of the main meeting themes results from ongoing Brexit fallout (yes, the separation of the UK from the EU may be out of the news but hardly out of what the investment markets are evaluating) combined with rising interbank credit concerns impacting upon London. This will result in the revision of significant global hydrocarbon and other financing as the former premier position of London’s financial center (“The City”) as the source of funding is challenged.
The UK end use energy market is also not in focus here. Yes, the pound sterling remains weak and the uncertainty factors surrounding what may still be a nasty UK-EU divorce is fueling another spike in volatility, one already having a spillover effect on some London banks. But the UK market comprises only a small percentage of the global demand picture.
While this will be painted with a broader brush, the “double whammy” of Brexit and rising credit concerns is going to be falling on some countries more heavily than others over the next twelve months.
We spent a fair amount of time in last week’s meetings attempting to handicap the impact.
Nonetheless, in some cases the country-specific problems are surfacing already. Take Russia, as a prime example. Once my discussions last week moved from generalities, we spent more time considering what the post-Brexit world means to Moscow’s policy than any other.
It was a personal déjà vu because Russia was where I cut my teeth in both energy and government policy. Much of what we talked about brought me over very familiar territory.
And as it happens – unfortunately for Kremlin planners – Russian connections to both oil and natural gas have a major exposure to what is underway in London.
Russia already is in a vulnerable position on both natural gas and crude oil. The central budget is dependent on export revenues from both and has siphoned off proceeds to fund off budget lines (making the budget impact of any levelling off in export revenues even worse).
The problem becomes even more pronounced when only natural gas is considered. This is because what Gazprom (the world’s leading natural gas provider and Russia’s largest company) charges for exports is dictated in long term take-or-pay contracts pegged to a basket of oil and oil product prices.
As the price of oil comes under pressure, so does the price of natural gas, taking Gazprom profits (and the Russian central budget) with it. The result has been unraveling in Moscow over the past eighteen months. But it is about to get worse.
For Gazprom, this could not have happened at a worse time. It has come under pressure from liquefied natural gas (LNG) exports into Europe, while the prospect of diversifying into the Asian market via a pipeline agreement into China has yet to provide sufficient pricing to cover the decline in revenue from volume moving west.
Traditional production from Western Siberian basins is declining while attempts to offset the accelerating downward yield by moving elsewhere are thwarted by lack of both capital and technical expertise. New projects in the far north have begun on the Yamal Peninsula.
However, to counter the production shortfall, Gazprom has the same problem its sister Russian state giant Rosneft has on the oil side. They need to go above the Arctic Circle, out onto the continental shelf, and into Eastern Siberia.
Indications are there is plenty of new extraction to be had. But the cost in working capital and expertise is quite beyond what Moscow can afford. To make matters worse, pricing is restrained by global demand.
Yes, that demand is rising. But so are the alternative sources of gas.
As a state monopoly, Gazprom controls the export pipelines out of Russia, a matter that has resulted in Russian-EU disagreements for almost two decades. According to Article 7 (the “Transport Protocol”) of the Energy Charter Treaty, signatories must: (1) allow third parties access to domestic pipelines; and (2) separate producers from exporters.
Despite Russian having signed the document, Gazprom and the Kremlin have rejected both of these provisions. That has resulted in Brussels blocking Gazprom (and other Russian) moves to acquire assets in Europe and resulted in impediments being laid down to Gazprom pipeline projects into Europe. Even when these have been successful (e.g., the Nord Stream I from Russia to northern Germany across the Baltic Sea floor, and Nord Stream 2 – nearing completion, using the same route, and the subject of renewed US sanction threats), Gazprom has been prevented from having a position in European onshore distribution networks.
In addition, EU sanctions against Moscow following the Russian takeover of Crimea and the following civil strife in eastern Ukraine increased the cost of Gazprom exporting to Europe by restricting Russian usage of Continental banking.
All gas and oil export agreements are subject to pre-financing and use of hard currency. These, in turn, require access to external banking. And that, finally, brings us to the London connection.
Gazprom is so important to the Kremlin that it is often used as the vehicle through which Moscow’s foreign policy is expressed. As a corporate structure it is huge and complex. But when it comes to exports, the pecking order is this: Gazprom controls 100 percent owned Moscow-based Gazprom Export. Gazprom Export controls Berlin-based Gazprom Germania GmbH, which in turn controls the entity that actually does the pre-financing in foreign markets – Gazprom Marketing and Trading (GM&T).
Now GM&T has offices in Zug (Switzerland), Paris, Singapore, Houston, Hertogenbosch (the Netherlands), and Manchester (UK). However, its headquarters from which financing is coordinated is in London, a place I know well.
This is in Regent’s Place, close by one of my favorite London Italian eateries (Giovanni Rana), Regent’s Park, a short walk from my old haunts at the British Museum and a direct Underground ride from where I used to live in South Kensington.
In passing, if Washington ever decided to get really serious with economic sanctions against Moscow, the essential pre-shipment global finance issuing from GM&T in London (and contract swaps vis its office in Houston) would be a target having an immediate and painful impact.
Gazprom’s bottom line had already been adversely affected by the increased costs from the current EU sanctions. That had been counter-balanced somewhat by a series of Byzantine cross-financing arrangements through The City, involving a range of derivative, asset-based, and consignment-based paper.
This cumbersome network is now at risk, as the value of Gazprom shares on the London Stock Exchange (LSE) has recently indicated. Gazprom and its government parent back in Moscow cannot easily move this operation from London, despite the uncertainty about to descend on the financial houses they have relied upon and the ability or interest of those houses to continue the backdoor practices.
I observed over the weekend that more GM&T responsibilities could be moved to Zug, Switzerland. Unfortunately, Gazprom contacts admit banking from a Swiss base would simply add to the cost of replicating what had been taking place in London. It would be more expensive to conduct most of its pre-financing business from Zug.
The squeeze puts Gazprom in the center of attempting to act like a private company while at the same time serving as the Russian government’s energy arm. As the situation unravels in London, the vise is going to tighten.
Matters are hardly better on the oil side. Here, we direct attention to Rosneft, the majority state-controlled oil major.
The Kremlin in the past sold minority shares in Rosneft in a not particularly transparent privatization exercise obliged by some significant central budgetary shortfalls. Those shortfalls, in turn, had resulted from the downturn in crude oil prices.
Oil pricing has since recovered but Moscow still finds itself under severe pressure because the price remains well below the level set in the budget process. Given that Russia remains dependent upon oil and natural gas exports for the single largest portion of its revenue base, the projected price of crude is hitting central finance hard.
That exact percentage of the budget reliant on oil/gas exports depends on whose figures you accept, but can range from 21 to 50 percent. Regardless of the numbers used, however, this clearly remains the single biggest revenue source.
But that is not the sole problem. The Russian government continues to run major projects off budget and had been funding them with the proceeds of oil and gas exports. In other words, the decline in oil prices had a more damaging and hidden impact on the real ability of the Kremlin to meet expenses. The same revenue sources were being siphoned in two different directions.
Above I briefly noted how a sluggish oil price adversely impacts what is already a serious export situation for Gazprom. In addition to the expanding competition from LNG sales, domestic sources, and uncertain demand, Russian natural gas export prices are set by a formula based on the price of a basket of crude and oil product prices.
Oil prices, therefore, impact returns from the export of both commodities. Year-on-year, those revenues are down a staggering 48.3 percent through end of February. And a combination of factors is coming together to deteriorate further the situation.
First, the budget mess has obliged a raiding of both sovereign wealth funds, essentially established by earmarking oil and gas proceeds. The Reserve Fund essentially ran out of “surplus” money last year. That fund does have as one of its objectives to provide budgetary money in the event of stagnant oil prices. On the other hand, the second does not.
The National Wealth Fund (NWF) was established to provide for longer-term needs such as pensions, health care, and social programs. Ostensibly, it has nothing to do with energy exports. But the government has structured a drain off from the NWF to meet oil-produced budget problems anyway.
Official statements have denied the NWF has been touched. However, my sources in the Russian Ministry of Finance (MinFin) have confirmed that more than $12 billion was in fact used for that purpose in the second half of 2020 as COVID gripped the global market.
Second, the Kremlin decided on a three-year expenditure freeze, after approving what amounts to an across-the-board cut in the current fiscal budget. The process was torturous, and wildly unrealistic, cutting essentials well below minimum levels. It reminded me of the zero based budgeting craze we all went through decades ago, when people competed desperately to find projects to cut.
The easy cuts were made early on. Anything beyond that represented bone and tendon, not fat.
Third, the effect on the Russian Gross Domestic Product (GDP) is accelerating down. While the Russian Ministry of Economic Development (MED) is still officially estimating a deficit of 3.2 percent in 2021, the reality is much worse. According to sources, an internal MED forecast now virtually guarantees the deficit will exceed official statements. The document puts the actual toll at closer to 4.3 percent for the end of this year and approaching 5 percent within 12-14 months.
Fourth, as a result, a budgetary expenditure freeze will not be enough. My contacts in the Ministry of Energy are expecting an absolute cut in central capital expenditures for oil production projects. Remember, this is magnified when factoring in the off-budget financing network, itself a product of redirecting export revenues from the “official books.” This will result in a decline in production and an even more serious decline in forward investment.
With the increasingly serious decline in the traditional production basins of Western Siberia, Rosneft and other Russian producers must move in the same directions as Gazprom on the gas side: north above the Arctic Circle, out on to the continental shelf, and into Eastern Siberia. The estimated reserves are huge, but the staggering infrastructure and development expenses are quite beyond Moscow’s ability, without even factoring in the technical expertise requirements.
Finally, even the one improving economic indicator spells trouble for Russian oil exports. Over the past year, the ruble has been remarkably stable at about 75 to the US dollar. MinFin sources now suggest that the ruble may begin appreciating in value.
Unfortunately, that makes Russian crude more expensive to export as it improves in value against the greenback. The singular advantage of having production costs denominated in discounted rubles while being able to sell the export for more valuable hard currency is offset by the ruble improving in value.
And all of this brings us back to the Rosneft situation.
Moscow had expected to receive at least $11 billion in proceeds from the 19.5 percent privatization of Rosneft shares in 2016-17. This was supposed to parallel the result from a 2006 privatization of a 15 percent share on the Russian Trading System and the LSE that produced $10.7 billion.
The actual amount was never provided officially. But anecdotal information indicated the result was much less than anticipated, amounting to an embarrassing sale at discount to market.
Two matters of interest on Rosneft shares. First, as of mid-2017, Rosneft became the most valuable Russian company (in market cap), displacing Gazprom. Second, Rosneft has had a restrained free float in secondary trade of about 10 percent. That means the preponderance of shares are held long-term rather than traded.
In a normal market environment, that would be consonant with Kremlin policy objectives. But in the current situation, it would tend to depress the revenue gain from floating a privatization on an exchange.
And then there is the ongoing Brexit drama. The usage of LSE in 2006 had been commended by its unparalleled access to global investment funds. However, these days, the likelihood of a major IPO on LSE is dramatically reduced by the uncertainty of valuations and foreign exchange rates in London moving forward.
In addition, the foreign sanctions against Russia – in which the UK plays a continuing major role – hardly help here either.
Thanks to Brexit, the Russians are now looking seriously for one or more strategic investors to pick up any additional Rosneft privatization. While the first privatization resulted in BP picking up a multi-billion-dollar share package from the LSE IPO, any additional sales will have parties of interest coming from other locations and will have serious sovereign backing.
It seems without question that Chinese and Indian majors will be heading up the list. The preference remains for strategic investors. On the other hand, strategic investors like Chinese CNPC or Indian ONGC will be looking for a (you guessed it, based on the last experience) discounted share price and/or access to major new fields within Russia in return for a large investment. That would guarantee some prolonged policy disagreements within the Kremlin.
I expect Rosneft’s control of the huge Vankor project in Eastern Siberia will be the target of either CNPC or ONGC.
That means the budgetary crisis in Moscow may yet produce a major contest over some primary domestic oil prizes.
And a further wrinkle in the upcoming Russian financial crisis.
This is an installment of Classified Intelligence Brief, your guide to what’s really happening behind the headlines… and how to profit from it. Dr. Kent Moors served the United States for 30 years as one of the most highly decorated intelligence operatives alive today (including THREE Presidential commendations).
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