Love him or hate him, now might be the time to place a bet on Russian President Vladimir Putin.
Not exactly him, but rather the Russian stock market.
Soon to be enforced sanctions on Iran, combined with cheap stock values should help lift Russian share prices in short order. While the rally may not last, there should be some easy money to be made.
Investors wanting to profit from the likely move should consider buying the iShares MSCI Russia Capped exchange-traded fund (ticker: ERUS). The ETF tracks a basket of Russian stocks.
Oil matters
The price of energy, particularly crude oil, matters a lot to Russia's stock market. More than half of the holdings of the iShares MSCI Russia ETF (ticker: ERUS) are in energy companies, such as Lukoil and Gazprom, both of which tend to do better when energy prices rise.
The price of Brent Crude, Europe's benchmark price, will likely move higher. Futures contracts for nearby delivery were recently trading around $81.70 a barrel.
"The big issue around the corner is the Iran sanctions," says Joe McMonigle, senior energy policy analyst at risk management firm Hedgeye in Washington D.C. and former chief of staff at the U.S. Department of Energy.
Investors don't know quite how to gauge what is going on with the sanctions, he says. So there still seems to be some belief that some countries will get waivers from the sanctions which will allow them to buy Iranian oil. That view is likely wrong.
"I don’t think there are going to be any waivers," says McMonigle. He thinks that the Trump administration's approach will be 180 degrees different to that of the Obama administration which handed out waivers like confetti.
When it becomes clear on November 4, the sanctions start date, that the administration will be strict in implementing the sanctions then at least $5 a barrel could get added to the price of a barrel of crude, he says. "You could be close to $90," he says.
Market participants at the moment don't understand the robust desire by Trump to choke off Iran's oil sales, and there is also some confusion about how much Iranian oil has come off the global market. The price of oil is determined in the world market by the supply of and demand for oil. The oil market is sensitive so even seemingly small changes to supply can have an outsized impact of prices.
"I think there is some confusion about how much oil has come off the market," says McMonigle.
He thinks the amount of oil removed from the world market is probably around 750,000 barrels a day already, which is far short of some estimates of the eventual total drop of 1.5 million barrels that some forecast.
What happens on November 4 is likely at least another 500,000 cut in world supply as countries comply with U.S. sanctions. Then maybe some more coming off market after that.
No wiggle room in the market
However, the sanctions are only part of the story. Another important nuance is that there isn't much-unused oil pumping capacity left anywhere. In other words, if there is a production outage, then countries like Saudi Arabia may not be able to increase production enough to fill the gap.
According to Hedgeye, the global excess capacity may be a mere 2 million barrels a day extra. Spare capacity could quickly be eaten up by the combined effects of falling production in Venezuela, and a more than possible outage in Libya.
- Venezuela has seen its oil production drop to 1.4 million barrels a day in September from close to 2 million barrels a day last October, according to data collated by TradingEconomics. That drop is likely to continue as hyperinflation ravages the economy and much-needed oil extraction equipment wears out.
- Libya produced slightly less than a million barrels of oil a day in August. However, the production levels are not consistent. For instance. In February the average was 1 million barrels, while in July that plunged to 670,000 barrels, according to Trading Economics. In other words, if recent history is anything to go by Libyan oil production would drop off in an instant, so leaving the world with a far tighter supply-demand balance, and hence even higher prices.
- There are other places where oil supplies might see temporary outages including Nigeria's Niger Delta which has historically been prone to terrorist attacks on the oil pipelines. Then there is Iraq. Although peaceful recently it should be evident that it doesn't take much to cause a flare-up in tensions or interruptions in oil supplies.
Sanctions on Russia?
Russia may get hit with U.S. sanctions, but they likely won't be harsh.
Desire by Congress to impose sanctions on Russia for allegedly meddling with the U.S. election has taken a back seat to other matters lately. However, expect something to pass after the midterm elections, according to a recent report from political consulting firm Eurasia Group.
The good news for investors is that any sanctions passed will likely be nowhere near as harsh as some expect or even desire.
"We continue to expect that any sanctions law will be substantially weaker than the current proposals,' the Eurasia Group report states. In other words, investors who believe the political rhetoric from Washington probably has a far too negative view of the situation.
Also, Hedgeye's McGonigle says he'd be surprised to see Russia's oil companies getting hit with new sanctions. For investors that may be all you need to know.
Cheap stocks
The Russian stock market is relatively inexpensive based on metrics such as price-earnings (P/E) ratios.
"Based on forward multiples Russia has been very cheap, and it's yielding over 4 percent," says Abe Sheikh chief investment officer of Cougar Global Investments in Toronto, asset management.
The VanEck Vectors Russia ETF (RSX), which tracks a basket of Russian stocks currently yields 4.2% in dividends. It has slightly less exposure to the energy sector than the iShares MSCI Russia ETF which yields about 3.1%. Both are decent payouts.
The P/Es for Lukoil and Gazprom are 6.9 and 5.1 respectively versus about 16.5 for Exxon Mobil, according to analysis from Morningstar. In other words, the stocks are cheap.
However, Sheikh says he doesn't expect to see any multiple expansion unless the business climate in Russia improves. 'Multiple expansion' involves the stocks trading for a higher multiple of earnings.
There's another measure that shows the Russian market is undervalued.
It gets calculated by comparing the recent performance of a local emerging market stock market to the returns of all such markets. Economics and market consulting firm HCWE & Co recently published a paper on the matter. The report says:
[...] countries whose equity markets are estimated to be 'cheap' relative to an index of emerging markets tend to outperform countries whose markets are 'dear.' Our estimates of valuation are based purely on cumulative total return, and we depart from the asset management industry’s standard practice by placing no weight on accounting-based data such as earnings or cash flow.
The report continues by saying that cheap markets, by HCWE's metric, outperform dear markets by an average of 20 percentage points per year.
The even better news is that Russia is one of the top cheap markets, just behind Turkey and Argentina.
Currency?
This year unsuspecting investors watched in horror as some emerging market currencies plunged. A case in point is the Turkish lira which fell from one dollar fetching 3.8 lira at the beginning of the year to trading for 5.7 lira recently.
Is Russia at risk from such a move? Yes, it is, but less so than Turkey because Russia runs a consistent trade surplus (it exports more goods/services than it imports.) As a result, it doesn't need foreign investors to fund the trade deficit, as Turkey does.
Russia also has a low debt to GDP ratio of 12.6%, down from more than 80% before the year 2000. Put another way, the government doesn't have a significant a need to entice foreign investors to buy its bonds.
Low debt to GDP translates into stronger currency when things are going well, says Sheikh.
With oil prices likely rising then it would seem that the currency would at a minimum not weaken.
