Tags: Martin Hutchinson

Russia's Problems Impede its Long-Term Profit Promise

By , Money Morning •

By Martin Hutchinson
Contributing Editor
Money Morning

For global investors searching for long-term profit plays, the message is clear: Don't spend a lot of time looking at Russia.

Russia's Pravda, formerly the official organ of the Soviet Communist party, published a blistering attack on the United States last week. That would not seem so strange, except that the attack accused America of "descending into Marxism."

Meanwhile, the Russian stock market has doubled since January and the price of oil - Russia's principal export - has nearly reached $70 per barrel. Though it seems an extraordinary question to ask, we still have to ask it: Does the Russian economic model have something to teach us?

The writer of the Pravda article clearly enjoyed penning it. There were a lot of barbs about the United States, such as "the population was dumbed-down through a politicized and substandard education system based on pop culture."

There also were some attacks on the United States' policy toward Russia in the 1990s: "The initial testing grounds was conducted upon our Holy Russia and a bloody test it was." 

But then there is the claim that "Prime Minister [Vladimir] Putin warned [President] Obama and [former U.K. Prime Minister Tony] Blair not to follow Marxism, it only leads to disaster."

Enjoyable though it is to imagine the Russians lecturing the Obama administration about sound economic management, in reality they have no grounds to do so. A few months ago it appeared that the Russian economic model would not make it through 2009, as the state spent the last of its oil revenue to prop up both the banking system and the dodgier politically-connected oligarchs. 

A country that was wealthy when oil was $140 per barrel became deeply impoverished when oil prices dropped all the way down to the $30 range. Those of us who had been alarmed by Russia's increasing geopolitical and economic assertiveness indulged in a little schadenfreude, feeling that it couldn't happen to a nicer bunch of guys.

Now, the table has turned again. At $68.87 a barrel, the price of oil is far higher than the price assumptions on which the majority of Russia's oilfield-investment calculations were based.

Russia has effectively seized the assets of the British oil company BP PLC (NYSE ADR: BP).  Last week BP accepted the very unpleasant Mikhail Fridman as chairman of its joint venture TNK-BP, a sign that its attempt to control the investment into which it had put the majority of the capital was ended. In the long run, the forced expropriation of foreign investors will prevent the Russian oil sector from remaining truly competitive. But in the short run, the expropriated foreigners have found so much oil there that huge revenues are assured for at least a decade, provided the oil price remains reasonably high.

In other sectors, too, the free cash for those with political connections allows deals to be done. Opel, for example, General Motors Corp.'s (OTC: GMGMQ) European subsidiary, was sold not to the Italian company which had a strategic plan for it, nor to the Chinese company that could use it to enter the European market, but to Magma Group, a Canadian parts company controlled by Russian interests, with financing from the Russian state-controlled bank Sberbank Rossii OAO.

The result may not make much sense operationally, but it is another example of Russian interests controlling major strategic assets in Europe. Needless to say, the various gas and oil joint ventures undertaken by Gazprom OAO (OTC ADR: OGZPY) in Eastern Europe, the Mediterranean and North Africa are also extensions of Russian power.

The fact that Russia's MICEX stock index is up 100% since early January (albeit still 40% below its December 2007 high) is not very relevant to the people who run Russia.

They appear to have two objectives: Using the capitalist system to make themselves and their colleagues very rich and projecting Russia's power on the world stage - just as the former Soviet Union used to do.

To Prime Minister Putin, capitalism is an attractive discovery, because it works economically much better than Communism did, and thus allows Russia to regain more of its former power than would have been possible under the Soviet system.

In this sense, Putin and current Russian President Dmitri Medvedev have finally achieved the original goals of Mikhail Gorbachev's reforms in the 1980s; the objective of those was certainly not to bring down the Soviet government or upset the system, but simply to get the economy working more efficiently towards the leadership's objective of greater Soviet power. Minus the other ex-Soviet Republics, Russia has now achieved this objective - and it may not stay minus the other Republics for very long, if Russia's rulers have their way.

Given the way the system is rigged against the outsider, Russia is not a particularly attractive place to invest. Clearly, there may from time to time be a good short-term bet that Russia's rulers will overcome current difficulties. However, the world contains other good managers besides Putin, and some of those others have a genuine interest in shareholder value and determination to create more of it.

By all means, look for Russian companies in consumer sectors that are outside the grip of the oligarchs - but do not expect to do too well, because you may find your company has a new and very expensive sleeping partner. Probably the best vehicle is the Market Vectors Russia ETF (NYSE: RSX), which benefits from Russia's still-low Price/Earnings Ratio of 7.2.

But remember this: Russia isn't a great global growth market like China, India or Brazil. And without major changes, it never will be.

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