The Ukraine crisis has taken another turn.
A referendum is now set to take place on Sunday (March 16) to decide if the Crimean peninsula will become part of Russia, and the outcome is hardly in doubt.
The overwhelming majority of the population there is Russian ethnic, speaks Russian, and will almost certainly vote in huge numbers to become part of Russia.
On the other hand, the West has clearly stated that the referendum is a violation of the Ukrainian Constitution, as are the Russian troops sent in to control the outcome.
To the West, this referendum is simply not valid, will not be recognized by them, and will only increase the animosity along with the geopolitical temperature.
Last week in Oil & Energy Investor, I discussed what the United States and the EU will probably do in response to what is now a political fait accompli.
Today, however, I want to give you some perspective on what investors should do now to protect themselves from the disturbing signs of a return to the Cold War.
This will be an evolving process.
But here's what you need understand as the events unfold...
The Downside of a Deepening Political Game
Obviously, Sunday's referendum is just the first step in a political game where the rules are being made up on the fly.
Still, there are some moves investors can make to protect their portfolios. Better yet, there are even some opportunities to profit from the uncertainty coming.
Today's column deals mostly with portfolio protection, although I will also give you a short-term way to profit as additional pressure is put on the Russian stock market. In my next column, I will expand on the opportunities that are set now to emerge.
But let's stick to the effect this situation will have on energy stocks in the short to medium term.
There will be no war over Crimea, but it is also safe to say a simple appeasement is not in the cards either. It is into this uneasy middle ground that both geopolitics and an investor's response to it will need to be positioned.
First let's talk about the losers.
Short term, the Russian stock market and Russian companies available to outside investors as depository receipts (ADRs, GDRs) will be hit. In fact, Russian markets have already experienced a significant withdrawal of foreign money, despite the Russian Central Bank's move to increase interest rates (by 150 basis points) to more than 7% annualized.
There is a play here, but it involves an exchange-traded fund (ETF) that has a very small market cap (less than $10 million) and has been trading at three times its average daily volume.
It's called the Direxion Daily Russia Bear 3X Shares ETF (NYSE Arca: RUSS).
This is a contrarian fund that is designed to return a 300% movement based on any Russian stock market weakness. Now that can really work against you if the Russian market is moving up, but currently this ETF has been a good move.
RUSS is up 36.5% for the month, gaining more than 11% in just the last three days. However, remember that this is a short-term play. It was down more than 19% for the most recent month at the beginning of 2014.
As for the depository receipts, this has a much bigger impact on the London Stock Exchange (LSE) and its equivalent venture capital Alternative Investment Market (AIM). A number of Russian companies have issued stock on the LSE and AIM.
But for the U.S. investor, the downside exposure is usually limited to the ETFs that parallel market performance - the leader here being Market Vectors Russia (NYSE Arca: RSX), with a market cap of about $1 billion and daily trading volume averaging more than 4 million shares (although it's been only half that since the crisis began). RSX is down 11.6% for the month as of close Monday.
Meanwhile, equivalent losses are being posted by other similar Russian market ETFs. You should stay away from investments like these until further notice.
Blowback for Big Russian Energy Stocks
The same thing can be said for the Russian energy majors available via ADRs. Dominant Russian energy companies like Rosneft (OTCMKTS: RNFTF) and Gazprom (OTCMKTS: OGZPY) are going to experience some blowback from outside investors. Also under some pressure will be LUKOIL Co. (OTCMKTS: LUKOY), the largest private oil company in Russia. LUKOIL has significant foreign shareholders and is actually moving its primary operations outside Russia. But it will be swept up in the reaction nonetheless.
For its part, Gazprom is at the center of the Ukrainian controversy since it provides gas both to Ukraine and through the Ukrainian pipeline system to Western Europe. As I have explained previously, the pipeline politics surrounding Russia's attempt to bypass Ukraine in delivering gas to Europe was a festering problem even before Moscow's forces lumbered into Crimea.
Now, Gazprom is threatening another cut in gas to a Ukraine that cannot pay its bills. And Europe remembers all too well the last time that happened - a very cold January in which Europe had to scramble for warmth when the cut off caused users further west to freeze.
This time, the weather is warming and Europe is better off, having diversified energy sources. But it still sends up a warning flag to investors. This is because the dual threat of a gas cut or another hike in gas prices will have an immediate effect on European bottom lines.
And here investors need to watch out for two categories of foreign companies.
The first are European-based chemical producers reliant on imports from Gazprom. This sector has been laboring in any event, and this crisis certainly is not going to help their bottom lines.
Once again, these ripples will unfold as events proceed. But, assuming the crisis continues - and there are no indications at the moment that it won't - there will be repercussions for chemical and related companies from the effects in Europe. That will include some American manufacturers in a way still yet to be determined.
Potential Trouble for the Big International Energy Stocks
Finally, how about the companies with oil and gas projects inside Russia?
Remember, if the threatened sanctions take place from the West, they are likely to be paralleled by similar actions from Moscow. Presently there are some big boys like American majors Exxon Mobil Corp. (NYSE: XOM) and Chevron Corp. (NYSE: CVX), Italian dominant ENI SpA (NYSE: E), French Total SA (NYSE: TOT), and Dutch-Anglo Royal Dutch Shell Plc (NYSE: RDS-A) with projects at risk.
These companies are large enough to offset short- to medium-term problems prompted by the Kremlin, although all of them may still take a hit.
The greater concerns arise for smaller companies involved in Russia. Once again, it is too early to assess the genuine damage, since neither side has actually sanctioned anybody or moved on freezing assets. But this is certainly a matter I will be following closely.
For the moment, it may be prudent to lighten your exposure, either to companies in Russia or those either phasing in shale gas projects or offshore Black Sea exploration in Ukraine. Nonetheless, I believe this latter group will open up soon pending outside government support.
That will provide us some with interesting options. I'll have those and some other positive plays on this crisis in my next column in Oil & Energy Investor.
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About the Author
Dr. Kent Moors is an internationally recognized expert in oil and natural gas policy, risk assessment, and emerging market economic development. He serves as an advisor to many U.S. governors and foreign governments. Kent details his latest global travels in his free Oil & Energy Investor e-letter. He makes specific investment recommendations in his newsletter, the Energy Advantage. For more active investors, he issues shorter-term trades in his Energy Inner Circle.