Crude oil, Saudi Arabia and Russia

Russia’s return to the international capital markets and Saudi Arabia’s spectacular development story are worth putting your money where your mouth is

The onset of risk aversion has a traumatic impact on crude oil prices. After trading in a narrow $80-87 range for three months, crude oil prices lost almost a fifth in May, falling as low as $70 before the risk on trade that followed China’s stellar 50 per cent year-on-year growth export data lifted the black gold to the $74-76 range.

Oil’s brutal fall from grace vindicates the assertion of the Saudi Petroleum Minister that stratospheric prices above $85 resulted from speculative funds that dominate the London and New York futures exchange, where the marginal price of West Texas Intermediate and North Sea Brent market sweet crude is daily set by the leveraged gladiators in the NYMEX and ICE pits.

So investor’s psychology, Wall Street’s mood swings and the economics of margin calls, not physical supply and demand fundamentals, set the stage for the rampage of the oil bears.

Broken quota discipline
Yet, I would definitely caution against going long on crude oil above $80. OPEC compliance to its supply cuts is a mere 51 per cent, meaning quota discipline has broken down. Iraq and Angola, let alone Russia and Mexico, have begun to boost their production volumes. Summer seasonals argue against higher oil and gas prices. Global spare capacity has risen to six million barrels, mainly in Saudi Arabia and Ali Naimi has ruled out any additional cuts in the Kingdom’s production at a time when Riyadh, Kuwait and Abu Dhabi, suffer most from the impact of OPEC quota violations.

The IEA (International Energy Agency) has cut estimates of global demand, US oil inventories are bloated and Chinese industrial production data has softened. This means the next wave of sovereign risk aversion could hit oil prices by another $10-15 dollars, meaning it is entirely possible that crude oil bottoms at $65 this summer.

Undervalued but attractive
Saudi Arabia and Russia are the planet’s two energy superpowers. They are also two of the most undervalued financial markets in the world. Two attractive petrocurrency investment themes are Russian equities/sovereign debt and Saudi Arabian (non-bank) shares, ideally when crude oil trades in the $60-65 range.

Russia’s return to the international capital markets since the 1998 Yeltsin default is an event of seminal significance. In late April, just as the market fireworks began, the Kremlin raised $5.5bn in a dual tranche sovereign Eurobond with five and ten year maturity. Finally, Russia has a credible sovereign debt yield curve and a liquid, benchmark new issue. I was amazed that the world’s smart money investors bought Russian sovereign risk at a mere 125 points over US Treasury five years (135 basis points over ten year Uncle Sam paper for the ten year tranche), incredibly cheap pricing since the Russian Federation’s sovereign debt rating is a mere BBB.

Greek repercussion
Naturally, the bonds sank in the secondary markets, despite the best efforts of deal lead managers Barcap, Citi, VTB Capital and Credit Suisse, though the Greek debacle repriced emerging markets debt risk worldwide. Yet the Russian Eurobond proves beyond a shadow of doubt that the world’s perceptions of emerging markets risk has changed beyond recognition in the last three months.

We live in a world where Russian debt trades cheaper than Italian, Spanish, Portuguese and Irish government debt. Meanwhile, Russian equities trade at a mere eight times earnings, a huge discount to the Morgan Stanley emerging markets indices at a time when GDP growth is accelerating, $75bn of corporate debt has been refinanced, the rouble is undervalued, the Kremlin has cracked down on corruption and backed judicial reform, even promoted Moscow as a capital markets hub. Russian debt has been rerated in the global capital markets. Russian equities will be next.

Mauled market
Saudi Arabia’s seven-year bull market was as long as it was spectacular, with the Tadawul index rising sixfold to 21,000 by early 2006. However, the Saudi stock market has been mauled by the grizzlies in the past month, trading in a 6000 – 7000 range. While oil prices have fallen, the collapse of the Euro also means inflation rates will fall even as private bank credit growth revives and the kingdom’s epic $400bn infrastructure spending programme boosts economic growth. Saudi equities are reasonaßbly valued at 12 time earnings and twice book value, a fraction of bubble valuations four years ago. Saudi Arabia is the world’s largest oil producer, the OPEC central bank of black gold, the largest consumer market and economy in the Middle East.

Comforting factors
The Saudi population exceeds 25 million and boasts one of the lowest median ages in the world. This means investors in Saudi consumer shares face the most attractive secular growth story in the Middle East – telecoms, insurance, mortgages, consumer credit, and home appliances.

King Abdullah’s reforms, the six mega economic cities, a surge in FDI, new multibillion dollar downstream petroleum projects, the least leveraged banking system in the Gulf (a mere 70 per cent loan-deposit ratio) are reasons why someone should be bullish about Saudi Arabia. Further, the world’s lowest cost oil reserves, the opening of local capital markets to foreign investors are some of the other reasons I am bullish about Saudi Arabian equities in the next two years.

In fact, I believe the Tadawul index could well rise to 10,000 in the next two years, still half its bubble peak in 2006. The Tadawul is a buy anywhere in the 6000 – 6300 range.

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