Return of the Russian Bear

It’s no secret that President Vladimir Putin has been a strong, yet controversial force behind restoring Russian pride and power. In the essay below, Dan Amoss explains why TIME’s “Person of the Year” is good for oil services. Read on…

RETURN OF THE RUSSIAN BEAR

Imagine you’re a typical middle-aged Russian citizen. You survived the dangers of growing up in the Soviet Union. Your parents and grandparents toiled under the constant threat of absolute state power. In school, teachers said your government was building a better, more equal society.

But by the time you entered the workforce, you realized that the Soviets were only good at building conditions for shortages and black markets. With no prices or profits, the economy was destined to collapse, and everybody would become equal – equally poor. Finally, in 1991, the Soviet Union officially dissolved. Your suffering continued as you bartered your way through the economic chaos of the 1990s. Economic productivity kept falling until the 1998 financial crisis brought your country to the brink of failure.

But ever since then, things have been getting better. Since 2000, President Vladimir Putin has been a strong, yet controversial force behind restoring Russian pride and power. You don’t have a problem with Putin’s tough tactics, thinking that Russia’s turnaround required bold action. But it’s hard for the West to relate to your experience. They don’t realize how hopeless the Russian people felt before Putin came along.

Regardless of what the West thinks of your president, Putin is a hero where it counts – in his own country. He’s so popular and powerful that TIME Magazine named him “Person of the Year.” The currency is strong, the stock market is soaring, and Putin wants to keep the boom going.

The Financial Times reports that the Russian government is pushing a plan to invest $1 trillion, roughly the size of its entire GDP, in modernizing its infrastructure over the next 10 years. Most of this investment would come from private sources, a clear reversal from the Soviet days.

Russia will follow the lead of other emerging economies in establishing its own “sovereign wealth fund.” Export earnings that the Russian government had parked in U.S. Treasury bonds will start flowing into infrastructure and natural resource projects with higher long term returns. It’s likely that some of this money will find its way to Gazprom, the state-controlled natural gas monopoly.

Lately, Putin has been setting the stage to consolidate his political gains. He’s endorsed his protégé, Dmitri Medvedev, in the upcoming March 2008 Russian presidential elections. Putin’s endorsement means certain victory for Medvedev, who also happens to be chairman of Gazprom.

As part of his consolidation strategy, Putin will be prime minister in Medvedev’s administration. There’s even a legal precedent for Putin to return to his current post – president Yeltsin resigned in December 1999, handing Putin the top job. Medvedev could do the same thing.

Some suspect Putin’s stake in the future of Gazprom extends well beyond his relationship with chairman Medvedev. In November 2007, the Moscow Times described Putin’s alleged personal holdings: “Stanislav Belkovsky, the well-connected insider who initiated the Kremlin campaign against Yukos in 2003, made specific claims about Putin’s wealth. He alleged that Putin owned … 4.5 percent of Gazprom, [a stake worth $13 billion].”

Whether or not the rumors are true, Gazprom will likely remain the world’s most politically influential corporation well into the future. Gazprom will get what it needs, and what it needs right now is to accelerate its drilling activity.

The International Energy Agency projects Gazprom’s natural gas production will decline rapidly through the year 2020, and it tends to issue optimistic supply forecasts. Gazprom management knows production is too dependent on a few large, mature gas fields, so they greatly expanded drilling activity from 2001 to 2006.

Thus far, it has yielded disappointing results. As you can see in the first chart, Gazprom expanded its drilling activity at a 30% compound annual rate from 2001 to 2006. Industry sources estimate this was the fastest drilling growth rate among all national oil and gas companies over this period.

Gazprom will probably try improving its supply shortfall by acquiring smaller independent gas producers, and try to strike deals to transport Central Asian gas to its European customers. But eventually, the company will not be able to ignore the need to redouble its drilling activity. Morgan Stanley oil service analyst Ole Slorer agrees, and described the amazing growth in the Russian rig fleet since 2000:

“Activity in Russia is now shifting from rig-less activity towards more drilling intensive services. According to the MI-Swaco rig count, there were only 40 active rigs in Russia in 2000 or about 4% of the U.S. onshore activity. This stabilized at about 75 rigs in operation over the 2001 through 2003 period (about 7% of average U.S. activity), before escalating by 70% to average 128. The growth has continued unabated and rig count averaged 246 rigs in 2006 although exiting the year at a 300 run-rate. In our view, we are entering a period of double-digit drilling growth.”

Gazprom management is on record with a goal of quadrupling the company’s market value to $1 trillion within a decade. “We’d like to be the most valued and most capitalized company in the world,” said Deputy CEO Alexander Medvedev in an April 2007 interview. He expects Gazprom’s market value will double in five years. To achieve this goal, there’s no question the company will have to drill heavily to stem its gas production declines.

Gazprom isn’t the only Russian energy company with aggressive growth plans. The December 2007 Lehman Brothers E&P Spending Survey estimates that the six largest Russian oil and gas companies will spend $28.5 billion on exploration and production in 2008, up 21% from 2007 levels. Out of all the Western oil services companies, Schlumberger has the largest chunk of this business – with Baker Hughes, Halliburton, and Weatherford contending as well. Russian companies still perform most oil service work. But they use inferior technology and equipment, so Western oil service companies should keep winning contracts.

On the equipment side, our own National Oilwell Varco (NOV) has repeatedly cited Russia as an enormous growth opportunity. Once NOV’s acquisition of Grant Prideco (GRP) closes, the combined company will be even more of a “one-stop shop” to retool and supply the Russian rig fleet. Tesco (TESO) has a huge opportunity to outfit this antiquated fleet with top drives, which improve productivity and efficiency. Natco Group (NTG) is a major player in wellhead gas processing equipment. As more oil and gas wells are completed, the opportunity for Natco equipment sales grows. Chart Industries’ (GTLS) equipment will play a key role in building LNG liquefaction plants to process the huge untapped gas resources under the Barents Sea and on Sakhalin Island.

Regards,

Dan Amoss, CFA
for The Daily Reckoning

February 26, 2008

P.S. I’ll keep looking for more stock ideas that benefit from the energy infrastructure boom in Russia and around the world. Russia has the resources demanded by an energy-hungry world, but Gazprom and its peers must keep expanding their exploration and production budgets to bring it to market. Putin and his associates will ensure that the oil and gas industry – the most important in Russia – will receive the investment they need. Suppliers to the Russian oil and gas industry should gear up for a long boom.

Dan Amoss, CFA is managing editor for Strategic Investment and the new Strategic Short Report, and is a contributing editor for Whiskey & Gunpowder. Dan joined Agora Financial from Investment Counselors of Maryland, investment advisor for one of the top small-cap value mutual funds over the past 15 years.

Dan brings with him the unique experience of an institutional background and a drive to seek out the most attractive investments within favored “big picture” trends. He develops investment ideas for his readers with a global network of geopolitical and macroeconomic analysts. Dan holds the Chartered Financial Analyst designation, a professional designation widely recognized within the investment community.

The “ultimate sell signal,” is how our old friend Bill Donoghue describes it.

“Government’s lone fiscal watchdog resigns,” is the relevant headline. It refers to David Walker, head of the Government Accountability Office. Mr. Walker has been alarmed at the growing indebtedness of the U.S. government for a long time. He regularly travels, doing what he calls the ‘Fiscal Wake-Up Tour”, warning all who will listen that the United States is headed for big trouble if it doesn’t get its finances under control.

The basic problem is well known and has been frequently illustrated throughout history. Democracy responds to the mob of voters; and the mob wants bread and circuses – at someone else’s expense, of course. In America, circa 2008, Congress responds to the desires of people who vote in current elections. The voting age has been lowered to 18, but the next generation, the unborn generation, has no voice in modern government. Not even a whimper. Inevitably, politicians pander to the living in order to get votes…and inevitably the next generation gets the bills.

We will return to this theme in a minute…but let us first look at yesterday’s news:

The Dow had a good day on Monday – up 189 points. Oil stayed just under $100 a barrel. And gold lost 7 bucks, to rest at $940, after hitting a new record high last week of $958.

Meanwhile, we read the news we expected:

House resales are at a 9-year low. And the housing slump is working its way into family budgets. The housing boom of ’97-’07 raised the real value of residential U.S. real estate by approximately $8 trillion. Americans “took out” $3 trillion, according to an estimate we saw recently. That $3 trillion boost was responsible for much – or perhaps all – of U.S. GDP growth over the past five years. But now that housing prices are going down, the implied wealth in residential housing is shrinking. And instead of taking money out of their homes, mortgage lenders are demanding that they put it back in. Millions of families are already said to be ‘upside down’ with more mortgage than house. If they sell – and many must sell – lenders expect them to make up the difference.

Americans have only three major assets. They have property – houses, mostly. They have financial assets – stocks and bonds. And they have the value of their own labor. All of those assets are stagnant…or actually going down. And they may continue going down for many years.

Under these circumstances, families have no choice. They have to reduce their standards of living.

Of course, they fought against it. When housing boom no longer provided ready cash, Americans turned to credit cards. But the rates are much too high…and credit card lenders grew wary very quickly. Then, they turned to their retirement accounts.

Americans “crack open their 401(k) nest eggs,” is the way the Houston Chronicle described it. But they don’t have that much in their retirement accounts…and they’re getting older at an alarming rate.

Finally, they had no other choice…and here comes the headline:

“Americans at all income levels tighten belts,” says the Christian Science Monitor. But here’s the interesting twist; just as we predicted, thrift is becoming a virtue again. The article:

“Looking at things differently is a theme running through conversations of Americans at all income levels these days as they review their spending habits. Nearly 2 out of 3 consumers intend to reduce indulgent spending in 2008, according to a new survey by HSBC Bank USA. Four out of 5 want to increase the amount they save.

“Even at the top layers of luxury, there has been some softening in spending,” says Milton Pedraza, CEO of The Luxury Institute in New York. That includes yachts, jets, cars, and additional homes.

“Among those who do not dwell in that economic stratosphere, the new prudence is often a necessity, stemming from uncertainty about jobs, high fuel costs, heating bills, and the price of healthcare. For others, like Palmer, it is voluntary and represents, at least in part, a shifting of values. They regard an economic downturn as an opportunity to reassess their priorities.

“It’s a good wake-up call for a lot of people, that the good times don’t last forever,” says Kim Danger, founder of Mommysavers.com. “People realize they don’t need an expensive lifestyle to focus on the things that really matter.”

Left to their own devices, people would adjust. They would cut back. They would make do. They would increase savings and prepare for whatever the world threw their way. The next few years would be rough for many people. Many are in need of major downscaling. Still, Americans are resilient. And they have great resources to work with. They would accept change if they had to.

But they also have the feds. And the feds want to prevent change in the worst possible way. What would be the worst way to prevent a correction? Simple – more cash and credit…in short, more inflation. But inflation only works when people are fooled by it. That is, when it makes them feel richer…the way inflation in the housing market made them feel richer…or inflation in the stock market made them feel richer. Inflation in consumer prices has the opposite effect – it makes them feel poorer.

All over the world, inflation seems to have shifted from housing and stocks to prices for basic materials – such as oil, wheat, and copper. And now it’s working its way into consumer prices. In Mexico, the government has had to freeze prices of tortillas. In China, rice prices have been nabbed. In Argentina, the government holds down the price of energy.

And in America, the feds are handing out cash…and artificially pushing down the price of credit.

It if were only that easy!

*** “Homebuilding bulls are hoping for a quick housing market recovery, because they need one for the stocks to have a sustainable rally. This spring, as selling season kicks off, you’ll start hearing ‘affordability’ arguments from housing bulls in the media. I suggest ignoring them,” colleague Dan Amoss tells us.

“Housing bulls fail to appreciate how the easiest mortgage environment in history magnified every homebuyer¹s purchasing power. They also focus on monthly payments in a 5-6% mortgage environment, without incorporating the burden of falling house prices. Incomes and 5% mortgages can support housing prices in many areas of the U.S., but not in areas like Las Vegas, Phoenix, and most of California and Florida.

“According to the latest S&P/Case-Shiller index, average home prices are down 8% year over year,” continues Dan. “With 6% mortgages available for creditworthy borrowers, this makes the real mortgage rate about 14% on a nationwide basis. The real mortgage rate feels like 19% if you are looking to buy in one of the previously hot markets suffering 13% price declines.

“It’s reasonable to assume that the housing bust is about half over, in terms of price declines. The odds heavily favor further price declines in the most overextended markets, followed by years of flat prices. This doomsday scenario¹s epicenter will be homebuilding stocks.”

Luckily, Dan has a way to make the best out of, what would otherwise be, a sticky situation for investors. You can read all about it in his latest issue of Strategic Short Report. Not a subscriber yet? Well, now is the best time to join. Until tomorrow night at midnight, we are offering three FREE months of this elite service. But you have to act fast…time is running out.

*** Poor David Walker…howling in the wilderness…

The last time we looked, the shortfall between what had been promised – in the form of Treasury bonds, Medicare, Medicaid, Social Security and the like – and what might reasonably be collected in taxes toted up to some $50 trillion, or about a half a million dollars per family. In other words, the whole country is bankrupt…and the financial obligations of the U.S. federal government should be regarded by investors as though they were subprime debt. It is a huge debt that the debtor cannot pay.

As headman at the General Accounting Office, David Walker, has been fretting about this for years…and trying to get the politicians to cut spending and balance the budget. He might as well have been trying to get a pack of wolves to eat Greek salads for lunch. It has been a thankless, frustrating job, especially during the Bush II years. This ‘conservative’ administration added more to America’s burden than all the administrations since George Washington – put together.

During an interview for I.O.U.S.A., Addison found out that Mr. Walker had read our book – Empire of Debt – on his own accord. This, we believe, is what pushed him over the edge. So, now he’s resigned…but isn’t giving up on the cause he’s been fighting for all of those years at the GAO. Pete Peterson, Commerce Secretary under Richard Nixon and founder of the Blackstone Group, has set up a foundation and given Mr. Walker a job. He’ll have $1 billion to work with…and the impossible task of trying to bring U.S. government finances in order.

Of course, we’d be delighted to see him succeed. But there’s a big gap between what we’d like and what we’ve got. The former may be public spirited; but the latter is definitely bloody-minded. The former may wish to imagine that the United States will cut spending, balance the budget, encourage savings and restore America’s economic vigor. But the latter knows the voters wouldn’t stand for it. We wish him luck.

History must run its course, says The Daily Reckoning, with a superior air. Old empires must decay and collapse, so as to make room for new ones.

Sic transit gloria mundi.

Sell the United States. Buy Japan. Buy Latin America. Buy gold.

Until tomorrow,

Bill Bonner
The Daily Reckoning