Downgrading Russia Given Notable Oil Uncertainties September 5, 2017
In this article, we provide an update on the Russian equity market and review our star ratings for the said market.
Author : iFAST Research Team

Downgrading Russia Given Notable Oil Uncertainties
  • With around 50% of the Russian equity market comprised of energy companies, the market’s performance is significantly dependent on the performance of energy sector;

  • It would be unsurprising the recovery in oil prices remains slow and volatile amid structural headwinds and higher US shale oil production, presenting risks to earnings prospects of Russian oil companies;

  • It remains likely that the Russia’s economic growth would turn positive for the whole of 2017, thus emerging from their recent two-year recession;

  • The market’s forecasted annualised total return has dipped amid earnings having been revised downwards and a lower potential valuation multiple expansion;

  • Considering the aforementioned factors, we lower the market’s star ratings a notch, from 4.0 Stars “Very Attractive” to 3.5 Stars “Attractive”.

In 1H 2017, especially in the second quarter, Russian equities have taken a toll amid the easing of oil prices from their high of USD 54.45 per barrel in end-February. An increase in US shale oil production (sparked by the improvement in oil prices through 2016 and the first 2 months of 2017) as well as the falling compliance rates of OPEC members in meeting their agreed cuts had fed concerns regarding the rate of recovery of oil prices. Additionally, the prices of other commodities such as that of industrial metals had dipped, affecting the materials sector in the Russian equity market. Diminishing hopes regarding the country’s improved relations with the West amid a change in presidential administration over in the US had further contributed to falling valuations.

As a major producer and exporter of crude oil, around 50% of the Russian equity market is comprised of energy-related companies. Consequently, this has resulted in the market’s high dependence on the overall progression of crude oil prices and the oil industry’s performance.

CHART 1: Energy Sector Accounts For Almost Half Of Russian Equity Market.
CHART 2: Historically Significant Correlation Between Russian Market Performance & Oil Prices.

In this market update, we take a deeper look into some of the vital points to consider with regards to the market’s performance. More specifically, these factors are: the progression of oil prices going forward as well as the earnings prospects of Russian oil companies; the country’s economic progress; and the market’s forecasted annualised total return and total return components.

Bumps Ahead For Russian Oil Companies

From the 7-8 August 2017, the Organization of the Petroleum Exporting Countries (OPEC) held a summit to better understand the difficulties and obstacles faced by the OPEC and non-OPEC countries participating in the oil production cut agreement in meeting their committed oil production cuts.

According to the International Energy Agency (IEA)’s monthly Oil Market Report released on the 11 August 2017, the cartel’s production cut compliance rate had fallen for a third consecutive month to a new low of 75% in July. This was down from the highest compliance rate of 90% recorded in January 2017, which was the first month in which the oil production cut agreement took effect. This is unsurprising given structural headwinds which result in the difficulties of the participating countries in continuously fulfilling their agreed production cuts, particularly for extended periods. Major oil producers heavily depend on the oil industry for government tax revenues. Additionally, inherent concerns such as a loss of market share due to compliance issues could result in further resistance to cut oil output, especially for an extended period. In May this year, the participating members of the oil production cut deal have come to an agreement to extend their production cuts till March 2018. Given structural difficulties, however, it is unsurprising that it remains a challenge to achieve reasonably high compliance rates and that even further extensions of oil cuts could be met with resistance. Looking beyond March 2018, it would be unsurprising that production volumes rise again after the production cut deal, reintroducing some downward pressure to oil prices.

Apart from the structural difficulties of major oil producers in cutting oil production levels for an extended period, the increase in shale oil production over in the US adds to the headwinds facing the recovery of oil prices. US shale oil producers had been quick to react on the back of an uptick in oil prices last year and improved cost efficiency which they had improved amid the fall in oil prices in the previous years, leading to overall improved profitability in the sector. As seen in the chart below, data gathered by the US Energy Information Administration (EIA) and oil company Baker Hughes had shown a strong uptrend in the number of crude oil rigs in the US since mid-2016 as well as a resulting increase in crude oil production since October 2016.

CHART 3: Uptrend In US Crude Oil Production & Number of Crude Oil Rigs Since Mid-2016.

Amid the aforementioned risks facing oil prices, there exist some positives in the oil market which could cushion the potential negative impact brought about by those risks. These positives include the world’s major oil producers’ pressing need for oil prices to improve (which would continue to be a motivation for them to collaborate and come up with solutions) as well as Saudi Arabia’s planned listing of a minority stake in government-run oil giant Saudi Aramco, which is currently expected to take place in the second half of 2018 (could result in additional motivation for Saudi Arabia, OPEC’s largest oil producer, to see oil prices improve over the coming quarters). Additionally, as economies globally continue to pick up, including economic stabilisation in the world’s second largest economy, China, it remains likely that oil demand would continue to be supported.

Despite the positives, it would be unsurprising that the imbalance between oil demand and supply be prolonged given the significant supply side issues, thus contributing to a prolonged and volatile oil price recovery and presenting risks to the earnings of Russian oil companies. In addition, the latest advancements in Russia’s energy taxes (gradual increase in its mineral extraction tax (MET) as well as a postponement of the abolishment of its oil export duties by four years, to sometime between 2022 and 2025) present further risks to the earnings prospects of Russian oil companies. In the near term, potentially lower production volumes given the country’s commitment with the OPEC to cut production volumes add to the risks facing the earnings of Russian oil companies. Conclusively, we believe several bumps lie ahead with regards to the performance of Russian oil companies as well as the Russian equity market as a whole.

An Economy Emerging From The Rubble

CHART 4: GDP Growth Reflects Good Economic Progression.

Thus far the Russian economy, which had fallen into a recession in 2014, has shown good economic progress, with its 4Q 2016 and 1Q 2017 GDP growth coming in at 0.3% and 0.5% year-on-year respectively and its 2Q 2017 GDP clocking an even higher growth rate of 2.5% year-on-year.

The economy’s labour market has continued to strengthen, as consumer price inflation continued to tick downwards and the country’s unemployment rate had continuously dipped since the beginning of the year. Consequently, real wages and retail sales extended their overall upward trends and in April this year, retail sales had exited contractionary territory. The strengthening labour market bodes well for household consumption over the coming quarters, which contributes to around half of Russia’s GDP.

CHART 5: Strengthening Labour Market Supports Domestic Consumption.

In addition, the notably lower inflation rates would likely create room for further interest rate cuts should the central bank deem it apt, as lower rates would in turn support business investment and provide support to economic activity. At this juncture, expectations are for the country’s key rate, which currently stands at 9.00%, to fall to 8.25% and 7.10% by the end of 2017 and 2018 respectively.

Industrial production has improved significantly since 2015 and has expanded 5.6% year-on-year in May 2017, a growth rate which was its highest in more than 5 years. Excluding February’s industrial production contraction, the country has registered positive industrial growth since February 2016, signalling overall relatively resilient manufacturing expansion since early 2016.

CHART 6: Relatively Resilient Manufacturing Expansion Since February 2016.

The latest manufacturing and services PMI readings have shown the pace of expansion in the manufacturing and services sectors to have moderated. Nonetheless growth in both sectors has remained in expansionary territory.

CHART 7: PMIs Remained In Expansionary Territory, Albeit Having Moderated Thus Far This Year.

Business confidence levels in Russia’s industrial segment have continued to improve in the recent months, signalling overall improving business sentiments in the segment. In July, business confidence level in the economy’s manufacturing, mining, and electric & gas distribution sectors have improved to around 4-year, 1-year and 6-months highs respectively. Overall good business confidence levels are likely to provide support to industrial activities over the coming quarters.

In the services sector, July’s Services PMI, which came in at 52.6, had moderated from its high in January where it came in at 58.4. Nonetheless, the upturn in new orders remained moderate and backlogs had risen for a second month running. In IHS Markit’s Russia Services PMI Report for the month of July, it was mentioned that the sector still remains largely confident about the coming 12 months, although optimism has softened year-to-date.

There are signs that the pace of expansion in the country’s manufacturing and services sectors over the coming quarters may come in at levels lower than their highs in the beginning of the year. Nonetheless, expectations are for industrial production to grow 1.8% and 2.0% for the whole of 2017 and 2018 respectively, up from 0.4% in 2016. At this juncture, it remains likely that overall economic conditions in the country would continue see improvement in the coming quarters and expectations are for the economy to grow 1.4% for the whole of 2017, up from -0.2% in 2016.

Still Attractive Forecasted Total Return, Although It Has Dipped...

As of 23 August 2017, the market’s forecasted annualised total return (by end-2019) of 16.6% continues appear reasonably attractive, especially when compared to other markets under our coverage. Nonetheless, when compared to the time when we decided to maintain the market’s Star Ratings at 4.0 Stars on the 3 March 2017, the market’s forecasted annualised total return has dipped, suggesting a reduction in the market’s attractiveness. More specifically, the market’s lower expected earnings growth as well as its lower potential valuation multiple expansion has contributed to its lower forecasted annualised total return, as seen in the chart below.

CHART 8: Lower Forecasted Total Returns By End-2019.

The earnings estimates of Russian corporations have been significantly revised downwards since their high in April 2017, suggesting a drop in positivity with regards to the profitability of Russian companies ahead, as seen in the chart below.

CHART 9: Earnings Estimates Have Been Revised Downwards In Recent Months.

As of 31 August 2017, consensus expectations are for the earnings of Russian companies to grow 4.7% and 11.7% in the whole of 2017 and 2018 respectively. The Russian economy’s good likelihood of emerging from its recession and registering positive growth for the whole of this year would likely continue to provide support to the aggregate earnings of Russian companies over the coming quarters. Nonetheless, structural headwinds and greater US shale oil production could hamper significant increases in oil prices. Lower oil production in the near term on the back of the ongoing on the oil production cut agreement as well as energy tax expenses could also present risks to the earnings prospects of Russian oil companies.

Table 1: Valuations, Earnings Growth & Dividend Yields.

  Fair Value 2017 2018 2019
PE Ratio (X) 7.0 6.8 6.1 5.8
Earnings Growth (%) - 4.7 11.7 5.7
Dividend Yields (%) - 5.4 6.1 6.8
Source: Bloomberg, iFAST compilations. Data as of 31 August 2017.

As of 31 August 2017, the Russian equity market, as represented by the RTSI$ Index, trades at PE ratios of 6.8X and 6.1X based on 2017 and 2018 estimated earnings respectively, thus representing a discount, albeit a smaller discount than previously, from the market’s fair PE ratio of 7.0X. Dividend yields offered by the market have continued to come in at attractive levels of 5.4% and 6.1% respectively for 2017 and 2018 respectively.  From the time the market was upgraded to 4.5 Stars to the time it was downgraded back to 4.0 Stars (6 March 2015 – 13 July 2016), the market had clocked a total return of 21.8% in MYR terms (13.0 % in USD terms). From 6 March 2015 till 31 August 2017, the market had garnered a whooping total return of 61.2% in MYR terms (39.0% in USD terms)! From a Ringgit perspective, investors should note that returns were bloated by the hefty depreciation of our home currency over the past 2-3 years, with the Russian Rubble appreciated 16.6% against MYR over the aforementioned period. With a consideration for the mentioned factors in this article, we lower the market’s star ratings a notch from 4.0 Stars “Very Attractive” to 3.5 Stars “Attractive” on the back of significant oil uncertainties.

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