The Market Vectors Russia ETF – Low Oil Is An Existential Threat, The Worst Is Yet To Come
Summary Low oil prices have important implications for Russian economy and RSX holdings. These implications go beyond the direct damage. I explain my views on this topic, as well as on the Central Bank’s policy and the ruble exchange rate. In my latest article titled ” RSX: Ready For December Wipeout ” on the Market Vectors Russia ETF (NYSE: RSX ), I discussed the recent developments including the weakness of oil and the relative strength of the Russian ruble. In this article, I will focus on the role of the ruble exchange rate for the economy, the Russian Central Bank’s policy and its implications for RSX. Why the ruble is so important? First, I would like to address the role of the Russian ruble exchange rate for the country’s economy. In my view, failure to acknowledge the governing role of the exchange rate for the Russian economy will lead to wrong assumptions and wrong conclusions about the state of the economy, the state of individual firms and, ultimately, the direction of RSX. One of the first comments on my preceding article stated that Russia, perhaps, was relying on champagne from France, and could live without it. This is very far from truth. For years, the Russian ruble suffered from the so-called Dutch disease – it was very strong. The combination of high oil prices and a strong ruble made production in Russia not viable in many cases. Why produce something, risk capital and wait for years for return on this capital when you can just buy what you need with the funds from energy and materials exports? This tactic was also politically convenient, as it brought immediate results that anyone can feel through increased consumption levels. However, there was a major flaw in the whole system that everyone knew but did not want to address. The whole system was (and still is) heavily dependent on just one variable – the price of oil. Back in 2009, Russia was lucky and oil rebounded fast. This time, luck is over. From the comments that I read here on SA I see that many people think that low oil prices just make life for the Russian economy harder through lower oil income. However, the damage spreads wider. Low oil prices are an existential threat to the current economic system, and it will take time to develop a real response to challenges. When people think about Russian imports, they typically imagine something like clothes, pork or the abovementioned champagne. Yes, these could be internally substituted. The price will be high, the quality will likely be so-so, but a substitute can be made. However, when we think about capital goods like tools and machines, the situation starts to look dire. Here’s a snapshot of top Russian imports. Source: www. worldrichestcountries.com As you can see, Russia imports things that are necessary to produce other things. This means that it will take long time before the country can internally source the means of production. Below is the graph of Russian industrial production this year. (click to enlarge) Source: tradingeconomics.com The devaluation of the ruble failed to improve situation on this front. Also, please note that quality is not included in such calculations. What do you think about the quality of internally produced tools and machines when the country chose the easy way and just bought them for 15 years in a row? The Central Bank’s dilemma This puts the Russian Central Bank in an unpleasant situation. If the ruble is too strong, the budget suffers. If the ruble becomes weaker, you immediately get inflation and producers cannot afford to buy the means of production – and you get negative industrial production growth numbers. So far, the Russian energy sector was immune from such problems. However, if oil prices stay at low levels for a longer time, the companies will have to invest in production or face production declines. Yes, I’m talking about production declines while Russia pumps record amounts of oil. This is a short-term reaction which was anticipated. In the longer run, if oil stays lower for longer, the absence of investment will inevitably lead to the decline in production. Recently, the Central Bank stated ( Google translate link ) that it was targeting lower inflation. It looks like it is doing so through keeping the ruble stronger in the short-term. As I’m writing this, the ruble-denominated price of oil is 2670, further down from 2693 that I mentioned in my previous article. I restate my view that this cannot last forever, as it hurts both the Russian budget and the majority of RSX holdings – energy and basic materials companies. When the next year starts, the Central Bank will face a tough choice between targeting inflation and filling the budget. My bet is that “filling the budget” will win, sending ruble and RSX lower. The longer oil stays around current levels, the lower RSX will fall. The Russian economy and Russian companies have previously shown that they were able to sustain low oil prices for a short period of time. This time is different, and the economy is facing a prolonged period of low oil prices. I believe that this is an existential threat to the current economic model. At the same time, I see no changes in policy that would have signaled a shift from the current economic model to something different. When I look at RSX chart, I believe that investors are too optimistic about Russian companies and Russian economy in general. As oil prices stay lower for longer, the numbers will show the continuing contraction and early optimists will likely run for cover. I remain bearish on RSX.