In a previous blog, “The coronavirus is proving to be a black swan event — unpredictable and with massive consequences,” we noted that black swan events create consequences, but opportunities for investors can arise from them. We see this as a black swan event that will have profound systemic consequences including a massive competitive shift in the global energy market.
The collapse in demand for energy — coupled with a dramatic retreat in crude oil and gas prices — should result in a pruning of weak players, particularly the marginal producers in North American shale. Russia — the provocateur of the OPEC+ cartel breakdown in recent weeks — stands to gain considerably in the medium term. And with its fortress-like (strong) balance sheets and competitive cost structures, we believe high-quality Russian companies will not just survive, but thrive when energy prices eventually recover.
The reasons behind our long-term confidence in Russia are threefold:
1. With a sustainable cost advantage and a fortress balance sheet, Russia presents a more promising prospect for capturing greater market share in the global oil and gas market, particularly in the wake of the oil price collapse.As inventories of the two largest oil markets – Russia and Saudi Arabia – continue to pile up, the supply curve will be impacted with potential devastating consequences for non-OPEC producers and stakeholders. Specifically, by refusing to collaborate with OPEC, Russia can leverage the ever-deepening demand collapse to force the industry into consolidation and squeeze out the less advantaged competitors, namely the North American shale producers operating in the $45-$60 range of their marginal cost to production. The Gulf producers are the next in line to suffer from the price war. Saudi Arabia could run double-digit deficits and see its net debt to GDP soar to 53% in three years.
2. The Russian economy has historically been exposed to external stressors, as exemplified by geopolitical volatility and the resulting sanctions. These repeated shocks have forced its system to constantly recalibrate and overcompensate by strengthening its fiscal position and letting its currency and market react to crises in real time. Specifically, Russia tightened its real spending during the past two oil price shocks and allowed interest rates to rise sharply in the near term. Its overall fiscal position strengthened from a moderate deficit in 2014 to an outright surplus in 2017, as a result of rapid ruble depreciation that protected oil revenues in local currency and public austerity measures. In the wake of the oil price collapse in February, Russia has already ridden out the worst of the impact on the ruble, which has declined 20% over the past month. And paradoxically, as the result of Western sanctions, Russian companies have adapted to economic isolation by paying down debt and becoming more self-sufficient. This has helped position the country to be better cushioned against wider economic shocks than many of its EM peers are today.
Figure 1: The Russian ruble has been one of the currencies most affected by oil price volatility
In contrast, Saudi Arabia did not bide its time over the historical stressful periods. It did not take the appropriate fiscal adjustments during the previous oil price collapses. It has been stuck in chronic structural fiscal deficits, as evidenced by rising public debt and prolonged twin deficits. Saudi’s fiscal surplus collapsed from 10% of its GDP in 2014 and became a deficit of 10% by 2016.
Figure 2: Russia vs. Gulf States – current account
Figure 3: Russia vs. Gulf States – fiscal balance
3. We are long-term investors and believe there are several extraordinary companies that could particularly benefit from these trends. We think as oil prices and the ruble gradually recover in the years to come, high-quality companies with robust balance sheets will be able to generate strong free-cash-flow yields and become more competitively advantaged.
- We believe Novatek will see considerable structural growth, as the result of its scalable asset base and flawless execution. In contrast to the lack of capital discipline in the oil and gas industry, Novatek’s practice of de-risking assets by syndicating projects through partnerships with national oil companies in China and Europe for its LNG production has created nearly capital-free, massive options for the company.
- In our view, Sberbank is one of the most competitively advantaged banks in the world. It enjoys a significant funding advantage while operating under a relatively conservative regulatory environment. The state-owned bank is also run by one of the few economic liberalizers in Russia, who have transformed the institution by embracing digital innovation and taking effective cost-reduction measures.
- We think Yandex is the dominant internet company in Russia. The company owns the leading search engine, and it is incubating extensions to its online advertising positions in newsfeed and video. The business holds a series of valuable real options that will likely create significant value over the next few years, including leading ride-hailing/food-delivery services, online grocery businesses, and autonomous vehicle technology.
Russia’s emphasis on preparedness and crisis adjustment was also reflected in the decisive containment measures taken in the course of the virus outbreak. As of this week, Russia has fewer than 700 confirmed cases of coronavirus, a small fraction of the number of cases in the US. Russia’s early response measures – including shutting down its 2,600-mile border with China as early as January 31 and swiftly setting up quarantine zones and testing facilities – have effectively helped control the spread of cases, and that may allow it to come out of the public health crisis relatively untouched.
Despite the near-team challenges that all of us are facing, we remain excited about the opportunity that emerging market equities can provide for investors. We believe the most compelling opportunity for investors is to avoid short-term tactical positions and macroeconomic calls and instead focus on companies that have the potential to deliver strong, long-term financial performance. We believe investors should focus on sustainable competitive advantages and real options that can manifest over time.
With our investment approach, we do not analyze stock prices by looking for mean reversion or specific patterns. Our entire focus is on looking for companies that have innovative products or unique assets that capture demand domestically and/or outside their home economies and real options that can manifest over time. We look to avoid capital-intensive, cyclical industries; companies without sustainable advantages; firms whose fortunes depend on product cycles or gadgets; and state-owned businesses or companies with other governance conflicts. We believe these types of opportunities offer investors the greatest potential for compelling results over time.
Credit: Medvedkov / Getty
As of December 31, 2019, Invesco Oppenheimer Developing Markets Fund had assets in the following companies: Novatek (4.54%), Sberbank (1.51%), and Yandex (1.05%).
As of December 31, 2019, Invesco Oppenheimer Emerging Markets Innovators Fund had assets in the following companies: Novatek (0.00%), Sberbank (0.00%), and Yandex (3.75%)
Foreign investments may be volatile and involve additional expenses and special risks, including currency fluctuations, foreign taxes, regulatory and geopolitical risks. Investments in securities of growth companies may be volatile. Emerging and developing market investments may be especially volatile. Eurozone investments may be subject to volatility and liquidity issues. Investing significantly in a particular region, industry, sector or issuer may increase volatility and risk.
The opinions expressed are those of the author as of March 27, 2020, are based on current market conditions and are subject to change without notice. These opinions may differ from those of other Invesco investment professionals.
This does not constitute a recommendation of any investment strategy or product for a particular investor. Investors should consult a financial advisor/financial consultant before making any investment decisions. Invesco does not provide tax advice. The tax information contained herein is general and is not exhaustive by nature. Federal and state tax laws are complex and constantly changing. Investors should always consult their own legal or tax professional for information concerning their individual situation. The opinions expressed are those of the authors, are based on current market conditions and are subject to change without notice. These opinions may differ from those of other Invesco investment professionals.
Holdings are subject to change and are for illustrative purposes only and should not be construed as buy/sell recommendations.