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Monday, 23 October 2017

Getting high on commodities

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The commodities industry in Russia has been likened to a drug: what feels good now may turn out to have a nastier side effect. Others insist Russia is spending its oil and mineral largesse in a way that will ensure growth for years to come, smoothing out future volatility. Solomon Teague investigates Russia’s commodities habit.

Many Russian commodities companies have found themselves in an enviable position of strength, having benefited from a multi-year bull market, widely expected to continue for the foreseeable future.

In the short term, high commodity prices act like a buffer to Russia’s economy, said Steven Fisher, corporate bank head of Russia and CIS at Citi in Moscow. The country has pressing needs in terms of infrastructure spending and almost every other sector, he said, and the government has no choice but to tackle these problems with significant spending, bankrolled by earnings from high commodity prices.

“But in the long term, perhaps these high prices are an evil; they can be like an opiate,” said Fisher. It is, he said, imperative that Russia makes significant progress in its modernisation agenda while prices remain at current levels. His concern is that the ready availability of cash in the near term can make governments complacent, lulling them into the illusion it will always be available. The history of commodity cycles, like other cycles, clearly indicates this will not be the case.

Stephen Cohen, managing director of asset management at Troika Dialog UK, which invests extensively in Russia, believes the principal driver for GDP growth is not the commodities sector at all. Calculating the tax take on oil revenue is achieved by means of very complex calculations, but effectively, he said, the government currently takes around 90 cents out of the dollar on oil priced over US$45, limiting the benefits it brings to the broader economy.

This creates an incentive to refine oil in Russia but not to invest in exploration or production, therefore encouraging companies to squeeze every last drop out of existing fields before opening new ones. “Tax changes mooted by the government in recent weeks may change this, as a response to the beginning of a clear downward trend in Russian oil output,” Cohen said.

For now, however, the outlook looks good for many Russian companies operating across the spectrum of the commodities sector. UC Rusal, for example, has the advantage of being the world’s largest producer of aluminium and alumina. Its strong cashflow and dominant market position give it considerable clout in negotiating financing.

UC Rusal is emerging as one of a growing number of world class Russian commodities companies. With operations from Guyana in South America to Queensland in Australia, and Sweden in Northern Europe to Nigeria in Africa, its breadth of operations necessitates a similarly expansive web of relationships with banks operating in all the regions in which it is active.

Choosing your partner

The single most important factor in determining the availability of financing is a company’s cashflow, said Oleg Mukhamedshin, director of capital markets at UC Rusal. Like many companies in its position, macroeconomic conditions have helped generate a very strong cashflow, he said, giving it a strong hand in negotiating financing with banks.

“Our business has strong, fundamental drivers so we shouldn’t be affected by liquidity problems, though of course to an extent we are,” Mukhamedshin said. In the current environment the markets are essentially closed, even to the best quality names, he admitted, though he remains convinced the problems will prove temporary. Cash-rich investors will soon be back in the market for companies with strong cashflows, he predicted.

The commodities boom has created a lot of business for investment banks, both local and foreign, in Russia. Many companies formerly about US$100m in capitalisation are now about US$1bn, pointed out Andrew Chulack, head of global banking Russia and CIS at Deutsche Bank, and it is commodities companies that are leading the charge.

Diversification is important too. At Citi, Fisher is wary of overexposing the bank to just one sector, but he also appreciates the global opportunities for the bank created by the commodities projects undertaken by some of the gas, oil and energy companies based in Russia. “We prioritise based on the importance of a particular project and the risk and return profile it offers us,” said Fisher.

Aluminium and steel

Rusal’s Mukhamedshin believes the demand for aluminium – both current and projected – is particularly favourable from a producer’s perspective. It is an important metal in construction and is likely to play an increasingly important role in the auto sector, as manufacturers look to make lighter, and therefore more environmentally friendly, cars. He said that Mercedes, Nissan and Audi are among those manufacturers looking at developing aluminium cars.

Aeroplanes are another important driver in aluminium demand. Mukhamedshin cited Middle Eastern countries extending their fleets and Russia modernising its own over the coming five to 10 years as just part of the expected demand in coming years.

Dmitry Snesar, co-head of global banking at Deutsche Bank in Russia, agreed that Russian aluminium has the advantage of access to such cheap energy that it makes prices extremely competitive compared with what is possible elsewhere in the world. But he rejected the notion that aluminium and steel are likely to compete on any significant level, and therefore that the growth of one might be at the expense of the other.

In fact, Snesar believes the outlook for steel and other commodities is very positive, with Russia’s infrastructure upgrade programme set to maintain high demand throughout Russia, including the construction of roads, bridges, ports, railways and buildings – both commercial and residential. This is providing a boost to the metals and mining sectors, he said – particularly iron ore, coke and coal.

Steel, he predicted, would experience some cost pressure but vertical integration of steel companies would ensure they mostly remain profitable. There is often talk of a steel cycle, he said, with many predicting a steel downturn in 2009, but he does not give this theory much credence.

“People have been predicting this for the last six years and it never happens,” he said. “It is all linked to China, which produces seven times more steel than Russia does. But it can’t compete on price, and while China is importing so much steel, will it let its own losing producers fail? There is such a huge demand for steel from infrastructure projects and elsewhere it almost guarantees bottlenecks which will boost prices.”

There has also often been talk about products like plastic replacing steel in various industries, said Snesar, but this has also never materialised, in part due to the prohibitive price of oil – essential in the production of plastic. “Besides plastic does not quite have all characteristics as steel and cannot substitute steel currently,” Snesar added.

Whichever specific commodities emerge as the winners and losers over the coming months, Russian companies are often well positioned relative to their global competitors. Rusal, for example, has access to cheap power that surely makes it the envy of not just aluminium producers but commodities companies of all stripes around the world. Based in Siberia, it runs on cheap hydroelectric power, keeping production costs low and protecting it from price volatility, further stimulating its cashflow and reducing financing costs. Only Quebec has a similar capacity to produce cheap hydro-electric power, Mukhamedshin said, though he insisted Siberia’s capacity is much bigger.

Energy accounts for around 30% the overall production costs of aluminium, said Hugo Stolkin, partner for the corporate M&A practice at Linklaters in Moscow, giving some idea of the natural advantage, with the corresponding figure for steel in the same region. With vast deposits of gas and uranium, as well as its hydroelectricity, these advantages are enjoyed by many of Russia’s commodity giants.

The size of a company and the industry in which it is involved are also important factors in determining the availability of financing. “Companies with bigger balance sheets find it easier to raise financing,” said Mukhamedshin. “Banks want bigger clients because there are better profits when working on a bigger scale. You can service a bigger client with a similar amount of resources.”

How Rusal raises money depends on the project for which the financing is to be used, explained Mukhamedshin. Management has the option of using the company’s cashflow or debt at the corporate or project level. For example, Rusal financed one Greenfield smelting project in Siberia with a project financing initiative that raised $500m.

As a private company Rusal has not tapped the equity market, with its external financing requirements to date fulfilled by loans – both syndicated and bilateral – and by bond issues. But Mukhamedshin indicated that Rusal is ready to tap this new potential avenue of financing once market conditions make an IPO more favourable.

The main consideration in financing Rusal is efficiency, according to Mukhamedshin, and a significant part of this is not cost but nurturing long-term relationships.

“Banks compete and you can always get the business at the right price,” he said. “We want our relationships with banks to last a long time, where they can offer us a range of products, including project finance, trade finance and syndicated loans.”

He also stressed the importance of relationships with big and financial sound banks. “We need to feel comfortable that they will keep the exposure on their own balance sheet at times, like now, when there might be a temptation to sell it off cheaply.”

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