Should Russian oil companies attract our investment?

It was interesting getting a glimpse of Russia in person. We visited a few companies’ headquarters or production plants, and got to walk around both cities. One surprise was the vast difference between the cities – which came across as thriving and metropolitan, as impressive as the cities of Western Europe -and the areas outside these cities. The scenery on my trips outside the city often showed signs of underdevelopment and decay, with large, seemingly abandoned spaces, and often decrepit buildings and houses.

I also got an account of what life is like inside the huge Soviet-style housing blocks. One Russian, Leo, who accompanied us on our investment visit, had some insight into these giant structures.

“They are pretty miserable places to live,” he explained. “For instance, the way people get hot water in these apartments is from a ‘hot water factory’ situated sometimes quite far from the buildings it supplies. Between the factory and the buildings, however, a lot of the heat and the water is lost because the pipes are so poorly insulated and maintained. By the time it gets to the homes, people are lucky to get any hot water.”

While in Russia, I attended an investment tour led by Prosperity Capital Management, which has run a family of funds focused on Russia since 1996. Russia should also interest natural resource investors, because their economy is highly leveraged to commodities – in particular hydrocarbons. In fact, as of 2013, oil and gas accounted for about 24% of Russian GDP1 and drove around half of the country’s GDP growth since 2000.2 The country is estimated to have been the second largest producer of oil and gas in 2013 after the US and Saudi Arabia.3

Despite the huge importance of the sector to Russia, and the vastness of its resources, the sector is notoriously poorly managed. In April 2013, the Organization for Economic Co-operation and Development (OECD) recommended that the country make serious changes to its oil and gas industry in order to improve the outlook for the country:

The energy sector needs about USD 100 billion in investments per year until 2030 to modernize aging power generation assets, develop new oil and gas production sites, and build new transmission infrastructure to accompany stronger economic growth. This will not be possible without a massive increase in investment, including foreign direct investment.

The PCM team in Russia said they were starting to look at state-owned oil and gas companies because they were encouraged by some of the new developments in these companies. For instance, Bashneft, which is a mid-size oil producer, recently launched two new oilfields which they project will produce 18,000 barrels per day in 2014.4

Why would this be of interest? I learned during my trip to Russia that historically, the government’s role in the energy business had a huge detrimental effect on oil and gas production. There was no emphasis on efficiency for its own sake; instead, managers focused on defending their respective regions of control. This meant that they rarely sought to share techniques or look to new areas of potential expansion. A new set of oil fields could show that the management culture in Russian state-owned oil companies is becoming somewhat less sclerotic and inert.

The sheer vastness of Russia’s resources mean that if they are able to modernize and continue to improve state-run companies like Bashneft, then Russia should be an interesting story for natural resource investors.

1 http://www.oecd.org/russia/Russia-Modernising-the-Economy-EN.pdf

2 http://www.foreignaffairs.com/articles/138363/thane-gustafson/putins-petroleum-problem

3 http://www.eia.gov/todayinenergy/detail.cfm?id=13251

4 http://www.reuters.com/article/2013/09/23/us-russia-bashneft-idUSBRE98M0YQ20130923