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Oil Topping $80 Is Making Putin's Ambitious Social Investment Program Fundable

Brent futures passed the $80 a barrel mark on May 16 and transformed Russia’s profile.

The Kremlin is just launching a massive RUB8 trillion – RUB10 trillion spending programme on infrastructure and the social sphere following a raft of extremely audacious promises made by President Vladimir Putin in his state of the nation speech at the start of March.

Oil tops $80 a barrel and changes Russia’s fiscal landscape

Putin unveiled a very ambitious reform plan during his state of the nation speech on March 1. The president wants productivity growth to accelerate to 5% per year (since 2009, the average growth was only 1%) during the next decade, the share of SMEs in GDP to go up to 40% (from the current level of 20%), the number of people employed in SMEs to go up from 19mn to 25mn people, and to halve the number of people living below the poverty line (currently 13.8% of the population or 20mn people).

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However, it remained unclear where the money was going to come from to pay for this largess. The federal budget has been in deficit for about four years and in 2016 the Ministry of Finance nearly got into serious trouble as it couldn't fill a missing RUB2 trillion hole in the budget.

With the steady rise of oil prices these problems are melting away. The budget assumes an extremely modest $44 per barrel, but average oil prices have been in the $60s since October last year, starting the year at $66.2 rising to $68.8 in April. With oil over $70 in May and now at $80 the average is only going to rise further. Indeed, oil prices would now have to fall to $33 and stay there for the rest of the year for the average price this year to be less than $44. That is not going to happen.

Russia Inc is back in profit. Thanks to a reorganisation, cost cutting, more discipline and a crackdown on corruption the breakeven price of oil for the Russian federal budget is now around $60 or less, according to various estimates, and continuing to fall. Amongst the new sources of revenue are things like grain exports which brought in $20bn last year and are set to double this year, according to the Ministry of Agriculture.

All this is important as if oil stays where it is then it will provide all the money the Kremlin needs to cover Putin’s promises.

“While the amount of money needed for implementing Putin's new May decree looks impressive, the truth is it is a relatively small amount and may not be enough to ensure Russia's progress into the top-5 economic club. But, we still need more details before making any final conclusions over the future of the new agenda,” says BCS Global Marketschief economist Vladimir Tikhomirov. "On a yearly basis, the new programme will cost RUB4 trillion or roughly 25%-27% of annual federal budget expenditures. The additional funds required for the new policy will total c. RUB1.3 trillion a year or some 7%-8% of gross spending."

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The magic number is RUB1.3 trillion of new money. The rise in oil this year has already transformed Russia’s budget outlook for this year from ending 2018 with a modest 1.3% of GDP deficit to a prospective 0.45% surplus, or an extra RUB450bn, the finance ministry recently said. With some re-jigging of taxes, a hike in the retirement age and a bit of borrowing then the RUB850bn gap that still needed to be closed to meet the spending promises looked entirely doable.

However, now it is starting to look like closing the gap will be easy.

The finance ministry has a rule of thumb that estimates every $1 increase in the price of oil from the level of $40 per barrel brings the budget an additional RUB87bn. And if you also add in the effect that rising oil revenues have on the value of the ruble, sending it up, then the state gets even more money – an extra RUB144bn for every $1 rise in oil prices.

The $60-plus average price of oil over the start of this year should have already generated an extra RUB1.2 trillion of revenues for the budget, according to the rule of thumb, even if the average price of oil now falls back to $40 and stays there for the rest of this year.

If, on the other hand, the average price stays at $60 for the rest of the year — which seems more likely — then the budget will receive an extra RUB3 trillion of revenues and easily meet its spending needs.

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The other point of interest in the strong price of oil is that it has had no effect on the stock market. In the past the value of the leading RTS index was intimately tied to the price of oil, and the RTS index should be roughly x20 the price of oil in what is a remarkably robust relationship. bne IntelliNews explored this dependence in depth in an article “What is the fair value for Russia’s equity market?”.

This dependence has been so strong that the RTS keeps going through super cycles that are related to the cyclical nature of the commodities market, and the fifth such super cycle is currently underway. The dependence on oil has meant that a “buy-and-hold” strategy never works in Russia, but for investors that get their timing right the market can deliver stellar returns.

But this relationship has broken down recently. As the chart below shows while prices have soared this year the RTS has fallen and according to the x20 oil rule of thumb is currently some 200 points undervalued. The selling began with fears of new US sanctions during the publication of the so-called Kremlin Report in January, but got worse with the actual imposition of really painful sanctions in April.

Currently the value of the RTS is suppressed by geopolitical tensions, but what that means in practice is any easing of the tensions between Washington and Moscow should result in a strong stock market rally. That has already happened once in 2016 when the RTS gained 50% in a year, but don't hold your breath for it to happen again anytime soon.

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