The Daily Update - Russia and Gazprom

On 22 September Fitch affirmed its rating on Russia’s long-term foreign debt at BBB- and upgraded its outlook to positive from stable.

One of the reasons cited for the positive outlook revision is the improvement in the policy framework underpinned by the flexible exchange rate, ‘strong commitment to inflation targeting’ and a ‘prudent fiscal strategy’ reinforced by the recently approved budget rule. The budget rule uses a conservative oil price of $40 (real) and one positive aspect is that revenues in excess of the budget will be used to rebuild Russia’s fiscal buffers. The external and fiscal position is robust, Fitch estimate the net foreign asset position at a healthy 28% and the economic backdrop has improved: Fitch forecast 2% GDP growth for 2017 and 2.1% for the 2017/2018 period. Although he is still to affirm his candidacy, Vladimir Putin is expected stand for another term as President in the March 2018 elections implying policy continuity.

Fitch’s rating assumes that the EU and US sanctions remain in place over the long term. The recent move by the US Congress to codify existing sanctions into law has complicated their removal as Congressional approval is now required. A step up in geopolitical tensions and/or the imposition of additional sanctions is seen as a potential risk to the positive outlook, along with a weakening of the policy framework supporting the macroeconomic performance or a fall in international reserves.

Russia has been extremely adept at looking East for new markets and sources of investment: Russia’s abundant energy resources and geographic location is helping it to become one of the main suppliers of gas to China. In 2014 Gazprom reached a 30 year supply deal with CNPC to supply 38 bn cubic meters (BCM) per annum of gas to China. CNPC estimate that China gas imports could reach as much as 360 BCM a year in 2020 up from 190 BCM in 2016 as it moves away from coal sources. But this will only take gas to 10% of the primary energy consumption suggesting huge scope for growth. Gazprom is also in discussions with China for the route of the Power of Siberia 2 pipeline (Western route) which is expected to deliver an additional 30 BCM of gas per annum.

On another encouraging note, the S&P Platts Annual Rankings of the Top 250 Energy Companies for 2017 ranked Gazprom first and in so doing ended ExxonMobil’s 12 year reign at the top. The survey ranks companies using four metrics: asset worth, revenue, profit and return on invested capital. They note that ExxonMobil ‘has been hit hard by the drop in oil prices’ whereas fears ‘about the potential for a coming gas price war between Gazprom and LNG suppliers’ has so far proved unfounded.

Gazprom is in a heavy capex phase as it undertakes the Nord Stream 2, TurkStream and the Power of Siberia pipeline expansions. High capex requirements and higher mineral extraction taxes are expected to eat into its free cash-flow generation such that it is expected to be cash-flow neutral on a pre-dividend basis and slightly negative after dividends. Fortunately, Gazprom is starting from a position of strength in terms of its balance sheet with total debt/capital estimated at 21.9% and its adjusted debt: EBITDA at 2x and expected it to remain in the 2-2.3x range over the next 12-18 months (Moody’s estimates).  Moreover, Gazprom had a cash balance of RUB780bn as of 30 June plus EUB503bn in short term deposits. Gazprom avoided being named on the 2014 sanction list so has retained access to overseas debt markets: for example, Gazprom via (Gaz Capital) issued an £850m tranche of sterling bonds in April this year, the 4.25% 2024 issue is trading up close to 4.5 points since issue.

We believe Russia’s credit fundamentals remain robust and the positive outlook now from both Fitch and S&P suggests an improving trend. Even with the current sanctions in place we think it deserves an investment grade rating and our favoured exposures are through quasi-sovereigns such as RZD (Russian Railways) and Gazprom.