By Chris Weafer, Chief Strategist at Troika Dialog.
On the face of it, there is little in common between the Russian capital, population 11.5 mln, and Cushing, Oklahoma, population 8,400. But they do have one important factor in common; Cushing is where the price of WTI is fixed, and over the past six months, the weakening WTI price is one of the reasons why investors have been even more wary of Russian risk. This is despite the fact that Russia’s oil export price is actually linked to Brent.
Before late 2010, WTI routinely traded at a small premium to Brent and Urals. Because of a supply bottleneck in Cushing, WTI has fallen sharply and recently traded at a record discount of over $26/bbl to Brent and $24/bbl to Urals.
Based on the historic correlation between the RTS Index and Urals crude, the equity market’s level should today be closer to 2,000. Either that, or Urals should be trading nearer to $75/bbl rather than above $100/bbl. Russia’s relatively stable Sovereign debt yields are a more accurate reflection of oil revenues and the country’s investment risk.
Unraveling the supply bottleneck in Cushing requires the construction of a major new pipeline system, which is now subject to a lengthy and increasingly politicized review process. Traders on NYMEX are currently betting the issue is unresolved (i.e. WTI and Brent reach parity again, until at least mid-2016).
The huge WTI discount is of course not the only reason why the Russian equity market is trading at discount of around one third to EM peers. However, investors fear a repeat of 2H08, when the price of oil bounced off a record high, fell sharply toward year end, and brought Moscow’s bourses and the ruble with it.
Investors are, however, already pricing into the valuation of Russian equities a big fall in the oil price, despite the fact that Brent and Urals prices have been relatively resilient this year. This is because Asian demand growth has become a more important driver of the oil price. While there has been slight scaling back in demand expectations for the US and Europe, there are few concerns so far that Asian demand growth is impacted.
For now, the more important drivers of where oil will trade through autumn and winter will be the trade-weighted strength of the dollar, how quickly Libyan oil returns to market, and OPEC’s reaction time. A very significant change in oil market dynamics over the past 12 months is the fact that Saudi Arabia now needs some $100-110/bbl (Brent) to balance its annual budget because of the sharp ratcheting up of social spending as a reaction to the “Arab Spring” across the Middle East and North Africa.
The fact that Saudi Arabia now needs $100-110/bbl average Brent is a significant change in the oil market dynamic and lessens the possibility of a severe collapse in the oil price.
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