International investors remain overweight in Russian stocks and believe the risks of lower oil and more sanctions are already priced in, but after stellar returns last year, investors are now underweight Russian oil stocks, BCS Global Markets said in a note following a survey of its clients.

The oil sector has been a bit of rollercoaster ride in recent years. Following the collapse of the oil price at the end of 2014, the VTB Capital (VTBC) oil sector index was down over 40% by the end of that year. The following year was one of pain as Russia’s economy tried to recover from the shock of the deep associated ruble devaluation, and the oil index was flat y/y in 2015.

However, from 2016 the salutary effects devaluation had on costs, which are priced in rubles whereas income is in dollars, saw the oil index soar and return near 50% y/y. 2017 was more difficult for oil stocks as oil prices fell again into the $40s, but as the year came to an end they started to rise strongly, finishing 2017 with an overall gain for the sector of about 10%.

Last year was another good one for oil stocks as price growth continues, with oil rising from an average price of around $65 in the first half of the year to around $75 in the second. However, as the year came to an end oil prices started falling again and in January the average oil price fell to $56.

That has taken the wind out of the sails for portfolio investors looking at oil. However, there is still some upside left as oil prices recovered in February and were $66 for a barrel of Brent at the time of writing. Bankers are assuming prices will return to an average of $65 this year, but much will depend on if the production cuts deal with OPEC will be extended at a meeting in Vienna scheduled for April.

In the meantime BCS reports that while three quarters of its clients were overweight Russian oil stocks in November, now 60% are either flat or underweight. It seems the oil recovery story has run its course. In November half of some international investors’ portfolios were made up of oil and gas stocks.

Investors have switched to more domestic stories and currently the utilities sector is the best performing, up 14% YTD according to BCS, followed by the financial sector up 12% YTD.

“The cautious view on future oil prices is the key reason for the downgrade. Lukoil and Tatneft prefs are the most popular names in Russian O&G. Gazprom is becoming interesting thanks to resilience, low multiples. Domestic players are now the top picks in Russia. Rosneft is the key outcast due to write-offs,” Kirill Tachennikov, director and senior analyst at BCS Global Markets, said in a note.

Despite the switch out of oil, Russia remains portfolio favourite from the leading emerging markets (EMs), partly because of the high dividend yields, partly because of the low valuations and partly because investors believe that the risks from potential new US sanctions have already been priced in.

“Our institutional clients still prefer the Russian market to that of other EM countries. Most of them said they are overweight in Russian stocks v other EM companies’ stocks. They consider risks to be priced in. We believe that low valuations combined with high dividend yields will keep the Russian stock market resilient against possible new US sanctions and other problems typical of emerging markets,” Tachennikov added.

Investors are still holding names like the privately owned Lukoil that has seen its share price almost double last year; privately owned Surgutneftegaz prefs, thanks to its $40bn cash pile, interest on which account for about three quarters of its dividend payments; and, independently owned gas producer Novatek. The state-owned bluechips have been treading water, as bne IntelliNews recently reported in “Sberbank retakes Russia’s equity King of the Castle title.”

Sectors connected to the consumer are coming back into focus with the traditional favourites catching the most attention, including: state-owned retail bank Sberbank, internet search engine giant Yandex and supermarket chain Magnit among the most popular names, according to BCS.

Eyes on Gazprom

The state-owned gas giant Gazprom has started to pique investors’ curiosity and as is a possible candidate for good returns this year. The company’s stock has been an under-performer for most of the last two years and had a particularly bad year in 2018, having lost some 30% of its value.

However, things are about to change significantly for the company’s business. On February 27 the company announced construction of the Power of Siberia gas pipeline to China is now “99% complete” and it expects to start delivering gas over the border from December this year.

At the same time the company said this month that 700km of the 1,200km Nord Stream 2 pipeline is now complete, and recently moved up the completion date from the start of 2020 to the end of 2019.

Gazprom has been investing a record RUB1.1 trillion in these big construction projects, but as the capex on them falls away at the start of 2020 the company will have significantly more free cash to share with its shareholders – including the cash strapped government that is keen for all state-owned enterprises (SOEs) to pay 50% in dividends.

And Gazprom just hinted that it would pay record dividends its 2018 dividend payments, up from the 20% dividend yield it has paid in the last two years, blaming the low level on the need for investment into its mega-pipeline projects.

“The high yield in favourites means all eyes are on Gazprom, but investors are still not overweight in the name. Lukoil and Tatneft prefs seem to be everyone’s choice now thanks to a decent yield either in the form of dividends or buyback,” says Tachennikov. “Gazprom was frequently the centre of discussion, but although the street agrees that downside is limited, concerns about future capex plans, dividend per share (DPS) and the impact of the new mineral extraction tax (MET) still limit exposure to the stock.”

Rosneft was until recently briefly Russia’s most valuable stock on the back of outsized profits in 2017, but the appeal has fallen back now and it is out of favour, as investors are concerned about possible write-offs connected to the Venezuelan crisis, where the company has significant projects. 

Gas producer Novatek has also become the focus of investors as its investments into LNG go from strength to strength. The company is again on investors’ radar, according to BCS, ahead of the anticipated sale of a stake in its Arctic LNG 2 project.

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Russian oil stocks have outperformed the RTS index for most of the last two years, but are off the boil now