Rosneft And Sanctions: European Dam May Be About To Burst

As the devastation in Ukraine approaches its sixth week, I have finally decided to put (digital) pen to paper about the pivotal events taking place there. I write about business, not politics, and I wasn’t sure I would ever touch this issue, which of course has things far more important than money riding on its outcome.

I am writing now because we may be approaching (yet another) crucial point in this sad tale. One of the most persistent requests from Ukraine since this conflict began has been for a comprehensive system of energy sanctions, literally sanctioning Russian fuel to make the Russian invasion run out of fuel. That question, behind its many moral and geopolitical implications, also has major implications for Rosneft (OTCPK:RNFTF) investors, who have already seen their investment fall by almost half since the war broke out.

Actually, so far, Rosneft probably hasn’t been hurt by the conflict too badly. Energy is just about the only thing out of Russia that isn’t being sanctioned so far, and while many Western traders are shunning Russian oil anyway – in effect, “self-sanctioning,” as some call it – the substantial increase in price such restrictions have produced has substantially diminished the hit to Rosneft’s bottom line.

Does this mean Rosneft is oversold? I don’t think so. If anything it’s probably still too high. Rosneft’s early resilience rests almost entirely on the fact that so far, energy is the giant gaping loophole in the Western sanctions regime. Without that, investors would be even worse off.

And the ground may be shifting beneath their feet.

Premiums And Discounts

Let’s look at the numbers first.

Global Crude Prices

Brent Oil prices are now roughly at $108 per barrel. While this marks only a 20% increase from prices the day before the invasion, it is up almost 50% from the $75 at which it traded at Christmas time, and more than 50% from the $71 it averaged in 2021.

Russian And Rosneft Production

For now, we will assume that sanctions are hitting all Russian oil producers proportionally. We have no reason thus far to suspect differently. Russia’s global exports were 4 to 5 million bpd of oil as well as 2 to 3 million barrels of refined petroleum products before hostilities commenced. We will call it 7.5 million bpd.

Self-Sanctions And Price Discounts

According to reports, self-sanctioning appears to be around 2.5 million bpd. Meanwhile, even to sell the remaining barrels, Russia appears to be accepting discounts of as much as $30 per barrel, which spiked right after the outbreak of hostilities and have hardly budged back down since. This discount is almost 1/3 of the benchmark price.

Capital Structure

What’s more, the war has compelled certain changes to the capital structure that, at first glance, might seem to be favorable. Almost immediately after the war broke out, BP (BP) announced that it would be liquidating its stake in Rosneft, whether of its own volition or because it was under enormous pressure from the British government. It quickly found, however, that hardly anyone else wanted the suddenly toxic asset either.

The plan then became to sell the stake back to Rosneft itself. Following the massive sanctions imposed on the Russian economy, however, this plan became rather complicated. The ruble almost immediately plunged to 150 to the dollar, and the highly respected Russian central banker Elvira Nabiullina – who wanted to quit, but wasn’t allowed to – not only hiked interest rates to 20%, but also implemented sweeping capital controls and limited the ability of Russian companies and individuals to sell rubles to buy foreign currency.

So Rosneft has, for now, not indicated it has any intention of buying the stake. But if it should, in fact, ultimately prove to be the only viable bidder, such a sale would be a veritable bonanza. At almost 20% of the total company, BP’s stake, if sold to Rosneft at what would have to be fire sale prices, would effectively allow Rosneft’s other shareholders to increase their EPS by 25% almost for free.

Revenue Change

This means that while Rosneft is only selling two barrels for every three it did in 2021, and is only receiving two of every three dollars a benchmark seller is receiving, the benchmark itself is up 50%. In other words, Rosneft is probably still receiving about eight of the nine dollars that it was in 2021.

Retained Storage

A couple other small positives can be added to that. It is likely that the unsold oil in question is being put into storage for later sale. This could almost mean that Rosneft is actually doing better than before because, to continue with our previous example, it has surrendered one of every nine dollars to retain one of every three barrels. If those barrels sell for anywhere near their fellows, Rosneft might actually come out ahead.

The Coming Storm

With only limited revenue losses, combined with some extra oil and a potential windfall of free shares, some might think that the selloff in Rosneft has been overdone.

They should think again. For one thing, there are qualifiers to a lot of those upsides I just listed, but more importantly, self-sanctioning appears increasingly likely to give way to real sanctioning, and perhaps very soon.

Latest Disturbing News

The single biggest question is, how much oil is Russia going to be allowed to sell on the open market? I suppose it is not inconceivable it will continue to sell all the oil it is today, and perhaps even recover some sales as self-sanctioning wears off – each day sanctions are not imposed makes the discount Russian oil is selling at more appealing for traders. But inside Russia, fears that the West may eventually impose a full embargo on oil never stopped percolating, even as talk of it briefly abated in diplomatic circles.

Now, such talk is back with a vengeance, following the disclosure of accusations of atrocities perpetuated against Ukrainian civilians behind Russian lines. The real significance of these accusations, and the Western media’s disclosure of the evidence to support them, is probably best understood through the prism of the European Union’s two most important power brokers following the United Kindgom’s Brexit: France and Germany.

Let me start with France. France is not quite the hub of Russian energy in Europe that Germany allowed itself to become, but it has, like many, pushed back on the notion of an immediate embargo until quite recently. Following the latest reports, however, President Macron seems to have been converted; he is now openly calling for an embargo on Russian coal and oil to be agreed, potentially as soon as this week.

One will note the absence of the third fossil fuel, natural gas, on that list. There are many reasons Macron phrased it in just that way, both geopolitical, economic and a couple of other categories as well. A full examination of that issue is not needed to analyze Rosneft, which would not benefit from a gas exemption nearly enough to counteract the oil damage, anyway, so let’s table that issue for now.

An Increasingly Isolated Chancellor

Germany, surely, one of Russia’s closest friends in Europe, will block such a move? And it wouldn’t even be purely an act of friendship; Germany is one of the largest recipients of Russian energy in the EU and would see its industry suffer greatly from an embargo.

For now, Chancellor Olaf Scholz still appear determined to stick to his guns. He has proposed and received, up till now, EU backing for a plan to gradually wean off Russian oil and gas over the next few years. At most, he thinks, Europe might cut imports by 2/3 this year, but a lot of things could go wrong and lower that number.

However, the issue here for investors is that the chancellor is increasingly isolating himself with such a position, and it’s not clear how much longer he can hold out. As the leader of a three-party coalition, it was always questionable how long his Social Democratic Party would be able to keep the Greens onside with continued imports; their unease is growing now seemingly almost by the hour.

More alarming to Scholz is that his other partner, the Free Democrats, is getting uneasy as well. Their leader, who also serves as finance minister, tried to gently nudge the chancellor by “clarifying” that a gas embargo was out of the question, but that embargoes on oil and coal were more possible – again, essentially echoing Macron’s call for replacing the gaping energy loophole in the West’s sanctions regime with a still significant but much smaller gas loophole.

And now, finally, even his own party is starting to abandon him. The defense minister, a fellow Social Democrat, says that the government should discuss an immediate ban on gas, as well as oil and coal, after all. The President of Germany, who is meant in the German system to be a nonpolitical and unifying figure, made a public apology, saying “I was wrong” for being a leading member of the wing of Scholz’s party that had pushed hardest for closer Russian ties and energy purchases for the past two decades.

It seems unlikely, altogether, that Germany will hold out against sanctions much longer.

A Cumbersome Process

This brings us to the rest of Europe, and here it is important to understand the mechanisms by which European nations take decisions on issues like this. While the EU increasingly has turned to QMV(Qualified Majority Voting) to make the institution run more smoothly, the imposition of sanctions remains a power which requires unanimity among all of the EU’s 27 members. So technically, Russia doesn’t need Germany or France; it just needs a single one of those 27 to stay onside and issue a veto.

Politically, that would almost be preferable from Scholz’s view, and probably several other European leaders as well. The European public is pushing for stronger sanctions regimens to match those of America and Britain; but there is concern that once implemented, the sanctions would cripple the EU economies and voters would turn against the politicians who gave them exactly what they asked for. What EU politicians would really like is to support the sanctions in Council, but see another country veto them, effectively getting them off the hook with their own voters. But since everyone is thinking that way, they can’t support sanctions without running the risk that everyone else will support them as well.

This geopolitical variation of the Prisoner’s Dilemma means that European nations have spent the past thirty-six hours essentially signaling each other about who gets the hot potato of vetoing. And so far, no one has definitely stepped up besides Germany, whose holdout might not last much longer.

Italy and Spain are definitely not vetoing; neither is Belgium. Baltic and Eastern European states are generally more hawkish on Russia than the Western Europeans, so it’s hard to see any of them blocking it except maybe Hungary, but they’re already such a troublemaker they may not want any additional heat. Austria may very well end up the final ‘no’ vote if Germany cracks, and it would be an awfully thin limb for Austria to be out on all alone if no one else will stand with them in vetoing.

But At What Cost?

To be sure, sanctions are not inevitable, yet. There are still persistent warnings that if Russian oil were to be cut off, European nations would be rationing oil products by summer – and, depending on how much oil they successfully pulled in off the global market from other sources, the rest of the world might be joining them.

For some European countries, the gas issue is even more pressing; German unions are screaming themselves hoarse that an embargo is even being considered, in light of what it would do to German manufacturing; energy is a crucial input to steelmaking and other heavy industrial sectors.

But European nations are, ultimately, democracies – Hungary edging ever closer to being the one exception – and the public pressure is only growing; even in Germany, historically closely aligned with Russia, one poll had a staggering 77% of voters in favor of an embargo; no poll has been below 55% for weeks.

The Fork In The Road

Still, let’s say that somehow, Austria or Germany kills the idea and takes the political hit at home; where does that leave Rosneft?

Well, better off than the alternative, certainly; and depending on whether self-sanctioning wanes at some point and where prices go, perhaps even better off than it was last year. But that still isn’t a reason to buy it.

Even if someone is buying Rosneft stock, they almost certainly aren’t looking to get into Russia in a major way; in my opinion, it appears doomed to be one of the most isolated and stagnating economies in the world for the foreseeable future. Any potential Rosneft investor almost certainly just wants exposure to the oil industry, in general.

And this is the central dilemma with any investment in Rosneft; it’s not so much that it’s impossible to imagine a scenario where Rosneft’s value goes up; it’s that it’s impossible to imagine a scenario where Rosneft goes up and other oil stocks don’t go up just as much, or even more.

Peer Comparisons

In order for Rosneft to actually be a better investment than a non-Russian (ie., non-sanctioned) peer, the market would have to bid up that peer’s stock so high in expectation of sanctions that the absence of them made the peer overvalued relative to Rosneft; enough to run the risk that sanctions would be imposed after all and crater their Rosneft investment.

But by and large, that just hasn’t happened. Yes, Rosneft has collapses, as one would expect, but other oil companies haven’t been bid up to high heaven on the other end of the scale. At this writing, Exxon Mobil (XOM) is up only 10% since the invasion launched. Shell (SHEL) is up only 8% and BP is up by a miserly 2%. Only Chevron (CVX) is up a more respectable 22%, but even that hardly matches the scale of the upside for oil companies if Russian taps are decisively turned off.

Playing The Odds

This article is plenty long already, so I will keep this final number crunch very simplified. We will assume that the only fundamental change in the last month has been the Ukraine war. I assign a 75% probability that sanctions are forthcoming, and a 25% chance they are not.

Let’s assume that Rosneft is able to acquire the entire BP stake for practically nothing, and boost its EPS by 25% in the event sanctions happen. The only other variable is what profit we think Rosneft can turn from purely domestic operations if it is shut out of international markets; I will assume 10% of prewar cash flow, since Russia usually nudges its petro-gas companies to favor domestic consumers.

Under these circumstances, Rosneft has a 25% chance of generating 125% of prewar earnings (100% of old earnings restored, now spread over only 80% of shares) and a 75% chance of generating only 10% of what it did before spread over that same 80%; if you do the math, you’ll find that comes out to a probabilistic fair value of just over 40% of its prewar value. But Rosneft has only fallen 50% since the war started, suggesting that on a risk-adjusted basis it actually remains overvalued.

Meanwhile, even Exxon, the highest of the non-Chevron peers, has only seen a 10% boost, despite a 75% chance of sanctions that could boost earnings by as much as 100%. My gosh, with those numbers even Chevron’s 22% rise doesn’t look like a bad investment.

Investment Summary

I recognize that this last exercise was very oversimplified; obviously there is more to analyzing an alternative investment than just multiplying probabilistic percentages. But this article is already too long. I hope readers at least come away with a greater understanding of the factors, both political and economic, that are driving the EU process which I increasingly think may actually produce a strong energy sanctions regime after all.

Whether oil is a good investment at all depends on many factors, including interest rates, growth rates, alternative energy investment and potential regulatory changes, to list just a few; this article is not meant as a comprehensive examination of all of them and investors should always do their own due diligence before entering any investment.

I honestly haven’t made up my own mind yet about whether oil as a whole is a good industry to invest in or not right now; if I do invest, however, I feel I can find a much better company to do so than Rosneft.