Agora Financial’s Rude Awakening

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Vancouver, Canada

• Europe and Asia move higher in Wall Street strength,
• And then Kazakhstan found oil,
• The overlooked path on the Silk Road and plenty more…

Joel Bowman, Reporting from Vancouver, Canada…

Usually, your editors try to use this space to articulate an important idea, an interesting observation or, at least, a relatively witty remark. Today is not one of those times. Today we’ve got nothing. After a 39 hour Monday (thanks, International Date Line!) we are drained, lamed and bordering on brain-dead

And so, in light of our mitigated cerebral capacity, we’ll dive straight into today’s column. Please enjoy a wayfaring essay from Rude favorite, Chris Mayer, as he visits the seldom-reviewed investment region of Central Asia. Enjoy…

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What Would Borat Do?
By Chris Mayer

Kazakhstan was once a nation of nomads wandering vast steppes. They herded cattle, goats and camels. On the country’s western edge lies the Caspian Sea. Towns grew up along the shore there, hauling in catches of sturgeon and black caviar.

But otherwise, Kazakhstan was an empty desert. Even in the days of the old Silk Road, traders would skirt Kazakhstan’s southern border rather than try to cross that hell of a desert. It was remote. Desolate. The Soviets used parts of the northeast to test nuclear weapons.

The Aral Sea, site of one of the greatest environmental disasters ever, is in Kazakhstan. A century ago, carp, perch, caviar-bloated sturgeon and much more filled the Aral Sea. Fisherman hauled hundreds of tons of fish per year, fed themselves and loaded trains full of fish headed to Moscow. Then the Communists had some harebrained scheme to use the water for irrigation. And the great Aral Sea eventually ran dry.

It seems fitting. Kazakhstan has been a relatively barren and primitive place for millennia. The Soviets didn’t help that much.

Then Kazakhstan found oil.

The stuff just bubbled up from salt-encrusted lowlands. Exploratory drilling dates to 1979, but the oil and gas only really started to flow in 1991. That’s when Chevron hooked up with the Kazakh national oil company, Tengizneftgaz. Chevron supplied the technology to boost production.

Since then, many of the world’s largest oil companies are now active in Kazakhstan. Today, Kazakhstan has about 3% of the world’s oil reserves. Vast areas remain unexplored. And more than $130 billion in spending is on tap for the region.

In 2001, a pipeline opened up connecting the Tengiz oil field to the Black Sea. Another pipeline serves China. But the delivery of oil through here still has challenges. Oil flows through the pipeline only seven months out of the year. In the winter, they have to mix a less viscous fluid with the oil so it doesn’t freeze.

China would love to expand its oil supply from Kazakhstan. It helps diversify away the risks China takes by relying heavily on oil from the Straits of Hormuz (out of the Persian Gulf) and the Straits of Malacca (from across the Indian Ocean; the U.S. Seventh Fleet controls these Straits, only adding to China’s oil security concerns). By getting its oil from an overland source, China is less susceptible to oil blockades. That must make Chinese defense ministers smile.

And Kazakhstan is China’s western neighbor. The two share almost a thousand miles of border. Kazakhstan’s oil fields are not far from China’s border. It seems a natural partnership, but there are a couple of flies in the sugar.

The first is that the history between the two countries is complicated and ancient. The Qing Dynasty did some brutal things to the Muslim peoples of Central Asia in the 17th century. And even today, there is suspicion of the Chinese. It may seem strange from an American point of view, but people here have long memories of such things.

Then there is Russia.

Russia has ambitions here as well. That makes things much more complex. Kazakhstan’s closest ally is Russia, historically speaking. About a third of the population is of Russian descent. And the two countries maintain a tight dialogue. The president of Kazakhstan meets with Putin once a month.

The Russians have a complex history with Kazakhstan, too. Stalin and his goons killed millions of Kazakhs. In 1926, there were 6 million people in Kazakhstan. By 1933, after Stalin’s bloody work, 2.5 million of them were dead. Yet somehow, the Kazakhs overlook this more recent tragedy in snuggling up with Russia.

Even the U.S. has tried to make nice with Kazakhstan, but it runs a distant third. Kazakhstan is like the girl everyone wants to date in high school.

Meanwhile, billions of dollars from oil sales flows to Kazakhstan’s coffers. Oil and gas now make up nearly 60% of the country’s exports. Economic growth tops 8%. (Still most of its people are poor. Monthly per capita income is about $770, which is less than it sounds because as is typical with great boomtowns, the cost of living where the money is, namely the oil towns, is pretty high.)

To invest in the boom directly, you can own a Kazakh oil producer. The one that stands out is JSC KazMunaiGas. JSC is the second largest producer of oil in Kazakhstan. Even if you have no intention of buying a Kazakh oil producer, this is a fascinating story on the face of it.

JSC is the only listed Kazakh oil producer. It trades in London under the ticker symbol KMG. JSC had a $2 billion IPO back in 2006. Today, the market values the stock at $8 billion. It generated $2 billion in net profit last year, so it trades for 4 times earnings. Since the IPO, the company has made about $1.3 billion in distributions to shareholders. It’s also buying back stock now.

The government owns 62% of JSC – which is not a bad thing, I would say. It’s like having a fight judge in your corner as a boxer. In fact, JSC has right of first refusal on any takeover for oil and gas assets in Kazakhstan – thanks to the government. So there you go.

JSC exports about 75% of its oil at market prices. So it is not forced to sell a lot to Kazakhs at below-market prices. About 25% is sold at home at prices about 40% less than market prices. There are no hedges, so investors get the full benefit of any upside in oil prices.

JSC is cash-rich and has zero net debt. So no financial risk, either. The company also has some of lowest finding and development costs in the world at only $4.80 per barrel of oil. It has proven reserves of 700 million barrels and has been successful in building new reserves.

Plus, Kazakhstan is lowering its tax burden. As a result, JSC pays less in taxes than Chevron does as a percentage of profits.

Finally, JSC enjoys low geologic risk. In the past, this has been a problem in Kazakhstan. The geology is complex and hard to predict. But most of JSC’s oil fields are traditional sandstone formations.

All in all, JSC looks like a great way to play the growth in Kazakhstan’s oil industry. So, if you’re feeling speculative – and can buy LSE shares – then you might look to dip your toes in the water here. And there may be U.S. shares one day. I’ll be watching, and so should you.

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[Rude Endnote: Stocks in Europe and Asia were up sharply yesterday after Wall Street continued its recent rally. Major measures in Europe jumped over 1% with London’s FTSE and France’s CAC up 1.1% by the end of yesterday\s session. Germany’s DAX ended up 1.3%.

Japan’s Nikkei 225 led the way in Asia finishing the day up 2.75% while Hong Kong’s Hang Seng and the Aussie All Ordinaries remained relatively unchanged. China’s CSI 300 did fall 1.4%.

Over in the commodity pits, oil continues its slow creep north. A barrel of the world’s goo goes for just shy of $65 this morning. Gold, meanwhile, inched higher to within a swhisker of $950 per ounce.

We’ll be back tomorrow with more Rude views.

Until then…

Cheers,

Joel Bowman

The Rude Awakening
aussiejoel@the-rude-awakening.com