The Nord Stream 2 pipeline has created a massive amount of controversy. The U.S. vehemently opposes the project on the basis of “European energy security” as it will further bind Europe’s future energy needs to Russia’s Gazprom (OTCPK:OGZPY).
Through proxies, such as Poland and The Baltic states, primarily Latvia, the U.S. has worked tirelessly to stop the project. But the most recent statements by the U.S. State Department make is clear that stopping Nord Stream 2 is a high priority for U.S policy-makers.
Per a report from RT recently:
‘Everything is on the table. The administration is taking a whole-of-government approach to stopping the Nord Stream project,’ the source said, as cited by the media.
Last summer, Congress approved the so-called Countering America’s Adversaries Through Sanctions Act (CAATSA). The legislation allows the White House to introduce punitive measures against the participants of the energy project, investing over $5 million in those enterprises.
‘We have been clear that firms working in the Russian energy export pipeline sector are engaging in a line of business that carries sanctions risk,’ a State Department spokeswoman told the media.
Since 2014’s imposition of sanctions on Russia over the reunification of Crimea, the U.S. and European Union have played power politics over Europe’s future natural gas supplies. Nord Stream 2 is Gazprom’s attempt to circumvent problems with Ukraine and its miserable relationship with Natfogaz.
I don’t want to go into a detailed history of the situation, because it has been very well covered. To make a long story short, Gazprom has overcome every hurdle placed in front of it to not only resolve lingering issues with the EU’s ever-changing energy market rules, like the recent settlement of the anti-trust suit, but also opposition to Nord Stream 2. And since the project has cleared legal challenges and has been issued all the necessary permits for construction, the only avenue left to its opponents is the naked application of political and economic pressure on its EU partners.
They are five European oil and gas majors – Royal Dutch Shell (RDS.A), OMV, Engie, Wintershall and Uniper. Each of them are potentially exposed to new sanctions imposed by the U.S. for continuing to do business with Gazprom on Nord Stream 2.
So, why do I believe all of this is simply nothing more than the big bad U.S. huffing and puffing? Because Russia’s fiscal situation is such that today it is a brick house rather than a straw one. Unemployment is low, inflation is tamed, GDP is growing, albeit slowly, and loan growth is good, as evidenced by Sberbank’s (OTCPK:SBRCY) recent earnings report as well as a recent press release from the Bank of Russia.
Mortgage loan growth, year over year, is 20.2% with NPL rates of just 1.3%. And there is plenty of room for those numbers to improve. This type of loan growth is impressive despite the Bank of Russia being at least 50 basis points behind the curve.
So, to turn on the heat a little in Russia, another 50-basis point cut would be welcome and accelerate capital inflow by allowing foreign investment at lower costs of capital. The Bank of Russia has been too conservative in its handling of the recovery from 2014/15’s ruble crisis, in my opinion.
And it has hampered Russia’s economic recovery. Russian banks are already cut out of U.S. dollar markets, so sanctions on them really do not matter. Any dollars they need they can get through the central bank, which still has $100 billion in U.S. treasury holdings according to the latest Treasury International Capital report or relationships with Chinese banks whom the U.S. dare not sanction.
In the worst-case scenario, the five companies listed above all pull out of their deal with Gazprom, it would leave the company needing to re-issue the loans locally. Currently, these are loans payable in euros. Converting those loans to Rubles issued through currently stable Russian banks would be trivial with the Bank of Russia providing the needed euro (FXE) liquidity. We’re only talking €4.9 billion here.
Gazprom’s latest earnings report was stellar with solid expansion across all verticals. Financially, the company is well positioned to complete each of the three major projects currently under construction – Turkish Stream, Nord Stream 2, and Power of Siberia.
Politics Cuts Both Ways
Nord Stream 2 is too important politically to future Russian/European Union relations for it to fall apart at the last minute like South Stream did after U.S. pressure on Bulgaria forced Russian President Vladimir Putin to pull the project and reroute it through Turkey, resurrected as Turkish Stream.
That miscalculation cost eastern Europe gas supplies it needed for growth as well as billions in transit fees for Bulgaria. That decision cost the Bulgarian government its rule and today’s leadership is openly lobbying for a new version of South Stream which Gazprom has not committed to yet. This time, it could be German Chancellor Angela Merkel who would feel the wrath of voters. Germany needs Nord Stream 2, and, if Gazprom’s Chairman of the Board Alexander Medvedev is to be taken seriously, Nord Stream 3 as well.
So, if she folds here to Trump’s pressure it will likely spell the end of her government within the year. Local anger over her immigration policy as well as serving the EU rather than Germany first puts her chancellorship on shaky ground. And that’s before the new government in Italy even makes its first official move.
Speaking of the Italians, the new Prime Minister Guiseppi Conte spooked markets with his inaugural remarks stating bluntly that current EU sanctions on Russia over Crimea need to be lifted. Will he instruct his Foreign Minister to veto their extension in July?
It’s very possible. It’s also possible that getting another six-month extension of those sanctions will be a very serious bargaining chip between Italy, Germany and the U.S.
Merkel has an out here, as I described in a blog post a couple of weeks ago, that could win her a ton of political capital domestically. And given what we just heard from Conte, this is now a very likely course of action.
As investors, if Italy ends the sanctions this will be very positive for Russian assets. It will open up investor floodgates fleeing the uncertainty of both Italian debt restructuring talks. Spain is now waiting in the wings thanks to Mariano Rajoy’s ouster from power.
Expect Merkel and Putin to begin seeing eye to eye on ending the conflict in Ukraine again and pushing for commitments from Gazprom to guarantee gas transit through those pipelines after the current contract expires in 2019. Gazprom is a steal at RUB146 per share, or $4.62. It’s trading at well below multiples of other oil and gas majors, heavily discounted for perceived political risk.
For U.S. investors, however, a rising dollar will impact the upside in dollar terms as will a drop in oil prices. The markets are anticipating upwards of 1 million barrels to come off the market once new sanctions go on Iran and Trump now wants lower oil prices heading into the midterm elections. So, currency effects could shave five percent off the price. But, all the other positives, both near and long term should outweigh those concerns.
Look at Gazprom over a three to five-year investment horizon and layer in a position accordingly. Remember, the firm pays its annual dividend in July so this is always a good time to begin building your stake.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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