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Markets: Petrol Politics:
New York: September 01, 2008
By John R. Stephenson

"Russia is behaving in a very erratic way."

--James Woolsey, former director of the CIA

Oil is power. Nothing fuels the modern economy like oil and the all-important access to oil at a reasonable price. Fears are mounting in the west that Russia may start restricting oil and natural gas deliveries to Western Europe, as a newly resurgent Russia starts to flex its military and economic muscles. Flush with massive foreign currency reserves, a reinvigorated military machine and an urge to regain its past glories, Russia has shown renewed aggression towards its neighbors.

A recent article in London's Daily Telegraph cited unnamed sources in Moscow who reported that Russian oil companies are under orders from the Kremlin to prepare for a supply cut to Germany and Poland through the Druzhba (Friendship) pipeline. This potential restriction in oil deliveries would likely be in response to the threat of European Union ("EU") sanctions and NATO naval actions in the Black Sea. While such action on the part of Russia is strictly conjecture at this point, if it were to happen, this would be tantamount to economic warfare.

However, Russia appears to risk its reputation as a reliable player on the world stage in order to pursue its strategic ambitions. While Russia is saying niet to such talk, there is little doubt that Russia is infuriated with NATO meddling around in its backyard. Flush with cash, Russia is more prepared than it has been in quite some time for anything. According to Russian President Dmitry Medvedev, "we are not afraid of anything, including the prospect of a Cold War."

According to Mr. Putin, "the greatest tragedy of the 20 th century was the collapse of the Soviet Union." The Soviet defeat in Afghanistan, the orange revolution in the Ukraine and America's attempt to site a missile defense shield in Poland and the Czech Republic have all been viewed with disdain by the Kremlin. Now, with its movement into Georgia, Russia is sending a clear message not only to Georgia, but also the other states in its former of influence — Russia is back.

The geopolitical map of Europe is beginning to be redrawn, as parts of Georgia are now firmly under Moscow's control. The entry and partial withdrawal of Russian troops in Georgia, while widely heralded at home, has been loudly condemned in the West. But, tough talk seems to be about all that the west is willing to mount to defend South Ossetia — a part of the world few people know anything about.

European reluctance to fully denounce Russia stems in part from the fact that most of Europe is dependent on Russian energy for the smooth functioning of their economies. Russia is Europe's single biggest supplier of energy. By 2030, Europe's dependency on Russian energy is set to double as Norway and other traditional European suppliers experience production declines.

Russia supplies about half of the European Union's natural gas needs and about 30% of its crude oil needs. Germany now imports about 40% of its natural gas and 32% of its oil from Russia. Belgium. Sweden, the Czech Republic and the Baltic States are even more heavily dependent on Russian energy making a confrontation with Moscow a risky proposition.

Figure 1: Russia is the 800-Pound Gorilla of European Energy Supply!

Source: International Energy Agency

Since the late 1990s, the Russian economy has undergone a major transformation. With rising oil and gas exports, the country's economy has grown at an average annual rate of over 7% and its foreign currency reserves (US$580 billion) are the third largest in the world. This has made Vladimir Putin, the Russian prime minister, an extremely popular figure at home. Much of his domestic appeal wrests on his attempts to restore Russia to its former place of influence on the world stage.

Within Russia, per capita income is up sharply and domestic demand has been growing at a whopping 13.5% on the back of higher commodity prices. This has made Russia flush with cash and transformed it into a major player on global financial markets. Russia holds some $60 billion of Fannie Mae and Freddie Mac paper, making it a force to be reckoned with on the world financial stage.

A richer, defiant and more assertive Russia will be something for the world to contend with in the coming years. But what this latest round of saber rattling underscores is that increasingly, access to cheap, reliable energy is something that should not be taken for granted. In spite of an economic downturn that is engulfing North America, Europe and Japan, global crude oil supplies remain tight. Even a supply cut of 1million barrels of oil a day to Europe could cause the price of oil to spike on the world markets to $150 or $200 per barrel.

Figure 2: It's Always Better to Walk Tall and Carry a Big Stick!

Source: Bloomberg

The Russian incursion into Georgia and the rumors of a curtailment in European energy delivery, underscores another critical issue. Buyers of energy assets are not just concerned with the economics of these transactions, they are also concerned with the strategic importance of holding these assets. Savvy investors should expect that oil and gas assets that are acquired in the future might well be acquired at an additional premium that reflects their strategic value to the buyer.

With Gustav bearing down on the US gulf coast region and Russia reasserting its economic and strategic importance, investors should consider snapping up some of the best investments around — publicly listed oil and gas companies.

StephensonFiles is a division of Stephenson & Company Inc. an investment research and asset management firm which publishes research reports and commentary from time to time on securities and trends in the marketplace. The opinions and information contained herein are based upon sources which we believe to be reliable, but Stephenson & Company makes no representation as to their timeliness, accuracy or completeness. Mr. Stephenson writes a regular commentary on the markets and individual securities and the opinions expressed in this commentary are his own. This report is not an offer to sell or a solicitation of an offer to buy any security. Nothing in this article constitutes individual investment, legal or tax advice. Investments involve risk and an investor may incur profits and losses. We, our affiliates, and any officer, director or stockholder or any member of their families may have a position in and may from time to time purchase or sell any securities discussed in our articles. At the time of writing this article, Mr. Stephenson may or may not have had an investment position in the securities mentioned in this article
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