Feature

posted 26 Jun 2009 in Volume 12 Issue 8

First person

All quiet on the Eastern Front?

Rollo Tomasi takes a long, hard look at Russia and the CIS, but fails to see the disaster that some in the West would like to see.

Those of us who read the Western press, especially the stories on those pink pages in which we all have such touching faith, could be forgiven for thinking that the Cold War was still on.

Russian Prime Minister Vladimir Putin seems to hold a special place in the demonology of certain Western journalists, and even the BBC seems to see him as a latter-day Stalin poised rather menacingly on our eastern borders, if today armed with petro-dollars and gas taps rather than tank and missile divisions.

There was barely concealed glee in certain quarters when the unprecedented radical collapse of commodity prices in late 2008 threatened to derail the Russian leviathan. The theory of ‘de-coupling’, which had perhaps optimistically suggested we were not in fact all doomed to follow the Anglo-Saxons into the abyss, was enthusiastically de-bunked (notably, for those who noticed, by Anglo-Saxon commentators, which might tell us something).

But what is the truth? The Russian and wider CIS markets have been rather good over the past decade and longer to those who make their money from trade finance, in all its infinite variety of forms. From pre-export finance (PXF) to trade loans to Russian banks and the humble letter of credit (LC) business, Russia has been the principal locomotive of many a trade finance budget in Western firms and banks.

Yet today, this is now in doubt. Has the gravy train really come off the rails? Or does the current schadenfreude in the West also embody thinking that is every bit as wishful as the hope that de-coupling would de-sensitise Russia and, indeed, the other BRICs from the crisis of the Anglo-Saxon economic model in the first place?

Should we worry about Russia?
There has certainly been a perception of increased country risk, not just in Russia but across the CIS. Western observers cast a jaundiced eye over Ukraine’s currency meltdown and banking sector crisis, and assume that:

a. It means all Ukrainian companies are in trouble; and,

b. Russia is next.

Indeed, some of the numbers certainly are not good. In the first quarter of 2009, Russian customs revenues, which are as good an indication of trade and export activity as any, were 41% down, year-on-year. Crude steel production over the same period in Russia was down a hefty 30.9% and by 38.5% in Ukraine. Such year-on-year declines actually disguise an even steeper fall in the fourth quarter of 2008 and, hence, some modest recovery in the following quarter.

Much has been made in the Western press about the Central Bank of Russia burning through a cool $100bn of its reserves in defence of the rouble during the past 12 months, which fell anyway. Then, there was the further $58bn dedicated to the state-sponsored refinancing scheme, in which a number of borrowers saw their Western bank debt refinanced by Vnesheconombank (VEB), and both the implementation of the plan and its subsequent suspension attracted criticism. Share prices, of course, dropped off the radar during the ‘winter of discontent’, but then as trade financiers it’s tempting to ask, does this really matter to us?

In fact, it is not all bad news. Oil production has risen by a modest, yet under the circumstances surprising, 1.3%. Credit default swap (CDS) rates are back under 3% – which considering that earlier this year CDSs were around 26% for some of the major natural resources names tells you just how much use they are as a measure of risk.

The International Monetary Fund (IMF) has agreed its loan for Ukraine (no one in the UK should cast too many stones about this one – we were rescued by the IMF in 1976, then under a Labour government…). In a development that would have the current UK administration green with envy, Central Bank of Russia reserves actually went up in April and May, and now stand at $390bn.

Despite the ‘burning’ of reserves to support currency and industry, this still leaves them number three in the world.

At least, unlike Washington, London, Paris and Berlin, the Kremlin actually had the money in the bank to burn and doesn’t have to fall back on either borrowing it or printing it. With hindsight, the finance given to industry doesn’t look like such a bad plan and, dare we say it, is surely more palatable to the man on the street than the hundreds of billions of tax dollars, pounds and euros poured by Western governments into the banking sector.

The Russians also seem to have discovered a willing and important partner in China. Chinese growth in 2009 will be ‘only’ 6%-8% (depending on whether you listen to International Finance Corporation or the Chinese government). Macquarie Bank says China is now buying 40% of all commodities and, certainly, the Russian steel industry has every reason to be grateful for sustained Chinese interest, even if the Chinese have yet to really cut back on their state-subsidised aluminium production.

Analysts elsewhere ‘assured’ us that Russian oil major Rosneft couldn’t possibly raise the finance to meet its 2009 refinancing requirements and then, lo and behold, the Chinese lend them $17bn over 20 years (with a rather helpful five-year grace period) against future oil deliveries (or a crude oil PXF to you and me). With friends like that, who needs the West?

In fact, while we’re talking ‘country risk’, we might have a long hard look at what’s been going on in the West. There is also a perception of mounting country risk in the USA and European Union. We have seen a wave of bank failures, bailouts and nationalisations. Just to set some context to the Russian statistics, US crude steel production is down 52.7% year-on-year. Western government bond issuance has struggled on occasion, and there is uncertainty over the political direction in certain Western countries if, indeed, we don’t already see the politics of the mob quite close to home. It’s beginning to feel like those famous stress tests were more ‘stress’ than ‘test’.

Structural failure?
To be fair to those cynical about Russia, we have been through a decidedly rocky period in 2009, not least on any Russian deal done in 2008. One look at the commodity price graphs across the full spectrum of what Russia produces, tells you that no-one survives an 80% collapse in the price of their product (as we saw, for example, in steel prices) without a certain amount of collateral damage to their business plan, not to mention ‘covenant stretch’.

Metals conglomerate Severstal, one of the best run companies in Russia, produced three versions of its 2009 business plan over a five-week period in September and October 2008, which were not just mildly tweaked, but simply wildly different. Anyone working on their 2009 budget in a Western bank at the time will sympathise. Forecast turnover was reduced from $22bn to around $14bn, which in normal circumstances – and for a non-commodity firm – might look like the economic equivalent of losing your right leg.

Still, Severstal finished the year with profits not significantly out of line with 2007 and a cash pile of $2.8bn, so perhaps we shouldn’t worry about them too much.

Indeed, they haven’t asked about their covenants, having been in the happy position of having their 2008 jumbo launch after the price collapse/Lehmans bankruptcy/Libor crisis.

In fact, what’s impressive is that under such circumstances it got its $1.2bn PXF away at all, though those with longer memories will remember that Severstal also performed immaculately through an earlier crisis, back in 1998, and to some extent it reaped a ten-year harvest with the new deal. The analysts, however, will point to the fourth quarter when the firm lost money – but who was in a better position after the calamitous impact of Lehman Brothers’ collapse?

The key issue, however, not just for Severstal but for all the commodity producers and indeed for Russia, was and is whether having experienced such a dramatic correction in prices, they can cut their suit according to the new cloth: Can they also correct costs to make themselves profitable again in the new price environment?

One aspect that provides a little more comfort is signposted by the very word ‘correction’. It implies that something was wrong and has now been put right. So what was wrong in the summer of 2008? Well, how about oil at $147 per barrel? Or steel billet at $1,250 per metric tonne (PMT)? A look at the longer-term graphs show that seen in perspective, the the prices in 2005-2008 were the anomaly rather than the prices of the first quarter of 2009.

Indeed, the bounce off of the year-end bottom has left us today around the levels of 2006-7, depending on the commodity. Again, going back to the Russian crisis of 1998, oil was just $10 per barrel, copper around $1,600pmt and nickel below $5,000pmt. Steel billet, in those distant days before exchange-traded contracts, was lucky to change hands at $150pmt. So they should all be capable of making money at current prices, shouldn’t they?

Sadly, it doesn’t seem to be quite as straightforward as that. Since the 1998 crisis, and probably reinforced by the Yukos experience in which PXF lenders were repaid in full, (structured) commodity trade-finance lenders (and all those others who jumped on the bandwagon) had thought they were ‘safe’ doing PXF in Russia. Yet a tidal wave of waivers is sweeping across the market just now, with some borrowers clearly struggling to get costs down with quite the same alacrity seen in the collapse of their commodity sales prices with which they met the initial collapse in commodity prices.

Others suffer from, shall we politely say, ‘shareholder stretch’.

Again, look at those price graphs. How far back does our market memory stretch? I’ve been examining commodity prices for decades and we simply have not seen volatility on this scale since the 1970s. It has been a test of everybody’s structure. So does this mean we have seen structural failure in the Russian PXF market? Is ‘PXF’, as the answer to the challenges of emerging markets, as debunked as the theory of de-coupling?

Certainly, we are probably all suffering from a sufficiency of the dreaded ‘bankers’ meetings’ just now. Many of these seem to generate significantly more heat than light and the casual observer could probably be forgiven for seeing motion that is more circular than forward.

The recurring themes in these meetings seem to be the significance of a breach of EBITDA [earnings before interest, tax, depreciation and ammortisation] covenants, the value of the (in)famous ‘model’ (which seems to be de rigeur these days) and the cynicism with which the possibility of ‘using the PXF structure’ is seen, not least by lawyers from the very same firms that charged banks and their clients several hundred thousand dollars per deal to produce the PXF documentation in the first place, which they insisted at the time was “legally valid, binding and enforceable”.

To be fair, the lawyers now telling us not to bother taking cargo proceeds actually come from the ‘litigation and insolvency’ teams rather than the trade or corporate finance teams. No surprise, then, that perhaps what they really want to steer us towards is litigation and insolvency. Yet the counter argument (which, to be honest, seems widely ignored just now) is that in fact this is precisely how this stuff works anyway.

Our biggest challenge on the syndicated loan front in trade finance is the EBITDA covenant. Not to have one these days is a significant ‘syndication risk’. Yet there was a time when no self-respecting commodity banker would put such a covenant into his ‘docs’. Why do trade finance lenders rely on a covenant, the conformity of which cannot be tested until the balance sheet comes out? Basel II tells us that trade finance is lower risk because we should have ‘knowledge of the transaction’ and ‘robust mechanisms’ for monitoring transactional performance. If we’re just going to wait for the balance sheet to come out (some months after financial year end!), we might as well be bond holders (and then get the bond price!).

Worse, what is a borrower meant to do about non-compliance with the EBITDA covenant? Presumably, they didn’t set out to make a loss. Yet what power do they, or the lenders, have to rectify breach of EBITDA covenant? The only possible action is to ask for a waiver and if the banks are happy with granting that, it rather makes you wonder why they asked for it in the first place. Surely not just to justify a waiver fee???

At its simplest, PXF shouldn’t be getting repaid from EBITDA. It should be getting repaid from liquidation of cargo proceeds, with the cashflow going to the lenders before going anywhere else – including the central bank, the borrower’s treasury department and certainly before the shareholder.

A distinguished (litigation and insolvency) lawyer at one recent bankers’ meeting on a Russian borrower told the assembled banks that taking cargo proceeds would “only work for one cargo and then the pipeline will be empty”.

This strikes me as a bit like saying that if you drink water you’re going to drown. It’s all a question of degree, and you have to use some common sense. In the Yukos case, banks took 75% of cargo proceeds, which was sufficient to pay down the loan over time and yet return sufficient funds to the borrower to cover the logistics.

In these more straitened times, it might be desirable to negotiate an even higher repatriation of export proceeds to the beleaguered borrower. On the 1998 Sidanko PXF, at a certain stage and in the context of that $10/bbl oil price (when the logistics were costing them $8.5/bbl), lenders agreed just to cover the interest from export proceeds to keep the PXF ‘current’.

However, in a not unimportant footnote, that loan still repaid early, once oil prices recovered and the value of those export flows picked up. Some at the time said, “ah, they were lucky – they were saved by the oil price”, which rather misses the point. This isn’t a fluke – this is exactly how it works.

With any commodity-backed loan, the risk is that a fall in commodity prices threatens timely repayment. Yet equally, recovery in commodity prices should lead to recovery of the debt. At the same time, the borrower should be aware that the PXF lenders have their hands on their carotid artery – export proceeds go to the agent first, before anyone else.

Perhaps this is an appropriate point to mention aluminium giant Rusal. No discussion of the Russian trade finance market in 2009 can ignore Rusal and its well-publicised challenges. This restructuring overhangs both the Russian PXF market and, indeed, the broader aluminium market (as anyone who has tried to do an alu PXF elsewhere in the world will know). The bankers’ meetings are huge – no fewer than 70

Western banks appear on the rosters, which covers a very broad church of views. While there are clearly many issues, the central one is that the alu price is currently simply too low for this major producer. How long will this last? Well, ‘who knows?’ is probably the most honest answer.

However, it seems unlikely that the principal production assets are going to shut down – if they did then the impact on the alu price would likely be a self-levelling mechanism.

It is also pretty clear that the Kremlin is not about to let any foreigners acquire the company. Before we hear the usual protests of economic nationalism, let’s not forget that the French government, not so long ago, declared the yoghurt industry to be a key strategic sector, to justify ruling out a foreign takeover, and we have seen similar examples from pretty much every Western government.

So, should we do nothing and just sit tight? Well, no. Most lenders accepted a lower price than they could have achieved on an unsecured basis, because they gave some value to the assignment of export contracts, and few seem keen on giving this up. At the time of writing, lenders have agreed a temporary ‘standstill’ on principal repayment in order to give time to negotiate a longer-term solution.

There is clearly still a long way to go, and the Rusal bankers’ meetings may not so far be generating much light, yet there is remarkably little heat either. At least one reason for this may be that many of the leading banks involved were also on the Yukos case and so are, shall we say, sanguine about the impact of a potential change of ownership.

Another element of comfort is, perhaps, that the commodity cognoscenti will be aware that there is significant hedge-fund activity short-selling the aluminium complex just now. Much of this is driven by the analysis that, until there are genuine and significant reductions in global alu production, prices may yet have further to fall. This doesn’t seem likely to happen any time soon this side of a major change of heart by the Chinese authorities, who subsidise much of their domestic industry.

Indeed, alu has remained almost uniquely immune to the price rally that has sustained the rest of the commodities complex in the first half of the year (and which probably accounts for the recent increases in Central Bank of Russia’s reserves).

So if the Rusal situation isn’t terminal, should any of the others cause us undue concern? Well, everything is relative, as they say. The ferrous metal sector generally is going through tough times too, and a number of the big names in Russian steel are at least in ‘waiver’ mode, if not in outright restructuring discussions.

Yet have we seen any actual payment defaults? The short answer is, of course, no. Just, perhaps, as some in the West put too much faith in EBITDA covenants, so equally in Russia (and, indeed, in emerging markets generally) no one is too exercised about covenant breaches, so long as borrowers are current to debt service.

For example, Mechel is in intensive discussions with its bankers, according to the press. Yet, in the middle of all this, they were (again, according to press reports) able to get away a 43 billion Russian rouble bond issue, with tenors between seven and ten years. That’s about $1bn. Clearly, rouble investors were not so worried about any technical breaches that may or may not have sparked those intensive discussions and looked instead at the physical attributes of a major coal, iron and steel producer.

Meanwhile, for those who have asked for ‘escalation’ or ‘top up’ of the underlying collateral, we have seen several ferrous-sector producers top up with both cash and additional contracts which, again, is one of the bog-standard features of commodity PXF.

Should oil frighten us? The fall from grace of the oil price was every bit as sharp as for steel. Bothered? Well no, not really, not least thanks to the Russian taxman. For most of the period of the price rises, he was taking everything north of $27/bbl anyway, so the price crash only hurt the Russian oil producers in so far as it took a little while for the tax rates to adjust to the lower sales prices.

After the tax-rate adjustment, in fact, most producers were better off, despite lower turnover. With many of the players that used to be active lending in the metals sector retiring ‘hurt’ (by provisioning rather than by payment default), or at least concentrating on their next bankers’ meeting, it has been the oil space that has seen what activity there is on the Russian PXF front in 2009.

Of the older oil PXF deals, which for many just means Rosneft (which we have seen successfully back-up its 2008 facilities with additional volumes as requested and operationally), you have to say the oil PXFs have run very smoothly. Also, it is probably worth saying that the credit quality of the counterparties coming to the PXF market just now is of the highest order – not just in terms of EBITDA (yes, we do look at it, we’re just reluctant to covenant it), but also in terms of track record through previous crises – so passing the ‘leopard spot’ test.

We always used to say that there had to be something wrong with the picture to get a PXF structure. Historically, it was the country risk. In some circumstances, it might be the counterparty risk. These days, it seems to be more or less entirely the state of the international capital markets that is wrong with the picture.

Natural hedge
So where does this leave us in Russia? Well, perhaps not altogether relaxed, and certainly not complacent; nevertheless, we should be able to say this is no time to panic either. At a macro level, the country is in a rather happier position than ever before, and noticeably happier than many of us in the West.

To be a commodity exporter in times of crisis is always something of a natural hedge. If the domestic economy struggles and the currency depreciates, then the commodity producing exporters face local currency costs and hard currency revenues, which isn’t such a bad place to be. If the international economies recover, then the commodity prices seem likely to go with it and that also can’t be all bad.

In the shorter term, the commodity-price rally this year seems to be sustained by the famous ‘Chinese buying’ (so maybe de-coupling is not altogether de-bunked, even if it was probably a bit oversold in the past). And, while many anticipate that we may well have another dip in commodity prices before year-end (meaning that the worst may not yet be behind us), there is very real value in those oil and gas fields and – yes – in those smelters, too.

Russia may still be the ultimate ‘commodity play’, subject to all the vicissitudes of commodity price volatility that this implies. Yet the two great things about commodities are that they will always have some sort of value because we simply cannot do without them, and that one day they will all run out, which in the long-term will always support the price.

Before then, there may yet be quite some devil in the details and there is no immediate end in sight to the dreaded bankers’ meetings. Certainly, the current wave of waivers restricts the prospects of many Western banks getting new credit approvals. Yet we must say that the PXF structure still seems to be immune from transfer risk (as we have seen in Ukraine).

Also, commodity collateral may be volatile, but ‘escalation’ or ‘top up’ clauses do work and have been shown to work in Russia, where lenders have asked for them. Commodity price recovery has had an immediate positive impact on the commodity-backed deals, too. Of course, what goes back up can always go back down again, and we should be prepared for that, perhaps, before too long. But it may also be useful to point out that most waivers have been for technical breaches of covenant rather than for actual payment default or deferral, much less for debt forgiveness, haircut, or conversion to equity.

And, in this last regard, perhaps we can agree that lenders to most Russian commodity companies are in a substantially happier position than lenders to many other sectors in many other countries – as any lender to General Motors, Chrysler or the soybean sector in Brazil will tell us. If the object of the exercise is to get repaid in full, then perhaps the odd waiver is not too high a price to pay and Russia is the place to be.