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Regional Report - Russia & the CIS: the comeback king

Published by
World Coal,

Dr Elizabeth Stephens and Adam Nash, JLT Specialty Ltd, UK, outline the risks that face investors looking to cash-in on the potential resurgence of coal in Russia and the CIS.

Global coal production may be dominated by China and the US, but Russia and key countries within the Commonwealth of Independent States (CIS) are demonstrating an appetite and capacity for expansion. Rising natural gas prices and sustained demand from East Asia may produce a Eurasian coal revival of sufficient scale to justify large-scale investment in supporting infrastructure.

Regional coal production

In line with its plans to free up more of its lucrative natural gas reserves for export, Russia is targeting coal to satisfy 31 – 38% of its domestic electricity demands by 2020. In accordance with this, speaking on 25 August 2013 – Russian Miner’s Day – the country’s president, Vladimir Putin, stressed the need to increase coal-fired power generating capabilities and develop the internal coal market. Production and exports of coal increased by 1.5% and 7.9%, respectively, between January and June of 2013, demonstrating that the sector is a key component of growth and will continue to be for the foreseeable future.

Similarly, Ukraine’s production levels increased by 4.8% in 2012, as the government’s overhaul of the sector appeared to take effect. This reform programme set in motion a three-stage development plan – set to be completed in 2030 – of privatisation, modernisation and consolidation. However, with Ukraine’s coal-producing heartland lying in the east, where ethnic Russians are large in number, the recent tensions between Kiev and Moscow could serve to disrupt this progress.

Despite being comparatively much less significant than Russia and Ukraine in terms of production capacity, the Uzbekistan coal industry is also expanding. In H1 2013, over 2.67 million t of coal was produced, far surpassing expectations. Enhancing this positive outlook, the government has begun looking for investment partners for a series of planned technical upgrades and general modernisations that are expected to cost around US$ 500 million.

Neighbouring Kazakhstan, in contrast, is among the global top ten in terms of coal production, with output expected to hit 150 million t by 2030, as foreign investors are drawn by the recent lifting of a ban on new mineral exploration licenses and a stabilisation in the investment code governing the natural resources sector.

Supply-side restrictions in the Russian and CIS coal industry

Although Russia and the CIS are geographically well placed to exploit the burgeoning Asian coal market, infrastructural weaknesses are a significant drawback on this potential. In Russia specifically, an oversupply of rail wagons, caused by the poorly-managed privatisation of its railroads, persistently results in delays that not only contribute to Russia’s coal transportation costs being the highest in the world (between US$ 80/t and US$ 90/t), but also prevent Russian exporters from making lucrative spot sales to Japanese buyers.

Putin’s pledge to increase the carrying capacity of the Trans-Siberian and Baikul-Amur railways, as well as upgrade the Port of Vanino and construct a supplementary facility in the far east of the country, are aimed at driving transport costs down and increasing mobility. Some industry experts are sceptical as to whether these measures will adequately address the deficiencies, believing them to be expressly logistical issues that require better planning and expertise rather than capacity upgrades. Despite these reservations, Putin’s plans to rejuvenate the country’s moribund Soviet-era infrastructure are gaining momentum.

The Federal Concession Law of 2005 has provided the legal framework for a new wave of Public-Private Partnership initiatives in infrastructure development that, in combination with a US$ 13.7 billion injection from Russia’s sovereign wealth fund and private sector participation, should ensure progress. In spite of this, bottlenecks will continue to frustrate import-export operations over the medium term, as results will not be seen on the ground for a number of years.

Across the former Soviet satellite states – which now form the CIS – deficiencies in the road networks, electricity grids and water supply systems blight the industrial sector. A lack of foreign expertise has meant progress towards modernisation has been patchy and slow. Parts of Uzbekistan still rely on Soviet-era installations, while even in Kazakhstan, the most developed state in the region, little progress has been made towards updating crucial sections of its infrastructure. Money has instead been poured into large-scale vanity projects in Astana and Almaty. Despite governments across the region committing significant funds towards improving connectivity, much of the capital and expertise required will have to be sourced abroad.

Chinese companies have been the most proactive in this regard, specifically China Coal Technology & Engineering Group, which has been investing heavily in the modernisation of the coal-linked infrastructure at Shargunm in Uzbekistan and Luhansk, in Ukraine, to increase production capacity, thereby making the sites more commercially viable.

Government interference in the coal sector

While providing something of a lifeline to the coal industry in light of EU and US policy on carbon emissions, the prominence of the Asian coal market has also created an increased risk of contractual uncertainty and expropriation risk for some investors in areas of the CIS and, potentially, Russia. With China becoming a net importer of coal in 2009 and its demand forecast to continue to grow at least until 2020, the shift in emphasis within the coal industry towards Asia is palpable. Indeed, the Asian continent at large now accounts for 67% of global consumption. But as a corollary of this trend there is a danger that certain governments in coal producing countries will favour investment partners who can offer greater access to Asian markets, particularly China.

An instance of this was seen in Kazakhstan last August, when the Kazakh Government pre-empted the sale of Conoco Phillip’s 8.4% stake in the North Caspian Operating Co. to India’s Oil and Natural Gas Organisation and opted to re-sell it to the Chinese National Petroleum Corp. Although this did not directly affect the coal sector, it reinforced the predilection of the Kazakh Government to intervene in the energy sector to position itself better vis-a-vis the Asian market. This is a particularly dangerous development, given that Kazakh law provides the sovereign with automatic contractual pre-emption rights in all major strategic sectors.

As Kazakhstan re-opens its doors to mineral prospectors after the moratorium on exploration licenses was lifted in April last year, it is likely that energy sector ties between Beijing and Astana will grow even closer. In this context, there is an increased risk of selective discrimination, forced divestiture and other acts of expropriation, which investors should remain wary of, particularly given the lack of legal safeguards for foreign investors in Russia and the CIS. Nor does this risk apply solely to Western investors in the region: the Caspian states see Chinese investment in its energy sector as a way of reducing dependence on its historic patron, Russia. China is viewed as a more pragmatic trade partner, one which is less disposed to instigating costly trade wars as part of a political strategy.

Similarly to Kazakhstan, Russia’s mining codes also allow for expropriation in sectors of strategic importance to the government. Yet more recently there have been signs that the legislative environment may be improving after amendments were made to federal laws to streamline procedure and clarify the terms of foreign investor participation in strategic sectors – although for Western companies in Russia, Putin’s de facto annexation of Crimea and the West’s mooted response now threaten to negate any such positive developments. Russia’s parliament has prepared a draft law to allow the confiscation of property, assets and accounts of European or US companies, to be applied in the event that the EU or the US impose sanctions in response to the ongoing crisis in Ukraine. This highlights the susceptibility of international investment to high geopolitics – but, in the present context, it is unlikely that the US and the EU will force Putin’s hand on the issue. Despite unanimous disapproval of Russian actions, support for hard-hitting sanctions among European and US political elites is weak, particularly within the EU, where significant business interests are at stake.

Investor confidence in Uzbekistan is also in decline and has been since the expropriations of a UK-owned gold mine in 2011 and a Russian-operated telecommunications company in 2012. Moreover, as President Islam Karimov’s old age and ill health continues to generate talk of succession and encourage competition among the ruling elite, political interference in the business environment could increase as key figures seek to assert their control over the sources of economic wealth, while simultaneously undermining rival claims.

Expanded Russian influence

The ongoing crisis in Ukraine has served for many as a stark reminder of Putin’s nationalist tendencies, his willingness to depart from international norms and challenge US power. It is no secret that Putin rues the collapse of the Soviet Union and in recent weeks his aspirations for and commitment to regional hegemony in Eastern Europe and Central Asia have been made abundantly clear. The implications of Putin upping the stakes in this way for industrial interests in Ukraine and Central Asia could prove significant.

Ukraine’s industrial heartland and most of its coal industry is located in eastern provinces where Putin deems Russian interests to be significant enough to warrant direct intervention. In a situation where Russian troops were to advance further into these territories, there would likely be massive disruption to industrial activity as a response from the Ukrainian military would likely be triggered. If these areas were to fall under Russian influence in the same way that Crimea has, the ownership of assets would be cast into uncertainty and potential losses incurred. Nevertheless, at the time of writing, it appears unlikely that Russian troops will expand their operations beyond Crimea into eastern and southern parts of Ukraine, unless attacked by Ukrainian forces. As Russian troops outnumber Ukrainian troops by 6:1, this is implausible. Kiev will therefore likely push for a negotiated solution, lowering the probability of Russian troops seizing or destroying assets in Crimea or beyond.

Written by Dr Elizabeth Stephens and Adam Nash. Edited by

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