Sectornomics: Energy

Guess what country's energy sector is up 22%

Bryan Borzykowski, special to
Russia extraordinarily cheap: Gartman
Russia extraordinarily cheap: Gartman

Most investors are probably steering clear of the global energy sector these days—nearly every country has seen their oil and gas sectors fall—but there has been one unlikely bright spot among all the bad news: Russia.

Year-to-date, Russian energy sector returns have risen by about 22 percent. No other country comes close. Canada, another oil- and gas-heavy nation, has seen industry equity returns rise by just 1.8 percent this year, while the MSCI USA Index is up only 0.7 percent.

Why is Russia, which is fraught with geopolitical problems and currency issues, dramatically outperforming everyone else? In part, because its market dropped well before the oil crisis began.

Oil storage tanks stand illuminated at night at an oil plant operated by Salym Petroleum in Salym, Khanty-Mansi autonomous region, Russia.
Andrey Rudakov | Bloomberg | Getty Images

Russian equities—prices and valuations—started to fall when the country entered Ukraine earlier last year. Between January 1 and March 14, 2014, the MSCI Russia Energy Index fell by 21 percent. So it was already cheap when oil prices started to crumble.

"The market fell when the oil environment was good," said Karen Kostanian, an oil and gas analyst with Merrill Lynch Russia. "So when everyone downgraded their oil price assumptions, these companies were already cheap."

They continue to be inexpensive today. At the moment, the Russian energy names Lukoil and Gazprom have a 2015 price-to-earnings ratio of about 4.1 times, while developed-nation oil stocks are trading at about 11.5 times earnings, said Will Riley, a portfolio manager with Woodland Hills, California-based Guinness Atkinson Funds. His Global Energy Fund has about 3.3 percent of its assets in Russian energy stocks.

Finding hidden value

Russian valuations are always more depressed than developed markets, but these ratios are below the usual 6 or 7 times PE. With valuations as low as they are today, some investors don't mind taking on the risk that comes with Russia.

"The discount is particularly acute," said Riley. "Despite all the problems, people do see some value there."

There's another reason why the country hasn't suffered as badly as some other nations. Oil is priced in U.S. dollars, so it generates revenue in greenbacks.

Read MoreBest ways to profit from beaten-down energy stocks

The ruble has fallen by 42 percent against the U.S. dollar over the last 12 months, and while that has had a negative effect on a lot of sectors inside the country, it's actually made production costs cheaper for Russian oil companies.

"These stocks have some insulation from the falling ruble," said Riley. "So currency moves have been a net positive for the sector."

Thanks to the surging U.S. dollar, Russia, which typically produces a barrel of oil for about $40, can now produce one for closer to $30, said Kostanian. In other words, these companies can make more per barrel of oil than businesses in some other countries.

Finally, the Russian market is just so levered to the price of oil—the sector makes up 58 percent of the MSCI Russia Index—that any rise in oil prices will have a dramatic effect on equity markets.

At the moment, it appears the bleeding has leveled off. Add to that a slightly steadier geopolitical environment—it seems the Russia-Ukraine situation has stabilized—and investors are starting to feel more comfortable with the country again.

Of course, buying any stock in Russia is not without its risks. The geopolitical situation does have the most significant impact on sentiment in the region, said Evgeny Solovyov, a London-based analyst with Societe Generale.

While things may be quieter on the Ukraine front, it's still too early to tell how Boris Nemtsov's murder might impact the country.

Other factors that could send the stock in the opposite direction are a rising ruble and more government intervention in the sector, said Pavel Kushnir, an analyst with Deutsche Bank. The government already taxes these companies heavily, and if oil revenues fall, then they could tax them more.

However, for those who have some money to play with, the Russian energy sector may be a good place to invest going forward. Valuations are still below their historical norm, and any uptick in prices will have a big impact on the sector.

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Investors should look at companies with little debt, since those payments are usually denominated in U.S. dollars, said Solovyov. Companies also have had a harder time borrowing money from foreign intuitions, even ones that aren't subject to sanctions, so the more projects a company can fund on its own, the better.

It should also have limited ties to the government. Every company will have some relationship with the Russian authorities. The more independent the operation, the more freedom it has to do as it pleases.

One company that hits all the positive points is Lukoil, Russia's second-largest oil company. It's not controlled by the state, it has a clean balance sheet, and it's actually increasing its dividend. Its yield could increase to 8 percent, said Kushnir.

It's also trading at a massive discount to its historical average. Typically it trades at a 40 percent discount to big international players, but it's now trading at a 75 percent discount, added Kushnir.

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American investors shouldn't put too much money in the region, as only one U.S.-based fund, GMO Resources III, has more than 3.5 percent of its assets in the country's oil and gas sector. But add a few bucks there instead of in another energy market and you could get a solid boost. According to Lipper GMO Resources, the company has 10.93 percent of its assets in Russia.

"It's clear there's risk involved, but the rewards are relatively high there," said Riley. "If the multiples reset, then some oil and gas equities could potentially double in price."

—By Bryan Borzykowski, special to