Russian commodities: Giving investors food for thought

THE SOCIO-ECONOMIC dislocation of the 1990s wrought widespread havoc in the Russian countryside and relegated agriculture to a bit part role in the country’s unfolding financial drama. Before the break-up of the USSR in 1991, agriculture in Russia was a big industry, accounting for 15.3% of GDP. As of last year that figure had slumped to just 4.4%.

But given surging soft commodity prices across the globe and recent political upheaval in countries such as Haiti and Egypt as a result of soaring food prices, Russian agriculture could enjoy a dramatic reversal of fortune.

"Food security is now as big an issue as energy security," says Richard Ferguson, soft commodities analyst at Nomura in London. Given the growing supply-demand mismatch in the global food chain, he believes that agriculture is set for one of the periodic revolutions that as a rule of thumb occur every 50 years or so. The principal drivers are set to be a combination of demographics, urbanization and globalization. Put simply, with the world’s population in excess of 6 billion, there are more mouths than ever to feed. Meanwhile, growing urbanization is boosting incomes, which have changed the affordability of food, as well as displacing valuable farmland. Finally, globalization has promoted greater international trade in agricultural goods.

The favourable changes in the macroeconomic environment have ushered in a fundamental change in investor attitudes towards agriculture in Russia. "When you hear the words ‘agriculture’ and ‘Russia’ in the same sentence, you tend to take notice now," says Michail Kart, managing partner at hedge fund group Marcuard Spectrum.

James Fenkner, managing partner at Red Star Asset Management, says that given Russia’s massive land reserves there is certainly scope for the creation of a big agri-business company in Russia. "One of the agricultural companies out there could become the Archer Daniels Midland of Russia," he says, referring to the US agribusiness group, which is the global market leader and boasts a $25 billion market capitalization.

Ferguson at Nomura in London agrees. "It’s perfectly feasible that by 2015 you could see a Russian agricultural company with a market capitalization of $10 billion or more given the ability to scale up operations in Russia."

Although the sheer size of Russia creates its own logistics problems, it’s the availability of cheap, easily cultivable farmland that is exciting investor interest. At an average $500 per hectare, Russian agricultural land is much cheaper than the $2,000 to $3,000 average for central and eastern Europe and a positive snip compared with the $15,000 to $30,000 common in western Europe. What’s more, there is plenty of it. Estimates vary but a consensus figure would suggest there is at least 40 million hectares of arable land lying fallow in Russia. Bringing that up to full production could cost between $40 billion and $60 billion depending on the quality of the land. But with wheat prices at $500 a tonne and rising, for example, agriculture in Russia could conceivably become a trillion rather than a billion dollar play. "We are talking about a massive, strategically important industry," says Ferguson.

As of now, none of the agricultural companies in Russia even remotely approaches the scale of Archer Daniels Midland but there is certainly no lack of ambition among those looking to position themselves as the agricultural play of choice in Russia.

Transforming perception

The company that has captured investors’ imaginations in recent months is Black Earth Farming. Founded in 2005, it has developed from greenfield start-up to an internationally listed public company with a $1 billion-plus market cap in what in farming terms is a twinkling of the eye. Formed by a former private equity banker, Michel Orlov, Black Earth Farming is trying to do what nobody has attempted before – to transform the popular perception of Russian agriculture as being a backward, twilight year industry into the high-tech, high-yield sector of the future.

At a time when other Russian initial public offerings were falling by the wayside, Black Earth Farming’s flotation on the First North Stockholm section of the OMX exchange in Sweden in the run-up to Christmas 2007 romped home. At the equivalent of roughly $300 million, it was the largest ever European IPO in the agricultural sector. Marketed at a range of SKr43 to SKr53, the offer priced towards the upper end of the range at SKr50, attracting a strong institutional and retail following. The deal defied the global bear market for equities at the start of the year, as the shares soared to SKr73 by the end of February, before succumbing to a softening in wheat futures to trade at SKr60.25 by mid-April – up 20% since listing versus a 5% fall for the benchmark Russian RTS exchange over the same period.

"We thought the IPO pricing was pretty ambitious, but the stock has performed well on the back of strong demand," concedes Thies Ziemke, a director at Parus Kreml Capital Management.

Investors expect that in the wake of the Black Earth Farming IPO there will be a series of copycat issues from companies looking to mimic its success. "We’re hearing a lot of stories about people looking to put together Black Earth Farming-type businesses," says Kevin Dougherty, portfolio manager at Pharos Financial Group.

For his part, Black Earth Farming’s Orlov relishes the prospect of increased competition. "We look forward to other people trying the same business model – we are more than happy to be the industry benchmark."

Although the business model pursued by Black Earth Farming is simple in theory, there are concerns about its viability in practice. "Agriculture in Russia is not simple," says Ivan Nikolaev, consumer analyst at investment bank Renaissance Capital. "Labour and labour productivity is a key problem." He adds that even experienced Russian farming groups such as Razgulay have struggled to match the yields produced by their international peers. "The average sugar beet yield in Russia is 28 tonnes per hectare, while Razgulay manages 34 tonnes per hectare. But in western Europe the figure is 56 tonnes per hectare." Nikolaev says that traditionally farm workers in Russia have been poorly paid and consequently poorly motivated. "There’s a Russian saying ‘I’ll pretend to work, if you’ll pretend to pay me’ which sums up the situation." He says that by paying higher than average wages, Razgulay has built up a pool of skilled, motivated labour but this has come at a cost to bottom-line profits.