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November 1, 2005

12 Min Read
International Molding Report: Tackling the Russian bear (Web-exclusive content)


Web-exclusive data: Telecommunications equipment
From January-November 2004, Russian cellular subscribers grew by 216%, fix-line connections jumped 6%, and Internet subscribers grew 35%.


Web-exclusive data: Automotive parts and aftermarket
In 2004 there were 23 million cars in Russia, 50% of which were 10 or more years old, and another 30% were between five and 10 years old.


Web-exclusive data: Oil and gas equipment
New discoveries and increased prices are dramatically increasing capital expenditures on upstream development, infrastructure, and rehabilitation equipment in Russia's oil and gas industries.


Web-exclusive data: Medical
Medical equipment imports, which now account for more than 70% of the market, are expected to grow as Russian medical facilities replace aging equipment.


Web-exclusive data: Computer hardware and software
Increased per capita incomes, budget surpluses, and increased corporate returns are all expected to continue to drive the Russian software and hardware markets.


Web-exclusive data: Agricultural machinery
In 2004, the Russian Ministry of Agriculture reported equipment shortfalls for tractors (46%), cultivators (37%), seeders (44%), forage harvesters (33%), and combine harvesters (35%).

There’s still a lot of Wild West uncertainty and risk in Russia, but the payoff potential is just as big. A molder willing to do the due diligence will find opportunity in this maturing market.

There are many political and economic reasons why North American molders might initially overlook this region of the world’s economy. However, for the brave of heart, Russia’s growing markets offer molders many opportunities.On one hand, Russia’s huge oil and gas reserves offer an undoubtedly strong lure to processors looking to reap the benefits of cheap energy products, and as Russians’ real disposable income continues to climb at rates around 9% in 2004—well above the 7.1% GDP growth witnessed during this same period—the Russian market appears ripe for exporters and domestic plastics processors.

Mitigating these promising factors are difficulties with Russia’s aging and underdeveloped transportation infrastructure, high taxes, and concerns over the quality of resins produced, as well as many other problems typically associated with developing economies.

Molders looking to expand into this region will need to carefully examine the potential problems and promises associated with this market. To help in this endeavor, here is a brief review of some of the more critical issues facing potential investors.

The Rosy Picture

Increased economic growth, now forecast to reach 5.7-6% in 2005, should continue to spur domestic consumption of consumer and industrial goods. This economic prosperity has helped boost retail sales by an impressive 12.1% in 2004, a trend that appears to have accelerated in 2005; August retail sales figures rose by an annual 12.2%. Molders can be confident that domestic plastic consumption, which to-date only amounts to 5 kg per capita annually, will benefit from this increased consumer spending.

The Russian consumer market also received additional support on June 17, when Russian legislatures approved a $1 billion spending plan intended to complement President Putin’s ambitious goal to double wages and pensions by 2008. Average gross monthly wages are estimated at around $260-$280, but wages vary greatly throughout Russia. In Moscow, for example, average wages are at least three times the national average.

Russia’s industrial sales in 2005 have also risen alongside growing output, albeit at a more moderate pace than in 2004. While the country’s banking system still has not come of age, average lending rates have steadily fallen over the last several years, measuring 10.4% in April 2005, down from 17.9% in 2001. As access to capital becomes more affordable for domestic producers, increased investment should help ensure continued expansion.

Just as important for molders exporting to this market, Russia’s bid for WTO membership will help reduce and eventually eliminate import tariffs on commodity plastics. Presently, import tariffs on resin range from 5-10%; this tax has hurt the development of many plastics-consuming industries, especially considering the inability of domestic suppliers to satisfy local demand. Similarly, if Russia’s WTO bid pans out, import duties for finished plastics goods like molded parts, which are currently taxed as high as 20%, should also fall substantially.

WTO membership also would provide Russian businesses with improved access to the services of key multilateral institutions, including easier access to foreign credit institutions—a key requirement for small- and medium-scale business expansion in many Russian markets.

A Different View

Despite these more promising signs, investors in this market will also have to contend with several factors that have discouraged investment and frustrated more diversified growth. These hurdles include:

  • Poor and ill-planned shipping infrastructure.

  • A constantly changing and confusing tax system.

  • Substandard quality of many domestic resins.

  • Insufficient access to business credit.

  • Rising production costs, which are currently outpacing similar improvements in productivity.

  • Dutch disease, an economic phenomenon in which a country exports a disproportionately high amount of one key commodity (oil in this case), and the resulting inflow of foreign money distorts the value of the exporting currency by causing it to appreciate well beyond its true value.

  • Corruption.

Russia’s aging road, rail, and port infrastructure has created a hindrance for manufacturers producing and selling in this market. As the market grows and attracts new investment, even greater demand is expected to exacerbate shipping logjams and boost transportation costs.

Russia’s antiquated transportation system places a particularly strenuous tax on plastics-consuming industries like molding. Due to Soviet-era politics, most of Russia’s 41 oil refineries and chemical plants (many in need of reconstruction and modernization) are situated far from their feedstocks and away from major seaports and industrial areas. The cost of these poor logistics gets incorporated into the price of Russian resins.

The Russian tax system remains a source of stress and confusion for many U.S. businesses. Yet some improvements are worth noting; for example, in 2004 the state eliminated the sales and natural gas excise taxes, and earlier legislation reduced corporate taxes on profits to 24%, and also granted regional authorities the discretion to lower that figure by another 4%.Of course, the Russian government also places a duty on its own exports, and these taxes can hurt global competitiveness and discourage foreign investment in new world-scale plants that are desperately needed to grow Russia’s plastics market. Russian resin production facilities, like most Russian refineries and other chemical plants, are generally in need of technological upgrades. As a result of these conditions, molders using higher-grade engineering plastics must for the most part rely on imported resins. However, the upgrade and reconstruction of Russia’s refineries and other petrochemical facilities have been outlined in initial government plans for economic development during 2005-2008.

While we don’t buy into the conclusion of the Dutch disease theory, huge inflows of petro-dollars have undoubtedly helped to raise the value of the Russian ruble, in effect making it more difficult for domestically produced goods to compete in local and global markets.

However, Russian manufacturers have also reaped many benefits from this energy trade. For instance, government revenue for oil and gas exports have helped reduce the tax burden on domestic businesses, and an appreciated ruble has made imported technology and other foreign inputs more affordable.

Understanding Renationalization

Obviously, much of Russia’s growth continues to be driven by the country’s enormous energy reserves; Russia is the world’s leading exporter of natural gas and second leading exporter of oil following Saudi Arabia, and has occasionally even taken the number one position. This abundance of cheap oil and gas naturally holds a great attraction for downstream petrochemical and resin producers, just as it has in the Middle East.

However, recent government maneuvers to regain control of the country’s energy sector have put nearly one-third of the nation’s oil output into state hands, and in the process have spooked many foreign investors inside and outside of the energy industry. Most notable among these maneuvers have been the government-forced auction of oil giant Yukos’ most valuable subsidiary, Yuganskneftegaz; the subsequent merger of state-controlled Rosneft and gas giant Gazprom; and Gazprom’s purchase of Sibneft. Still, these troubling moves should not be construed as any indication of further renationalization ambitions outside of the highly sensitive markets such as energy.

Like many of the world’s leading oil-exporting economies, the Russian market is characterized by its disproportionately high reliance on energy exports. World Bank estimates for 2003 suggest that the oil and gas sectors accounted for about 25% of the country’s GDP. This energy dependency makes the national economy vulnerable to global energy price fluctuations; for example, it’s estimated that a $1/bbl change in oil prices translates into a $1.4 billion change in Russian revenues.

Russian Resins

The desire to diversify has most naturally led many investors to eye downstream petrochemical industries like plastics. In 2005, there were plenty of examples of new investment in Russia’s plastics industry. In July, Lukoil announced that it had signed a deal with Dow Chemical, which would allow it to use Dow’s production technologies at its future 120,000-ton/year polypropylene plant in southern Russia. The newly privatized Polief also has plans to build an additional 120,000-ton/year PET production line.

This drive to expand has also been driven by Russia’s steadily increasing appetite for commodity plastics. At the ICIS-LOR Russia & CIS Plastics Conference in Moscow last June, industry experts forecasted that Russia’s growing demand for plastics would surpass current supply by 2006 or 2007. Currently, Russia’s existing PE, PP, and PVC production capacities are running at 88-97% utilization.

Russia’s domestic polystyrene market is a prime example of this blazing growth, with some projections forecasting that the market will triple over the next five years. Already, domestic PS output has grown 7.8% over the first eight months of 2005.Molders should expect, however, that Russia’s overall output of synthetic resin, which rose by 4.6% in 2004, will continue to cool in 2005. Already, industry figures show a decline of 2.6% from January to August of this year. This decline is largely attributed to capacity restraints, rising energy and labor costs, and the appreciation of the ruble. Despite an overall decline, production volumes in many areas like PVC (+3.4%), polymer film (+12.3%), and thermoplastic pipes and pipe components (+2.4%) still showed healthy growth.

All of these factors will have a mixed impact on molders looking to establish production facilities in Russia. On the one hand, Russia’s energy resources will offer producers access to relatively inexpensive energy (natural gas prices for Russian industrial producers are five times cheaper than in the United States and around three and a half times cheaper than the EU average; see chart).

On the other hand, the tight resin supplies and already high capacity rates will hold prices steady for the immediate future, and this when resin prices in other markets are experiencing mild relief. Longer-term prospects are brighter as increased investment in new resin production technologies and strong efforts to replace imported resins like PET with domestic production (current estimates are that Russia imports more than 80% of its PET) should help alleviate price and supply tensions, as should expected cuts in plastics import tariffs.

Targeting Demand

A look at the U.S. Foreign Commercial Service’s hot market picks will help North American molders better identify demand. Russia’s telecommunications equipment market should be of particular interest to North American molders as the country continues to upgrade outdated equipment and infrastructure. Estimates for 2004 value the market at $2.6 billion, of which U.S. imports accounted for $600 million. Cellular communications make up a significant portion of this market, as the number of cellular subscribers grew to 66.05 million by November 2004—a 216% increase over 2003 figures.

Automotive parts and aftermarket sales also offer much promise for molders. Over the past few years the general automotive market recorded annual growth rates between 10% and 15%. As Russia opens its market to comply with its future WTO obligations, U.S. competitors should be in a good position to compete against many of the country’s outdated manufacturers. U.S. producers can also target existing U.S. automotive operations in Russia as both Ford and GM have had facilities there since 2002.

Suppliers to oil and gas equipment manufacturers will no doubt benefit from plans to further develop the nation’s vast untapped oil and gas fields, as well as from efforts to upgrade and rehabilitate existing facilities. U.S. equipment imports were estimated at $570 million in 2004. The U.S. Commercial Service recommends that U.S. producers consider relocating production so as to cut labor and transportation costs.

The medical equipment and devices market is garnering even more attention in recent years, and not just for its steady growth rates, which have exceeded 10% annually. Speculation exists concerning how the government might spend some of its surplus revenues, now accumulating in the country’s fiscal stabilization fund. Designed to help ease the economic problems associated with a volatile energy market by stocking away excess petro-dollars, the fund has grown to more than 4% of the nation’s GDP. Many feel that the government will use some of this fund to upgrade the county’s aging healthcare facilities and equipment.Computer hardware and software is also expected to remain a hot market for U.S. manufacturers. Current forecasts suggest that the country’s IT market grew by 25% in 2004. The total number of computers in Russia was purported to be more than 13 million in January 2004; this represents a 9% penetration rate. Increasing per capita incomes are expected to drive this number upward over the remainder of 2005 and into 2006.

The agricultural machinery market also has benefited from increased personal income as growing retail sales have included food and beverage purchases. This increased appetite has strained local farmers burdened with outdated equipment. Limited domestic financing opportunities will give U.S. suppliers willing to offer financing a good opportunity to win new contacts. Industry reviews suggest a current market demand for around 180,000 additional machines.

Finally, the need to improve and expand the country’s transportation infrastructure should offer molders servicing the construction industries many new opportunities. Additionally, new legislation effective this year has made it more affordable to obtain a mortgage in Russia; coupled with rising wages, it is hoped that this new legislation will help spur the residential building market in Russia.

Contact information
The Repton Group LLC
New York, NY
Agostino von Hassell and Mark Bella
(212) 750-0824
[email protected]
[email protected]
www.thereptongroup.com

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