Betting on the Russian farm

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Aug 5th, 2008 (Reuters) - Murat Shamshinurov (L) general director of Nastyusha Black Earth, and Valery Yurov, executive director of Nastyusha-Petrovsky farm, inspect wheat prior to harvesting in the village of Petrovsky, Lipetsk region, July 16, 2008. (Reuters)

Institutional Investor | 08 Jan 2009

Jonathan Kandell

Foreign investors are restoring Russia's role as one of Europe’s leading breadbaskets.

It is mid-September in the Black Earth region of southern Russia, and the fertile, gently rolling farmland stretches to the horizon. On a 212-hectare (525-acre) field surrounded by rows of white birch trees, a John Deere tractor pulls a red-and-white seeder sowing winter wheat. Swallows dart behind, feeding on insects stirred up by the rumbling machines. In the nearby village of Stanovoye, brick-and-wood homes have been repaired and painted in bright pastels. Their gardens are flush with cabbages and sunflowers. Plump geese waddle down the freshly paved streets, while cows graze in nearby meadows. An indoor swimming pool has just opened at the local school, for use by students and the community. The local Russian Orthodox church sports a shiny onion dome that towers over the town. "All of this is recent," says Vladimir Gerasimov, mayor of the Stanovoye district, some 330 kilometers south of Moscow near the Ukraine border. "Ten years ago the farming situation was horrible."

Back then this tradition-rich region was on its knees. The giant state agricultural collectives of the Soviet era were all but bankrupt; their ancient equipment was in disrepair, and their land stood largely fallow. Young people fled to urban areas, leaving behind aging parents, decrepit farmhouses and weed-choked gardens.

Today, however, the region has burst to life. The capitalist upheaval that years ago began sweeping through Russia’s big cities and oil and gas fields has finally made its way to the country’s rural heartland. Newly imported tractors and harvesters with the latest ground-positioning satellite systems navigate vast privatized estates, producing bumper crops of wheat, barley, rapeseed, sugar beets and corn. Shedding its reputation for agrarian inefficiency, Russia now ranks as the world’s third-largest wheat exporter. The country shipped abroad an estimated 11 million metric tons of wheat in the 12 months ended May 31, 2008, trailing the U.S. (29.5 million) and Canada (13.7 million) and just ahead of Argentina (10 million), according to the Food and Agricultural Policy Research Institute (Fapri) at Iowa State University in Ames. "Our projections for the next ten years show a definite upward trend in Russian wheat production and exports," notes Simla Tokgöz, a grain analyst at the institute.

Foreign investment has played a key role in the revival. Rising prices for agricultural commodities and a liberal stance by the Russian government have spurred an influx of investment by foreign companies as well as Russian oligarchs. Over the past four years, foreign investors — led by Scandinavians — have snapped up more than 1.5 million acres of the Black Earth region. "We are seeing a land grab bigger than anywhere else in the world, and it has attracted a mighty cast of characters," says Kingsmill Bond, chief strategist at Troika Dialog, a Moscow brokerage firm.

It remains to be seen how durable this rural recovery will be, though. The global financial crisis has battered Russia as severely as any of the world’s emerging-markets economies in recent months, sending stock prices plummeting and sparking fears about the country’s banks. The government has propped up the banking system with 450 billion rubles ($15 billion) in loans, set aside $50 billion to help Russian companies service foreign debts and allowed the ruble to depreciate after having spent more than $100 billion of reserves to defend it.

The harsh investment climate is hitting the farm sector with full force. Since the summer a combination of falling grain prices and scarce capital has prompted foreign companies to slow or halt their Russian expansion. "During the next year our focus will be on controlling costs, not buying more land," says Sture Gustavsson, the newly appointed acting president of Black Earth Farming, a Swedish-owned company that is by far the largest foreign agricultural investor in Russia, with 330,000 hectares — an area one quarter larger than Luxembourg — of farmland in southern Russia, including tracts in the Stanovoye district. Gustavsson, an agronomist, took over in November after Black Earth Farming’s charismatic founder, Mikhail Orlov, resigned. "I’m not the sort of person who focuses on details," Orlov says of his decision to step down. "What is needed now is somebody who can consolidate what I put together and take the company to the next phase."

Yet even as they slow their expansion, foreign investors continue to have a big impact on Russia’s farm sector. Foreign-owned ventures control an estimated 700,000 hectares of farmland, or 4.4 percent of the 16 million hectares in private hands. (The rest of Russia’s 110 million hectares of farmland are still under some form of cooperative or collective ownership.) The management, technology and financial resources of foreign investors have enabled them to achieve wheat yields that are more than double the 1.85 tons a hectare reaped by collective farms. The higher yields helped Russia raise wheat production to 56.1 million tons in the 12 months ended May 31, 2008, up from 49.4 million tons a year earlier.

The dramatic increase is helping Russia turn the page on its collectivist past and return to its historic role as one of Europe’s leading breadbaskets. In czarist times the country often led the world in wheat exports. Although the Soviet era produced some big harvests, output was uneven at best, and the country in some years has been among the world’s biggest grain importers.

After the collapse of the Soviet Union in 1991, the Russian government of president Boris Yeltsin tried to break up the state collectives by giving farm workers vouchers for their land in the hopes that they would become small, private farmers. But farming is capital-intensive, and few workers were able to fulfill that vision. Private investors have purchased vouchers for about 16 million hectares, according to Agriculture Ministry figures.

Even for well-heeled investors, Russian farming poses mounting risks. Grain prices are dropping from recent record highs. According to Fapri, the world wheat price, which reached $313.55 per metric ton in 2008, is projected to decrease to $251.28 per metric ton next year. Meanwhile, the global credit crunch is shrinking access to capital. Russia’s recent invasion of Georgia, furthermore, has scared off foreign investors. "Like other businesses, agriculture is being punished by high domestic inflation, a commodities cycle that is turning over and generally unfriendly policies by the government, whether toward Russia’s neighbors or corporations," notes James Fenkner, chairman of Red Star Asset Management, a Moscow-based hedge fund.

Moreover, there are concerns that as agricultural investments by foreigners become increasingly profitable, they will be squeezed by the government and the oligarchs, as happened in recent years with some foreign oil and gas ventures.

But for now foreign investors, government officials and farmers are enjoying a rural honeymoon. Private agricultural companies, both domestic and foreign-owned, are behind the transformation. One of the biggest is Black Earth Farming, whose Russian subsidiaries operate under the name Agro-Invest. It owns two farms in Stanovoye district totaling 20,800 hectares and employing 144 local villagers. "The farms here used to be part of collectives, and more than half of the land was fallow when we bought it," says Victor Fefelov, the local Agro-Invest manager.

Black Earth Farming is the brainchild of Orlov, 42. He was born Michel Orloff in Lausanne, Switzerland, with noble pedigrees on both sides of his family. His paternal grandfather, Prince Orlov, was a favorite of the last czar, Nicholas II, and fought in the White Russian army against the Bolsheviks before going into exile in Switzerland in 1921. Orlov owes his round face, stocky torso and dark Middle Eastern complexion to his maternal grandfather, King Farouk, the Egyptian monarch who was deposed in the 1952 pan-Arabist revolution led by Gamal Abdel Nasser.

Orlov moved to Moscow in the mid-1990s to work in private equity and real estate, first as executive director of money manager Invesco, then as managing director of the Carlyle Group and finally as founder of real estate and private equity firm Bailington Investments. He closed that venture in 2004 to go into agriculture, inspired by family lore. "I remember my grandparents’ stories about the Russian countryside before the revolution," says Orlov, a Moscow resident who has taken Russian citizenship along with the Russian spelling of his name.

Orlov launched his seemingly quixotic quest with visits to the Black Earth region’s depressed villages and dismal collectives. In leaky-roofed assembly halls with mud-tracked floors, he laid out a vision of agrarian prosperity for Mother Russia: industrial-size private estates financed by foreign investors and powered by modern tractors and threshers; swollen harvests that would feed the nation and provide an exportable surplus; well-paying jobs to lift local communities out of poverty.

Slowly, the ebullient Orlov began to make headway with local officials like Stanovoye district mayor Gerasimov. A silver-haired career politician, Gerasimov, 57, at first doubted Orlov’s ambitions but decided to give him a chance. "I liked the idea his family was Russian and that he spoke the language so well," recalls Gerasimov. He liked even more Orlov’s promises of donations to the mayor’s pet projects, including judo schools, concerts by local folk musicians and beautification campaigns to plant flowers and trees along village streets. Agro-Invest agreed to create more jobs by expanding from grain production into far less profitable dairy farming. "We did it for political reasons — the mayor asked us to do so," says manager Fefelov.

With local opinion turning favorable, Orlov began amassing acreage. Land was cheap, but getting legal title to it was problematic. Beginning in the mid-1990s employees of collectives who had held their jobs for at least five years were each given a voucher for one to several hectares of farmland, depending on seniority. Because few former collective workers could afford to farm on their own, they were easily induced to sell their vouchers. But foreigners — or entities that were more than 50 percent foreign-owned — were legally forbidden to own Russian land. To circumvent these restrictions, Black Earth Farming and other foreign investors created Russian subsidiaries in which they had less than 50 percent ownership and consolidated them under a wholly owned holding company. The Russian subsidiaries then went about buying vouchers from former collective employees for as little as $90 a hectare when the land grab began in 2004.

Ana Klimova, 58, a retired collective employee from the outskirts of Stanovoye, is typical of the locals who sold their vouchers for a song. In 1978 she started working at Lenin’s Path Collective, large chunks of which are now Agro-Invest farmland, keeping the ledgers on wheat deliveries. Her husband drove a tractor. In the mid-1990s the collective ground to a halt, and the couple received a voucher for eight hectares. Her husband died, and Klimova retired three years ago. Unable to get by on her pension of 3,700 rubles ($148) a month, she sold her voucher Agro-Invest for 16,000 rubles in 2005. Her son and daughter have jobs with the company and help her out, so Klimova feels optimistic. "Life in the collective was awful, and young people moved to Moscow and other cities," she says. "Nowadays they are finding work here at good salaries."

With thousands of vouchers from villagers like Klimova, Orlov turned to wooing foreign investors. He argued that agriculture was a hitherto-ignored asset class in Russia and offered potentially strong cash flow, given rising world grain prices. "I was looking for anchor investors with nerve and capital to build up land acquisitions," explains Orlov. He received $7 million from two Swedish investment groups: Vostok Nafta Investment, with more than a dozen years of business experience in postcommunist Russia, took a 24.9 percent stake in Black Earth Farming, and Investment AB Kinnevik, with long involvement in agrarian ventures, bought a 19.4 percent interest. (Orlov holds 1.9 percent plus options to buy a further 1.1 percent.)

Vostok Nafta’s biggest coup in Russia was its 1995 purchase of a 1.5 percent stake in Gazprom, now worth about $1.4 billion, which makes the Swedish company the third-largest shareholder in the state-controlled Russian gas and oil giant. Per Brilioth, Vostok Nafta’s chief executive and chairman of Black Earth Farming, likens his firm’s approach to Russian agriculture to its Gazprom strategy. "They are both investments in very large assets that were undervalued because of the way in which they were being run," he notes.

The task of better managing Black Earth Farming’s land assets was largely entrusted to Kinnevik. For more than six decades, the company invested in Swedish farms of less than 100 hectares before venturing in 2001 into Poland, where it took over two former communist-era collectives totaling 6,700 hectares and turned them into profitable operations. Kinnevik applied the lessons it learned in Poland to Black Earth Farming’s much larger Russian land holdings. "We took over farms that had always focused on maximizing output," says Henrik Persson, Kinnevik’s head of investment. "Instead, we emphasized profitability by combining Western business practices with industrial-size farming."

With his two anchor investors in place, Orlov embarked on road shows in Finland, Sweden, Switzerland and the U.K., among other countries, in 2006 and 2007. As a highlight of his presentations, he would pass around the room a muddy clump of black earth, extolling its richness. "I wanted them to see and feel what they were sinking their money into," says Orlov. He raised $155 million with three private placements of shares between March 2006 and August 2007, and got a further $75 million through a bond issue. Then in December 2007, Black Earth Farming gathered an additional $295 million in an IPO and listed its shares on First North, an exchange for growth stocks operated by the Nasdaq OMX Nordic Exchange.

In 2007, Black Earth Farming posted a net loss of $15.8 million on revenues of $21.3 million, compared with a loss of $8.4 million and revenues of $501,000 in 2006, its first full year in business. With operations ramping up, the company harvested 437,127 tons of grain — mostly wheat and barley — in 2008, a fourfold increase from the previous year, but with grain prices falling sharply from their recent peaks, management decided to warehouse most of the crop in hopes of an upturn. The result was a loss of $5.0 million on revenues of $37.3 million for the first nine months of 2008. The company’s stock, which rose from an IPO price of 50.00 kronor ($7.71) to a high of Skr78.25 in February, fell back to Skr19.20 in late December.

Most of the growth in Black Earth Farming’s harvest comes from an almost threefold increase in cultivated land area, to 138,965 hectares from 52,781 in 2007. Thanks to high-tech equipment and more fertilizer, the company boosted yields of wheat, its most important crop, to 4.3 tons a hectare in 2008 from 3.3 tons in 2007; it aims to eventually increase yields to 5.0 tons a hectare, closer to the U.S. average of 6.4 tons. Yields of other crops also increased sharply. Wheat accounted for 50 percent of the company’s 2008 harvest and barley 33 percent; the rest was divided among rapeseed, sunflower seed, corn and forage crops.

Vast distances pose the biggest immediate challenge to operations. Black Earth Farming’s far-flung properties lie in ten clusters stretching from the Kursk region near Russia’s border with Ukraine to Tambov some 600 kilometers to the east. "Getting the right machines in the right place at the right time is a big logistical problem," notes Gustavsson, who was promoted to acting president after serving for two years as chief agronomist and director for the Kursk region.

One solution being considered by Black Earth Farming is to swap land with other companies to create as few as three main clusters. Some of the larger farm investment companies operating nearby include Sweden’s Alpcot Agro, with 145,000 hectares under its control; Denmark’s Trigon Agri, with 134,000 hectares in Russia and Ukraine; and Russia’s Agrico, with 102,000 hectares.

Black Earth Farming has gained some unwanted attention from Russian competitors and politicians. The company’s Swedish backers worry that they could be squeezed out in the same way that Western companies such as BP and Royal Dutch/Shell have been forced out of Russian oil and gas investments. "If they want your land, they will arrange to have it inspected," says Black Earth chairman Brilioth. "Something wrong will always be found, and somehow land ownership gets challenged."

To reduce these risks, Black Earth Farming in August hired Vasily Shestakov, a longtime confidant of Prime Minister Vladimir Putin and a ranking member of the Russian Parliament, or Duma, and made him chairman of the Agro-Invest advisory board. Shestakov is best known by outsiders as co-author with Putin of an illustrated book, Learning Judo with Vladimir Putin . The walls of his Duma office are covered with photos showing him with the prime minister. One, taken when the two were teenagers at a judo class in St. Petersburg (then Leningrad), shows the diminutive Putin flipping the burly Shestakov over his back. "We were both good and always on the same team," recalls Shestakov.

According to Shestakov, his role at Black Earth Farming is "to help establish good relations with local governments." He plays down the prospect of friction with Russian oligarchs who have become interested in agriculture. The most prominent of these is Yelena Baturina, the billionaire wife of the powerful mayor of Moscow, Yuri Luzhkov. Her agrarian company, Inteko-Agro, owns more than 72,000 hectares in the Belgorod region along the Ukrainian border, near a cluster of Black Earth Farming properties. "There should be competition between Russian and foreign investors for the good of our agriculture," asserts Shestakov. He also offers basic judo principles for Black Earth Farming: "Respect your opponent, and be prepared to take a step back to win."

The government may pose an even more formidable threat to private farming companies. The Ministry of Agriculture in July announced plans to transform its Agency for the Regulation of Food Markets into a trading corporation that would dominate 40 to 50 percent of grain exports. Such a move, warned a July 10 report by the agricultural attaché’s office at the U.S. Embassy in Moscow, "will be a giant step backward, essentially the latest in a series of industry renationalizations and a reversal of what till now has been one of Russia’s privatization success stories." Currently, more than half of grain exports are handled by foreign companies, led by Glencore International, a Swiss-based commodities trading firm founded by former U.S. fugitive Marc Rich.

Another long-term threat is that Russians will come to resent foreign investors owning large tracts of prime farmland. The European Bank for Reconstruction and Development supports the use of foreign capital to improve the efficiency of Russian farming and has invested €1.4 billion ($1.8 billion) in retail and processing operations in more than 50 agribusiness projects across Russia. "But at the same time, one would not want to provoke nationalist sentiments," says Sevki Acuner, London-based deputy director for agribusiness at the EBRD, which has steered clear of farmland ownership in Russia. "Huge foreign megaliths owning land will arouse resentment anywhere in the world."

The more coveted stretches of southern Russian farmland have multiplied in market value several times in the past four years and are already within 50 to 60 percent of the prices that farmland fetches in the U.S. and Western Europe. When Black Earth Farming began purchasing vouchers in 2005, prices averaged $150 a hectare. But now there are so few vouchers available that they are going for an average of $800, and that figure rises to $2,000 for land that is properly registered — a bureaucratic process involving lawyers and local notary publics that can take up two years before a foreign holding company gains ownership of the property. "But from the perspective of potential returns, the land should be selling for about $8,000 a hectare," notes Brilioth. "So there is definitely an upside."

That’s if foreigners are able to make the kind of investments that Black Earth Farming and Alpcot Agro have poured into equipment, fertilizer and management to improve yields. But the global credit crunch has become a major hurdle to such spending. "These operations are capital-intensive, and clearly capital isn’t easily available on the markets anymore," says Troika Dialog’s Bond.

There are already signs that turmoil in the global capital markets is affecting Russian agricultural ventures. In September, Alpcot Agro revised its year-end 2008 target for Russian farmland under its control from 200,000 hectares to 150,000 and postponed plans to launch an IPO, blaming "the current conditions and valuation levels on the capital market." Because of elevated costs, the company has thus far harvested only 54,000 hectares, barely a third of the land it controls.

Black Earth Farming harvests close to half of its 330,000 hectares. The company says it remains committed to amassing 400,000 hectares but has not set a date for reaching that target. Instead, it will focus on cultivating more of the land it already controls; it aims to boost productive acreage by 20 percent in 2009. "Eventually, we will be harvesting 80 to 90 percent of our land," asserts Brilioth.

Whether Black Earth Farming can reap profits as well remains to be seen.

Original source: Institutional Investor
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