Gazprom once symbolised Russia’s claim to be an energy superpower but is losing its hold

June 5, 2013 6:44 pm

A cap on Gazprom’s ambitions

By Guy Chazan and Neil Buckley

Gazprom once symbolised Russia’s claim to be an energy superpower but is losing its hold

It is more than 20 years since Lithuania broke free from the Soviet Union. But the Baltic state remains tethered to Moscow, relying on Gazprom, the Russian state-controlled energy group, for its gas.

Now, aided by new EU rules, Lithuania is fighting to shake off Gazprom’s grip. Its way of doing so illustrates the challenges confronting Russia’s energy champion in Europe, its biggest market.Lithuania is restructuring its national gas utility, which is 37 per cent-owned by Gazprom, spinning off its pipeline network into a new state-owned entity. It is doing so under EU rules designed to increase competition in the energy sector by forcing companies to separate supply from transmission. Gazprom must sell its stake in the pipeline company by October 2014.

A country of only 3m people, Lithuania has long claimed that Russia is charging it too much for its gas. Taking control of its pipelines is only part of a broader drive to reduce its dependence on Russia as it looks for alternative and cheaper supplies. It is also constructing a liquefied natural gas terminal on the Baltic to tap increasingly plentiful shipments of the supercooled fuel.

The pipeline moves have proved contentious, with Gazprom and Lithuania embroiled in international arbitration. The Russian group reportedly offered to cut prices by 20 per cent if Lithuania delayed the spin-off. Lithuania is standing firm.

“Russia is shooting itself in the foot,” Dalia Grybauskaite, Lithuania’s president, said recently. Linking gas prices to political demands was, she said, an “absolutely outdated, 30-year-old method”.

Gazprom says a principle is at stake. “They’re trying to expropriate our assets without even discussing compensation,” Alexander Medvedev, Gazprom’s deputy chief executive and head of its export arm, tells the Financial Times.

But Lithuania is just one of Gazprom’s many problems. Wherever it turns in Europe – by far the biggest contributor to its $38bn net profit last year – it faces difficulties. Often, they are the result of the US shale gas boom of the past decade that has sent shockwaves through the global energy market.

Gazprom has been forced to cut prices to its western customers and is being investigated by the EU for suspected market abuse. At home, it is facing growing competition and may lose its treasured monopoly on gas exports.

“Gazprom is a stagnating company,” says Igor Mikhailov, portfolio manager at Uralsib, a Moscow investment bank. “It’s losing market share inside Russia, its negotiating power in Europe is waning and it spends all its cash flow on big projects that don’t add value.”

The new challenges could threaten Russia’s entire energy model. Gazprom contributes about 8 per cent of economic output and 20 per cent of budget revenues. As such, it supplies a large chunk of the natural resource rents on which Vladimir Putin, the Russian president, relies.

The company’s decline represents a remarkable fall for a one-time heavyweight. In its pomp, Gazprom symbolised Russia’s claim to be an energy superpower and swaggered on the world stage. It threatened customers in Europe and Russia’s former Soviet neighbours and twice cut off the gas to Ukraine in pricing disputes – a step that left thousands of eastern Europeans shivering in their beds.

In 2008, Alexei Miller, the chief executive, predicted Gazprom’s market capitalisation would be $1tn by 2015, making it the world’s most valuable company. The boast did not seem too far-fetched. Sitting on a sixth of the world’s natural gas reserves, Gazprom was already one of the world’s five biggest companies, worth more than $250bn.

Today, its market value is $90bn, its shares at the lows to which they tumbled in 2009 after Russian stocks lost three-quarters of their value in the global financial crisis. It has been hit by changes in the gas sector that have upended energy markets and challenged the old ways of doing business – not least the US shale boom.

Shale was a phenomenon Gazprom was not prepared for. As late as 2010, Mr Miller spoke of the “myths” of “shale fever”. Others told it not to underestimate the transformation.

One western oil banker says he warned Gazprom’s top managers about shale four years ago but was given short shrift. “I sat in a room with the best and brightest in Gazprom and they said: ‘That’s North America, why should it worry us?’” he says. “I told them if this thing keeps going, the US will surpass Russia in gas production – and it did. They were asleep at the wheel.”

He cites as an example the fate of Shtokman, a huge gasfield in the Barents Sea. Gazprom had intended to sell gas from there in the US but, with plentiful stocks of domestic shale gas, the US does not need it. Last month, Gazprom officially shelved Shtokman, leaving it “for future generations”.

Although shale gas production in Europe has been slow to take off, the US boom is already indirectly affecting European markets. Late last decade, with the US drowning in gas, cargoes of LNG it no longer needed were diverted to Europe, creating a competitively priced alternative to Russian gas.

. . .

The heightened competition triggered intense scrutiny of Gazprom’s pricing. The company sells gas to big European customers under long-term contracts indexed to the price of oil. Take-or-pay provisions mean buyers have to pay a penalty if they fail to take minimum volumes stipulated in their contracts.

Suddenly European utilities, already hit by the financial crisis and plummeting demand, began insisting on changes. When they did not get them, they took Gazprom to arbitration. The company made steep discounts and indexed a proportion of its sales to spot prices.

Last year it had to pay $3.2bn in refunds to its European customers and expects to cough up as much as $900m this year.

Gazprom has said it will make no more concessions on oil-indexed prices. But others have shown more flexibility – and seen their market share grow. Since 2009, Norway’s Statoil has renegotiated 80 per cent of its gas supply contracts, reducing the oil-indexed element. As a result, the company enjoyed record high gas sales to Europe last year as Gazprom’s sales fell.

The US shale boom has had other knock-on effects. European utilities are burning cheap American coal displaced from its domestic market by US shale gas. The result is that European gas demand, already softened by recession, declined by 8 per cent in 2011 and by a further 2 per cent last year. That, too, has dented Gazprom’s sales.

But even more significant changes lie ahead. Soon, North America will start exporting gas in the form of LNG, possibly to Europe. In a potential sign of things to come, Eon, the German utility and one of Gazprom’s oldest customers, recently signed a deal with Pieridae Energy of Canada to import LNG from a plant that will be built on Canada’s Atlantic coast.

Many think Gazprom will simply have to bow to the inevitable and break from oil indexing to preserve its market share. “The gas business will change dramatically in the years to come,” says Antonio Brufau, chief executive of Spain’s Repsol. “Oil and gas prices will have to decouple. All new contracts should be linked to indexes other than oil.”

As if the competitive challenges were not enough, Gazprom also faces regulatory problems. Last September, EU antitrust authorities opened a formal investigation into suspected market abuses by the company, focusing on whether it used its dominant position in the European gas market to thwart competitors and push up prices in central and eastern Europe. Mr Medvedev says the accusations are groundless and accuses the EU of “political posturing”. Many competition lawyers believe the results of the probe, expected in six to 12 months, could be far-reaching.

Its relationship with its single biggest customer, Ukraine, has also come under strain. Ukraine last year reduced its gas imports below its minimum take-or-pay volumes. The company slapped it with a $7bn bill for the gas. Kiev did not take delivery and refuses to pay.

At home, Gazprom was once considered unassailable. But in recent years, other companies have been allowed to exploit opportunities provided by Russia’s massive gas reserves. For example, Novatek, an independent producer, has poached some of Gazprom’s biggest industrial customers.

Few things symbolise the new dispensation better than Vlada Rusakova. Once a member of the Gazprom executive team, she was recently poached by Rosneft to become its new head of gas strategy. At a roadshow in April she told investors that Rosneft would take 20 per cent of the domestic gas market by 2020, producing as much as 100bn cubic metres a year. The Kremlin is now weighing proposals that would allow Novatek and Rosneft to export LNG, a move that would breach Gazprom’s gas export monopoly.

. . .

Gazprom’s financial position is not rosy. Its profit plunged 9.5 per cent last year, the first fall in more than a decade, amid weak gas demand in Europe and rising operating costs. The company is investing billions of dollars in new fields to offset declines in its traditional producing areas but has little to show for it. Last year its gas production fell.

The company has also taken flak for big construction projects, such as the $21bn South Stream pipeline between southern Russia and Europe, which would bypass Ukraine. Some investors say the venture, which is not tapping new markets, will add little value.

Gazprom insists it is turning a corner. It expects its exports to Europe to rise by 9.4 per cent to 151.8bn cubic metres this year. Mr Medvedev sees its market share in Europe increasing from 26 per cent last year to 30-32 per cent by 2025-30. “After the price correction, our gas is absolutely competitive,” he says.

Gazprom’s export chief likes to cite what he calls conservative estimates that in 10 years Europe will have to import an extra 110bn cubic metres a year of gas as the economy recovers and polluting coal-fired power stations are replaced by gas plants.

But supply could also increase substantially, meaning more competition for Russian pipeline exports. Jonathan Stern, chairman of the natural gas research programme at the Oxford Institute for Energy Studies, says: “There’s a possibility that in the second half of the decade a huge amount of LNG will enter the market as Australian and US export projects, and later east Africa, come on stream.” Meanwhile, as Japan reopens nuclear power stations that were shut down after the 2011 Fukushima disaster, “a lot of that LNG will come to Europe”.

None of that seems to bother Mr Medvedev. “Gazprom will continue to play a leading role as a gas exporter,” he asserts. “As The Beatles sang, ‘All you need is gas’.”

Eastern programme offers hope

Gazprom may be struggling in Europe but on the other side of the world its prospects are much brighter.

After years of talks, it is close to a gas supply deal with Beijing. China is an attractive market: it is on Russia’s doorstep and has experienced a huge increase in gas demand.

In March a 30-year memorandum of understanding was signed under whichGazprom will supply China with at least 38bn cubic metres of gas a year from new fields in eastern Siberia, starting in 2018. The gas will be delivered through a 3,200km pipeline that is to run from the snowy wastes of Yakutia to Russia’s Pacific port of Vladivostok, with a spur to China. Final documents are to be signed by the end of 2013.

The deal is part of Gazprom’s so-called eastern programme, a push to improve its position in Asian markets. As part of that drive, it is planning to build a liquefied natural gas plant in Vladivostok. The first phase of the plant is due to come on line in 2018.

But despite progress with the Chinese on direct shipments, there is still no agreement on price, long a sticking point in the negotiations. Gazprom is under pressure to give ground. Since the talks started, China’s import options have improved significantly, with new pipelines from central Asia and LNG supply deals signed with Australia and others. China is also eager to develop its own shale gas reserves, which are thought to be huge.

In addition, there are doubts about Gazprom’s ability to start producing from its new Siberian fields by the 2018 deadline. The fields, such as the mammoth Kovykta, lie in remote areas with little infrastructure and will require billions of dollars of investment.

Some analysts are sceptical that the China supply deal will materialise. “They have been blowing hot and cold on that pipeline scheme for a very long time,” says Howard Rogers of the Oxford Institute for Energy Studies.

In spite of the challenges, says Mr Rogers, the idea of supplying China with gas from fields such as Kovykta does make sense. “There’s nowhere else for it to go,” he adds.

About bambooinnovator
Kee Koon Boon (“KB”) is the co-founder and director of HERO Investment Management which provides specialized fund management and investment advisory services to the ARCHEA Asia HERO Innovators Fund (www.heroinnovator.com), the only Asian SMID-cap tech-focused fund in the industry. KB is an internationally featured investor rooted in the principles of value investing for over a decade as a fund manager and analyst in the Asian capital markets who started his career at a boutique hedge fund in Singapore where he was with the firm since 2002 and was also part of the core investment committee in significantly outperforming the index in the 10-year-plus-old flagship Asian fund. He was also the portfolio manager for Asia-Pacific equities at Korea’s largest mutual fund company. Prior to setting up the H.E.R.O. Innovators Fund, KB was the Chief Investment Officer & CEO of a Singapore Registered Fund Management Company (RFMC) where he is responsible for listed Asian equity investments. KB had taught accounting at the Singapore Management University (SMU) as a faculty member and also pioneered the 15-week course on Accounting Fraud in Asia as an official module at SMU. KB remains grateful and honored to be invited by Singapore’s financial regulator Monetary Authority of Singapore (MAS) to present to their top management team about implementing a world’s first fact-based forward-looking fraud detection framework to bring about benefits for the capital markets in Singapore and for the public and investment community. KB also served the community in sharing his insights in writing articles about value investing and corporate governance in the media that include Business Times, Straits Times, Jakarta Post, Manual of Ideas, Investopedia, TedXWallStreet. He had also presented in top investment, banking and finance conferences in America, Italy, Sydney, Cape Town, HK, China. He has trained CEOs, entrepreneurs, CFOs, management executives in business strategy & business model innovation in Singapore, HK and China.

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