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Russia's gas champion Gazprom under pressure

Shifting global fundamentals have weakened Russia's gas champion. A shake-up may be on the cards

While the Russian government denied in May that it was planning to split Gazprom, there is no doubt the state-controlled gas monopoly remains under intense pressure both at home and abroad.

It's hard to pinpoint exactly when it all started to go wrong for Gazprom, which has long held a sacrosanct position in Russia's state-owned corporate firmament. Russian President Vladimir Putin went so far as to say at the company's 10th anniversary bash in 2003 that the company was an "explicit tool of foreign policy".

But since 2007, when, in a moment of hubris, Gazprom chief executive Alexei Miller promised to create the world's first $1 trillion company, the firm has seen its market capitalisation drop from a peak of $360bn to $92bn today.

That year marked the beginning of the financial crisis in the US and what has turned into a perfect storm for Gazprom. The subsequent drop in demand for gas as the global crisis took hold in 2008 also coincided with the rise in shale-gas production in the US, turning that country into a net exporter of gas for the first time.

This diverted cheaper liquefied natural gas (LNG) cargoes to other markets in the world, including Europe, which according to Eurostat relies on Gazprom for roughly a quarter of its gas needs, or about 124bn cubic metres (cm) annually.

From a peak in the first half of 2008, US gas prices have fallen from about $13 per million British thermal units (Btu) to around $4/m Btu today. "The reasons for Gazprom's change of fortune are myriad and complex, but the simplest immediate answer is that new sources of natural gas are shortly coming online, broadening EU options," says John Daly, chief analyst for Oilprice.com.

This has had knock-on effects. Europe has felt emboldened to take on Gazprom, which is under investigation by the European Commission over alleged unfair competition and price fixing, while European states have demanded rebates running into the billions of euros.

The Russian company's pricing model of linking gas to oil was dealt a further blow in June when an arbitration court ruled that Gazprom had charged RWE, a big German utility, too much for its gas from May 2010 and it needed to introduce market rates for the fuel. In the same month, Gazprom revealed it would cut the lucrative take-or-pay requirements for major domestic customers as it looks to renew contracts this year.

Inevitably, all this has eaten into profits for the world's largest gas producer and holder of about 18% of global gas reserves.

In 2012, its net income fell 9.5% to 1.18 trillion rubles ($38bn), the first decline in more than a decade, and many analysts expect profits to fall again this year.

Nor are things going much better for Gazprom's oil subsidiary Gazprom Neft, which saw its net profit fall by 18% year-on-year during the first quarter of 2013.

Even so, the company continues to acquire assets in a headlong expansion that worries some. "The company's plans to expand into Latin America, West Africa and other international markets look the most alarming to us, as the historical track record indicates that Russian oil companies are rarely successful when it comes to international M&A," said VTB Capital earlier this year in a note to investors.

The Gazprom group has ongoing foreign exploration projects in Vietnam, India, Libya, Algeria and Iraq, as well as Uzbekistan, Kyrgyzstan and Tajikistan.

Weaker standing

As Gazprom's economic clout has waned, so has its political usefulness. The government has tired of its profligacy (reports put the cost of its 20th anniversary celebrations this year at more than $1bn, much of it on staff bonuses) and inefficiency, and has indicated several times this year that a shake-up is imminent. Gazprom alone accounts for about 8% of Russia's GDP, and with economic growth proving hard to come by, the government needs to find ways of raising more revenue, making this cash cow an ideal target.

The first salvo was fired by the powerful head of the state-owned oil and gas firm Rosneft, Igor Sechin, who in February called for an end to Gazprom's total monopoly of gas exports, starting with liquefied natural gas (LNG) from offshore projects. Russia's energy minister, Alexander Novak, said on 9 June that legislation to liberalise LNG exports is planned to come into effect from 1 January 2014.

"Amendments to the export law: will enable Novatek, Russia's second-largest gas producer, to proceed with plans to sell LNG from its $20 billion Yamal LNG project directly to buyers, bypassing Gazprom as an export agent," says IHS Global Insight, a research firm. "Rosneft and ExxonMobil have also recently unveiled plans for their own LNG project in Russia's Far East that would enable the Sakhalin-1 consortium to market its gas output directly to potential buyers in Asia."

With European demand feeble, Asia is now the crucial market for Russian gas. The country is, however, competing with Australia, the Middle East and perhaps eventually the US to supply it. On 17 July, Putin underlined Moscow's shift in energy policy toward Asia, saying that Russia needs to find a 'niche' in this fast-developing market. "The Asia-Pacific region is developing rapidly. Its consumption is growing rapidly, and Russia can play a prominent role," he said.

For that to happen, Gazprom needs to lose its export monopoly and Russia must tie up more deals, specifically with China. The latter is already happening; in June, independent gas producer Novatek signed an agreement to supply at least 3m tonnes of LNG annually to China, while China National Petroleum Corporation (CNPC) also agreed to buy a 20% stake in Novatek's Yamal-LNG project.

Yet Gazprom has consistently failed to sign a supply deal with China even though the two sides first signed a memorandum of understanding back in 2006, with the main sticking point being price. The Kremlin's move to allow other suppliers to sign deals with China has clearly spurred Gazprom into action. Miller said in June that a deal could be done as soon as September. The fall in Gazprom's share price is a clear sign of investors' disquiet, though they also appear confident enough in the company's financial strength to continue funding it at attractive terms.

In July, the "Baa1/BBB" rated company successfully issued a £900m ($1.1bn), five-year bond, proving, say analysts, its ability to tap the debt capital markets in volatile times. "A better revenue outlook and lower than expected retroactive payments in 2013 should support group profitability," argues Apostolos Bantis of Commerzbank.

Big ideas

Gazprom's huge projects suck up a lot of the company's cash flow, some 75% on average, though the company's low leverage gives it the flexibility to adjust its capital spending to meet current market conditions.

And it's taking steps to cut spending; in 2012, Gazprom's group capital expenditure reached $43bn, a 13% decline from record high levels in 2011. Gazprom aims to achieve minimum internal rates of return of 12% for transportation-related projects and 15% for its upstream investments.

Gazprom's bonds continue to trade with higher spreads compared with its Latin American peers such as Petrobras and Pemex.

Given that Gazprom has a stronger operational profile, Bantis says most of the extra premium reflects concerns about corporate governance - clearly something that both the Kremlin and the firm's management have decided needs to be urgently addressed. 

Table 1: Gazprom by the numbers
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