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Russian domestic battlefield

Rosneft and Novatek are biting at Gazprom's heels in the domestic market. Its focus is international

Gazprom has dominated Russia's gas industry for decades. Now, as Rosneft and Novatek encroach on its territory, the domestic market looks increasingly like an afterthought for the firm.

Three of the company's top executives were in Hong Kong on 2 March for an investor day titled Strong Foothold in Challenging Times. Just one of the 50 slides shown to investors was dedicated to Gazprom's domestic market.

Alternative producers are outstripping the monopoly in terms of production growth rates while Gazprom is focusing most of its energies on protecting its market share in Europe. About half of Gazprom's gas is sold domestically—but it only represents about 23% of its sales revenue.

"The Russian market is just not a priority for Gazprom," says Alexei Kokin, a senior oil analyst at UralSib Bank.

That's not true for Gazprom's local rivals. In just three years, Rosneft has tripled its production and built an effective gas-marketing platform. It has overtaken Novatek to become the country's second-biggest producer.

Both companies have increased their market share in Russia's regions using a tried technique: cheap gas. They offer supplies to consumers at a discount to the regulated minimum price. Gazprom can't—it has to sell its product at a minimum price. It's one reason its sales volumes are waning.

In 2000, Gazprom controlled 90% of Russia's gas output. For the past eight years, it has shed market share to the tune of 2% a year, and stands at just 65% now. Analysts expect Gazprom will control just half of the market by 2020.

Gazprom even intends to raise domestic gas prices by 3-3.5% over the next few years—hardly a method of defending market share, even if Andrei Kruglov, deputy chairman of the board of Gazprom, says the new tariffs will rise at a slower rate than inflation.

2% - annual loss of Gazprom's domestic market share in past eight years

He has a better solution. Kruglov says the company is seeking approval to offer discounts of up to 10% for its large customers. "This issue is being considered and we expect that we will be heard," he told investors in Hong Kong.

The gap in price between exports to Europe and domestic clients has always been wide; exports can fetch as much as three times their local price. This has allowed Gazprom to subsidise its home market with revenues from European customers. But this model is looking increasingly unsustainable given the queue of costly greenfield development projects and the scarcity of cheap financing for the Russian monopoly. Potential cheap exports to Europe from the US are also weighing on Gazprom's strategy.

The Russian upstream isn't holding back. Output this year is expected to reach 0.64 trillion cubic metres, up slightly by 0.5 trillion cm in 2016, according to the Ministry of Energy. Production is tipped to increase further, to almost 0.65 trillion cm in 2018, and to nearly 0.7 trillion cm 2019.

Rosneft and Novatek will account for most of the increment—although the ministry's estimates depend on economic growth and therefore stronger demand. Exports were strong in 2016, but might tail off slightly this year, the ministry thinks.

Looming market threats

Gazprom's other problem is Rosneft's and Novatek's efforts to break its near-monopoly on exports. Gazprom, irritated by the threat, has lobbied the government to argue that if the two firms are allowed to export gas, it should be allowed to sell domestic gas at unregulated prices.

The Federal Anti-Monopoly Service (FAS), which has been advocating gas liberalisation, is implementing a pilot project to change the state regulation of gas prices in the Khanty-Mansiysk Autonomous Okrug Region and Tyumen Region. These regions account for the bulk of gas production in Russia.

The market may be fully liberalised in the next three years, according to the watchdog. Still, Gazprom argues that these regions cannot serve as reliable indicators, because they are located too close to areas of gas production. Instead, Gazprom has proposed 10 regions with different models of gas consumption for a trial to deregulate pricing for industrial consumers.

The government is attempting to use the St Petersburg International Mercantile Exchange (Spimex) to help Russia develop its own pricing for both gas and oil, though analysts say that the liquidity may not be deep enough to form a benchmark gas price.

Gas producers will be obliged to sell as much as 10% of their output on the bourse. Alexei Rybnikov, chief executive of Spimex, told Petroleum Economist in November the creation of a natural gas index had been delayed due to their focus on establishing a benchmark for Russian crude.

While this domestic debate rumbles on, Gazprom is optimising its capex programme to cope with economic challenges, focusing on core strategic projects such as Nord Stream 2 (to Germany) and Power of Siberia, which will deliver gas from the Yakutia and Irkutsk to Russia's east and China.

The company plans investments of $0.664bn to explore offshore blocks in 2017, compared with $0.541bn spent in 2016, according to Sergei Donskoi, the natural resources minister. Gazprom's overall investment this year is expected to reach $16bn, compared with $14.8bn in 2016. Several major projects are either running behind schedule or have been delayed.

Novatek is expected to release its first strategic plan since 2011 later this year. Its focus will be maintaining its domestic gas market share and beefing up liquefied natural gas. Its flagship project, Yamal LNG, should launch its first 5.5m tonnes-a-year train this year. But it also wants to buy four Yamal gasfields from Gazprom—feedstock for a plan to make Yamal LNG a world-scale exporter.

"If accomplished with as little of its own financing as possible, this could once again transform Novatek's investment case, almost regardless of the state of the global gas market," says Alex Fak, senior energy analyst at Sberbank CIB.

Still, Gazprom's rivals have much catching up to do. Rosneft overtook Novatek last year to become the second-largest gas producer, with output of 67.1bn cm (mostly from Rospan and former Itera's gasfields). Its target is 100bn cm/y by 2020, which analysts say is unlikely to be achieved organically. And even if the target is reached, it will be a fraction of the 418bn cm Gazprom produced in 2015.

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