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Gazprom – Gas Company or Russia’s Battering Ram?

Don Wolcott and Michael J. Economides - 12/19/2009

In early September Russian President Dmitry Medvedev accused Ukraine of not playing by the rules, trying to change the contract for the natural gas transit to Western Europe across its territory. Earlier in August Ukranian Prime Minister Yulia Tymoshenko surprised everybody, apparently including the Russians, saying that Ukraine and Russia had sorted out all their differences in the energy sphere. This was after two traumatic and almost identical total cutoffs of natural gas flow in January 2006 and in January 2009. The critical issue is that conflict between Ukraine and Russia does not affect just Ukraine. It is a lot of the rest of Europe that freezes in the dark and future worry in the continent is not unfounded. Medvedev said that Moscow would not be sending a new ambassador to Kiev because of President Victor Yushchenko’s “anti-Russian” policies and was hoping for better relations after the January presidential election.

Gazprom, Russia’s natural gas monopoly and the vital commodity it controls have been used routinely as a political tool of the state, and although officially, Gazprom presents a dispute or deal as a pure business exercise, the pricing and transport are personally approved by the President of Russia and the real power holder, the ubiquitous Prime Minister and likely president again, Vladimir Putin. Gazprom’s natural gas is used by the Kremlin as a central element of its foreign policy, whether with the former Soviet republics or with Western Europe.

Gazprom and natural gas are God-sent for Russia and are used to cover up gaping deficiencies with massive influx of cash from energy hungry neighboring countries. They provide the vestiges of power that a dysfunctional economy and a highly corrupt state could not otherwise muster. The company has the largest gas reserves in the world by a wide margin: 1,172 trillion cubic feet (Tcf) of recoverable gas reserves, a 60 year supply based on current production. Even by far more stringent US definitions, which apply economic (time value of money) and license criteria, the number is still enormous, 781 Tcf, at least four times the reserves of the United States. Gazprom reserves-to-production (RP) ratio is one of the largest in the world. For example in the US the RP ratio has been for many decades approximately 10. The US industry is far more efficient and drills and develops more gas using more sophisticated technology.
Inefficient or not, Gazprom’s performance has been massive, producing 19.3 Tcf of gas in 2008, roughly equal to US production of 19.5 Tcf. The company is also a major oil producer with 870 thousand barrels of oil and condensate per day. In addition to gas and oil production Gazprom has another unique asset in Russia, a monopoly on gas transportation and distribution. In 2008, Gazprom’s activities accounted for 10% of Russia’s gross domestic product.

But not everything is rosy and quite a bit of it is dysfunctional. Over the last few years Gazprom has experienced a large gap between its stagnant production and internal and external commitments. The incentive and the capital to expand production are simply not there. Russian internal consumption is huge, larger per capita than the US by almost 25 percent. But prices have been practically giveaways, in some case less than $1 per million Btu, one tenth to one fifth of the price earned internationally. In the US the price, considered to be depressed, is five times larger. Increasing domestic prices has been the constant demand by Gazprom but the subject is understandably a politically explosive issue with Russian consumers.

The pressure on Gazprom was temporarily relieved by the recent economic slowdown and the demand destruction inside Russia. Industry has practically come to a standstill. But the day of reckoning is not far behind and capital for re-investment has been exacerbated by the fact that international prices have also dropped. The reasons are because of the economic slowdown but also because of massive gas supplies available in the form of liquid natural gas (LNG) mostly from Qatar which has emerged as the Saudi Arabia of natural gas.

The production gap, which three years ago and before the economic crisis we estimated to be at least 3.5 Tcf per year, looms even wider in the years ahead as the offers to external customers have grown, coupled with internal commitments exceeding projected output. Moscow’s solution has been to assign more production licenses to Gazprom. Because of limited domestic funds and the company’s inability to profitably develop the new licenses, the CEO, Alexei Miller, has been asking for tax holidays.

The reservoirs that Gazprom produces from are primarily located in the Yamalo-Nenets northern area of Western Siberia. They are large, high-permeability fields developed during Soviet times. They are dry gas accumulations (primarily methane) that have required little or no surface treatment making them some of the easiest fields in the world to manage. These fields during Soviet time and since have been a significant employer in the country. Production practices have been to drill the wells, hook them up, open the valve and employ more people per well than in any country except China. From 2006, where the company reached a peak production of 19.7 Tcf, production has declined to 19.3 Tcf in 2008 inspite of the fact that during that period capital spending increased to $23.8 billion, up 30% over 2007. For 2009, reflecting the economic downturn the company has planned to spend less. Operating expenses have also increased 26% year on year to $72 billion in 2008. Although the company is spending massively on capital projects there is curiously no increase in production or performance.

Gazprom’s market capitalization in January of this year dropped to as low as $85 billion, but has recovered to around $120 billion. This for a company that Alexi Miller boasted less than a year earlier that it was on its way to become the first trillion dollar company. In the summer of 2007 Gazprom’s deputy executive Alexander Medvedev (no relation to the President) announced the company would aim to achieve a market capitalization of $1 trillion dollars in a period of seven to ten years. He added: “we’d like to be the most valued and most capitalized company in the world”.

To compose the equivalent to Gazprom’s activities in the United States one would have to put together all natural gas producers, the pipeline companies and all the utility companies across the country as well as one of the major media companies and throw in a top bank. The US industry market capitalization of these companies is closer to $2 trillion.

To all observers, including many Russians, Gazprom would benefit enormously by divesting its assets and opening up to private capital and foreign companies. But habits of control and monopoly are hard to shed and a recent example offers stark evidence. In the government’s effort to add even more assets to Gazprom’s already enormous portfolio, in April 2008 the giant Chayanda field with 44 Tcf of gas and 513 million barrels of oil and condensate were transferred to Gazprom, with no competitive process.

Such a transfer would create a multibillion dollar company anywhere else. But in Gazprom’s case the market did not react to this massive infusion of reserves, and the company’s market capitalization did not change and no perceived market value was added. A principal factor is that with one of the largest RP ratios these reserves are simply added to those on the books already and simply further extending the RP ratio beyond 60 years. More reserves are not solving the problem of low market capitalization and flat or declining production.

Buying more assets through predatory lending practices, the favorite pastime of Gazprom bank, also does not get the market excited. The solution is painfully obvious: breaking the Gazprom conglomerate into individual industry segments, even still state controlled. Smaller companies, focused on industry segments, regional upstream gas, distribution, banking, media would obviously be more efficient. The market would reward the more efficient companies with better valuations if for no other reason than clarity. But no matter how compelling this argument is, it is not likely to happen in the current world of Russian politics that started with Putin and the assault on Yukos in 2004. The Kremlin wants to have clear central control over industries, which it views as strategic. Strategic has taken a broad and paranoid view, which includes, oil, gas, mining, media, banking, aircraft manufacture, etc. These industries are being accumulated into a handful of large companies, exactly as in Soviet times, and give the Kremlin clear control with local and foreign governments.

These big Russian companies reporting to the President and more importantly to Putin give Russia the power and prestige it feels it deserves but lost after the collapse of the Soviet Union. For Gazprom it is clear that biggest is beautiful, a gargantuan company that gives illusions to power even if it happens at an enormous cost in the absence of a robust diverse market. Instead the company seems to be consumed by its plans, to build the tallest building in Europe as its headquarters.