Commentary Type

Gazprom's Demise Could Topple Putin

Op-ed in Bloomberg


No large company in the world has been so spectacularly mismanaged as Russia's state-dominated natural-gas corporation, Gazprom OAO (GAZP). In the last decade, its management has made every conceivable mistake.

Even so, Russian President Vladimir Putin denies the very existence of a crisis and maintains his support for Alexei Miller, the chief executive officer since 2001. Gazprom's situation is serious not only because it is Russia's biggest company by market value, but because Putin is its real chairman. Where Gazprom goes, so goes Russia and the Putin government.

In May 2008, Gazprom was one of the world's most valuable companies with a market capitalization of $369 billion. Miller boasted that it would be the first global company to reach $1 trillion. Today, its market value has plummeted to $83 billion, and the decline continues. Although it claimed the largest net income of any global company in 2011 at $44.5 billion and still at $38 billion in 2012, its price-earnings ratio has dropped to a fatally low 2.4 for 2013. It has no credibility with shareholders.

At the heart of Gazprom's mismanagement lies extreme inertia; reluctance to absorb new information; corruption and outlandish arrogance. Its managers are used to exercising Soviet-style monopoly over consumers, not having realized that the market has taken over. The company has traditionally varied prices by countries for opaque reasons. For example, Lithuania pays 15 percent more for Gazprom gas than neighboring Latvia.

Supply Cutoffs

When consumers behave inappropriately in its eyes, Gazprom cuts off supplies, as it did to Ukraine and much of Eastern Europe in January 2006 and 2009. As a result, these dismayed customers have reduced their dependence on Gazprom, by cutting consumption, building converters and storage, and developing alternative supplies.

The Gazprom business model is as simple as it is old: to produce conventional gas from giant fields in West Siberia and pump it through pipelines to Europe. In the last decade, the company has missed three big revolutions in the industry: the shale-gas expansion in the United States, the global liquefied-natural-gas (LNG) boom, and the rise of Chinese demand.

In a call-in program in April, Putin dismissed shale gas, claiming implausibly that it was more expensive than conventional gas—of which Russia has one-quarter of global reserves—and not environmentally sustainable. (He didn't mention that Russia burns billions of cubic meters of surplus gas because private producers aren't allowed to use Gazprom's pipelines.) Miller has gone so far as to call shale gas "a bubble that will burst soon." Yet LNG designed for the US market is now flooding Europe, depressing prices there below Gazprom's oil-linked prices.

Nor has the Gazprom management understood the importance of the European Union. Last September, the European Commission launched a case against Gazprom, accusing it of dividing the continental markets by hindering the free flow of gas across member states, preventing the diversification of gas supply and imposing unfair prices on its customers by linking the price of gas to oil prices.

It may take years for a verdict, yet Gazprom will probably be fined billions of euros for these long-lasting malpractices. Its whole business model is at risk. Its main clients, the large European gas-distribution companies, have already lost lesser cases against the European Commission.

Oil-linked gas prices are likely to be deemed anti-competitive. Last year, Gazprom had to pay $4.3 billion in retroactive price discounts to Germany's EON AG (EOAN), Italy's Eni SpA (ENI), Poland's Polskie Gornictwo Naftowe i Gazownictwo SA and the Czech Republic's RWE Transgas. Prohibitions on reselling natural gas are clearly anti-competitive.

Putin's Incomprehension

Putin has revealed his incomprehension at the case, objecting that the European Union subsidizes the Eastern European economies. "Now it seems that someone in the EU has decided to shift part of the burden, some of the subsidies, to us," he said.

On a parallel track, the European Union has adopted its third energy package, which prohibits one company from both distributing gas and owning the pipelines. The Kremlin has called this ordinary antitrust policy "confiscation," but in Europe, Gazprom has to obey EU law and will probably be forced to divest.

Gazprom is losing out on the European market. Its share of the 27 EU countries' natural-gas imports has fallen from a peak of 47 percent in 2003 to 34 percent in 2011. The two main beneficiaries are Norway's Statoil ASA and Qatar, which adjust their prices to market conditions and increasingly sell at lower spot prices.

Gazprom's market share has fallen in Russia, too, from a traditional 85 percent to 65 percent in 2012. The beneficiaries are the privately owned NovaTek OAO (NVTK) and state-controlled Rosneft OAO (ROSN), companies more favored by the Kremlin.

Gazprom's sales are falling most in other ex-Soviet states—by 19 percent in 2012 alone—because its methods there are particularly rough and politicized. Ukraine used to be its biggest customer, but since the company's apparent objective has been to force Ukraine into the protectionist Customs Union of Russia, Belarus, and Kazakhstan, Ukraine has minimized its purchases from Gazprom.

Thus, Gazprom is left with far more gas than it can sell. Russia's gas production has been almost stagnant for two decades, but Gazprom's production has fallen steadily. In 2012, its total sales fell to 482 billion cubic meters from 519 billion cubic meters in 2011. In the first five months of 2013, Gazprom's production dropped 4.3 percent, while NovaTek's rose 4.6 percent. Now NovaTek (NVTK) is lobbying to break Gazprom's export monopoly and start exporting LNG.

Until 2009, Gazprom benefited from plentiful captive gas from Central Asia, mainly Turkmenistan. But the pipeline exploded in April of that year, after Gazprom suddenly closed the flow from Turkmenistan during a supply surplus caused by the global financial crisis.

Alternative Pipeline

Turkmenistan gave up on Gazprom and opted for the swift construction of a pipeline to China. With its large reserves, Turkmenistan can supply much of the Chinese market, while Gazprom has lost both cheap supplies from Central Asia and access to China.

All this speaks of incompetence, but what really irritates shareholders is the company's enormous waste and corruption. This takes various forms, such as asset stripping. The most egregious form is excessive capital spending.

Analysts at the state-controlled Sberbank (SBER) assess that Gazprom would need $11 billion a year for its gas production, but in 2011 its capital expenditure soared from an originally planned level of $27 billion to $53 billion. It stopped at $43.2 billion last year.

The analysts call this excess expenditure "value destruction," which is their euphemism for waste and corruption, amounting to $30 billion to $40 billion a year. Investment analysts in Moscow suggest privately that two-thirds of this might be sheer corruption, while the rest is wasteful overinvestment. Corruption at that level may explain the poor management of the company's official business.

Rather than reducing capital investment, however, Putin comes up with ever more expensive projects. Last October, he decided that Gazprom should develop the giant virgin Chayadinsk field in Yakutia in eastern Siberia, building a pipeline to Vladivostok on the Pacific Coast and an LNG plant there for export to China.

Officially, this project is supposed to be completed by 2017 and cost $40 billion, but Sberbank analysts assessed it at $65 billion. This production would be too expensive for it ever to be profitable, and Russia has no supply contract with China. This is as white an elephant as there ever was.

Last December, Gazprom went ahead with its South Stream pipeline through the Black Sea to the Balkans. It was supposed to cost $21 billion, but in February Gazprom announced it would cost $39 billion. In April, Putin and Miller decided to build a second pipeline from the Yamal field in northwestern Siberia to Europe. (The project, which was supposed to go through Poland, was immediately repudiated by Polish Prime Minister Donald Tusk.)

Superfluous Projects

In addition, Gazprom has plans to build two more superfluous Nord Stream pipes through the Baltic Sea at a cost of probably $20 billion. They have the single purpose of replacing the existing pipeline through Ukraine that Putin wants to abandon. None adds any value.

Altogether, Gazprom plans capital expenditures of $40 billion to $45 billion a year for the next five years, equaling its 2011 peak profit. This isn't sustainable even in the short term, let alone in a market changed by competition from shale and liquefied natural gas.

Since 1997, Russia's reformers have called for the breakup of Gazprom into a pipeline company and several production entities. Recently, this proposal has reemerged as a real threat because NovaTek and Rosneft have designs on expansion at Gazprom's expense.

Where Gazprom goes, so does the Russian stock market. Investors don't buy Gazprom shares expecting to enjoy ownership, but as a bond, only looking at the yield. Worse, the new national oil champion, Rosneft, has swiftly adopted several of Gazprom's flaws, notably uneconomical overinvestment and cold disregard of dividends and minority shareholders, aggravating the drag on the stock market.

For Putin, the greatest concern might be the negative impact on state revenue. In recent years, Gazprom has paid 7 percent to 11 percent of total state revenue, and the oil sector has contributed about 40 percent. Both these shares are likely to fall fast in the next few years. That may force the Kremlin to reconsider its economic policies.

The silver lining of the Gazprom crisis is that by becoming too corrupt to work, it has caused its own demise. It will no longer be able to dominate Russian politics, and the country will become less of a petro state. This must be greeted with relief by all true friends of Russia.

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