Commentary Type

Gazprom's Strategy

Testimony before Hearing on EU Economic and Trade Relations with Russia, Committee on International Trade, European Parliament, Brussels


I am happy to fill in for a Gazprom representative to discuss Gazprom's strategy, but I must make clear that I do this as an independent analyst and not as a representative of Gazprom. Yet, I have chosen the Gazprom perspective to explain what this company is doing.

Gazprom is a peculiar corporate giant. It is a ministry that has become a corporation, and the fundamental question is to what extent it represents the state and business interests, respectively. The last Soviet Minister of Gas Industry Viktor Chernomyrdin formed Gazprom out of the Russian part of his ministry. It incorporated all the elements of the old ministry-production, transportation, distribution, sales, research, and even regulation. This corporation produces close to one-fifth of all natural gas in the world. Unlike oil production, which plummeted by almost half from 1987 to 1996, gas production held up well.

In the mid-1990s, a large minority share of Gazprom was privatized to managers and employees, but share sales were restricted. As a result, a considerable price differentiation evolved between domestic, restricted shares and the few internationally tradable shares. Another consequence was that all Gazprom shares were extremely cheap in relation to the purported asset values. Arguably, Gazprom remained a ministry until President Vladimir Putin changed the management in 2001.

Since 2001, the Gazprom management has been divided into three roughly equal groups. One group, led by CEO Alexei Miller, consists of young economists who worked with Miller and Putin in the mayor's office in St. Petersburg. A second group consists of KGB people from St. Petersburg, while old Gazprom hands form a third group. President Putin takes a very active interest in Gazprom's management, and its split into these three groups gives him great leeway to balance them.

My argument is that the main objective of Gazprom's new management is to boost the stock price. They have done so very successfully. The stock price has increased more than ten times in the last three years. Such a spectacular result cannot be accomplished without being focused on it, however large your assets happen to be. At present, Gazprom has a market capitalization of $250 billion, rendering it about the third most valuable company in the world. It is currently worth three times more than the most valuable German companies, Siemens and Eon.

pany's stock price. Initially, it focused on recovering assets that had been sold off cheaply to other companies by the old management, and it managed to recover most of them.

Another important step was to liberalize the stock trade so that domestic and international stocks could be traded freely. That was accomplished early this year, which greatly contributed to the stock's price rise.

While Gazprom's Western European customers have paid negotiated market prices all along, former Soviet republics have paid highly differentiated prices, which could only be explained by old political inclinations. In the last year, Gazprom has undertaken radical changes in this price structure. To judge from its dominant public statements, it aspires to eliminate all political discounts and more or less homogenize its prices of natural gas on the Russian border to about $150 per 1,000 cubic meters (mcm), which is currently the approximate netback price from Europe. These prices are set to rise significantly in the next year. European countries pay much higher prices, but they include large transportation costs in pipelines and substantial taxes. This offensive has led to a number of incidents that appear political, notably aggressive tactics against Ukraine, Moldova, and Georgia, but Gazprom has been approximately as aggressive against supposed friends such as Belarus and Armenia. While politics undoubtedly played a role in these dramas, and bluster over prices was standard, the overarching impression is that Gazprom raises the prices relatively fast to a plausible market level.

The next key task to enhance Gazprom's profitability and thus stock price is to raise the domestic Russian gas price. At present, the wholesale price for gas, without taxes is some $42 per mcm. The current government policy is to let the gas price rise by 15 percent next year. After a couple of postponements, the Russian government was to discuss its price policy for gas on November 22. Three important constituencies are arguing for a partial deregulation of the domestic gas market, namely Gazprom itself, Minister of Industry and Energy Viktor Khristenko, and the Unified Energy System, which despairs at the shortage of gas in Russia. The minimum solution is that the domestic price rise accelerates, so that it reaches $90 per mcm in 2010. But I do not think it will take that long. Russia may experience a shortage of natural gas as early as this winter, and the domestic price is just too low. The Russian discussion over the domestic gas price is the key drama to watch today.

Meanwhile, Gazprom has invested little in the development of new major findings of gas. One reason is that these fields are very expensive to develop, and if the domestic price is Gazprom's marginal price, it is not worth doing so. Another reason is that Gazprom's current main objective is to raise the domestic gas price, which is most easily done if a real shortage of gas erupts. Therefore, the European Union has a common interest with Gazprom in the domestic Russian gas price going up, because such a price hike will help safeguard Europe's supply of natural gas. In addition, it will contribute to energy saving in Russia and thus lessen emission of greenhouse gases.

Naturally, Gazprom wants to maintain and if possible extend its monopoly over gas pipeline transportation. It wants to take over trunk pipelines in other countries, and it works hard on doing so. Gazprom and thus Russia are dead against the European Energy Charter and its Transit Protocol, because it will reduce Gazprom's monopoly powers. In this regard, Gazprom and the European Union have contradictory interests. For years, the European Union has demanded that Russia ratify the Energy Charter, but Russia will never do so. The Energy Charter was negotiated in 1991, before Russia's new energy interests had been formed. The United States and Canada never even signed the charter because of legal concerns, and Norway had other legal concerns, which made it not ratify the charter. The only sensible EU approach would be to renegotiate the Energy Charter so that at least Europe's main producer countries, Russia and Norway, can join it. An Energy Charter that only the consumers approve of cannot be of much significance, and Europe needs a common trade framework for energy, notably natural gas.

At present, Gazprom has only two outlets to its markets outside of the former Soviet Union, the pipeline through Ukraine, which accounts for 80 percent of Russia's gas exports to Europe, and the pipeline through Belarus and Poland, which takes care of the remaining 20 percent. To Gazprom this cannot be a satisfactory situation. Therefore, it has chosen the Baltic pipeline directly from Russia to Germany through the Baltic Sea. From a market economy perspective, a multitude of transportation options seems desirable.

More troublesome is the Russian ambition to block the construction of a Transcaspian gas pipeline from Central Asia to Europe. Such a pipeline would greatly enhance Europe's energy security and should be a key EU interest.

Other aspects of Gazprom's activities are even less attractive. Gazprom is picking up various assets within Russia quite cheaply because of its combination of monopoly power over pipelines, pricing and exports and state regulation. Small independent gas producers have been squeezed out and forced to sell their assets cheaply to Gazprom. In East Siberia, TNK-BP, half-owned by BP, is being hindered to develop the giant Kovykta gas field in East Siberia. In the Sakhalin II project, Shell Royal Dutch is under pressure to renegotiate its Product-Sharing Agreement, presumably being forced to give a large share of its investment to Gazprom.

So far, I have discussed Gazprom in business terms, but politics remain important. One example is President Putin's recent decision that Gazprom build one or two gas pipelines to China rather than building a liquefied natural gas plant designed for exports to the United States. The bluster in negotiations with the former Soviet republic does have many political overtones.

Recommendations for EU Policy on Gazprom

The ultimate question today is of course what the European Union should care about with regard to Gazprom. I would make three suggestions:

  1. It makes no sense for the European Union to continue insisting that Russia ratify the Energy Charter when it is all too obvious that Russia will never do so. Instead, the European Union should open a renegotiation of the Energy Charter. The European Union needs to insist on its fundamental demands, a liberalization of the Russian (an European) gas market, free and nondiscriminatory access to pipeline systems throughout Europe, including Russia, commitments to uninterrupted supplies, and mutually equal conditions for investment in the energy sector. But the European Union also needs to acknowledge justified Russian demand to reach a balanced and mutually beneficial agreement that can be ratified by consumers and producers alike. If Gazprom is to be allowed to buy downstream gas assets in EU countries, the European Union must demand the corresponding right to buy upstream gas assets in Russia, and vice versa.

  2. The most serious conflict in Russia's negotiations with the European Union about its WTO accession was Russia's domestic price of natural gas. This was settled on conditions favorable to Russia, when the European Union signed its bilateral protocol with Russia, a milestone that was reached in May 2004. Russia has complied with that agreement, but international gas prices have risen further. Producers of mineral fertilizers around the world are now complaining anew that the Russian domestic gas price is too low. The European Union had better to return to the issue of the domestic Russia prices of natural gas in the multilateral part of the negotiations on Russia's WTO accession. The United States is likely to do so, and when Gazprom itself lobbies for higher domestic gas prices in Russia the chances of success are considerable. This price question has also bearing on Europe's energy security, the prospects for investments in Russia's gas production, and the transparency of the gas sector.

  3. Finally, the European Union has an interest in multiple supply lines of energy to Europe. Therefore, the European Union should strongly support the construction of a Transcaspian gas pipeline from Central Asia to Europe outside of Russia's control.

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