The Birch, Fall 2005

The Rise of Gazprom
A Natural Gas giant grows even bigger

David Schor

In the southwestern borough of Moscow, a monolithic building stands 500 feet in the air, topped off by a triangular atrium and four pointed stone columns. It is built like a fortress, and perhaps for good reason, as it houses the headquarters of Gazprom, the world's largest natural gas producer and the centerpiece of the economy of the Russian Federation.

Despite its immense importance, the stateowned Gazprom is something of a mystery. In an interview with The Birch, Columbia University Professor of Economics Padma Desai calls it a "black-box." And given the centrality of Russia to global energy markets, it is critically important for western observers to understand the role Gazprom plays in the Russian economy.

In 2004, Gazprom produced 20 percent of the world's natural gas, and about a third of Western Europe's. It held 60 percent of all Russian natural gas reserves, and 16 percent of the world's natural gas reserves, accumulating revenues of over $31 billion. In October, aspiring to diversify its holdings and expand into the oil industry, Gazprom acquired a 75 percent stake in Sibneft, the world's eleventh largest oil company, for $13 billion financed by a syndicate of western investment banks. Sibneft was formerly owned by Roman Abramovich, one of the Russian "oligarchs" who managed to profit enormously from the privatization of state assets during the 1990s.

Gazprom's expansion shows no signs of yielding. Sakhalin II, a $20 billion joint venture between Shell and Gazprom, is set to deliver Liquefied Natural Gas (LNG) to the U.S. via Mexico by 2010. On September 8 of this year, Gazprom, BASF AG and E.ON AG announced an agreement to construct the North European Gas Pipeline (NEGP) through the Baltic Sea to Germany, Russia's largest gas export market. With the recent purchase of an additional 10.47 percent of Gazprom stock, the state now owns a majority stake in the company, meeting the majority state ownership criterion of the 1997 restriction on foreign investment in "strategic" industries. According to the Kremlin, this so-called "ring-fence" is set to come down by the end of the year, thereby attracting foreign investors who anticipate that Gazprom's free-float will immediately turn it into a blue-chip emerging market stock. Its inclusion in major emerging market indices would mean a huge surge in demand for the stock from institutional money managers whose performance is measured against such indices. At the moment, only 4.5 percent of the company is available to foreigners in American Depository Shares traded in New York and London. The free-float is likely to bring in pools of capital to finance Gazprom's further growth. Insiders expect Gazprom to outearn Exxon-Mobil within the next five years.

As Gazprom attempts to meet western demand and to cooperate with western investors, it would appear that there is much to be optimistic about in Russia. As the Financial Times reported on October 21 of this year, "Putin is building a state-controlled, internationally powerful energy giant. In less than two years, the Russian president has effectively renationalized much of an oil and gas sector that had been dominated by private oligarchs, even as he has opened unprecedented opportunities for private foreign investment."

But despite this bullishness, there is serious concern about the level of state involvement in Gazprom. On October 11, the Financial Times reported Jonathan Stern, director of gas research at the Oxford Institute for Energy Studies, as saying that "Gazprom has too many priorities. No company has the institutional capacity to focus on so many tasks. Gazprom has to do what the state wants even if that means following an unrecognizable model." Furthermore, in early October, two top Russian economic policy makers - both widely viewed as market liberals - condemned the excessive involvement of the state. Finance Minister Alexei Kudrin said "Today, unfortunately the share of the state and its interference in the economy is excessive," while Economic Development and Trade Minister German Gref said that "the point of view that the state should broaden its presence in the economy and put certain branches under its guardianship is Neanderthal…the Neanderthals died out, and this ideology must die too."

Indeed, critics like Kudrin and Gref draw ammunition from the fact that economic growth in Russia has slowed since the interventionist trend began despite soaring prices in the gas and oil sectors, which taken together constitute approximately 40 percent of Russian GDP. In November 2005, the World Bank reported a slowdown in economic growth from 7.4 to 5.7 percent. A major factor in this decline is the serious slowdown in the extraction industry, which grew at about 4 percent in the first half of 2005, compared to about 8 percent in the first half of 2004. The World Bank does note that this slowdown is partially explained by the Yukos affair (in which the government arrested and jailed oil tycoon Mikhail Khodorkovsky, who was widely believed to pose a political threat to President Putin, and bought out his company, Yukos), which many hope was an aberration.

The acquisition of Sibneft by Gazprom was a much more benign takeover than the state's dismantling of Yukos in that the price paid was considered a fair market price, but some analysts think that Sibneft would have sold for double that price if auctioned competitively in the international markets. Even Desai, a cautious optimist in this debate, has her concerns: "Whether this kind of link between a company and the state can amount to efficient, profit-oriented decision making - I think that is a very legitimate worry - and I worry about it too. Repeatedly, I have mentioned that Gazprom is a black box that really needs to be cracked open."

Nevertheless, Desai sympathizes with the argument for state involvement. "The whole energy sector is a very critical sector," she says. The fact that the energy sector will be responsible for Russia's economic recovery as well as for bringing in much of the tax revenue that finances the federal budget means that "the state wants to have an important role." State management of the energy sector does not concern Desai: "All over the world the energy sector is more or less state-owned, state-controlled, state-managed, and Russia doesn't want to be an exception to that - simply because it is so important to the economy." Indeed, in 2004, Gazprom's tax payments accounted for about 25 percent of federal tax revenues. Furthermore, in response to concerns that anti-competitiveness in the energy sector has led and will continue to lead to a slowdown in growth, Desai argues that "Putin and his policymakers visualize a picture whereby there is competition - Russian private companies, the state owned companies, and then foreign participants - which will create a competitive environment." Indeed, the Kremlin has pursued joint efforts with Western energy companies such as Sakhalin II, as well as cooperation with domestic players such as Novatek, a domestic natural gas producer with a bright future.

Still, others are concerned that Gazprom's status as something between a company and a branch of the state will enable Russia to throw around its geopolitical weight, or to use Gazprom as a cash-cow for politically (rather than economically) strategic investments. The first red flag is the fact that Dmitrii Medvedev works as Putin's chief of staff by day and moonlights as Gazprom's chairman. Another concern is with Gazprom's questionable investments in its media arm - such as purchasing NTV and Izvestia at a loss. Motivations for these acquisitions are commercially dubious, and seem to be political, or even personal, in nature. NTV has been controlled by the state since its prowestern founder Vladimir Gusinsky used it as a platform to criticize the ongoing war in Chechnya, thus earning Putin's enmity.

In a similar vein, many critics believe that Gazprom may be used by the Kremlin to strong-arm importers of Russian energy. Since last year's "Orange Revolution", Ukraine's new pro-western government has been in a hurry to enter the WTO. The opening up of Ukraine's markets would be damaging to Russia, as competition would almost certainly push prices for Russian commodities lower. But at the same time, Gazprom offers Ukraine one third of the natural gas it consumes, at a fraction of the price at which gas is sold to Western Europe -- $50 per thousand cubic meters (tcm) as opposed to $140/tcm. Some (but certainly not all) of this discount is accounted for in transit fees from Gazprom's use of Ukrainian pipeline. Kremlin officials made sure to let the Ukrainians know that if they want to be a part of Europe, they can start paying European prices for Gazprom's natural gas. Shortly thereafter, Kyiv eased its stance on WTO accession. In short, Gazprom has become an easy way for the Kremlin to remind CIS countries wishing to break free of the Russian sphere of influence of who butters their bread.

Desai makes the opposite point, that Russia now touches the rest of the world through delivery of its energy resources, and that its ability to meet those obligations will define Russia's image as a legitimate world power. "I think Putin and his advisors realize the importance of Gazprom - they realize the importance of Russia as a dominating player in the world energy markets. Countries like China, India, and South Korea are going to be demanding more energy, so there is a big role for Russia - and they want to play that role," Desai says.

But beyond all of this, there is something very commercially unsound about Gazprom: its domestic role. By law, Gazprom is obligated to sell the majority of its gas domestically. Thus, it sells gas at about $30 per tcm at home, while selling it at about $140 per tcm to Western Europe. While its exports are a profit center, its domestic business just barely breaks even. In essence, Gazprom is doing charity work in Russia and making real money abroad. It is scenarios like these which con- cern analysts and investors. With regard to this pricing discrepancy, which market analysts allege makes up the lion's share of the discount in Gazprom's stock (considered very low for a company with such a large amount of proven reserves), Desai admits that the two prices should converge, but offers a concern not often voiced: inflation. "Prices need to be gradually raised - but there [Russian leaders] are sort of caught in a bind because every time they raise the price - and the prices have been raised at interval for domestic buyers of natural gas - there is a blip in inflation and that is what they worry about - so this process is going to be a slow one."

Having studied Russia for thirty years, Desai is able to look beyond the obvious concerns about Gazprom to a potentially productive reconciliation. "When I discuss Putin's role in this scenario, some Russian commentators bring up the fact that he keeps Russia's national interest at heart, and does what any leader is supposed to. He tends to be very pragmatic, and, as we say, a cool cat, very skillfully and carefully weighing the plusses and minuses of any decision. I think that's a change for the better." The financial press often looks to Russia as a world of fantastic investment potential, and criticizes the state's role in the economy as contributing to opaqueness and inefficiency. But this critique is superficial. The critical question that needs to be addressed is how the Kremlin can do what is best for Russia while still supporting and strengthening its legal infrastructure. Gazprom, as a Kremlin-run global energy giant, embodies a country struggling both to empower itself and to fit into the dominant legal mold. In that sense, Gazprom is an experiment, the results of which will hopefully bring Russia closer to answering that question.