Gazprom wants all of Sakhalin : Is the monopoly too big to handle?

The Russian government may now have a very big headache to deal with in its oil and gas sector, its own creation - Gazprom. The more you feed the giant, the greedier it gets. After the Russian monopoly was given sizable stakes in most natural gas projects on Russian soil, in some cases the stakes were taken away from foreign companies, as well as being granted the exclusive right to export Russian natural gas, Gazprom remains unsatisfied.

Earlier this week, Gazprom's deputy head Sergei Ananenkov stated that because Gazprom would not be able to fulfill the natural gas supply requirements to Russia's Far East before 2014 with its new Sakhalin-3 project, it should be given the right to buy the natural gas produced on Sakhalin-1 (co-owned by Exxon Mobil and Rosneft, among others) who are already in talks of exporting that gas to China.

Many see such statements as Gazprom's attempts to wrest control over all the major Sakhalin energy projects. After buying out Royal Dutch Shell's 50% + 1 share stake in Sakhalin-2 late last year amid active pressuring from the Kremlin to revoke Shell's license for the project outright, Gazrpom with the help of the Russian government's several ministries is seeking to attain control over the Sakhalin-3 project without a formal auctioning process. And now, Gazprom has been complaining about the violation of its unique natural gas exporting right status while the companies controlling Sakhalin-1 plan to export gas to China.

Kommersant cites experts saying Gazprom's statements of a deficit of energy resources in Russia's Far East are only a pretext. Gazprom's real goal is to negotiate export prices to China out of Sakahlin-1 itself (and presumably decide on further allocations of natural gas) rather than let the consortium members do it. Right now exporting natural gas is a much more lucrative business than selling it within Russia, due to a large disparity in prices and government subsidies.

As Vremya Novostey reports, Gazprom's actions are already seeing criticism from the Russian government. Russian minister of Natural Resources Yuri Trutnev has communicated his discontent with the transfer of Sakhalin-3 to Gazprom without a formal bidding process, calling it a procedure not in compliance with Russia's regulations. Russian finance minister Alexei Kudrin called out Gazprom's aggressive actions aimed at preventing its competitors to have any ability to export gas by blocking possible pipeline construction projects.

Yet another interesting development arises in Gazprom's recent statement. Not only is it attempting to affirm its power over foreign-based energy giants doing business in Russia, now it is also battling another Russian state-owned giant Rosneft, a large stakeholder in Sakhalin-1 and a contender for Sakhalin-3. The Russian governmental ministries now find themselves in a delicate position in the middle of a corporate dispute; some as Alexei Kudrin, have already picked sides.

Many have warned the Russian government of ballooning the size of Gazprom to a point when it would be both hard to control and harder to manage. The former is already a fact. Will Gazprom be able to deny the latter is a matter of time. Upon assuming control of Russia's key natural gas-producing projects Gazprom will have to show that it can work as effectively as its foreign colleagues, who have been moved to the sidelines with the help of the Russian government.

Scissors are cutting up the Russian oil & gas industry

Oil & gas companies operating in Russia have been crushed in the past few years by record-high taxation, making their business perspectives seem very unattractive. And given the fact that Russian companies now dominate the sector, courtesy of the Kremlin, Russian companies bear most of the taxation burden.

The taxation, which many have termed "Kudrin's scissors" (after Russia's Economic minister Alexei Kudrin) involves taxing 90% of the revenues (not profits) gained when Russian crude (Urals brand) trades above 25$ per barrel. Given the fact that Urals brand crude oil has been flirting above the $50 mark, the amount of taxation is huge. According to the Financial Times, Citigroup analysts have calculated an internal rate of return of under 10 per cent on a typical new Russian greenfield (undeveloped) project – lower than the hurdle rates for most majors. This means that Russian companies (which constitute the bulk of companies in the Russian oil & gas sector) are forced to pursue projects, that no other Western company would pursue outside Russia.

Investors, meanwhile, are fearful of investing into efficient independent oil & gas companies in Russia, such as Lukoil, BP or Royal Dutch Shell, due to the continuing regulatory problems these companies encounter from the Russian government. This leaves Gazprom and Rosneft as the only choices for investors, both of which have been on a spending spree; but not on investing in new fields, rather on buying out the assets of bankrupt YUKOS and other companies forced to sell their stakes to the government. Gazprom and Rosneft's shopping bonanza has ensured their debt remains at an alarming level for quite some time.

Add the two problems together, and you are left to invest in inefficient state-run companies, with huge piles of debt and little incentive to invest in new projects in Russia due to "Kudrin's scissors" (outside Russia taxation is lower but competition is fierce), and the overall picture for the Russian oil & gas industry so far is not optimistic. Profits for the two most recent quarters have been falling, as global oil prices have not been rising and as local production has been stagnant.

But the troubles in the Russian oil & gas industry may not be all that bad for the Russian economy overall. Investors have been shifting their capital out of oil & gas and into utilities and the banking sector which are scheduled for a booming growth period. The utilities sector has seen a big boost after the launch of the Russian energy trading market; the banking sector has seen a rise as well due to the recent successful IPO of Vneshtorgbank and the additional offering of Sberbank. The growth of the Russian credit market has proceeded at lightning speed recently and will continue to do so.

Overall, the trouble in the oil & gas sector may play well for the goal of diversifying the economy away from oil & gas, but taxation may have to be eased to give companies the incentive to look for new oil & gas projects; otherwise, Russia's production in the sector may begin falling in the near future.

Surprise-surprise, Mr. Blair - Gazprom goes for Britain

In an apparent test of Britain's free-market intentions, Gazprom's deputy executive Alexander Medvedev (not to be confused with Dmitri Medvedev, Gazprom's Chairman and potential successor to Mr. Putin) announced at the St. Petersburg Economic Forum on Sunday that the Russian gas monopoly was close to a deal increasing its presence in the British energy market. As CNN Money reports Mr. Medvedev' announcement:

"In the near future, there will be a deal to further increase the customer base on the British market," Medvedev said, according to media reports.

The executive added that anyone in London for the Wimbledon tennis tournament, which starts at the end of June, would hear about the deal.

The announcement comes as a surprise and bears a slight degree of mockery (perhaps unrelated) at the statements made by the departing British prime-minister Blair. Over the past month, Mr. Blair has been voicing concerns about Russia flexing its energy muscle as well as giving warnings to European businesses actively involved or considering to enter the booming Russian economy.

As soon as the statement by Gazprom was made, speculations were made as to the target of the gas monopoly's acquisition: Centrica (the UK's largest gas retailer) and Scottish Southern Energy (a UK utility) immediately appeared on the radar screen of most analysts. Although, according to The Herald, one of Gazprom's UK executives stated that SSE was not an acquisition target, the market still was optimistic about a possible Centrica takeover.

Gazprom has been eying Centrica since January of 2006, when as today controversial statements about acquisitions of UK downstream (to customers) operators were floating in the media. To date Gazprom has already acquired British energy retailer Pennine Natural Gas, and has planned to expand its stake in the energy market to 10% by 2010.

The Russian behemoth already has a presence in several countries. In Belgium it has signed a memorandum of understanding to look at potential gas storage projects in the north of the country. It supplies around one quarter of France's gas needs under term contracts with Gaz de France and has a similar deal with Italy's Eni. In the Netherlands it's in talks with pipeline operator Gasunie on a pipeline stake swap. According to analysts cited by CNN Money, the primary motivations behind Gazprom's expansion into Europe's downstream energy business is the higher profitability, as well as the removal of the middleman by directly selling its energy resources from Russia to European retail customers.

Russian companies have significant political bargaining power in such situations. While western energy giants such as BP and Shell are actively involved in the energy sourcing business in Russia, the presence of Russian companies in the downstream markets of Britain is minuscule. With BP facing possible license suspension in the Kovykta Siberian energy project, there is plenty of bargaining options on the table if the British government chooses to intervene in the situation.

Unlike its European counterparts, Britain has been a strong supporter of free-market principles and the principles of nonintervention of the government into cross-border acquisitions. With significant fears in the West about the Kremlin's seeming use of Gazprom as its foreign policy tool, Britain faces a tough test. If it acts to block a possible Gazprom deal, it faces the potential to look embarrassingly hypocritical, and doing more harm than good to UK energy companies who are shadowed by the heavy hand of the Kremlin at this moment. British executives have already criticized Mr. Blair for his criticism of Russia's business practices.

It still is not clear if Centrica is the company Gazprom was talking about in its announcement, but it is likely that Gazprom is very serious this time around. Its goals of expanding into the British downstream market have been a priority for some time, and with the departure of Tony Blair, there is a possibility for warmer relations between the two countries, at least in the business sphere.

Britain Goes Without Russia in Energy Needs : Should Russia Worry?

Several developments on the subject of EU-Russia energy cooperation have popped up yesterday that deserve attention. British PM Tony Blair in a statement in The Times talked about the future of British energy policy; the article, specifically the paragraphs below, caused a lot of anxiety in the Russian press, heightened by the tensions over the "severe cooling of British-Russian relations" amid the Lugovoi extradition:

As if that were not enough, we are now faced with countries such as Russia, who are prepared to use their energy resources as an instrument of policy. Over ten years I have watched energy policy go from being a relatively quiet backwater to something taking on a strategic importance that could be as crucial to our country’s future as defence.

Russian daily Vremya Novostey cites evidence for the specific anti-Russian nature of the British white paper on energy in the focus of PM Blair on the Langeled natural gas pipeline from Norway rather than on the Nordstream pipeline into Germany from Russia, as the principal future source of British gas. Another reason cited by the Russian newspaper is the shielding of the British energy market from Russian energy giants, in the face of Gazprom. The Russian monopoly was not cited as one of the consultants on British energy policy development, and rumors have circulated among top officials that Russian companies may no longer be given access to downstream energy operations on the British Isles.



Yet the language of the media seems to take too seriously the "threats", if they are such from Britain's white paper on energy. Britain was one of the least dependent countries in the EU on Russian energy supplies, and only recently has it felt the need to import large quantities of oil and gas, as the resources of the North Sea began shrinking. Many forget the mood that dominated the British energy regulators when news circulated of Gazprom's attempts to acquire British downstream operator Centrica; the mood was far from supportive explaining why the bid never materialized. Although Gazprom has set plans to increase its stake in the British energy market to 10% or more by 2010, no significant guarantees or notes of support were ever given by the British government.

Another quandary that should be noted when talking about British energy policy is their undefeated commitment to a 60% reduction in greenhouse gases below 1990 levels by 2050, which raises the need to create nuclear powerplants, and greener energy generators (wind, solar, wave, etc.), by itself reducing the dependence of Britain on foreign suppliers. The jab at Russia in the British prime-minister's speech probably means that the chances of Gazprom entering the British downstream energy market or Britain relying heavily on Russian oil and gas have gone from low to very low. British energy policy will not see a fundamental shift away from Russia as a major supplier, since the latter was never in such a position.

Little is lost from the new British energy policies; the rest of the EU has done a lot to keep relations in the energy sphere with Russia as warm as in a sauna. Austria, recently visited by President Putin, which passes on a third of Russia's energy supplies through its territory has signed a long-term supply deal with Gazprom until 2027, something that others in the EU are expected to do in the near future.

In another key development, European energy giants called for greater political support for increased business ties with Russian Gazprom, saying growing tensions between Moscow and the European Union should not be allowed to jeopardize energy security. As the International Herald Tribune reports:

As EU and Russian leaders continue to disagree, the bloc's big energy companies are making their own deals with Gazprom. With Russia as Europe's most important supplier of natural gas - demand for which is expected to rise sharply over the coming 10 years - officials at an energy conference in Berlin, sponsored by the Russian Gas Society said both sides had an interest in increasing energy security.

"It is about long term contracts, infrastructure joint ventures and asset swaps," said Uwe Fip, senior vice president of E.ON Rurhgas.

Edouard Sauvage, vice president of the supply division of Gaz de France, said the strategy toward Russia was to have reliable and secure contracts for energy delivery.

This is not surprising, since E.ON Ruhrgas is the only non-Russian company with a seat on Gazprom's board of directors and is part of the Nordstream project, set to deliver more gas into Europe via the Baltic sea reducing the transit bargaining abilities of the Baltic states, as well as Poland, Belarus, and Ukraine. Eni has also secured several long-term supply deals with Gazprom, as well as several asset purchases and swaps amid the auctioning of the defunct YUKOS oil company. Europe's energy companies have been very welcome in giving up operations in their own countries for anticipations of entry into the Russian market.

Russia's long-term success in being the exclusive supplier of energy to Europe (currently 30% for oil and 50% for natural gas) is rooted in the interconnection of the interests of European and Russian corporate giants who will lobby extensively future supply projects from Russia with the hope of taping Russia's oil and gas fields. These fields, such as Kovytka, Sakhalin, Shtokman, and others, despite government attempts to reduce foreign ownership will require heavy foreign participation, a lucrative source of revenue for the European energy giants, and something that they will fight for.

Britain's chances of becoming once again a self-sufficient country in terms of energy needs are slim, as nuclear power stations face mighty environmental hurdles and green energy has not yet been implemented in a major world economy to sustain more than 20% of energy needs. Norway by itself has little capacity to provide the deficiency, and the Middle East and North Africa hardly seem that more reliable suppliers than Russia. The hard-pressed lobbying of German, French, and Italian energy companies gives the confidence to say that any lack for Russian energy demand from the British Isles will be gladly made up by the rest in the EU.

Doing Business in Russia and Russians doing Business Abroad

This week's issue of BusinessWeek carries two interesting articles on Russia's internal and external business environment. In "The Kremlin's Big Squeeze" BW talks of BP's struggles and major successes in the Russian market through the TNK-BP joint venture, as well as the looming desire of Gazprom to take a stake (majority or minority) in the $31.3 billion in revenue and $6.7 billion in net income business that provides 25% of BP's commodity output. The question is whether Gazprom will get in at the expense of BP or TNK, or both:

The question is what TNK-BP might be able to get for its stake. Speculation in the market ranges from cash to asset swaps to partnerships in other energy projects with Gazprom. If the terms are acceptable to BP and its Russian partners, development at Kovykta might pick up speed. Company officials say it would cost $20 billion to develop the field and build pipelines. But that wouldn't be profitable without exports—most likely to China and South Korea—which could be permitted if Gazprom were on board.

A deal with Gazprom on Kovykta may not solve all of TNK-BP's problems. Some figure that pressure on the company will continue until Gazprom gets a big stake in the entire venture, not just the Kovykta field. Gazprom last year declared its interest in buying out BP's Russian partners, which could happen after the end of 2007, when the joint venture agreement allows for changes in the company's share structure.

Would BP want to work that closely with Gazprom? It might mean ceding some strategic decisions to Gazprom's management, which has close ties to the Kremlin. Still, BP shows no signs of losing interest in Russia. The company has a minority stake in a venture with state oil giant Rosneft to drill for crude on Sakhalin Island. And last year BP acquired 35 new operating licenses in the country and plowed $1.25 billion into TNK-BP. This year it's likely to invest about that much again.

Despite the tension over Kovykta, BP has tried hard to maintain good relations with Moscow. It snapped up $1 billion in Rosneft shares last year when the Kremlin canvassed support for the company's initial public offering in London. And by bidding in a controversial March auction of assets of bankrupt oil company Yukos, it helped legitimize their sale to Rosneft. That may be the price for global oil companies that want to do business in Putin's Russia.

Note: the Kovytka field is a recent addition to Russia's oil/gas reserves boasting 1.9 trillion cubic meters in reserves.

In another article, titled "Rubles Across Russia", BW talks about the very hungry Russian companies that have signed up for $13 billion dollars of M&A deals in 2006 out-of-Russia, and originally attempted to participate in over $70 billion of such deals. The key highlights are Vneshtorgbank's acquisition of a 5% in European Airbus owner EADS, the $2.3 billion acquisition of Oregon Steel Mills by Evraz Inc, and the recently announced collaboration between Unicredit and Aeroflot to bid for Italian flagship air-carrier Alitalia:

Russian money, though, doesn't always get a warm welcome. Gas giant Gazprom (OGZPY) sparked a media furor in Britain last year when it said it might bid for Centrica PLC, Britain's No. 1 gas supplier. Russian companies lost international deals worth $50 billion in 2006, in part because of political attitudes, Foreign Minister Sergei Lavrov told a meeting of business leaders in Moscow in February. As a result, Gazprom and others have hired Western public-relations consultants to polish their image.

Despite such obstacles, there's little doubt the Russian acquisition trend will intensify. Many big Russian companies see expansion into international markets as a necessary step in their development. Energy and metals groups want to move beyond raw materials into higher-profit areas such as refining and manufacturing. Steelmaker Evraz, controlled by tycoons Roman Abramovich and Alexander Abramov, is rumored to be considering a bid for Ipsco Inc. (IPS), a pipemaker in Illinois. (Evraz had no comment.) Russia's telecommunications companies are on the prowl, too. Altimo, a holding company that owns mobile-phone operator VimpelCom, has taken out a $1.5 billion loan to fund acquisitions in India, Indonesia, and Vietnam. "The saturation of the market means we are looking beyond Russia's borders," says Altimo Vice-President Kirill Babaev. These days, any such deal should come as no surprise.

New Rules or Old Methods?

Some interesting snippets from a New York Times article on Venezuelan oil resources and their soon-to-be expropriation:

Consider the quandary facing Exxon Mobil after its chairman, Rex W. Tillerson, recently suggested that Exxon might be forced to abandon a major Venezuelan oil project because of its growing troubles with Mr. Chávez.

The energy world took notice. So did Mr. Chávez’s government.

Only a day later, Venezuelan agents raided Exxon’s offices here in the San Ignacio towers, a bastion for this country’s business elite. The government said that the raid was part of a tax investigation, but energy analysts said the exchange of threat and counterthreat was all too clear. <...>

Mr. Chávez recently decreed that Venezuela would take control of heavy oil fields in the Orinoco Belt, a region southeast of Caracas of so much potential that some experts say it could give the country more reserves than Saudi Arabia. The United States Geological Survey describes the area as the “largest single hydrocarbon accumulation in the world,” making it highly coveted despite Mr. Chávez’s erratic policies. <...>

The oil companies decline to talk publicly about the negotiations, but people in the industry say Exxon and ConocoPhillips, two of the largest American companies in Venezuela, are digging in their heels. The companies, however, lack a united front: Chevron is expected to accept Mr. Chávez’s terms, since it is also negotiating access to a large natural gas project in Venezuela. <..> (New York Times, April 9, 2007)

These methods might sound familiar; familiar they are. In essence they are a more radical and populist way of imitating this:

The Russian government has won another concession from the foreign partners of the oil and natural-gas field being developed in Russia's remote Far East, known as Sakhalin 2.

Last week Gazprom, the Russian energy monopoly, took control of the project when foreign developers led by Royal Dutch Shell agreed to sell 50 percent plus one share to Gazprom, after months of pressure on the company and accusations about environmental issues from a Russian regulator. Critics called the sale a forced nationalization.

The latest twist came Thursday when the Russian government said the private developers had given up their right to recoup $3.6 billion in capital expenses on a priority basis. They were supposed to collect the money before the government began collecting sizable royalties. (New York Times, December 29, 2006)

Oh, I almost forgot this:

Gazprom forced BP's joint venture, TNK-BP, to give up export rights from a major gas field near the Chinese border. Now Gazprom will export from the field, called Kovytka; TNK-BP is selling only to local customers.

If Gazprom gains at least a blocking stake in the Shell project, then it will control all major gas supplies to Asia from Russia, critics say, with the pricing power and political influence that comes with a monopoly. Gazprom would still compete against liquefied natural gas from the Middle East and other sources. (New York Times, September 23, 2006)

Finally, during the last several decades, control of global oil reserves has steadily passed from private companies to national oil companies like Petróleos de Venezuela. According to a new Rice University study, 77 percent of the world’s 1.148 trillion barrels of proven reserves is in the hands of the national companies; 14 of the top 20 oil-producing companies are state-controlled.

Notably, Russian monopolies seem to function more efficiently without a blind pursuit of wasteful spending. However, several commentaries in today's Vedomosti newspaper have suggested that this seeming efficiency is very superficial. Most of the capital being raised in European and Russian capital markets does not flow into capital expenditures relating to existing operations, even less flows into new projects. Despite this, Gazprom continues to show the pure benefits of operating as a monopoly in the Russian market. Its latest move into power-generators, allows it to tap the soon-to-be liberalized energy market, where domestic (Russian) prices are set to rise to match those in Europe. While in control of the actual input resources for power generators, which it is able to acquire at prices of five times below those in Europe, as the market in Russia for input resources is unliberalized, it has the ability to widen the margin on the electricity it sells by several factors. A rough estimate shows that its profits from this venture would see triple-digit growth in the next few years.

However, the similarities in the Venezuelan and Russian scenario highlight the common features under which resource-driven economies operate, the rules that they establish, and the means by which investors operate. By following similar routes, these countries are already serving as an oligopoly in the global energy supply market without any formal cooperation.

Where will Putin retire?

We all know Mr. Putin has promised to leave his post in 2008; and there is a 99.9% chance that he will indeed step down. The remaining uncertainty is always needed for such a turbulent country as Russia. The main question that political analysts are pondering, concerns Mr. Putin's job title after he steps down. A recent article in the FT (Bermuda to liquidate Russian companies) leads us on the probable path.

One of Putin's closest allies in the government, Leonid Reiman, the Minister of Telecommunications, has been involved in many corporate scandals over his tenure. Without going into each of those disputes/scandals (all the relevant information is located at compromat.ru, for those interested) Mr. Reiman is involved with the ownership of the assets of telecommunications giant Megafon, operating in Russia and the CIS. It is also highly probable that a proportion of these assets is owned by Lyudmila Putina. Judging by the overall situation in Russia, it is highly probable that Mrs. Putina has stakes in other assets (we will assume they are fully legal, as no evidence proving otherwise exists).

My point now; Mr. Putin will be financially healthy well after he retires, given the replacement is not as opposed as Mr. Putin once was to Mr. Yeltsin. Thus, the current Russian president will not have a need to be in charge or chair over Gazprom for financial purposes. It also seems illogical for him to chair Gazprom, no matter how powerful it may be. It is an instrument of Russian foreign policy, but not the main one. Nuclear weapons, the accelerating economy, gold reserves, are also highly powerful. Chairing Gazprom, Mr. Putin will maintain status as the default Minister of Energy of Russia. Well below in the ranks of political influence. Neither Mr. Medvedev (in the post of Chairman of Gazprom), nor Mr. Miller (Gazprom CEO) have in their posts much influence on foreign policy. Foreign policy is dictated by the President, his administration and the Ministry of Foreign Affairs.

I do not see a Mr. Putin reporting to Mr. New-Russian president in 2008. It will just be darn weird. It makes more sense for Mr. Putin to just remain a very influential figure in Russia. Given, Russia becomes even more active in foreign relations, and crisis resolution, I can even see Mr. Putin using his communications skills as a consultant on foreign and internal Russian policy.