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Bloomberg: Gazprom May Thwart Putin Drive for Russian Energy Dominance

By Lucian Kim

June 4 (Bloomberg) — Four corporate heavyweights are arrayed before Russian President Vladimir Putin in his Kremlin office. Sitting across a white oval table from Putin are Shoei Utsuda and Yorihiko Kojima, chief executive officers of Japan’s largest trading companies, Mitsui & Co. and Mitsubishi Corp.; Jeroen van der Veer, head of Royal Dutch Shell Plc, Europe’s biggest oil producer; and Putin’s old friend, OAO Gazprom CEO Alexei Miller. The purpose of the Dec. 21, 2006, confab: to seal a deal made earlier that day in which Gazprom, the giant state-run gas company, will take control of Sakhalin-2, a $22 billion oil and gas project on Sakhalin Island in the Russian Far East.

Van der Veer and the Japanese executives make a show of endorsing Gazprom’s participation in Sakhalin-2, until now the biggest totally foreign-owned energy venture in Russia. “Thank you very much for your support on this historic day,” van der Veer says to Putin in remarks captured on camera and posted on the Kremlin’s Web site. “Gazprom is very welcome as a partner in our project.”

Gazprom, with Putin standing behind it, is reasserting Kremlin control over an energy industry that has become critical to Russia’s prosperity and global prestige. “Gazprom is emerging as the most important Russian enterprise, both as a driver of economic growth and international influence,” says Chris Weafer, chief strategist at Alfa Bank in Moscow.

Yet Gazprom’s demonstration of its political clout in December obscures an enterprise that some investors say is flawed by a lack of transparency, flat production, money-losing domestic sales and an increasingly competitive market for the gas it depends on from Central Asia.

Output Down

Last year, Gazprom, of which the government owns just over 50 percent, pumped 556 billion cubic meters (19.6 trillion cubic feet) of gas, slightly less than it produced 10 years before.

Mikhail Korchemkin, who heads Malvern, Pennsylvania-based consulting firm East European Gas Analysis, blames Gazprom’s marriage with the Kremlin for its underperformance. “It’s mismanaged but knows where it’s going,” Korchemkin says. “It’s a cash cow for the state. Does anybody care about the midterm strategy? I don’t think anybody thinks they’ll be there so long.”

The Kremlin meeting cementing the takeover of Sakhalin-2 shows why Gazprom is a poorly managed company, says Kim Iskyan, co-head of research at investment firm UralSib Financial Corp. in Moscow.

“What business does the president of a country have being there?” he asks. “It’s absurd he was even involved. At Gazprom, the interests of management are aligned with the government, not the shareholders, as in other global companies. It’s run like a private fiefdom, like a branch of the Kremlin.”

A Proxy for Russia

Investors consider Gazprom a proxy for Russia’s rapid growth. Its Russian Trading System-listed shares more than tripled in the three years ended on June 1. The stock has languished this year, on a lower oil price — it fell 8.5 percent for the year ended June 1 — and concern the Russian government will raise its tax on natural gas production. Gazprom shares were down 18 percent as of June 1.

Putin, 54, has no direct stake in Gazprom. “He’s not a shareholder as far as anybody knows,” says James Fenkner, who manages $100 million in East European stocks at Red Star Asset Management LP in Moscow.

The president does have personal connections to the men who run Gazprom. Putin worked in the office of then St. Petersburg Mayor Anatoly Sobchak from the collapse of the Soviet Union in 1991 to ’96. When Putin served as head of Sobchak’s foreign investment committee, Gazprom CEO Miller, 45, was his aide. Valery Golubev, 54, a Gazprom deputy CEO appointed last year, was, like Putin, born in St. Petersburg, served in the KGB intelligence service and worked in Sobchak’s office starting in 1991.

Old Friends

Dmitry Medvedev, Russia’s first deputy prime minister and Gazprom’s chairman, was Putin’s legal adviser in Sobchak’s office. In a poll released by the All-Russian Center for Public Opinion on April 17, those surveyed picked Medvedev, 42, along with Sergei Ivanov, also a first deputy prime minister, as most likely to succeed Putin. The president must leave office next year after completing his second four-year term.

“It’s not a state company; it’s the president’s personal company,” says Vladimir Milov, a former deputy energy minister who runs the Institute of Energy Policy in Moscow. “It’s a bunch of people from the St. Petersburg administration enjoying the windfall.”

In May, Gazprom reported on its Web site that it paid its top 16 managers 526.8 million rubles ($20.3 million) in 2006, up from 368 million rubles a year earlier, a 43 percent raise. The board of directors got 106 million rubles. No individual salaries were reported. Last December, Russian business newspaper Vedomosti said Miller earned $1.4 million in 2005, while his top deputies made $700,000.

Too Small for Putin

Less than a month after leaving office, in December 2005, former German Chancellor Gerhard Schroeder, who describes himself as a Putin family friend, took charge of a Gazprom Baltic pipeline project. Earlier that fall, the Economist suggested that Putin himself might take a top job at Gazprom following Russian elections next year. Milov discounts that theory. He says that even a company as big as Gazprom would seem small after running all of Russia for eight years.

Gazprom Deputy CEO Alexander Medvedev, 51, the head of its export division and no relation to Dmitry, calls it a “primitive” idea that the government is running Gazprom. He says the Putin administration exercises influence only in its role as a shareholder.

Gas Cartel

Already the world’s largest producer and exporter of natural gas, Gazprom is looking to increase its clout. At an April summit of gas-producing countries in Doha, Qatar, Russia took the lead in raising the possibility of cooperation in pricing. Asked at the meeting whether Russia was seeking to form a gas cartel along the lines of the Organization of Petroleum Exporting Countries, Miller said, “Call it what you like.”

“Gazprom is the new Saudi Arabia,” Alfa Bank’s Weafer says. “The emergence of a gas OPEC, in which Gazprom dominates, will finally confirm that. It means all major decisions concerning Gazprom are taken within the Kremlin.”

Gazprom holds 16 percent of the world’s proven natural gas reserves, operates 154,000 kilometers (96,000 miles) of pipelines and has 1,000 kilometers more under construction this year. It pumps the oil-and-gas equivalent of Saudi Arabia’s petroleum output. (After its $13.1 billion acquisition of OAO Sibneft from billionaire Roman Abramovich in 2005, Gazprom’s output of crude oil rose to 1.2 million barrels a day last year.)

Europe Dependent

Gazprom reported 1.4 trillion rubles of revenue in 2005. Last year, it took in a record $37 billion from sales to Europe, which depends on Russia for a quarter of its gas. The former Soviet bloc nations in Eastern Europe are almost entirely dependent on Gazprom for their gas supplies.

In 2005, Gazprom contributed 364.2 billion rubles to Russia’s federal, provincial and local budgets. In terms of market valuation, Gazprom ranks as a global giant. After the Russian government lifted restrictions on foreign share ownership in 2005, effective Jan. 1, 2006, foreign investors poured into the stock.

The share price rose 70 percent in 2006 in dollar terms, catapulting the company into the league of General Electric Co. and Microsoft Corp., with a year-end market value of $272 billion. The market capitalization on June 1 was $223 billion.

In Gazprom’s tinted-glass tower in southern Moscow, the company’s managers are wrestling with a raft of issues. Wood Mackenzie Consultants Ltd., an Edinburgh-based firm, says Gazprom’s annual production will grow no more than 1 percent a year until the end of the decade. Gazprom’s three major fields — Medvezhye, Urengoi and Yamburg — are all in decline, and its newest big development, the Zapolyarnoye field, peaked in 2005, producing 100 billion cubic meters of gas that year.

Needed: New Investment

“It’s not an immediate crisis, but within three to four years, it could be,” says Jonathan Stern, director of gas research at Britain’s Oxford Institute for Energy Studies. “Gazprom has a number of options, but it’s not an easy choice. The future is much more uncertain than the past.”

The International Energy Agency, the advisory body for wealthy energy-consuming nations, admonished Gazprom last year for not investing enough in new fields. “Gazprom’s annual investments have been on the order of $7 billion since 2003,” the IEA wrote in a report in the summer of 2006. “But much has been directed at foreign acquisitions and new export infrastructure.” The IEA estimated that Russia could face shortfalls of 50 billion cubic meters of gas by 2010 if its three big fields decline by 20 billion cubic meters annually and deliveries from Central Asia don’t rise.

Central Asia Deal

Gazprom now buys about 55 billion cubic meters a year from the former Soviet republics of Kazakhstan, Turkmenistan and Uzbekistan, which is 10 percent of its own production. Putin highlighted the importance of the region by making an unprecedented six-day visit to Central Asia in May. He agreed with his counterparts from Turkmenistan and Kazakhstan to refurbish and build pipelines to boost gas supplies to Russia by 40 percent.

The agreement could preempt a plan by the U.S. government to build a pipeline under the Caspian Sea, from Turkmenistan to Azerbaijan, bypassing Russia.

Energy Minister Viktor Khristenko estimates that Russia simply squanders a third of its own consumption, or about 100 billion cubic meters of gas annually, due to inefficiency and waste encouraged by low prices, which are about a quarter of what Gazprom charges Europeans.

During the long winters, most Russians regulate the temperature in their apartments by opening windows, since radiators are controlled by municipal heating plants and most lack thermostats. Last year, Gazprom lost $420 million selling gas within Russia.

Domestic Monopoly

“In the absence of a real domestic market, it’s hard to tell if there’s a gas deficit or not,” energy consultant Milov says. “There is no actual demand for gas in standard market terms. There are only bids from consumers for supplies.” A monopoly is not interested in increasing investment, he says, since tight supplies help keep prices high.

Prime Minister Mikhail Fradkov approved a plan last November to gradually raise gas prices for Russian industry to European levels over the next five years, forcing it to become more efficient and curbing demand. “If Gazprom can double domestic prices by 2011 compared with 2007, then we’re talking about a market that’s massively profitable,” Stern says.

Gazprom started life as the Soviet Gas Industry Ministry in 1965. It was recast as Gazprom in 1989, and three years later President Boris Yeltsin turned it into a joint stock company. A 1999 law limited foreign ownership of Gazprom stock to 20 percent. In a climate of low energy prices and economic turmoil in Russia, the company hemorrhaged money.

4 Cents a Share

The corporation Miller inherited from his predecessor, Rem Vyakhirev, in 2001 — one year after Putin’s election as president — was considered by minority shareholders to be little more than a source of enrichment for its management. “During the Yeltsin era, Gazprom was trading as low as 4 cents a share,” says Red Star’s Fenkner. “Value was being destroyed. Gazprom was just a candy store to provide sweet deals for whoever was running it.”

Putin brought order to the chaos by giving the state a leading role in the economy. As oil and gas prices rose, starting in 2001, part of his plan entailed taking back the assets of the petroleum industry that had been sold off by Yeltsin. His first target was OAO Yukos Oil Co.

In October 2003, Mikhail Khodorkovsky, then Russia’s richest man and the CEO of Yukos, was arrested on fraud charges. Tax authorities filed a series of back tax claims against the company that eventually totaled $30 billion. For 2001 and ’02, the tax bills exceeded revenues, Yukos said.

Khodorkovsky is now serving an eight-year sentence at a Siberian penal colony, and Yukos, once Russia’s largest oil producer, has been auctioned off to state oil company OAO Rosneft and Gazprom.

Sechin v. Medvedev

Putin unveiled a plan in September 2004 to create a single national energy champion for gas and oil by folding Rosneft into Gazprom. The merger fell apart the following spring as Gazprom and Rosneft openly disagreed over its terms. The dispute, says Korchemkin, was political: a fight between Igor Sechin, Putin’s deputy chief of staff and Rosneft’s chairman, and Gazprom Chairman Medvedev.

Rosneft remains a separate corporation, with 75.2 percent of its shares owned by the state. This spring, in a series of liquidation auctions, Rosneft paid $21 billion for Yukos’s oil fields and refineries, while Gazprom combined with Italy’s ENI SpA and Enel SpA to buy Yukos’s gas fields and its 20 percent stake in Gazprom’s oil unit.

The Sochi Olympics?

Gazprom’s rich cash flow gives it the resources to contribute to a variety of state projects. In the mountains overlooking the Black Sea resort of Sochi, it’s spending $375 million to build one of three skiing venues. The government hopes Sochi will be the site chosen by the International Olympic Committee for the 2014 Winter Olympics.

“Sochi and the Olympics are a very big Kremlin project,” UralSib’s Iskyan says. “Gazprom says it’s ‘investing,’ when it’s really a backhanded way of the government funneling money in a certain direction.”

Gazprom should instead focus on its most-urgent priority — finding new sources of gas, Milov says. “We shouldn’t forget the mess it has made out of its core activity; we should hold it responsible,” he says.

The options for expanding output are challenging. One is to open the 700-kilometer-long Yamal Peninsula that juts into the Arctic Ocean to gas production. While Gazprom said in October it would begin developing the project, the remoteness of Yamal, which holds an estimated 10.4 trillion cubic meters of gas, demands a huge investment.

A $45 Billion Investment

Stern estimates it will take eight years to develop Yamal’s Bovanenkovskoye field. Investments to get the project up and running could total $25 billion, Stern says. Wood Mackenzie puts the price tag at $45 billion over 10 years.

The other option is Shtokman, a field holding as much as 3.7 trillion cubic meters of gas and located 500 kilometers offshore in the icy Barents Sea. A year ago, Gazprom’s plan was to develop the site with the help of two or three foreign equity partners. The bidders were Norway’s Norsk Hydro ASA and Statoil ASA, Chevron Corp. and ConocoPhillips of the U.S. and France’s Total SA.

After months of delaying a decision on choosing its partners, Miller last October went on Russia Today, the Kremlin’s English- language satellite news channel, to tell the world that Gazprom would develop the project without foreign investors. “On the technical side, Gazprom needs foreign expertise,” says Roland Nash, chief strategist at Renaissance Capital in Moscow. “But Gazprom can afford to wait because there’s fierce competition for its reserves.”

Capital Projects

Gazprom has pushed back the earliest production date for Shtokman to 2013. Chevron puts the price tag of the project at as much as $20 billion.

Gazprom executives insist they won’t have any trouble meeting future demand. “We’re investing as much as necessary,” Deputy CEO Medvedev says. In January, Gazprom’s board approved total 2007 investments of more than $20 billion, including $1 billion for Yamal and $600 million for Shtokman. The company says it plans to spend $24 billion on capital projects in 2008 and $27 billion in 2009.

Economy Minister German Gref, who sits on the Gazprom board, is skeptical. At a government meeting in March, he complained the company still hadn’t submitted production plans through 2020. Miller replied that Gazprom wouldn’t produce new gas until there were concrete buyers for it.

Gazprom is depending on other Russian gas companies to satisfy some future demand. “I don’t have any doubt that Gazprom will meet its gas export commitments,” says Mark Gyetvay, the American chief financial officer of OAO Novatek, Russia’s largest independent gas producer. “The growing domestic demand will be met by the independent sector.”

Growing Independents

With about 5 percent of Gazprom’s production, Novatek might seem like a dwarf. Yet taken together with oil producers OAO Lukoil and Rosneft, the three companies have a combined gas production capacity of 180 billion cubic meters a year, or a third of Gazprom’s output in 2006, according to estimates by Moscow brokerage Deutsche UFG, a unit of Deutsche Bank AG.

Deutsche UFG expects the domestic market share of the independents to rise to 45 percent in 2020, up from less than 20 percent last year.

Even as their role grows, independent producers will continue to be at the mercy of Gazprom, since it owns the pipelines that deliver gas to customers. Last year, Gazprom agreed to “strategic partnerships” with Lukoil and Rosneft, which will probably focus on giving Gazprom access to so-called associated gas, a byproduct of crude.

Partners Forever

Gazprom also bought almost 20 percent of Novatek last year. Gyetvay says his company has always considered itself a partner of, not a competitor to, Gazprom. “All we’ve done now is solidify the relationship by having Gazprom take an equity stake in our group,” he says.

Just in case, Gazprom is counting on Russia’s other energy riches to make up for any shortfalls. In February, Putin said in a speech that coal should replace gas as the main fuel for Russian power plants. Days later, Gazprom announced that it would pool assets with OAO Siberian Coal Energy to create the country’s largest coal mining company. Putin has since called for “a second massive electrification” of the country powered by coal, nuclear and hydroelectric energy, not gas.

Meanwhile, Gazprom’s goal is to increase gas imports from Kazakhstan, Turkmenistan and Uzbekistan by 40 percent to 80 billion cubic meters a year by 2012, Putin said during his Central Asian visit in May. The new regional pipeline to Russia will cost $1 billion, Russian state media reported at the time.

Feeding the Gas-Starved

Yet the IEA says refurbishing the region’s Soviet-era pipeline system will cost some $6 billion. And Gazprom has to worry about oil- and gas-starved nations outbidding it for Central Asian supplies. Kazakhstan, for instance, plans to build a new gas export pipeline to China.

The Kremlin has been playing both energy and electoral politics in Ukraine and Belarus. Russia relies on Ukraine as a conduit for 80 percent of its gas shipments to Europe. In January 2006, a year after Viktor Yushchenko beat out the Kremlin’s favored candidate for president during Kiev’s so-called Orange Revolution, Gazprom halted gas supplies to Ukraine, leading to a drop in pressure in pipelines across the continent.

Gazprom’s explanation was that it needs to cut subsidies to former Soviet republics if it is to make any profit in Eastern Europe. The resolution of the crisis was that a little-known energy trader called RosUkrEnergo AG took over all gas sales to Ukraine, offering a compromise price by mixing cheap Turkmen gas with more- expensive Russian fuel. Gazprom owns 50 percent of RosUkrEnergo.

`Naked and Vulnerable’

Hungarian Prime Minister Ferenc Gyurcsány and other European political leaders called for more coordinated European Union efforts to diversify energy supplies in the wake of the Ukraine crisis. “EU countries must cooperate,” Gyurcsány said after the cutoff. “Sellers can easily make the buyers naked and vulnerable.”

No country is more vulnerable than Germany, already the biggest consumer of Russian gas in Western Europe. In part to bypass the troublesome Ukrainians, Gazprom is building a 5 billion euro pipeline under the Baltic Sea that will connect Russia directly to Germany. The first gas is scheduled to flow in 2010; by 2013, the pipeline will reach full capacity of up to 55 billion cubic meters a year, or almost two-thirds of Germany’s annual gas consumption.

In a December 2006 dispute with Belarus, Gazprom threatened to cut off gas supplies unless it got a fourfold gas price increase. With only a few minutes to spare before midnight on New Year’s Eve, Belarus submitted, agreeing to give Gazprom 50 percent of its state-owned pipeline company, Beltransgaz OJSC, in return for incremental price increases over four years.

A Question of Control

“On the Russian side, it’s a question of control,” says Julia Nanay, a senior director at Washington-based consulting firm PFC Energy. “Until Russia gains control of the pipeline networks, it won’t feel it’s won. That’s the ultimate goal.”

The U.S. is not immune to the Kremlin’s energy politics. Four years ago, Gazprom CEO Miller, during a visit to the U.S., announced that some of the gas from the company’s Shtokman field would be converted to liquefied natural gas and shipped aboard tankers to the U.S. Last year, as Russia’s World Trade Organization membership talks with the U.S. stalled, Gazprom abruptly changed its mind, saying all of the gas would go to Europe. Gazprom has since softened its stance. Medvedev says he expects LNG shipments to the U.S. to begin in 2014.

Even as experts question whether it can meet existing commitments, Gazprom is rolling out an ambitious new plan for expanding to the east. During a visit by Putin and Miller to Beijing in March last year, Miller announced Gazprom’s plans to build two gas pipelines to China, with the first going into operation as early as 2011. Miller has said the capacity of the two pipelines would reach 80 billion cubic meters, half the amount Gazprom now exports to Europe.

China Market

Stern asks whether China could even absorb so much new gas. In 2005, the country consumed just 47 billion cubic meters, less than Mexico. And China has a rudimentary gas distribution network compared with the dense web of pipelines that crisscrosses Europe. Chinese industry thrives on cheap coal-generated electricity, which costs a quarter of what Europeans pay for gas-generated power. China is part of Gazprom’s long-term strategy, Stern says. In the meantime, the potential of a competing Chinese market helps strengthen the company’s negotiating position with Europe.

One way for Gazprom to meet its promises to China would be to take control of Kovykta, a vast Siberian gas field west of Lake Baikal operated by TNK-BP, BP Plc’s Russian unit. The Natural Resources Ministry is threatening to revoke TNK-BP’s drilling permit for alleged license violations. At the same time, Gazprom is in talks with TNK-BP about buying a stake in the field, believed to hold 2 trillion cubic meters of gas. BP officials say they want Gazprom as a partner and are negotiating the terms of the Russian company’s investment.

“One of the main problems with Gazprom is that they’ll always put Russia’s interests before those of foreign investors,” says James Beadle, Moscow-based head of research at Nicosia, Cyprus-based Pilgrim Asset Management Ltd., which manages $40 million in Russia, including Gazprom shares. What would really be in Russia’s interests, former deputy energy minister Milov says, would be for Gazprom to shrug off its government mantle and operate like the independent, profit-hungry multinational corporation it claims to be.

To contact the reporter on this story: Lucian Kim in Moscow at [email protected]

Last Updated: June 3, 2007 22:08 EDT

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