Gazprom’s fight back has begun. President Putin has made crystal clear to the European Union that he considers Gazprom to be a strategic asset of the Russian state over the anti-trust case accusing them of monopolistic practices. You know it’s ‘serious’ when Mr. Putin signs a decree telling everyone so: Messy legal arguments simply don’t apply when it comes to prized Russian assets. That will certainly come as welcomed news for Gazprom that was starting to question its position in a ‘Putin 2.0’ Presidency, but if anything, highlights the gas giant’s core problem: Gazprom has gone beyond the point of any commercial return to play the role that Russia wants, due to shale developments elsewhere. Unless Putin backs up his words with credible actions, not just fobbing off the EU, but putting more ‘state’ and cash back into Gazprom to progress its global ambitions, it’s going to suffer a slow and painful market death. That’s not exactly good news for Mr. Putin either. Back to Soviet economics 101.
A core part of Gazprom’s problem is that it’s been caught playing two hands. One is supposed be an all-conquering Russian gas monolith, progressing the Kremlin’s position at every turn. The other is a market player with minority shareholders that need to keep a watchful eye on market developments, only making smart, cost effective investments. We’ve all had the briefings from Gazprom execs telling us projects have to conform to market principles, with clear economic upside for handsome return on investments. The message must be sinking in for some – even the politically savvy FT gave the Shtokman cancellation the thumbs up. Good call, it was way too expensive as a commercial proposition; whilst you’re at it, you might as well scrub the South Stream pipeline. That second Nord Stream pipe wasn’t really needed you know, and as for the Eastern gas programme, you’re chucking good money after bad in far flung East Siberia. Knock that stuff on the head, and you’ll start closing the $100bn shortfall between Gazprom’s market price and underling asset valuations in existing Siberian fields and sprawling pipeline networks.
Obviously on commercial grounds it’s all absolutely true. Serious energy analysts in Europe spent many years trying to warn Gazprom exactly of these types of outcomes. But the problem now, is that the gas world has transformed so far beyond anything Russia can be begin to comprehend from shale shifts, that it will never be able to maintain its global stake if it pretends to keep playing by upstream commercial rules. While Gazprom was (and still is) busy giving lectures on long term oil indexed contracts (cue the excellent Platt’s gas bash just held in Vienna), IOCs were more than happy to sink their capital into dirt cheap US shale, cheap(ish) LNG from the Middle East and West Africa. They’ve since been falling over themselves to get into East Africa. New shale plays have cropped up in North Africa; Latin America has been given a second shot at resource bounty, even Central Asian gas might make its way to European markets. Head down-under to Australia, and niggly cost inflation isn’t going to stop to 60-80mt/y of Kangaroo LNG hitting the market by 2020. Sunk costs will make sure of that.
That’s before you consider the incredibly smart hedging strategy China has put in place on the buy side, judiciously signing tepid ‘memoranda of understandings’ with Russia, while sourcing actual supplies from Central Asia, Australasia, the Middle East, West Africa and even North American markets, as the latest fertilizer to grow Beijing’s hedges a little higher. China’s own unconventional production will hit 100bcm by 2020. You get the picture. Global shale developments have been rocketing ahead; Gazprom was caught sitting on its hands, watching the gas world change around them.
The upshot is that the only way for Gazprom to survive in a new gas world is via ‘Kremlin Inc.’ Strategic investments will have to be made all the way along the value chain. Fundamentals frankly don’t allow for much else. Not only is Gazprom increasingly capital constrained (it forked out $40bn in CAPEX in 2011 to little effect); it was the worst performing stock in the global energy sector last year. Its share price is less than a third of 2008 levels, with a measly three times forecast 2012 earnings. Far more worryingly, production has flat-lined from 2001, and actually recorded an onshore drop from 556bcm in 2006 to 509bcm in 2012. Asset sweating is undoubtedly part of the problem, but the blunter point is once Bovanenkovo plateaus (at 100bcm) in 2016, the easy plays in Russia are gone. Gazprom’s remaining 35 trillion cubic metres of reserves are all in hard to reach places in the Yamal Peninsular, the Far East and Eastern Siberia – a daunting task when you consider Russia has to replace its entire 670bcm of gas by 2035 according to the IEA. That’s going to be very expensive indeed.
The normal route when you lack the cash and tech to develop fields is to offer attractive fiscal, tax, royalty and export exemption terms to bring IOCs onboard. That will still work for lucrative oil plays, but given the new swathe of gas plays cropping up on a global basis, Russia is close to the last place IOCs will want to do business – either on uncertain commercial, or politically pernicious, grounds for gas. They all have long memories of being burnt in Russia when the time suited Moscow; what’s more, they all know future Russian gas plays will be out of the money relative to easier unconventional developments elsewhere. Moscow might try to link Russian oil fields to pithy gas developments, but there is ultimately no getting around the fact if Putin wants to project any kind of serious molecular based power in future, he only has one choice; take Gazprom directly back under his wing.
Gazprom is arguably starting to pick up on this. It was no coincidence that its first retaliatory move against the European Commission’s probe wasn’t threatening to cut supplies to Europe, but to use it export monopoly status in Russia to suspend gas purchases from independent producers such as Novatek or Lukoil to support its own production amid dwindling demand. The message for President Putin was abundantly clear: assuming you aren’t going to do a ‘Yukos’ on us, stop promoting private entities that are never going deliver serious volumes of gas to achieve your broader Eurasian aims, and focus on what’s ‘good’ for you and ‘good’ for us; total upstream control. The fact Putin hasn’t blocked the move puts private Russian gas players in a very precarious position. 35% of Novatek’s 54bcm production could be hit. Attracting new capital will be very tough given the risks involved, striking supply side agreements (as Novatek did with Eon earlier in the year), even harder. Reaching 112bcm of LNG by 2020 looks close to impossible for Novatek to obtain now, let alone other independent players producing 300bcm by the same date across Russia. Logic therefore suggests that Putin’s mini privatization experiment is over. The statist tables have been turned. Gazprom will provide the gas. Rosneft (under the tutelage of Igor Sechin) will do the oil.
This oil-gas interplay certainly shouldn’t be underestimated either. While analysts tend to fixate on Russian gas issues, it’s actually the 10mb/d of Urals oil that makes the Russian economy tick. Putin has netted over $900m a day over the past few months from liquids, amassing around $500bn in cash reserves to use as the Kremlin sees fit. Given gas only accounts for a small part of the revenue equation, cross subsidising oil production to project Russian gas reach is certainly not beyond the realms of possibility given Gazprom’s structural problems. Oil is the money; gas is the power in Russia. And let’s face it – using massive oil receipts to stimulate Russian gas production – remains a far easier move for Putin to make compared to introducing highly unpopular domestic price reforms to help fill Gazprom’s coffers. Russian’s are used to cheap gas, typically set at a third (or less) compared to prevailing market rates.
Gazprom’s Next Steps
Piece all this together, and in practice, we’re likely to see four developments. Firstly, Putin will continue to totally reject the validity of the EC probe into Gazprom. As the Russian Ambassador to the EU (Vladimir Chizhov) has already said, “the EC is welcome to investigate Mars if it wants to”, the implication being that it can then send any invoices to Venus. Russia won’t pay. Keep asking, and CEE and South East European states will almost certainly face supply cuts back on planet earth.
The second, related move is to push through flagship projects in the European Southern Corridor to cover Gazprom’s most visible geopolitical weaknesses. The South Stream pipeline across the Black Sea into Central Europe is the easiest option (or indeed Blue Stream extension via Turkey), that can still be done off Gazprom’s balance sheets. That’s particularly true when you consider Russia would only need to divert 15-20bcm from Ukraine towards CEE states to knock out competing Azeri pipelines. The other 40bcm can come far later to complete South Stream’s 63bcm grand designs.
The third step is more contentious, but probably inevitable given global gas fundamentals. Moscow’s rhetoric will continue banging on about oil indexed contracts, (tactical co-operation with Qatar might buy a bit more time on that front), but if Putin is smart, he’ll quietly start underwriting the transitional losses from oil indexed contracts towards gas prices based on gas fundamentals, and doing so from the Kremlin’s books. That’s not because the European Union has got on its high horse about indexation, but because Russia stands very little chance of selling its gas into China on an oil indexed basis. There is only so long Gazprom can keep trying to ice skate uphill without getting hurt. Alexey Miller (CEO) won’t like it, but provided Gazprom gets incremental buffers to cushion the blow, they could end up benefiting most from global gas price convergence. And especially so if Putin forces Gazprom to do what they should have done over a decade ago as his fourth move; relegate petty pipeline politics in Europe to a minor concern, and start developing Russia’s LNG potential to make it the largest liquid player in the world.
That means looking at Sakhalin III options, building on recent Vladivostok agreements with Asian buyers, dusting down Shtokman plans far sooner than later, and looking at LNG prospects that could come from giant Bazhenov and Achimov fields. No more excuses; Russia’s 30% of global gas reserves need to be translated into an even higher percentage of global LNG share. That means plunging heavily into Russia’s oil revenues to do so, (‘loan for gas’ deals from Asian NOCs would be the default options if the kitty runs totally dry). Like it or not, if Russia doesn’t have the global volumes, it will be impossible to set the price. Going big on LNG is the only way Moscow would eventually be able to dictate (and arbitrage) Atlantic and Pacific Basin prices in the longer term.
Critics will rightly point out this is an impossible list to finance, and certainly not on market terms. But that’s the whole point here; the only way Gazprom can get close to any of this is to do away with commercial logic that’s been destroyed by the shale revolution, and take Gazprom fully back into the hands of the Russian state. Anything less and Gazprom is doomed to certain failure. Will that make Gazprom even more inefficient? Yes. Will it make all their moves inherently political to retain (and build) market share? Yes. Will they eventually look to capitalise on a single price point to one day manipulate prices? Yes.
But what seals the deal here, is not the parlous state of Gazprom, but that serious debates in Russia aren’t asking how well Putin will perform to 2018, but whether he can last that long? Putin is well aware if Gazprom suffers a humiliating fall from grace, the collateral damage will be more than enough to sweep him from office as well. There are only so many times Putin can go to China and come back empty hydrocarbon handed. There are only so many times that Putin can be seen being nice to European politicians, and there are only so many times Putin can tell the Russian population that his half-baked energy reforms are working in their favour.
Bottom line: Putin needs Gazprom as much as Gazprom needs Putin. Time to dump the ‘market thing’ that Gazprom has so miserably failed at, and get back to what Russia knows best: Soviet economic blue prints. Gazprom might end up bringing the entire Russian edifice down with them. But right now, it’s not like Mr. Miller or President Putin have much of a choice – not if they want to avoid literally becoming the laughing ‘stock’ of the energy world.