#12
Date: Sat, 30 Mar 2002
Subject: Some thoughts on Gazprom
From: The author, who requested to remain anonymous, is a Western consultant who has worked with Gazprom in the past. Comments and questions can be sent to gazpromjrl@yahoo.com

March 2002 – Some thoughts on Gazprom

Gazprom, as befits its role as Russia’s largest company and as the largest energy producer in the world, has been the object of intense debate for many months, with the main themes sadly being mismanagement, financial transparency (or lack thereof), minority shareholders rights, and asset stripping. This debate has been largely driven by Western investors who would like Gazprom’s market capitalization to get closer to its potential value by Western standards (based on its production or reserve levels) as reflected in the recent text by W. Bowder published in JRL#6149). This has led this debate to come into the mainstream newspapers and has seen these investors side with V. Putin in his attempts to take control of the company back from its former management led by Rem Viakhirev. This text presents a different perspective on what can realistically happen with Gazprom and argues that what Putin is doing could be dangerous for Gazprom and for Russia.

Many of the arguments on Gazprom are about the visible part of the iceberg, i.e. the hard-currency revenues generated by the export of gas to Europe at “real” international prices. The debate then focuses on the way these revenues are shared between legitimate company spending, taxes, other company expenses of various kinds, and returns to shareholders. The relationship between Gazprom and the Russian authorities (local and national) is seen mostly through the angle of control by the government. This text argues argue that the interactions between Gazprom and public bodies are complex and shape the way Gazprom is and has been run in many ways independently of the fact that the Government owns a controlling stake. The way Putin seems tempted to take over the company will not change these underlying influences which were understood by the previous management but not, it would appear, by the new one.

The “strategic deal” between Gazprom and the Russian government

The main elements of the relationship between Gazprom and Russian authorities are the following:

(i) Gazprom produces over 500 bcm/y of natural gas, of which less than a quarter is fully monetised (through exports to Europe) while the rest is distributed in Russia and some countries of the FSU at a very low cost. This means that most (at least 75%) of the economic rent generated by Gazprom through the exploitation of Russia’s gas reserves is captured by the Russian population and the Russian economy. Discussions on the monetised part of the rent focus, per force, on the more visible but smaller portion of the wealth created by Gazprom, while the rest, although much bigger, is neglected because it is domestic and much less measurable in monetary terms. It nevertheless constitutes the core of the relationship between Gazprom and Russian authorities.

(ii) Vis à vis Russian authorities, Gazprom’s core obligation is to provide (i.e. produce and transport over large distances) natural gas to its export and domestic clients on a continuous basis. Gazprom has fulfilled this obligation consistently over the past (turbulent) 10 years. To do so, it has taken advantage of its huge resource base (including several super-giant gas fields) and of the large infrastructure investments which were done at the end of the Soviet period. Nevertheless, and contrary to the current common wisdom, this is a significant achievement: gas production has been stable over the last 10 years (while Russian industrial production and GDP were almost divided by 2). Exports obligations were fulfilled to the maximum at all times (and have been growing regularly over the period), while domestic needs deemed essential (mostly heating and electricity generation) were met although formal prices bore no link to costs and effective payments even less. Whether this was a good thing for Russia should be debated, but one can argue that this allowed the Russian population and some of its industry to survive – and that was a clear and legitimate, if unsaid, goal of all Russian governments. Gazprom has managed to keep up with the necessary maintenance and investments throughout the period while at the same time contributing significant funds to public budgets, local and federal. That funds were also used for other, less legitimate, purposes does not eliminate the fact that Gazprom has fulfilled its main functions, i.e. keep the gas deliveries going and provide export revenues to the government.

(iii) An implicit "deal" between Gazprom and Russian authorities at all levels has made this possible. In exchange for reliably providing export revenues and delivering cheap gas inside Russia, the management of Gazprom has had a lot of autonomy to run the company as it saw fit. This autonomy was put to very different uses as concerns purely domestic activities and export related activities. Domestically, that autonomy was used mostly to gain political or personal advantages from the distribution of a vital good (see below). Outside Russia, Gazprom's management was granted control, within certain limits, of the monetised part of the gas rent generated by the monopoly on gas exports. The management allocated this hard cash as follows:

I. Priority uses

(a) pay all foreign debt,
(b) pay for vital maintenance and investment requiring imported equipment,
(c) provide a minimum amount of hard currency to the federal budget, and
(d) provide extra revenues to the top managers and their “partners”

II. Other uses (once the vital needs are fulfilled, any amount remaining can (and will) be fought over by all entities potentially having access to these funds :

(e) other investment requirements within Gazprom,
(f) more taxes to the federal government,
(g) politically useful expenses (including investments outside Gazprom's core business),
(h) increase the private slush funds.

The management of the monetised rent has been quite restrained, at least by Russian standards. The proportion of cash which was not put to legitimate use has probably been the lowest of all Russian export businesses (which, admittedly, and sadly for the country, is not saying much…). The sheer size of the company has made the amounts large in absolute terms. In the recent period of 2000/01 when export revenues were very high thanks to high gas prices and the management was on its way out, (g) and (h) - which are the least legitimate uses of the money - took over a larger share of the pie and became much more visible, although this did not have an impact on the underlying industrial activity. Conversely, it must be emphasized that in 1998/99, when European gas prices were very low, and Gazprom hard currency revenues correspondingly lower, priority was given to the most industry-legitimate uses of the funds and other uses (including tax payments to the government) were curtailed significantly.

This control by Gazprom's management over Gazprom's hard currency receipts has been used, for the most part, rationally, in the sense that any misappropriation was done after the vital task of producing and transporting the gas was fulfilled (i.e. after a reasonable level of legitimate expenses were incurred). The engineering culture of the company and background of its managers have probably helped in that respect. In any case, the important thing to note is that, contrary to perception, the cash / hard currency part of the company is probably the "cleanest". The biggest uncertainty for outside investors is to know what the tax payment to the federal budget will be, as a permanent negotiation goes on between Gazprom and the government on that subject, with the result depending a lot on the political and financial environment of the country. As a rule of thumb, the budget gets “everything but” : (a), (b) and (d) are usually safe, but the rest is not. Obviously, a lot depends on what is deemed “vital maintenance”, and on who are the creditors of Gazprom. The one quality of the Viakhirev management is to have been reasonable and realistic on maintenance and investment.

In that respect, it is not clear that the new team put together by V. Putin, with Alexei Miller at its head, will bring any progress, including from the perspective of minority shareholders. It appeared initially that (h) was cut back, with (f) benefiting, but current indications are not so favorable, with (h) beginning again (with new beneficiaries), (g) still continuing, and more worryingly, (e) and (b) being threatened. It seems that Putin/Miller, distrustful of Gazprom personnel in general and unable to ascertain the legitimacy of certain expenses, are limiting investments, in favor of (c)/(f) (money to the government). If lasting, this is a worrying trend that could ultimately have nasty consequences, as a probably growing minimum level of investments is needed to maintain the system, in a context where gas prices are unlikely to be as high as they were for the past 2 years.

(iv) The other side of the coin is that managing Gazprom on the domestic side is first and foremost a political job. The main part of the job is not to seek maximum returns on investment as in a normal enterprise, but to successfully conduct permanent negotiations with the government and local authorities on the allocation of the gas rent which Gazprom produces.

Locally, Gazprom will try to seek to limit its deliveries, lower its taxes and extract the highest political price (in terms of support in Moscow or assistance in "pet" projects). Centrally, Gazprom will try to lower its tax burden, to extract payment for gas in various ways (goods useful to or tradable by Gazprom) and to channel additional investments into activities which bring the most return, politically and personally, to the top managers of the company and their allies.

In that context, it is very likely that Gazprom itself has invented the tale that it does not have enough money to maintain gas production : this is a strong argument to deliver less gas inside Russia and pay less taxes. Anectodal evidence suggests that Gazprom voluntarily limits its production and could produce more if it wanted - and if it found markets to sell it profitably to. (This shows that Gazprom does not behave only as a old-style Soviet dinosaur and does take into account the profitability of its production if there are incentives, however distorted, to do so...).

These domestic negotiations involve the local authorities and enterprises (politicians/ businessmen being often undistinguishable…), their suppliers and clients, the federal government as such and via its local entities, and the various units of Gazprom (transportation, procurement,...) in a complex web of relationships to settle gas deliveries, tax payments, ownership of various assets, political quid pro quos,... Local and federal issues interact, and factions within all entities (including government bodies but also within Gazprom itself) will have conflicting goals. This is a permanent "market place" of favors (business or political), goods to barter, IOUs, as well as blackmail, threats, etc…, with Gazprom at its center as gas was for a time the most liquid commodity and is the most universally needed in that cold country. The domestic entity “Mejregiongaz” has been explicitly created to centralize all of Gazprom’s non-monetary transactions inside Russia, and is now one of the largest clearing centers of the country.

Gazprom’s top managers and their respective allies in the political world therefore have tremendous political clout inside Russia. Gazprom, under the current "deal", is forced to deliver gas cheaply and is therefore the single biggest source of largesse in Russia (political in the form of gas valued by the population or financial in the form of tax payments or participations to various domestic deals). This power gathered by Gazprom's top managers (and shared with the top echelons of the political world) is nevertheless constrained by the fact that it is hard to exercise (cutting gas deliveries cannot be done lightly ; political transactions cut both ways) and by the need to keep the system functioning, i.e. channeling in priority a significant (and probably growing) portion of available resources to legitimate production expenses.

In any case, as long as the massive subsidy to the domestic market remains, any attempt to alter the balance of the system, and in particular through the opening of gas exports to others, would be profoundly disruptive as it would prevent Gazprom from fulfilling its central domestic role, i.e. heating the population: if any portion of the hard currency generated by Russian gas exports were taken away from Gazprom and not compensated for, it would not be able to pay for the maintenance of the gas system for very long, even if its operations suddenly became totally "clean". The consequence could eventually be a decline in production but this would be preceded by local incidents in the transportation network leading to cuts and shortages with increasing frequency, with unpredictable but potentially wide social and political repercussions.

The new management will have the same power and the same constraints. It is possible, if the management is loyal to Putin, that the share of the rent which was captured or distributed by Gazprom's management and its cronies for its own benefit will be captured instead by the State. This would be a good evolution but that only concerns a small portion overall of the gas rent (it would not change the fact that most of it is still distributed to the population), and it would be optimistic to believe that the benefit will actually go towards the public good rather than to simply another small group of well-connected people.

In fact, an additional danger is that was is seen today as a sign of progress (the steady replacement of “Gazprom old-timers” by managers loyal to Putin/Miller) could become a liability in the future, as (i) State and other minority shareholder interests begin to diverge, after a period of unusual convergence, and (ii) the new management of the company becomes estranged from the industrial heart of the company and forgets the first part of the deal between Gazprom and the State : get the gas produced and transported. This issue should not be underestimated for the sake of reforms, however useful these are. There are disturbing signs in the way the government is interfering in the investment process within Gazprom. The government should have a say on how Gazprom invests ; it is also desirable that useless investments and overpaying be avoided, but that should not mean either that any capital expense is suspicious per se and that the money should go to government coffers instead (in line with point (i) above, it is unlikely that much of it will go to other shareholders, there are too many “outsiders” among them…). Thus Putin must avoid the temptation to starve off Gazprom in order to avoid waste or theft, because this would lead to underinvestment and distribution problems, thus breaking what works within Gazprom without any discernable benefit.

The relative value of Russian gas assets

Putting aside cash movements and moving on to assets, it is clear that there have been fewer restraints on the domestic side on Gazprom's management ability to gain personal benefit from Gazprom's transactions, so long as gas was delivered.

In 2000/01 in particular, Viakhirev et al. (knowing that they would in all likelihood leave the company) organised the distribution of contracts or assets to "interested parties" on a larger scale than before (also taking advantage of higher gas prices as well as a generally improving domestic situation). Again, some of these arrangements should be put in perspective, i.e., in a context whereby Gazprom has fulfilled one of its “duties” by exporting as much gas as the Western European markets will take, and bringing (most of) the proceeds back into Russia. It is meaningless, for instance, to evaluate domestic gas assets given (or sold at very low prices) to other companies on the basis of the price that the gas would fetch at European prices, because that market simply is not available in a context which requires Gazprom’s export monopoly to function. Any gas sold by another Russian company would reduce Gazprom’s market share (and revenues) and not add to it. Therefore, as Gazprom already produces enough for all its needs from its existing fields (and will continue to do so for many years), any non producing asset is currently not worth much to the company, nor to anyone else.

Unless, of course, those other potential producers have the possibility to sell gas where Gazprom cannot, or somewhere where it can get a better price than Gazprom. This is the case in some former Soviet republics or in some cases inside Russia, where Gazprom cannot charge for its deliveries, or cannot enforce payments, whereas a (well-connected) private company may do so.

This was the original rationale behind the creation of Itera : to sell Russian gas in Ukraine where Gazprom could not get paid for its deliveries. Gazprom has practically never been able to extract cash payments for gas delivered to Ukraine. This does not mean that gas was not paid for by consumers (for part it was not, as in Russia), but that the Ukrainian payment collector chose not to pay Gazprom because it could (for the very simple reason that it controls the pipelines through which 90% of Gazprom’s export to Europe flow). Gazprom’s solution was to have the gas delivered by someone else, would could cut off supplies to Ukraine without risking retaliation as Gazprom could not (each time it reduced its deliveries to Ukraine, deliveries to the West were effectively cut off). Gas was procured by Itera from Turkmenistan to build the fiction that it is not delivered from Russia. In practice, this meant that money that would go to Gazprom in an ideal world now went into the pockets of people with links to Gazprom’s management instead of into the pockets of people with links to Ukrainian authorities. There was no loss for Gazprom, but only in the narrow sense that money would not have reached the company in any case. Today, Gazprom delivers to Ukraine approx. 25-30 bcm per year as payment of transit tariffs for its export gas (by the way, this payment in kind can be legitimately accounted for at many different prices, as there is a set-off for another service, transport, which can also have many realistic prices). Another 25-30 bcm of gas are shipped every year from Russia, by Itera or others and not by Gazprom (who still acts as transporter of the gas to the Ukrainian border). If that gas came from Russia, any positive price that Gazprom gets is pure profit for Gazprom, because it previously had to deliver this gas without getting any payment. The question that arises is then a question of the fairness of the allocation of that payment between Gazprom and Itera (which is a legitimate question with Itera a vehicle for Gazprom-related investors), but not whether Gazprom lost out in the deal, because it did not, as far as the Ukrainian market is concerned. (If financial guarantees, or preferential transportation tariffs have been provided by Gazprom to Itera, this may need to be reassessed, but information on that subject is hard to come by). To improve the situation for Gazprom shareholders, the gas market in Ukraine would need to be changed. It is not clear at all here that competition between Russian exporters for access to Ukrainian pipelines would bring any improvement to this situation.

As far as domestic sales were concerned, the same line of reasoning (the inability of Gazprom, for political reasons, to cut off supplies in case of non payment) led to selective distribution by Itera and a few others to selected customers inside Russia (who had the means to pay but the political means to avoid it if the shipper was Gazprom, but not if it was another entity with enforcement capacity). This was initially profitable for Gazprom, because of the distorsions it had to live with in the first place. What has probably happened since these early days is that Itera has found a life of its own as it grew with Gazprom’s help (including easy access to the transportation network) ; its interests are now no longer aligned with those of Gazprom and it is likely to emerge as one of its most serious competitors. The ideal situation would see other competitors having the same rights and access to the pipeline network and other facilities…

To get back to valuation issues, abandoning Gazprom’s monopoly on exports would admittedly improve the potential value of fields inside Russia, but, that would threaten Gazprom’s ability to have the funds to produce gas for both exports and domestic use and therefore require a complete overhaul of the “strategic deal” which currently rules Gazprom’s motus operandi. In any case, Gazprom’s reserves are so staggeringly huge that the number is meaningless as a means to value the company – most of the gas will not be produced in the foreseeable future, and it may make sense for the company to dispose of assets if it finds a buyer. There are no reasonable arguments on Gazprom’s side against full transparency in such transactions and any lack of disclosure certainly reflects sub-optimal pricing for the company… This is probably the kind of transactions where minority shareholder efforts for better information make the most sense, especially as it is hard, as indicated above, to get a fair price evaluation for an asset in the current situation. A good test of the new management will be to see if efforts at transparency continue once control over Gazprom by Putin/Miller is complete.

Ideas for reform

The only way to reform the hard-currency part of Gazprom would be to reform at the same time the domestic part, and the only way to do that is to massively increase domestic gas prices - and enforce payments. This could be done progressively, as has been done for oil and oil product prices in the 90s, and does not in any case require that domestic prices reach international levels (taking into account transportation costs, gas will always be much cheaper to deliver in most of Russia anyway).

What would be required are price increases that eventually (i) generate sufficient cash-flow for Gazprom to pay normally for its operating costs, investments and a reasonable level of taxes without having to negotiate special deals at all stages to protect its hard-currency revenues, and (ii) make gas delivery a commercial and not a political business, with payment in cash and not in favors, bribes, votes, etc... Only if such conditions are met (and it is hard to know which one of the two is easiest) will it make sense to try and change the distribution of the monetized portion of the gas rent.

Industrially speaking, Gazprom is a reasonably efficient entity, able to produce large quantities of gas at low cost and transport it to where it is needed. That most of the rent created is distributed inside Russia, and that a part of the monetized fraction is further captured by privileged parties does not eliminate the fact that Gazprom is able to produce this value. Any reorganization of the company to change the repartition of the visible, "monetized", value between various parties (the company itself, its managers and other "interested parties", the government, shareholders, outsiders such as oil companies or Western majors) should take into consideration the impact of such a reorganization on the ability of Gazprom or the potential successor entities to keep on creating all the value added and the impact (economic, political) on current rent-holders in Russia, i.e. first and foremost the population and second, Gazprom managers and their politician/"biznessmen" friends.

In any case, it is very unlikely that Western companies will want to invest in the gas sector in Russia so long as gas prices remain low in the country : they will naturally require rights to future revenues to pay for their investments – and as a priority to export revenues (especially if they want to finance these investments), and Russia cannot afford to abandon any portion of these exports so long as this is the main resource to keep the gas production - and the gas distribution to the population - going. Russian oil companies would only be interested in the current context (low domestic prices, and an obligation to deliver a significant portion of their gas domestically) if they found an interest in converting these obligations into political clout, or if they could find ways to avoid fulfilling such obligations, in a sad repeat of the games of the oligarchs of the mid-90s. That does not seem likely today and is probably a good thing...(some of the oligarchs would probably be interested to go back to these games to which they are better suited than the good old-fashioned running of a big industrial enterprise, but the majority would probably rather remain in today’s Russia where the returns are not as high as before, but ownership of assets is assured beyond a few months).

Furthermore, from a strategic point of view, Russia probably has good reasons to maintain its export monopoly. Although the Russians themselves are among those who believe that the on-going liberalization in Europe will bring prices down, those hopes (or fears, in the Russians’s case) are likely to be dashed in the medium term. Europe’s need for imports is growing, and Gazprom is in a unique position to provide an also-growing share of these imports, thanks to its reserve base and to its unique infrastructure allowing it to bring its gas to the European market in large volumes. Throughout the last decade, (and this is another point in favor of the old management) Gazprom has relentlessly continued to build new export pipelines, including the Yamal-Europe line through Belarus and Poland, the Blue Stream pipeline to Turkey, and capacity increases on the Balkan pipe and other connecting lines. These pipelines are now in service or close to be, which makes it physically possible for Gazprom to sell its gas at marginal cost, which for the Russian company is extremely low (certainly lower than 1 $/mbtu). In view of the volumes of gas that Gazprom is able to deliver (close to 130 bcm/y to Europe in the past few years, with pipeline capacity for probably 30 bcm/y more today), its ability to flood the market with cheap gas is massive. The mere implied threat lowers the price threshold at which new investments to bring gas to the European market (by LNG or pipeline) must be profitable, thus making fewer such projects possible (or at least financeable), and eventually pushing prices up.

It is not clear yet that Russia will have the political will to trigger such a crisis with Europe (let alone the financial discipline to go with significantly lower gas revenues for several months or longer), but Gazprom has the capacity to influence gas prices in Europe upwards on a long term basis. In that context, it could make sense for Russia to use this power in the gas business to reinforce its position in Europe, which would require to keep some form of control over its gas exports. Whether Russia uses such a power intelligently or usefully, and whether it is used positively (for instance to get closer to Europe) or negatively, is another question altogether. (The example of Ukraine, which has made no positive use whatsoever of its absolute stranglehold on Gazprom, should be kept in mind here, and Gazprom, which is on the receiving end there, no doubt will).

In both cases (the domestic situation and the export markets), it is clear that with Gazprom, whoever controls transportation controls the gas business – or to be more precise in a post-Soviet context, whoever gets paid for transportation controls the gas business. Gas executives have long argued against the separation of production and transportation of gas, but it can be said that Gazprom’s core business already is gas transport rather than gas production, considering the technical constraints it faces (supergiant but relatively simple fields in locations requiring long distance pipeline transport capacity). By keeping control of the unified transport network within Gazprom (including control of the export lines) but progressively transferring production to third parties, Russia could conceivably develop a long term gas strategy whereby Gazprom would collect revenues via tariffs to maintain the network and ensure transportation of gas on behalf of many producers. Export tariffs could be set at a high level, thus ensuring revenue flows to State budget while making domestic deliveries relatively profitable (and allowing Russia to lead the external gas policy it chooses). This would allow competition to grow and make it possible to change domestic prices at the pace chosen by the government to reflect its other priorities (inflation, social policy…).

In the absence of such drastic overhaul, the big question today could be put in the following terms: given that the gas system ("Gazprom" in its original meaning of "gas industry") will probably require in the future much larger investments than what has been done in the past 10 years (to sustain domestic demand and provide for regularly growing exports), but that its resources are for the time being limited (to hard currency export payments) and fought over harder than ever, what will give in first? Will domestic prices be raised high enough and quickly enough to change the business model of Gazprom, or will the government choose to maintain low prices to protect domestic users, effectively preventing any real reform of the company? Will the current system collapse one day from the conflicting demands put on it? Gazprom has faithfully sustained Russia for the past 10 years; when will Russia give it the framework to grow again?