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Analysis & Opinion
06.04.10 The Besieged Behemoth Fights Back
By Tai Adelaja

Ill at ease and at a crossroads, the Russian gas behemoth Gazprom has lately been struggling to redefine itself, after being hit by an economic double whammy of a global oversupply of gas and lower demand projections for gas in the near future. Always known as a company of superlatives, Russia's largest corporation once boasted of becoming the world’s first trillion-dollar energy company by market value, but the global economic downturn struck at the very heart of this plan, teaching Gazporm some lessons in humility.

The Russian gas market “faces an extremely challenging environment in the short to medium term, with both prices and market share coming under pressure,” found a recent study on the future outlook for Russian gas by Wood Mackenzie, a London-based consultancy firm. Gazprom’s problems, however, started in the most unusual of places. In 2009, the United States unexpectedly surpassed Russia as the world’s biggest natural gas producer thanks to advanced technology in the production of shale gas.

The news sent shockwaves across the business and political spectrums, and led to a commotion among prominent gas lobbyists, directors of oil and gas institutions and top government executives. Sergei Shmatko, Russia’s energy minister, said last month that the growing supply of shale gas from the United States to Europe is “a matter of concern to Russia.” On March 25, the State Duma Committee on Energy summoned top managers, oil scientists and academics to an urgent roundtable to discuss the “perspectives of shale gas resources.”

The shale gas boom is also hitting Gazprom hard in other export markets. Gazprom’s ambitions to grow a major business in North America based on liquefied natural gas (LNG) imports from Russia now face considerable challenges, as the shifting landscape in shale gas production is forcing many Canadian companies to investigate and invest in the booming energy potential.

As long as unconventional gas supplies continue to grow in the North American market, the long-term pricing environment is unlikely to be sufficient to support the economic development of high-cost projects, such as the Shtokman liquefied natural gas project in the Russian Arctic or the Yamal LNG project, researchers at Wood Mackenzie found.

Another unpalatable consequence of the global economic recession for Gazprom is that the crisis slashed European gas usage last year and weakened the medium-term demand outlook. “Our analysis shows that while the interdependency between Europe and Russia will continue, Europe has been the hardest hit by the global gas glut, and there are two key uncertainties for Russian gas: demand growth and future gas pricing,” said Tim Lambert, study director and vice president of energy consulting for Wood Mackenzie.

The global financial crisis triggered a 7.4 percent decline in gas consumption in foreign countries last year, while domestic production fell by 6.4 percent, causing net imports to shrink by 8.5 percent, Gazprom said in emailed comments. "[Last year] supply considerably exceeded the demand on the European gas market, leading to a 12.3 percent decrease to 140,2 billion cubic meters in the volume of gas supplied under long-term contracts," the statement said.

Lambert said the expected global oversupply of gas is creating a competitive European gas market, which may lead to soft prices for the next five years. “Despite the general trend of rising imports into Europe, the European market will see a further increase in both established and new gas suppliers competing to place volumes,” he said.

With the United States consuming less liquefied natural gas, gas exporters like Qatar have been diverting LNG to the European market, further putting downward pressure on spot market gas prices. The situation poses a direct threat to Gazprom, which supplies over a quarter of European gas through its long-term “take-or-pay” contracts, which link its gas price to oil prices and penalize customers for gas they don’t buy. In a near-humiliating move last month, Gazprom renegotiated some of its long-term “take-or-pay” contracts with European customers for a three-year “crisis” period, according to Alexander Medvedev, the company’s deputy chief executive.

In the new agreements acquiesced to by Gazprom, European energy groups are allowed to link up to 15 percent of sales to gas prices on the spot market, which are about 25 percent cheaper than the oil-linked prices specified in long-term contracts. As global demand for gas fell last year, production volume plummeted, with the company producing only 461 billion cubic meters of gas, 16 percent less than a year earlier. The situation was so depressing that Gazprom executives described 2009 as the worst in the history of the gas industry.

To change the tide, Gazprom last week announced a raft of cost-cutting measures designed to help the company regain balance and whatever is left of its past glory. The company said it has been forced by the financial meltdown “to concentrate resources on the highest priority projects” in its investment program, thereby reducing capital expenditure by 31 percent of the total Investment Program approved in December of 2008. It has rescheduled the commissioning of the first phase of the Bovanenkovo field on Siberia's Yamal Peninsula and the gas pipeline network in Bovanenkovo-Ukhta from the third quarter of 2011 to the third quarter of 2012 “because of the projected decline in demand for gas.”

Gazprom said it has also reduced investment in mining facilities, processing facilities and underground gas storage, and has deferred implementing a comprehensive program of reconstruction and technical re-equipment of gas transportation facilities for the period of 2007 to 2010 in order to “optimize the cost of capital construction, renovation of production facilities and equipment.”

As a result of these cost-cutting measures, the company was able to reduce its investment program by 17 percent to 760 billion rubles compared to the previous year, the company said in its statement. Gazprom said it is buoyed by “a noticeable increase in demand for gas in all markets” and has earmarked 802 billion rubles to complete its investment programs in 2010.

For the gas behemoth, coming down to earth has also meant reordering its post-economic crisis priorities with an increasing focus on the Asian and domestic markets. The Asian gas market is potentially very attractive for Russia, as it provides diversification and the potential to monetize large quantities of remote East Siberian gas, analysts said. “With Chinese gas demand forecast to quadruple by 2030, it therefore offers substantial upside for Russian exports using gas reserves which would have been unlikely to find a market in Europe,” researchers from Wood Mackenzie said.

On the domestic front, Gazprom is expected to benefit from the implementation of price reform currently being undertaken by the government. The Russian gas market has been and remains the main one for Gazprom – the company supplies more than 50 percent of extracted gas to domestic consumers. “We are actively supplying gas to the Russian regions. In the past five years, gas supplies to domestic consumers have increased from 54.2 percent to 63.2 percent," the company said. Starting January 1, modest communal services reform has led to a 26 percent increase in gas tariffs for domestic consumers. The government is also planning to stop subsidizing domestic gas prices by 2014, with Gazprom expected to be a major benefactor, Bloomberg reported, citing a statement from the company. The company expects export and domestic gas prices to converge next year and reach parity by 2014, excluding transportation costs. “Despite it being among the hardest hit by the crisis in 2009, future Russian gas demand is forecast to resume growth, which, combined with the prospect of further domestic price increases, offers substantial opportunities for profit for suppliers to the domestic market,” Lambert said. “Gazprom will be eager to ensure that the Russian government continues the implementation of price reform,” he added.

With the economy showing some strong signs of recovery, analysts said electricity production and consumption are expected to go up, pushing up the internal price for gas sufficiently enough for domestic gas companies to reap high profits. “Most of the gas consumed in Russia is used by power plants to produce electricity, and Gazprom is expected to benefit from higher demand for electricity as the economy improves,” Maxim Moshkov, an oil and gas analyst at UBS, said. “We already see that gas production was up 16 percent in the first quarter, in part because of the cold winter in Russia and in Europe, but also as a result of GDP growth.”

Moshkov said that Gazprom could grow production by ten percent this year, while 2010 earnings before interest, tax, depreciation and amortization could increase by 30 percent, helped by higher domestic demand and a more flexible pricing policy by Gazprom through the inclusion of spot gas indexation in its gas sales agreement. “Gazprom should be able to weather the crisis through a combination of factors that include higher domestic gas tariffs, which rose by 26 percent in January, and its new export pricing policy,” he said. “Gazprom has also jettisoned those projects that are a clog in the wheel, such as the LNG phase of the Shtokman project.” Moshkov said Gazprom has also renegotiated its contract with the Central Asian nation of Turkmenistan last year, seriously decreasing its commitment to buy gas from 70 percent to 40 percent. Victor Mishnyakov, an oil and gas analyst at Uralsib, agreed: “Measures so far taken by Gazprom would buy the company much-needed time to consolidate and evolve better market pricing policies,” he said. “If things go as planned, it will be a different story in two years time, when the gas price would attain new equilibrium.”

Lambert said that while the new competitive environment “may impact Russia’s market share in Europe in the latter half of the decade, it is expected that Russian gas will solidify its dominant position in the long term from around 26 percent of the European market currently to over 29 percent by 2020 and 30 percent by 2030.”
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