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Mon 1 Aug 2005 04:00 AM

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Gazprom turns gas into gold

Could Russia’s Gazprom become the OPEC of the natural gas industry? SBI Finance looks at the evidence for and against.

I|~|featbig.jpg|~|Reaching the skies: Gazprom aims to become a natural gas supplier with global reach.|~|There were always three things in life that were inevitable: birth, death, and taxes. Now, there is potentially a fourth: Gazprom. Gazprom is a true powerhouse company by global standards, that has in the last few years made moves to unlock its potential. With the agreement to sell 10.74% of itself to the government for RUB 230.5 billion (US $8 billion), giving the government 51% control, Gazprom is set to unleash its vast potential.

What exactly is that potential? The statistics are daunting. Russia has the world’s largest gas resources by far. At year-end 2004, according to BP’s Statistical Review Of World Energy, proven gas reserves in Russia stood at an estimated 48.1 trillion cubic metres (tcm), representing 32.1% of the world’s total reserves. Russian gas output in the same year accounted for 22.5% of the global total, with Gazprom contributing 89.6% of this figure. In the meantime, Russia’s estimated reserves to production (R/P) ratio at year-end 2004 stood at 83.7 years, which compares to 61 years for the world as a whole, and 12.6 years for OECD-based gas resources.

Gazprom is a behemoth, and it is not a new company. It has long been, arguably, Russia’s single most important commercial/political strategic asset. That said, for over a decade, Gazprom was badly mismanaged, through the painful transition of Russia from a command to demand economy in the 1990s.

For example, between 1996 and 2000, the previous CEO Rem Vyakhirev saw a rather eye-catching US $16.313 billion in combined write-offs and provisions, according to International Accounting Standards (IAS) numbers. In fact, the old management created worthless assets by a number of means, including supplying gas to insolvent customers and incurring bloated investment costs. There are few better examples of the economic benfits of President Vladimir Putin’s centralising of power than Gazprom.

In the past, Gazprom had so many daughter companies and affiliates that were stripping the value out of the value chain, that when Alexei Miller, the current CEO of Gazprom, was appointed in 2001, many believed he was given a worthless and out of control shell.

Miller, whose appointment was directly sanctioned by President Vladimir Putin, is one of the new breed of managers in Russia, charged with improving the nature of corporate transparency. Miller’s appointment sent out various signals in May 2001 that this was a commitment to improve Russia’s parlous state of corporate transparency, whilst others judged it as a broader watershed point in Russia’s investment environment. The value of Russia’s equity markets, and Gazprom, have been steadily rising ever since.

So what, if anything, has changed at Gazprom since the arrival four years ago of Alexei Miller? Whilst much has been written, analysed, and prophesised about changes at Gazprom, one message is clear.
Gazprom needs to be, and is well on the way to being, a cornerstone of the new Russian economy. To this end, the Russian State has, rightfully, taken the decision to regain overall control of the company, with a 51% share. Foreigners are still limited from owning the company directly, due to the ‘ringfence’ that has kept the value of Gazprom shares artificially low and given Gazprom CEO Alexei Miller time and breathing space to re-create the value chain.

Firstly, Gazprom needed to plug the holes that were created in the value chain. Some believe that up to 10% of Gazprom’s gas reserves had been transferred off the balance sheet and outside the control of Gazprom. At the time, the opportunists who undertook this via various asset-stripping techniques understood the future potential of Gazprom.

However, under the new regime, Gazprom systematically went about re-appropriating these reserves back onto the balance sheet, at a fair price, but far short of the amounts that those who had transferred the reserves had hoped to garner. Simply, they were left millionaires, rather than billionaires.

Secondly, Gazprom needed some serious financial re-engineering. The practice of supplying gas to insolvent customers, mismanaging capital spending and bloating investment costs was addressed. Gazprom, as has been stated, intended to consolidate many of its daughter companies, which were responsible for these practices, back under the control of central management.
In fact, Gazprom has been quietly, but forcefully, consolidating these daughter companies, and thus halting the practice of supplying insolvent shell companies with gas. The aim of this has been to reduce the cost centres, while at the same time creating new profit centres. Added to this was a clear need for a workable management information system (MIS). Gazprom understood that there was no point tracking down its assets, and plugging the holes, if it did not create a new and dynamic MIS to effectively manage its future.

Simply understanding Gazprom’s cash flows has been a feat in itself. Gazprom has been producing accounts under IAS and more recently under IFRS (International Financial Reporting Standards) since 1996. IFRS is a combination of IAS, taken from British accounting standards, and GAAP (General Accepted Accounting Practises) taken from US standards.

Not everyone, however, would agree that Gazprom has made progress. While gas and oil prices have been soaring, and global peers have an excess of cash, Gazprom’s expenditure has been steadily going through the roof. Gazprom, despite the efforts of Miller and his team, has not been successful in reigning in costs. After all, Gazprom is, and will remain, a state-owned company. Russia’s cumbersome state bureaucracy remains one of the major stifling influences on business development in Russia.
||**||II|~||~||~|Nevertheless, Miller and his team are positioning Gazprom as a supplier of upstream oil and this is where the cash is being spent. Evidence of this is Gazprom’s intention to roll the recently acquired Yugansk asset from Yukos into its structure.

While this has not occurred as yet, there is little doubt that it will. Similarly, rumours continue to grow that Gazprom is looking to acquire Russian oil company Sibneft, to add to its upstream oil & gas portfolio. Could the ultimate bureaucracy, Gazprom, be emerging as the benchmark for the future of Russian companies, transforming itself into a fully integrated oil and gas conglomerate, while remaining state-owned?

So what does Gazprom have to offer? In 2002, it held 157 mineral resource licences, of which 104 were for exploration and production. The remainder was broadly for geological survey work. Subsidiaries held another 23, whilst affiliated units held some 18 licences.

As of 2004, Gazprom’s share of the official Russian gas reserves figure stood at 64.8% (or 30.5 tcm). Gazprom also has equity interests in a number of other licences, such as the 21% stake it held in Purgaz before the repurchase from ITERA. According to Gazprom, independent companies held some 8.4 tcm of reserves in total, with the remaining 8 tcm of Russia’s total reserves represented by the state’s undistributed stock. But is all this believable? Our answer is yes.

Since 1997, DeGolyer & Macnaughton has performed an independent assessment of Gazprom’s reserve base to internationally accepted standards. The last appraisal of around 20 selected properties showed a figure of proven and probable reserves of 19.5 tcm. However, some major fields are still to be appraised, as they are part-owned assets, and Gazprom has intermittently supplied adjusted figures to reflect this. These also apply to the Russian estimates, and the co-efficient of internal estimates to independent valuations seen so far.

All of this makes Gazprom the largest (part) private owner of hydrocarbon reserves in the world, swamping international majors, and placing it fourth globally when compared to state-owned oil companies. In fact, Gazprom is the world’s second-largest owner of gas reserves, after Iran’s NIOC, and it currently rates as the biggest producer of hydrocarbons in the world, almost five times larger than the second-placed ExxonMobil on a gas-only production ranking. And what of the future? Russian gas production peaked at 640 billion cubic metres (bcm) in 1991, and subsequently retrenched much more slowly than oil production, to a low of 571 bcm in 1997, before recovering to around 591 bcm in 1998.

Optimistic scenarios have annual production rising to 900 bcm per annum by 2014 and staying there for some years. Alternative assessments have production staying around the 600 bcm mark for some time.

Russia shares land borders with no less than 14 countries: a political tightrope to walk in anyone’s language. Gazprom also controls the largest gas delivery system in the world.
Apart from being Russia’s dominant domestic supplier, Gazprom controls an impressive 25% of the OECD Europe gas markets, with ambitions to increase this to around 36%, by some estimates. Gazprom offers considerable long term upside, should the Russian government undertake domestic gas market reform, which is to stop selling cheap gas to Russian citizens. Whilst this is easy in theory, in practice, simply increasing domestic gas prices could well crash the slowly evolving regional economies, and create widespread civil unrest. Clearly, wage reform and gas market reform need to go hand in hand.
However, with Russia’s hopes of accession to the WTO, which is expected to occur sooner rather than later, a clearer timeframe and framework will be put in place to effect domestic gas market reform. The WTO will lay out an agreed and understood way forward that will provide domestic gas reform, without crashing the Russian economy. What about the global gas market? In reality, there are two, rather than one. Whereas oil prices are quoted on a global basis, the gas markets are not. While in Europe, gas is delivered from Gazprom to its customers at around US $150/mcm (1,000 cubic metres), the US market pays nearer to US $250/mcm. This is largely due to supply constraints in North America, and the cost of delivering marginal gas to the United States from elsewhere. In LNG form, gas has to be sent on special LNG tankers. This is not cheap, as the gas must be frozen super-cooled to liquid form in order to transport it. However, as technology develops, and borders open up, the likelihood that Gazprom will deliver gas from Russia to the USA will increase.

On this basis, a phenomenon is likely to occur. That is, a price convergence of the European gas market and the US gas market. The likelihood is that gas in Europe will move from US $150/mcm (1,000 cubic metres) towards the US $250/mcm price of gas in the USA, rather than the other way around. For Gazprom, this will represent a windfall of huge proportions, vastly increasing its revenue, and in theory its profits.

If we add up the sum of the parts, we could end up with what rarely occurs in investment markets, which is betting on a sure thing. Gazprom will remove the current restrictions from ownership in its shares, known as the ‘ringfence.’ It is not a question of if, but when. And when this occurs, we could see an index event. That is, global funds that were previously barred from investing in Gazprom for legal or compliance reasons will be free to do so.

More than that, Gazprom, as part of any global index, will have a weighting increase, and fund managers will be obliged to partake. This, alone, will cause a rise in the company’s value.
From a political standpoint, as a 51% owner of Gazprom, the Russian government will be able to influence global gas markets in a way not seen before. This reason alone makes Gazprom a strategic cornerstone of the Russian economy. However, Gazprom and the Russian government could also begin to influence gas prices in the way that OPEC has been able to move oil prices since the 1970s.

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