Fares Kilzie – CREON Energy, Chairman of the Board of Directors
Kirill Rodionov – IndexBox Marketing, Oil&Gas Analyst
This summer, Alexey Miller began his fourth tenure as Gazprom’s CEO. In February, he was reelected without a dissenting vote by the company’s board of directors. That was hardly a surprise; Miller is trusted by Vladimir Putin, whose deputy he had been in the Committee of external relations of Saint Petersburg mayor’s office. However, his candidature would not have been approved if Gazprom was independent from the Government. The reason for such a guess is the company’s operational performance, which leaves a lot to be desired.
Gazprom is losing its market share not only in Europe, but also in Russia and the former FSU republics. Between 2008 and 2014, its gas deliveries to the EU dropped by 13.6% (from 184 billion to 159.4 billion cubic m), while its export to the CIS countries halved (from 96.5 billion to 48.1 billion cubic m). The company’s sales in Russia fell by one-quarter at the same time (from 287 billion to 217.2 billion cubic m).
What caused these problems of the largest European monopoly? How it can rebound from the crisis?
The heritage of the Soviet Ministry of the gas industry
Gazprom was established in 1989 as the basis of the Soviet Ministry of the gas industry, functioning since the first year of Brezhnev’s tenure. In the mid-1960’s, the Soviet geologists discovered giant Yamal gas fields, such as Urengoyskoye, Yamburgskoye, and Medvezhye, which began production in the 1970s and 1980s. Between 1965 and 1990, the gas production in Tyumen region rose from 0.2 to 552 billion cubic m, while the share of Western Siberia within the Soviet gas production rose from 0.2% to 67.7%.
The exploration of the Yamal gas resources became possible, thanks to the cooperation with the leading Western European companies, such as Ruhrgas (FRG), OMV (Austria), Eni (Italy), and Gaz de France. They provided materials and equipment to develop gas fields and construct pipelines. In 1968, the Soviets signed a 20-year agreement with OMV to supply 100 billion cubic m of gas. In 1969 and 1970, the USSR achieved similar agreements with Italy and Western Germany.
Thanks to these agreements, the USSR established infrastructure to export gas to Europe. Between 1965 and 1990, the length of the Soviet gas pipelines rose from 41.8 thousand to 220 thousand km. The Urengoy–Pomary–Uzhgorod pipeline that became the main Soviet export artery was constructed in 1983 because of the cooperation between Soyuzgazexport and Ruhrgas – the latter provided equipment, despite the protests of the US government that demanded to abandon all contact with the Soviets.
Constructing the pipelines made the USSR an influential player on the European gas market. In 1970, the USSR supplied to Europe 3.3 billion cubic m, while in 1990 – 110 billion cubic m. During the late Soviet times, the gas industry was in much better shape than the oil sector, which experienced the crisis because of the oil production slump in Western Siberia.
Between 1988 and 1996, Russia’s oil production decreased by 47.1% – from 569 million to 301 million tones. Contrary to this, the country’s gas production stayed stable; between 1991 and 2001, it dropped just by 9.6% – from 643 billion to 581 billion cubic m. Because of the absence of the crisis, the structure of the gas industry virtually hasn’t been changed. In 1989, Victor Chernomyrdin, who was then a head of the Soviet Ministry of the gas industry, placed all its assets under the umbrella of the new established Gazprom.
Because of the breakup of the USSR, Gazprom lost its production and transportation facilities in the new independent republics. Soon after the launch of the Russian market reforms, Gazprom lost its monopoly status in Russia. In 1992, Vladimir Lopukhin, who then served as Minister of Fuel and Energy, proposed a plan to divide Gazprom into several gas production companies that would have equal access to the pipeline system. A similar plan would later be realized within the oil industry; by the early 2000s, private companies with non-discriminatory access to the facilities of Transneft controlled over 80% of the Russian oil production.
However, the gas industry has hardly been reformed because of a huge lobbying potential of Gazprom. In May 1992, Yegor Gaidar, a Minister of Economy and Finance, ordered to check the foreign currency banking accounts of Gazprom. Soon after the audit, Lopukhin was ousted and replaced by Chernomyrdin, who became the deputy prime minister of the Fuel and Energy sector. On June 1, 1992, Boris Yeltsin signed presidential decree # 538 «On the united system of gas supplies» that preserved the monopoly of Gazprom. The other decree, signed the same day, gave the company the right to develop new resources of the Yamal peninsula, Barents Sea, and the shelf of the Sakhalin island.
However, in the 1990s, Gazprom struggled to exploit these resources. The only exclusion was the Zapolyarnoye gas field; in 1994, it was developed, and in 2001, it began production. The Yamal gas fields, such as Kharasaveyskoye and Bovanenkovskoye, should have been exploited in the late 1990s, but their development was frozen. And there was a justified reason for that. During the first ten years after the breakup of the USSR, Gazprom’s consumers were experiencing a severe non-payment crisis, and they could only pay for gas in exchange for barter.
In 1998, Moscow Mayor’s office paid off its debts by transferring the real estate and hard assets, totaling $250 million. In 1995, Belarus satisfied its debt by issuing bonds at the value of $1.4 billion. A year later, Ukraine issued government bills priced at $905 million for the same purpose. In 1996, Moldova passed 50% of the newly established joint venture Gassnabtransit, which controlled pipelines that were necessary to export gas to Romania, Bulgaria, and the former Yugoslav republics.
The non-payment crisis forced Gazprom to engage Turkmenistan in the gas export deals in the CIS. In 1995, Gazprom and the Turkmenian government established a joint venture, called Turkmenrosgaz, which provided barter deliveries of gas to Ukraine. At that time, the only way to get currency was to export gas to Europe, and Gazprom, using that option; between 1990 and 2000, its deliveries to the non-CIS states rose by 18.5% – from 110 billion to 130.3 billion cubic m.
By the time of the breakup of the USSR, the term of the gas-for-pipelines agreements concluded in the early 1970’s had expired. The fall of the Berlin wall meant Gazprom should no longer be supplied cheap gas to Eastern Europe for its disadvantage. The company could now get hard cash for its export deliveries outside the FSU. The latter became a cornerstone of Gazprom’s sustainability during the tenure of Rem Vyakhirev, who replaced Victor Chernomyrdin as the company’s CEO in 1992. That same year, Gazprom’s form of ownership was changed; the state concern was reorganized into the Russian Joint Stock Company.
In 1994, Gazprom built the Yamal – European pipeline that crossed the territories of Belarus, Poland and Germany. Its construction was proposed by Victor Chernomyrdin during his tenure as a head of the Soviet Ministry of the gas industry (1985-1989). The pipeline’s construction that cost $5.5 billion was finalized in 1999. In 2006, it achieved its project capacity. The other infrastructure project, the Blue Stream pipeline, launched in line with the agreement between Russia and Turkey, concluded in 1997.
The gas deliveries started in 2003; at that time, Vyakhirev wasn’t Gazprom’s CEO. In 2001, he was replaced by Alexey Miller, who had been Vladimir Putin’s depute in the Committee of external relations of Saint Petersburg mayor’s office (1991-1996), the director for development and investments of Saint Petersburg’s port (1996-1999), and the general director of the Baltic Pipeline System (1999-2000). Just before entering Gazprom, he served briefly as a deputy Minister of Energy (2000-2001).
In the 2000s, the paying capacity of Gazprom’s clients improved. That became possible, thanks to the dynamic economic growth that averaged 6.9% of GDP between 1999 and 2008. The rise of wealth resolved the non-payment crisis. In 2001, the share of cash settlements within payments for gas amounted to 83%. The barter trade had finally become history, despite the rise of gas prices for the Russian consumers. Between 2000 and 2007, they rose from $13.7 to $50.9 per 1000 cubic m.
The gas prices were also raised for the FSU republics and non-CIS countries. In 2007, they amounted to $110.9 and $269.4 per 1000 tones, respectively. The growth of export revenues should have resulted in the rise of production investments. However, it didn’t happen in reality. Soon after Miller’s appointment, Gazprom’s licenses for the exploration of the Kharasaveyskoye and Bovanenkovskoye fields were prolonged until 2008, but they didn’t start production that year. The reason was that production investments no longer were among the company’s top-priorities. Between 2003 and 2007, the monopoly spent $32.1 billion to buy financial and non-financial assets and just $18.5 billion to develop new fields. At the same time, the company’s annual operating expenditures rose from $19.4 billion to $66.2 billion.
The growth of operating expenditures negatively affected Gazprom’s labour efficiency. Between 2000 and 2006, the level of the extraction of the crude oil equivalent (COE) lowered from 11.5 thousand barrels per one employee to 9.1 thousand barrels per one employee. While in 2000, the company spent $0.44 to produce one barrel of the COE, in 2006, it needed $1.68 for the same purpose. By 2007, Gazprom’s staff of 370 thousand people exceeded the staff of such international oil majors as Chevron (62 thousand employees), Shell (108 thousand), and Pemex (150 thousand), the Mexican oil giant. But Gazprom hid its inefficiency, thanks to its domination in Russia, CIS, and Europe.
Gazprom’s current crisis
However, everything has its end. Several events undermined Gazprom’s positions within the EU and FSU. First, the growth of the LNG deliveries to Europe from the Middle East,; between 2006 and 2011, Qatargas increased its LNG supplies to the EU virtually nine-fold – from 5 billion cubic m to 44 billion cubic m. The LNG import became more accessible for the EU, thanks to the US shale gas revolution. Between 2007 and 2014, the shale gas production in the United States increased from 36.6 billion cubic m to 333.4 billion cubic m. It allowed the USA to lower its LNG import from 12.8 billion cubic m in 2009 to 1.7 billion cubic m in 2014. And that was a nasty surprise for Gazprom’s CEO. The evidence is Miller’s interview he gave to Süddeutsche Zeitung in 2013, in which he characterized the US shale gas revolution as the American Hollywood.
At the same time, Gazprom faced rising competition not only in Europe, but also in Russia. Between 1999 and 2014, the country’s independent gas producers raised their supplies from 33.2 billion cubic m to 208.2 billion cubic m. That became possible, because Novatek and those oil companies that produce gas (for example, Rosneft and Lukoil) proposed much more favorable price conditions than Gazprom did. As a result, between 2008 and 2014, the monopoly’s gas sales in Russia fell by one quarter – from 287 billion cubic m to 217.2 billion cubic m. Finally, the company is losing the CIS market. During the last winter, Ukraine abolished all the gas import deliveries from Russia; such a scenario could hardly be imagined ten years ago.
De-monopolization is the best cure
The current crisis of Gazprom is caused by its disastrous marketing policy. The company cannot sell gas on the conditions that would be suitable for the market, which is becoming more and more competitive. Despite the demands of the European consumers, Gazprom is refusing to abolish its long-term take-or-pay export agreements. The monopoly also is waging price wars in the CIS, which has resulted in the dramatic fall of its export deliveries in the region. Finally, the company is tightening its conditions for the Russian consumers. They are forced to pay for gas at the prices, tied to the Western European ones.Gazprom is losing its clients, who can buy gas on much more favorable conditions than those offered by the Russian monopoly.
To curb the crisis, Gazprom should sell gas on market conditions. To make this scenario possible, the company should be de-monopolized and privatized. The Russian gas industry needs a reform, which would be similar to what was carried in the country’s oil sector. In the 1990s, the latter was divided into several oil production companies, which received an equal access to the pipelines’ infrastructure of Transneft. In the early 2000s, the Russian government was planning to introduce such a reform in the gas industry. The outline of this reform was included in the mid-term Program of Social and Economic Development, which was adopted by the Government in July 2001. But in October 2003, Vladimir Putin said: «Gazprom will not be divided». The gas sector reform was excluded from the political agenda.
The current crisis of the largest European monopoly is a good reason to return it there.