Is Gazprom losing its market?

21.01.2013 — Analysis

In 2012, Russian gas exports to Europe diminished. The Gazprom Group has not seen such low sales in a decade. Experts claim these reduced gas shipments are due to the policies of the managers of Russia's leading gas-producer, who prefer to concentrate on profits rather than the number of cubic meters sold. But as this columnist for RusBusinessNews has determined, by reducing output and raising prices for its products, Gazprom is at risk of losing its sales markets and, thus, its revenue.

According to the group's chairman of the board, Alexei Miller, exports to non-CIS countries decreased last year from 150 to 138 billion cubic meters of gas. And in accordance with its model of business development, in 2012 Gazprom automatically reduced production by 4.9%. In December, the company was producing an average of 1.5 billion cubic meters per day, which is quite modest: for example, in 1997 average daily production measured 1.7 billion cubic meters.

This drop in production can be explained by the gas monopoly's own policy. Gazprom's managers have repeatedly told journalists that total sales are not as important as total revenue. But regular increases in prices have propped up the group's profits in recent years. In Europe, a thousand cubic meters of gas sold for an average of $384 USD in 2011. In 2012 this price grew to over $400. But nevertheless, the monopoly's managers expected to maintain their exports at the previous level, i.e., at least 150 billion cubic meters per year. That didn't happen.

The general director of East European Gas Analysis, Mikhail Korchemkin, thinks that lowering the maximum daily output is bad news. Naturally it's important to focus on the consumer, but by maintaining and even raising its prices, Gazprom is needlessly giving up the European market to other suppliers and is even energizing the expansion of the market for coal.

The head of the National Energy Security Foundation, Konstantin Simonov, is convinced that there is only one way to safeguard the market: by increasing the production of energy supplies. Consequently, immediate investment is needed to develop new deposits. But instead, this expert commented, "We're 'killing off' new oil and gas projects and rejoicing about it, which is a ridiculous position to take."

Gazprom claims to be trying to develop its raw-material base. In October 2012, Alexei Miller told Russian President Vladimir Putin that the group plans to start working on the second stage of its Eastern Gas Program, which is supposed to create two new centers of gas production: in Yakutsk and Irkutsk. The deposits there, the Chayandinskoye and Kovyktinskoye fields, contain 3.7 trillion cubic meters of gas. The plans are to sell the gas primarily on the domestic market (shipments to Western Siberia are anticipated) and also to liquefy it (a plant will be built near Vladivostok, and a 3,200-kilometer pipeline will stretch from there to Yakutia), in order to deliver the gas to countries in the Asia-Pacific region.

However, Alexei Belogoryev, the head of the bureau for expertise and analysis of the fuel and energy sector at the Institute for Energy Strategy, believes that the project is actually purely political. The federal authorities announced the construction of new gas pipelines in order to use them to link the Far East with the rest of Russia. But this is somewhat complicated from an economic standpoint, as gas from Chayanda and Kovykta costs twice as much as that coming from Urengoy. Siberian residents are unlikely to be pleased by that.

There are difficulties exporting the gas as well. There's not a great deal of demand in Japan or Korea - the only serious consumer in Asia is China. Twenty years ago that country suggested that Russia built a gas pipeline, but Gazprom was focused on Western markets and brushed aside the request. Turkmenistan quickly filled that niche, directing two pipeline branches into the Middle Kingdom. China gained control of the situation and now refuses to buy Russian gas costing more than $250 USD per thousand cubic meters. The parties involved cannot come to an agreement about the price, and so the construction of the Altai pipeline had to be put on hold.

Liquified natural gas from Kovykta is unlikely to improve the situation. The spot (exchange) prices for LNG are currently such that even Japan is turning instead to heavy fuel oil. Thus the world's leading LNG suppliers are trying to sign long-term contracts that can undercut the price for that oil. But this won't help Gazprom, because its production costs are higher than in other parts of the world.

The experts all agree: Gazprom will not be able to increase its output by converting methane into liquified natural gas. The group should alter its business model: Gazprom needs to seek out reserves in order to bring down expenses if it is to remain in the European market and expand into Asia.

Gennady Shmal, the president of the Union of Oil and Gas Industrialists, suggests reducing the amount of gas destined for domestic use. The compressor stations along Gazprom's pipeline network operate at no more than 25% efficiency, meaning that they "swallow up" a portion of the billions of cubic meters that pass through them. The installation of modern gas turbines would cut transportation costs in half.

In addition, market players note that it's time to stop building insanely expensive gas pipelines like the Sakhalin - Khabarovsk - Vladivostok or the Dzhubga-Sochi. The fact that Gazprom purchased large-diameter pipe helps explain the fact that the original estimates of $900,000 to build each kilometer of the Dzhubga-Sochi line ballooned to $2.7 million. The Federal Antimonopoly Service determined that the group contrived to exclude producers, i.e., pipeline companies, from the bidding process by forming trading lots of shares in a certain way. Instead of multiple suppliers, Gazprom only had one, which bought its products at inflated prices. That supplier appeared at almost the same moment as the launch of the Nord Stream project.

Nikolai Vasilyev, the general director of Optical Telecommunications Cables 01, CJSC, once stated in an interview that by buying products at 3-5 times their normal cost, Gazprom was sending its profits offshore. No serious development can take place if so much capital is leaving - and in Russia there are no promising projects in the gas sector. Natural gas sales are falling, and the management of that monopoly is not even contemplating lowering rates or producing new products. Nikolai Vasilyev complains that this leads to an odd situation: the country has oil and gas, and demand exists for polyethylene and polypropylene, but the processing of raw hydrocarbons is not operating as smoothly as it should.

Russia's gas industry still has work to do in this area. But Gazprom won't be able to rise to this challenge if it is fixated on short-term profits. Companies that think about the future sometimes have to operate at a loss while they develop new technology and production. Alexei Belogoryev says that Gazprom is not looking too far ahead - it needs to be investing money today, but instead of winning new markets, it is squandering its own future.

If Gazprom continues with its current business practices, it makes no sense to provide the corporation with tax breaks that are designed to encourage it to invest. However, Gennady Schmal believes the oil and gas sector should receive assistance, "We need to move away from straightforward taxes and begin to more tightly control the rules for setting rates and prices. All of these measures will help solve strategic problems, not only in the gas-processing industry, but throughout the real economy."

Vladimir Terletsky