Putin's Gazprom Problem

Putin signs a pipe during a ribbon-cutting ceremony for the 'Dalneye' gas-distribution station. (Courtesy Reuters) 

Just four years ago, the Western press commonly touted Russia's state-owned natural gas giant Gazprom as Vladimir Putin's premier instrument of power. Indeed, the $160 billion firm controls several mighty subsidiaries, including oil and power companies and groups that run Russia's export pipelines. It has the ability to leave millions in Europe in the cold, as it demonstrated when it turned off the taps to Ukraine in 2006 and 2009. And it even owns several media outlets, including NTV, a popular television station that was once a vehement critic of Moscow but is now a (somewhat reluctant) advocate of Putin's domestic agenda. In total, Gazprom's profits constitute about ten percent of Russia's GDP. Perhaps that is why the company -- which even has its own anthem -- is considered a bellwether of Russian power. 

Yet, as Vladimir Putin is sworn in this week for another six-year term as president, the energy giant is not what it used to be. Despite the Kremlin's best efforts, the Russian gas market has recently started to liberalize. In the coming years, Gazprom will not be able to rely on high profit margins to stay at the top of the energy business. And for his part, Putin will not be able to rely on Gazprom as a source of power. 

Gazprom was born out of the Soviet Ministry of Oil and Gas in 1989. Over the next few years, Viktor Chernomyrdin, its first head (and later Prime Minister of Russia), quietly watched as the company was gutted during a wave of privatizations. Meanwhile, a 45-year-old Putin was busy defending his Ph.D. thesis, "The Strategic Planning of Regional Resources Under the Formation of Market Relations," at the St. Petersburg Mining Institute. In it, he argued that Russian economic success would depend on creating national energy champions. 

And that is exactly what he tried to do when he came to power in 2000. Soon after he was sworn in, he appointed his political ally Dmitri Medvedev as chairman of Gazprom's board of directors. The following year, he installed Alexei Miller as chairman of the firm's management committee. Miller, an international affairs adviser, was later criticized for his utter lack of knowledge of Russia's oil and gas industry. No matter: By switching out the leadership, Putin graduated his "St. Petersburg clan" -- the group of associates who had surrounded him during his years working for St. Petersburg Mayor Anatoly Sobchak -- to the prime time.

During Putin's first two terms as president, the Duma strengthened Gazprom's position by guaranteeing it exclusive license to export gas. The Kremlin also made sure that Gazprom could do so cheaply; between 2003 and 2010, the share of the company's revenues that went to excise taxes and duties fell from 26 percent to 16 percent. In the same period, Putin generally turned a blind eye to Gazprom's monopoly on gas pipeline access, often rejecting suggestions that the lines be opened up. Because of the Kremlin's generosity, Gazprom grew to become one of the world's largest natural gas suppliers. 

The energy giant, however, was not without problems. By the mid-2000s, Gazprom was already struggling with falling production from its core West Siberian natural gas fields. It had harvested most of the easy-to-access gas there and was left trying to exploit ever-knottier caches. To prop up his powerhouse, Putin read from the standard state capitalism playbook. In 2006, he raised domestic gas prices with the goal of eventually matching them to those in Europe. As a result, over the past six years, gas prices have risen by an average of 15 percent per year. The increase has somewhat made up for Gazprom's burgeoning upstream costs. 

At the same time, Putin encouraged other Russian gas companies -- ones whose operating costs were not yet as high as Gazprom's -- to increase their production. Seemingly, Putin's idea was to support Gazprom while spurring the Russian economy and reducing the country's reliance on export sales. Any gas shortfalls on Gazprom's end could be made up by independent gas production. It would be just enough not to eat into Gazprom's market share. Finally, the independent firms were expected to put pressure on Gazprom to operate more efficiently. 

But that did not pan out. Instead, Putin's move undercut Gazprom's position and inadvertently liberalized the gas market. 

The first problem with Putin's plan was that such independent producers as Novatek and Itera were not subject to the same price regulations as Gazprom. They could essentially charge a tariff equal to a free-market price on much of the gas they sold. As a result, what Putin really created was a two-tier market, with Gazprom forced to sell its wares at a regulated price and non-Gazprom players able to charge whatever consumers would bear. As it turns out -- and as the results of a Kremlin-led experiment with a gas exchange in 2008 indicate -- consumers would tolerate paying about 35 percent above the industrial average. And that is what the new companies charge. Consumers pay because there is only so much Gazprom gas to be had.