Putin's Gazprom Problem

How the Kremlin Accidentally Liberalized Russia's Natural Gas Market


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.

With Gazprom hemmed in by below-market prices and gas fields that were more expensive to develop, the company was already at a competitive disadvantage to the growing unregulated gas firms. Then, last year, Russia's Finance Ministry doubled the taxes that Gazprom pays for the mineral resources it extracts. Gazprom now spends around 509 rubles ($17) per thousand cubic metres. That is expected to rise even further to 1,062 rubles ($36) for the same amount by the end of 2015. The increases are expected to cost Gazprom some $10 billion this year. To make up the loss, Miller, the company's CEO, asked Putin in March to raise the regulated natural gas prices by 26 percent, instead of the standard 15 percent. Putin, busy campaigning for the presidency on his commitment to curb inflation and protect the interests of ordinary Russians, balked. 

To add insult to Gazprom's injury, Putin then took to meddling in Gazprom's export strategy as well. Several weeks before this year's March presidential elections, the temperature in Moscow plummeted to -31 degrees Fahrenheit. Accordingly, daily natural gas demand skyrocketed. In a meeting with government and Gazprom representatives, Putin made it clear that Gazprom's "top priority" during the crisis would be to "meet the internal demand in the Russian Federation." Having to deprive itself of almost $125 million in sales to Italian customers alone -- who were worst hit -- Gazprom did as it was told, and its reputation as a reliable international supplier took a bullet.

Not surprisingly, the independent firms are making the most of the opportunity. In 2010, non-Gazprom players produced 142 BCM of gas, equivalent to 22 percent of the country's total gas output. Novatek's CEO, Leonid Mikhelson, estimates that non-Gazprom production in Russia will increase to 300 BCM per year by 2020. Moscow's investors and bankers have been whispering about Novatek's future since Gennady Timchenko, who is co-founder of the judo club Putin attends and an alleged long-time friend of the Russian president, acquired a 23 percent stake it in 2009. 

Following Timchenko's purchase, Novatek kicked into high gear. The company quickly purchased Gazprom assets in SeverEnergia, along with several other fields. Another important asset acquisition came in 2009, when Novatek bought the Yamal LNG company and its South Tambeyskoye field, which contains up to 25 BCM of proven gas reserves. In July 2011, in order to win foreign investors and ensure that the Yamal LNG project would be profitable, the Kremlin granted Novatek huge tax breaks and lifted the export duty on any liquefied natural gas it produces in the future.

Even as the Kremlin is starting to treat Novatek as its next Gazprom, the market is treating it like a serious player. Last October, the French firm Total acquired a 20 percent stake in Yamal. In an interview, Michael Borrell, a senior vice president at Total told me, "We only see Novatek as a success story." The company is profitable, thanks to its low-cost production. And the Kremlin, of course, has a hand in that. But Novatek has been able to parlay its success and good reputation into long-term contracts with major power and industrial sectors, further eating into Gazprom's position. Last December, Novatek bought a regional gas distribution company from Gazprom, thus taking over Gazprom's role as supplier to the Urals region, which is one of Russia's top ten regions of natural gas consumers. 

Although things look bad for Gazprom, it is inconceivable that the company will simply disappear; it is just too big and owns too many subsidiaries. It is likely, however, that the Kremlin will start allowing more independent companies to play on the gas scene. For his part, Putin will probably favor letting Gazprom keep its prominent position, but even that will depend on his political strength. Between 2000 and 2008, the Russian leader's defining characteristic was an ability to dictate what the Russian state should look like. And a large portion of that picture rested on Gazprom's national champion status. The company got economically ludicrous tax breaks, received favored access to licences, and secured a monopoly over the pipelines. Yet, now the two-tiered gas market is eating into Gazprom's status -- slowly but surely. And as Gazprom gets crowded out of the market, Putin will have to find some other basis for his power, or else be slowly edged out as well.

Browse Related Articles on {{search_model.selectedTerm.name}}

{{indexVM.results.hits.total | number}} Articles Found

  • {{bucket.key_as_string}}