The Nemtsov White Paper, Part II: Gazprom (the full text)

Vladmir Putin: The Bottom Line

Part II – Gazprom

by Boris Nemtsov and Vladimir Milov

Translated from the Russian by Dave Essel

(For the PDF version of this document, click here.)

Boris Nemtsov

In February 2008, the authors of the report you are now reading published an independent expert report Putin – The Bottom Line in which they presented their views on what the Russian Federation’s second president had done for Russia. In Putin – The Bottom Line we gave an unflattering but in our view fair evaluation, backed up by facts and figures, of the outcome of Vladimir Putin’s activities for the country – an outcome that is hidden from Russian eyes behind a smokescreen of official propaganda – in such fields as the economy, the army, the pension system, health and education, roads and highways, and others.

A good number of readers rightly pointed out that there was one problem which we had only partially covered – Russia’s energy situation in general and the issue of Gazprom, Russia’s main energy company, in particular. This was a deliberate omission on our part. We believe that the situation around Gazprom is worthy of individual attention and not something to be covered in just a few paragraphs.

This, firstly, is because Gazprom and what happens within it are of the utmost importance to our country. A second reason is because we have direct, first-hand knowledge of Gazprom’s problems because we were involved with it in our professional lives as former Russian minister of fuel and and energy and deputy minister of energy. Our last reason is that Gazprom has become a sort of personal special project of Putin’s: from the very beginning of his presidency he has carefully nurtured this corporation, appointed people close to him to key posts within it, and overseen its work in detail. Gazprom is one of only a few projects for which Putin can be considered to be personally responsible from the earliest days he was in power. One can, as a result, use it as a measure of the results of Putin’s doings.

In this report, we wish to enlarge on the analysis presented in Putin – The Bottom Line and examine what has happened with Gazprom over the years. If you are interested in the truth about this, read on….

Gazprom – Putin’s prime personal project

Gazprom is a unique phenomenon in Russia’s political and business life. Gazprom’s income in 2007 came to over $93 billion or 7% of Russian GDP. For perspective, note this is 2½ times the amount spent on defence. Gazprom accounts for over 12% of industrial production and about 16% of the value of Russia’s exports. Gazprom also accounts for 43% of Russia’s energy resources and consumption. Gazprom’s gas goes to make about 40% of the country’s electricity. In fact, it is the powerhouse of Russia’s economy: the stability and future of our economy actually depends on how well and reliably this corporation works.

Gazprom plays a key role in the world’s energy market. It produces 8.3% of the world’s oil and gas and supplies over 50% of the gas imported by EU countries.

No other corporation in Russia has such political and economic clout. Yevgenii Yasin {see note 1} was spot-on when he called Gazprom “the government’s wallet”: nothing else can equal the corporation’s ability to concentrate financial resources and put them at the disposal of the Kremlin for important tasks.

Back in the 1990s, the Kremlin periodically used Gazprom to resolve political issues. For example, in 1997, when the government needed to pay off delayed pension payments, president Yeltsin instructed Gazprom’s managers to promptly pay off $2 billion of its pensions contributions arrears in order to finance the country’s pensions payments.

Under president Putin’s rule, however, Gazprom’s money has been used for quite other purposes. This is what we propose to describe in this white paper.

Gazprom has become Putin’s prime personal project. He set a greedy eye on the corporation as soon as he came to power. In fact, during the 2000 presidential campaign, it became clear that energy resources and Gazprom were at the top of Putin’s agenda. In June 2000, just a month after taking office, Putin arranged for the prompt replacement of Gazprom chairman Viktor Chernomyrdin by his brother-in-arms Dmitri Medvedev and in May 2001 replaced Rem Vyakhirev, who had headed Gazprom from its inception in 1992 with Aleksei Miller.

“Gazprom is more than just a joint-stock company. Russia’s whole economy is in a large part based on its gas industry” , said Putin at meeting devoted to the firing of Vyakhirev and appointment of Miller on 30 May 2001 {see note 2}.  So there can be no doubt of his feelings about the corporation from the very start of his presidency.

Gazprom became the first business structure in which Putin by deliberate plan seized the commanding heights, in short order disposing his people into key posts while displacing all the old management team. Gazprom’s top ranks were rapidly filled with old Putin contacts from his St. Petersburg administration years. Today 11 of the 18 members of Gazprom’s board – all with important positions within the corporation, controlling finances, property, corporate management – are people who in the 1990s worked in the St. Petersburg administration, the privatised Port of St. Petersburg Authority, other Petersburg companies, or the FSB.

This is not the typical way in which global energy companies are run. Usually, leading positions are occupied by professionals with years of experience in top management in energy corporations. Former small-time regional bureaucrats, port and building company managers do not usually get given top management positions in major oil-and-gas corporations, especially in such numbers.

When making appointments to Gazprom, Putin (who without a doubt oversaw all this personally) was not demanding professionalism but rather looking for clan affiliation, for people from the “St. Pete clan”.

And we are not talking just about seizing the commanding heights of the company’s management: Putin devoted a considerable part of his every working day to internal Gazprom issues. Lobbying for Gazprom projects was high on his agenda at every international meeting and on foreign visits.

Putin nurtured the interests of Gazprom during the Russian government’s reviews of the regulation and development of the gas industry. When in 2002-2003 Mikhail Kasyanov’s cabinet attempted on a number of occasions to have gas industry reforms including the opening of the industry to competition put on the agenda, this was struck off each time at the Kremlin’s request. Despite more and more complaints (even by civil servants) about Gazprom’s unacceptably low tax payments, Putin has openly defended the corporation from having higher taxes imposed on it: the government has undertaken to maintain the current low level of taxes on it and not return to the matter until 2010.

With Putin’s approval, the government has signed off on a programme proving for sharp rises in the price Russian consumers pay for gas that will eventually lead to price parity with Europe. This had been lobbied for by Gazprom for 15 years but never got through under cabinet ministers Gaidar, Chernomyrdin, Kirienko, Primakov, and Kasyanov. This programme was passed by Mikhail Fradkov’s prime-ministerial decree #333 of 27 May 2007 and it will lead to internal prices for gas for Russian consumers to double from today’s price by 2011 – from today’s $64 per 1000 cubic meters to not less than $125. In fact, 2011 prices may be even higher than that since European gas prices have recently been sharply on the rise.

Throughout his years as President, Putin has been a very effective lobbyist for and defender of Gazprom’s interests.

Was this for the good of the country? Did Russians gain anything from the their president’s devoted attention to the country’s largest corporation?

Russia’s Gas Supplies – From Bad to Worse

The management inserted by Putin has been running Gazprom for over 7 years now so it is in no way unfair to see how they have coped and pass judgement. Their results are pathetic. First and foremost, Gazprom’s management has almost totally failed to make the corporation perform its main task – that of providing the Russian consumer with a reliable supply of gas. The idea was that Gazprom would get all its privileges, including its monopoly status and the active support of government, in exchange for delivering on this promise.

But no, Gazprom has to all intents and purpose not increased gas extraction over the whole period and in 2007 it actually fell back to nearly the 1999 level. Bearing in mind that some of the old gas fields are drawing close to empty, gas extraction may actually go from not just stagnating to actually dropping like a stone.

Table 1: Dropping like a stone

And Russian consumers have not had more gas delivered to them. Total supply to Russia’s internal market in 2007 was just 307 billion m3, just 2% more that the 2001 level. Over the same period, internal demand for gas has risen by 18% or 67 billion m3 per year!

So the gap between internal demand and gas supply is increased from 72 billion m3 in 2001 to nearly 132 billion cubic meters in 2007. Today, Russia is forced to get about one third of its gas fro non-Gazprom sources.

Table 2: Russia the gas importer

This gap has traditionally been filled by deliveries of gas from Russian independent producers and gas imports from the Central Asian countries. However, the independent producers have only a limited capacity to expand production and dependence on gas imports at rapidly rising prices from Central Asia is leading to a sharp rise in supply failures by Gazprom (more on this below).

The supply shortage on the internal market, exacerbated by Gazprom’s rising export obligations, is looking ever more of a threat. Gazprom has so far been unbelievably lucky with the weather: the last two winters have been relatively mild, leading to fewer demand peaks. However, favourable weather notwithstanding, demand in the peak winter months is rising.

This is indirectly illustrated by what happened in the last 2007-2008 winter season. With gas production stagnating, in January 2008 there was a sudden rise in gas withdrawals from underground storage. A record quantity of 50.1 billion m3 was required from storage, 20% more than in the three preceding winter seasons. By the end of January, Gazprom’s storage facilities stood practically at empty, this despite the fact that despite the start of production at the Yuzhno-Rossiisky gas field, the daily rate of gas production during winter 2007-2008 had grown by just 2-3% over the previous year.

Winter 2007-2008 brought a new record for gas taken from storage – 583.6 million m3 per day, beating the previous record set during the winter of 2005-2006.

This shows how much winter demand has risen during mild winters, so one can imagine the dreadful consequences awaiting Russia in the event that one of the forthcoming winters is a severe one. We can expect large-scale shut-downs of vital sites due to gas shortages.

We have already seen what happens then. Back in winter 2005-2006, consumers were faced with massive restrictions on gas supply. According to RAO UES (United Energy System of Russia), overall shortfalls of gas supply to power stations in the cold weeks of January-February 2006 were 12.5% under planned levels over the whole Russian power system and up to 80-83% for power stations located in the Central Region and the North-West {see note 3}.

January-February 2006 also saw serious worries about gas supplies for export. According to the press, on 18 January 2006 Gazprom suddenly reduced the volume of transit gas passing through the Ukraine to Europe from 390 to 350 million m3 per day due to gas shortage. On the same day, Gazprom informed its Italian partner, ENI, that it was unable to guarantee full delivery of contracted gas due to the abnormal cold. Similar announcements were then made by Gazprom to Serbia (25% reduction of supply), Croatia (6-10%), and Hungary (20%) {see note 4}.

The stagnation in gas supply to the internal market despite rising demand is the result of systemic underinvestment in gas production. Russia has proven gas deposits sufficient to last it 80 years at current extraction levels. However, many of these deposits are not being worked. A goodly proportion of these deposits are located in new areas that have not yet been fully explored, lack the necessary infrastructure, and present extreme difficulties.

For example, before starting to work the gas deposits of the Yamal peninsula located some 500-600 kilometres from those already in operation (in the South of the Yamal-Nenets Autonomous Region), a railway 540 kilometres long must be built between Obskaya and Bobanenkovo, over permafrost and bogs, with an immense number of river and stream crossings. Gas from the Yamal peninsula will also have to be brought back by a 1100-kilometre pipeline from Bobanenkovo to Ukhta, the underwater part of which will have to cross Baidaratskaya Bay as well as traverse permafrost and bogs.

Under the licenses awarded to it, Gazprom was to have got production under way by the late 1990s but in reality nothing much was done about these deposits. In 2000, Gazprom former head Rem Vyakhirev asked for an extension to the licences. This was initially refused but after Aleksei Miller’s appointment to the helm of Gazprom, the licenses were quietly and without any explanation given extended for a further 8-10 years. Now even those timescales are being broken.

Against a background of falling production in the old gas fields, above all the Urengoi and Yamburg fields, both of which began producing in the 1980s, Russia is facing the worrying prospect of being short of gas. The Yuzhno-Russkoe gas deposit, the last relatively large deposit remaining in the currently exploited areas where the infrastructure is present and gas extraction is easier, went on line in 2007. From now on “new gas” is going to have to come from virgin regions that are amongst the most difficult in the world to work and where preparation work and infrastructure creation will demand immense investments. Gazprom estimates that the Bobanenkovo-Ukhta pipeline alone will cost $80-90 billion and the whole Yamal peninsula project something in the order of $200 billion – more than the total amount accumulated in the Russian Stabilisation Fund!

Why were these investments not made in good time? After all, the plan was for Yamal gas to start being pumped to the “mainland” in the late 1990s?

The trouble is that all this time Gazprom has been knowingly spending only relatively small amounts on investments in its main business of gas extraction. The vast windfall profits Gazprom got from the rapid growth of its exports and rising internal prices have been spent not on investments but on buying assets and financing ever-growing costs {see note 5}.

Table 3: Ignoring the need to invest

So in the 7 years between 2001 and 2007, Gazprom has invested a mere smidgen over $27 billion on its core business of gas extraction.

Compare this with $44.6 billion spent on acquisitions. Of these, over $30 billion went to buy assets not connected with the gas business, above all to buy oil industry assets (Sibneft, Tomskneft) and electric power companies (RAO UES, Mosenergo, wholesale and local power generating companies), and also Rosukrenergo, the trading company.

Had these funds been put to use in readying the new deposits, there would be no gas supply crisis in Russia today.

And meanwhile, with the Yamal deposits not being brought online, Gazprom has become hooked on Central Asian gas. Back in 2002, Central Asian gas accounted for a little over 4% of the Gazprom’s gas. That is up to 8% today. Furthermore, this gas is getting steadily more expensive. In 2003, Turkmenian gas cost Gazprom $30 per 1000 m3; today it’s $150 and from 2009 that may be $250 or more.

It will come as no surprise therefore that Gazprom’s 2007 accounts prepared in accordance with international financial accounting standards show a paradoxical result: an 8% increase sales turnover is accompanied by an 11% drop in profits! This furthermore has taken place against a background of steadily rising gas prices in 2007 (22.5% for Russian consumers and an average of 25.2% for the CIS countries).

How can one at a time of rapidly rising prices simultaneously start making less profit? Gazprom’s management makes no secret of the fact that this is because of rising costs, of which one of the main constituents is the cost of buying in oil and gas from third parties. Gazprom’s spending on this has risen by 36%. In 2003, Gazprom purchases of oil and gas cost in all less than $1 billion. By 2007, they were spending $15 billion – which is more than one quarter of the whole corporation’s operating costs!

The greater part of this spending has gone on buying gas from Central Asia: $11.7 billion in 2007 as against $7.5 billion in 2006 and just over $1 billion in 2005.

In March 2008, the heads of the oil and gas corporation of Kazakhstan, Uzbekistan, and Turkmenistan announced to Gazprom that they intended from January 2009 to impose a new pricing system on the Russian monopolist with gas prices tied to European ones. This means that Gazprom may soon have to buy in gas at $250-$300 per 1000 m3 and spending on Central Asian gas may rise to $17-$21 billion a year.

Gazprom has yet another problem preventing it from increasing its investments in gas extraction: its shockingly low efficiency. Its operating costs (excluding taxes) have risen threefold since 2003 from $4.9 to $14.8 per barrel equivalent.

Besides its spending on bought-in gas (covered above), the other main reason for the increase is an increase in wages costs. These have risen from $3.7 billion in 2003 to $9.7 billion in 2007. Thus the cost of extraction of 1 barrel of oil equivalent has gone up from less than $1 per barrel in 2003 to $2.5 in 2007.

Gazprom’s number of employees has risen steadily – from 391,000 in 2003 to 445,000 in 2007 {see note 6}.

Table 4: Costs are exploding

Gazprom’s income was not sufficient to finance its growing appetite for asset purchases and its increasing costs As a result the corporation has gone deep into debt. It 2000, Gazprom carried debt of $13.5 billion. In 2007, Gazprom’s debt amounted to $61.6 billion – two-thirds of its annual income. (International oil and gas corporations generally think that a debt to income ratio of not more than 10-15% strikes the right balance.)

Table 5: Drowning in a sea of red ink

Massive repayment requirements prevent investment. To this one should add the risk that in the event of export prices becoming less favourable, the corporation may have to reduce investment still further or even become bankrupt {see note 7}.

The likely result is that gas prices will rise still higher for Russian consumers, gas extraction will become still more crisis ridden, and the government may even have to step in with its resources to rescue Gazprom from bankruptcy.

This is how it happens that our gas underground gas resources, our national wealth, is not really helping the nation and is having its fate decided, including the decision to extract it or not, by a small circle of people linked to the powers that be.

Gazprom Machinations: Asset Stripping

Instead of concentrating on Gazprom’s core responsibilities of ensuring the reliability of the country’s gas supplies and developing extraction, Putin and the management team he put in place have concentrated their efforts on assorted dodges and machinations to engender a new wave of asset stripping and outflow of finances from the corporation in favour of bodies close to Putin and his friends.

Initially, Putin was very keen for Gazprom to accumulate assets that had been taken out of the corporation and placed under outside concerns under Rem Vyakhirev. This included quantities of Gazprom’s own shares and the assets of Sibur, a petrochemical concern.

However, once most of the assets had been brought back under the corporation’s umbrella, the opposite began to happen and assets – in the majority of cases the selfsame assets that had been reacquired – again began to be leveraged away from Gazprom. Putin’s re-election to a second term marked the turning point.

It should be noted that back in the 1990s, this asset removal was done quite openly and was widely discussed in the independent media. Not so, however, during Putin’s second term. Now that he has well and truly clamped down on freedom of the press, the public is barely aware of this new wave of asset stripping. What business press is not under Putin’s control has written about it but their circulations are too small and their audiences too narrow for the information to become widely known. For obvious reasons, Russian television does not mention such matters at all.

And so as a result of a chain of strange commercial deals carried out during the time Putin was pulling the strings at Gazprom, assets worth tens of billions of dollars have been stripped from it. Many of these assets were shed only to pass into the control of a personal friend of the president of Russia. And such deals are continuing to take place: for example, in April 2008 it was announced that Gazprom was urgently divesting itself of the Sibur petrochemical company which was being sold to some Cyprus offshore company at well below its market price.

As a result of these dubious deals, funds have disappeared that could otherwise have been invested in gas extraction and help overcome the gas supply crisis we have described above.

Below we propose to collate all the information available on such machinations so that Russians may see the scale of the asset stripping that has taken place in Gazprom during president Putin’s rule. We will also show the amounts that could have been saved and used to develop Russia’s gas extraction industry had things been done otherwise.

Manipulating Gazprom shares

In early 2000, one of Putin’s widely publicised projects was the buy-back of Gazprom shares sold out from the corporation under Rem Vyakhirev’s control. A great hue and cry was raised in particular over the buy-back of 4.8% of Gazprom’s shares from Stroitransgaz.

However, once there shares were back in the corporation’s hands, they soon began to mysteriously disappear. The process was gradual but anyone who wishes to do so can see how it went by looking at Gazprom’s Quarterly Reports prepared to international accounting standards. These reports publish data on the number of Gazprom shares held by its subsidiaries.

Thus, as at 3 March 2003, the Quarterly Report shows that in the 1st quarter of 2003, Gazprom subsidiaries held 17.4% of Gazprom’s shares. As at 3 December 2007, the corresponding Quarterly Report has their holdings as just 0.3%. In the intervening period, a 10.7% shareholding was bought by state-owned Rosneftegaz.

But 17.4% – 10.7% – 0.3% = 6.4%. Thus, starting 2003, 6.4% of Gazprom’s shares have somehow fallen off its balance sheet. This tendency to disappear was greatest during 2007: at 1 January 2007, Gazprom subsidiaries still held 3.5% of its shares but by the end of the year this was down to 0.3%.

Some of these shareholdings, it would seem, were excluded from the balance sheet in connection with the fact that indices for Gazfond, the corporation’s pension fund (incidentally controlled by Putin friend Kovalchuk), ceased to be reported in Gazprom’s consolidated accounts. Gazprom also explains that it periodically buys and sells its own shares on the stock-market.

Nonetheless, we can see here that little by little over the last five years a large dollop of Gazprom shares has vanished from its subsidiaries’ books. Where did they go? No one knows.

Why is this important? Because 6.4% of Gazprom’s shares represents a quantity sufficient to give one the right to real participation in the corporation’s management. The market value of such a holding is in the region of $20 billion. It is in fact the next most valuable holding after the Russian state’s holding in the corporation and equal to that of E.ON Ruhrgas which also happens to own 6.4% of Gazprom’s shares. The dividends on such a holding, based on Gazprom’s 2007 distribution, is over $170 million a year. On the other hand, if one takes as a base the dividend paid by other private oil companies in Russia, the dividends could be as high as $1.1-1.7 billion. The owner of such a holding can be sure that he can place his candidate on Gazprom’s board of directors and directly influence the running of the company.

How such a holding could be allowed out of the government’s control is incomprehensible. In 1998, for example, the state sold off just 2.5% of Gazprom’s shares in an absolutely open auction. At that time the preparations for this and the actual sale were widely publicised on Russian television and Ruhrgas came out the winner in a transparent process. Nowadays, however, a considerably larger parcel of shares held by Gazprom subsidiaries can just vanish from their books without anyone knowing what happened.

Had this 6.4% holding been sold at open market today, Gazprom would have gained $20 billion which could have been used to develop gas extraction.

And the question of where these shares went still remains unanswered.

Another Gazprom deal also needs to be mentioned here: the “purchase” by the state of a 10.7% holding in Gazprom in order to make the state’s holding a controlling one.

Restoring the state’s control over Gazprom – lost during Rem Vyakhirev’s tenure – is a good thing. Not even the liberal reformers objected to the concept. But how was this done?

The state could have done this relatively painlessly and not too expensively by transferring shares held by Gazprom subsidiaries back to the owner corporation and then pay them off bonds. Proceeding in this way, the state would at no cost have increased its holding from 39.3% {see note 8} to nearly 48% and it could then have bought the remaining 2% plus a little more still needed on the market. (In 2003, this would not have cost more than $500-700 million.)

A proposal of this kind was discussed by the government back in 2000. Paying vast amounts out of the budget to buy back Gazprom shares was clearly not a sensible course from an economic point of view. Would it not be better to use state funds to clear the Pension Fund’s deficit?

But no, the state preferred, firstly, to wait until Gazprom’s market capitalisation had grown and the price of the shares to be bought back had risen, and, secondly, instead of doing a book transaction with bonds, to buy a 10.7% holding in Gazprom at great expense. The purchase cost the state $7.2 billion – 10 times more than would have been needed to buy 2% of Gazprom in 2003.

One gets the feeling that someone deliberately delayed the state’s restoration of a controlling share in Gazprom in order to get more state money onto Gazprom’s books and then to use that money to buy up Sibneft from Abramovich (at, incidentally, an inflated price – about which more below). The deal cost the state budget a cool $6.5 billion. One might well ask if a deal of this kind falls within the meaning of “criminal waste of state funds”?

Lastly, the 10.7% holding has never been transferred to the Russian Federation and continues to float around in Rosneftegaz’s books.

The purchase of Sibneft

In September-November 2005, Gazprom bought 75% of Sibneft from Millhouse Capital. This latter is believed belong to Roman Abramovich (although in our report Putin – The Bottom Line we note that its actual owners are unknown).

We have already describe this deal in detail, pointing out how Sibneft’s market value was pumped up prior to the sale (Sibneft’s Value Inflated, article in Vedomosti, 28 September 2005). It share price was $3 in early 2005 but stood at $4 when the deal was done.

Today, three years after the Sibneft purchase, we can state with certainty that Gazprom’s entry into the oil business has been a failure. Sibneft’s average daily output has fallen from 95,800 tonnes a day in September 2005, when the company was bought, to 84,700 tonnes a day in June 2008, a drop of 11.5% in less than three years.

Gazprom has invested $13.7 billion in a project which from the point of view of productive results is a failure and also clearly overpaid Roman Abramovich companies in the process.

The deal was overseen by none other that V. Putin. No one has been held responsible for the senseless failure of the Sibneft purchase.

Sogaz

The sale of Sogaz was the first instance of a sale of Gazprom assets to friends of Putin. Sogaz, the Gas Industry Insurance Association by its Russian initials, is one of Russia’s largest insurance companies. In 2004, Sogaz was the sixth most highly rated insurance company in Russia with premium income of about $500 million.

The insurance business is outside Gazprom’s remit of extracting, transporting, and processing gas and supplying the same to consumers. In 2000-2002, some members of government and groups of experts actively discussed the need for Gazprom to divest itself of non-core assets. Sogaz was on the list. It was assumed back then that the sale would be preceded by preparatory work on the company to increase its market value, that it would take place transparently, and that it would bring into Gazprom billions of dollars that it needed to invest in gas extraction.

In 2004, however, Sogaz was sold by Gazprom on the Moscow Interbank Currency Bourse to a consortium composed of Evrofinance Mosnarbank, Severstal Group, and Rossiya Bank. Sogaz’ quarterly report for Qtr1 2005 make it clear that 51% of Sogaz was later resold to a company called Abros, a 100% owned subsidiary of Rossiya Bank. Another 12.5% ended up in the hand of Aktsept, which owns 3.93% of Rossiya Bank.

According to the Russian media, Aktsept is 99.99% owned by Mikhail Shelomov, the son of the cousin of Russia’s second president, Vladimir Putin.

We have already written about Rossiya Bank in Putin – The Bottom Line. The bank was set up in 1990. Its main investor was the Administration Directorate of the Leningrad District Branch of the Communist Party of the Soviet Union. According to the Russian media, the bank’s largest shareholder is Yuri Kovalchuk, the chairman of its board of directors and a friend of Putin’s dating back to when the latter worked in Petersburg. Again according to the media, Yuri Kovalchuk is one of the businessmen who is closest to Putin.

It is worth mentioning in passing that Kovalchuk is in the diplomatic service of the Kingdom of Thailand, being Thailand’s honorary consul in St. Petersburg. His office is located inside the Thai Consulate, a location that enjoys diplomatic immunity.

And so Gazprom lost control of one of the country’s largest insurance companies. After passing into the hands of Rossiya Bank, Sogaz’ business grew rapidly: premium income went up from $500 million in 2004 to nearly $1.5 billion in 2007. According to Russian press estimates {see note 9} the main reason for this growth factor was that it began insuring the big state-owned companies (including Rosenergoatom, the Russian Railways, and others). In off-the-record interviews with Vedomosti newspaper, Sogaz customers referred to its having official support but refused to be quoted by name.

According to Rossiya Bank management estimates {see note 10} the purchase of Sogaz cost them about $120 million although the real value of the company is perhaps $1.5-$2 billion. Stripping one of Russia’s largest insurance companies away from Gazprom at a ridiculously low price and then “pumping it up” with income from government-owned companies directed to use it – that, it would seem, was the Putin clan’s strategy vis-à-vis Sogaz. Had Sogaz been properly prepared well before being put on the market and had the company itself then been sold at an open auction, Gazprom would probably have made $1 billion from the sale. And the funds could have been invested in developing gas extraction. But…

Gazfond and Gazprombank

In August 2006, Sogaz, by then already owned by Rossiya Bank, bought 75% + 1 share of Lider, the company which manages Gazfond, Gazprom’s pension fund. Gazfond is the largest non-state-owned pension fund in the country with reserves (as at 1 July 2006) of over $6 billion.

These funds do not belong to the pension fund or Lider, the company which manages them, but may be invested in any projects the management company decides. When Rossiya Bank’s owners bought Lider, they did so with the intention of gaining control over the pension fund: in 2005, Yuri Shalamov (son of Nikolai Shalamov, a Rossiya Bank shareholder from late 2004) became Gazfond president.

The next purchase to be made was done with Gazfond money: this was the acquisition of a controlling share in Gazprombank, one of the country’s largest banks (at the time of the purchase it had the 3rd largest assets in Russia although on occasion its assets would take it up to second place after Sberbank, relegating Vneshtorgbank to the third position).

In early 2000, the government had discussed the possible sale of Gazprom’s financial assets, including Gazprombank, for cash at open auction as part of a general move to divest Gazprom of non-core assets. As late as 2006, Gazprom’s board considered discussing the sale of a large shareholding in Gazprombank to a strategic investor, Dresdner Bank. Although this proposed deal was not particularly transparent and Dresdner Bank was headed by a former Stasi operative and long-time personal friend of Putin’s, Matthias Varnig, the sale was to be carried out for real money.

In late 2006, however, the Gazprom board approved the divestment of a quantity of Gazprombank shares not for money but in exchange for Gazfond’s shareholding in Mosenergo. Gazprom could have have held on to Mosenergo or could have sold this electric power generating company’s shares on the stockmarket – as indeed it could have sold Gazprombank shares. But they decided instead on this idea of a “swap” – with the result that by April 2007, as was announced by Gazprombank’s press office, Gazfond now controlled the bank with 50% + 1 share. Gazprombank, which according to a number of experts is worth $25 billion, slipped away from Gazprom without Gazprom getting so much as a kopeck of real money for its valuable asset.

Gazprom-media

In the course of innumerable asset swaps, it came about that Gazprom-media, Russia’s largest media holding, slid out of the direct control of Gazprom. (We wrote about this in our report Putin – The Bottom Line). Gazprom-media owns the NTV and TNT television channels and other media assets. Its shares were transferred into the ownership of Gazprombank prior to Gazfond’s getting a controlling share in the bank, or to put this in another way – prior to its ending up in the business empire of Rossiya Bank and Yuri Kovalchuk. When in July 2005 Gazprom-media’s and the NTV and TNT television channels’ shares were transferred into the books of Gazprombank (back then this was only a normal internal operation within Gazprom), Gazprom was paid $166 million for the shares by Gazprombank.

However, just 2 years later, after ownership of Gazprom-media as part of Gazprombank’s assets had passed to Rossiya Bank, vice-premier Dmitri Medvedev publicly put another value on Gazprom-media’s assets – $7.5 billion. This means Gazprom gave its assets away for an order of magnitude less than its real value, at a discount of say $7.3 billion!

Rossiya Bank today controls a number of other major media assets besides Gazprom-media. These are the Ren-TV and St. Petersburg Channel 5 television channels, the country’s largest circulation newspaper Komsomolskaya Pravda, and dozens of other TV, radio, and newspaper companies. In 2005-2007, the media group won the right to broadcast in 41 regions of Russia and then got allocated frequencies in a further 29 regions. And Gazprom, in losing Gazprom-media, lost, as we said, $7.3 billion.

Rosukrenergo

The dubious scheme whereby opaque intermediaries are used in the resale of Turkmen gas to the Ukraine for subsequent re-export in part to Europe was set up by the Putin clan back in 2002. Back in Rem Vyakhirev’s time, similar dubious operations were carried out by a company called Itera. Many Gazprom shareholders and outside analysts were strongly against these schemes under which, in Gazprom’s full cognisance, a large proportion of profits on sales disappeared into the hands of intermediary companies with ultra-complex ownership structures which had inserted themselves into the operation of the state-owned petrochemical companies of Russia, Turkmenistan, and the Ukraine.

At the start of Putin’s presidency, there had been serious hopes that such intermediaries would cease to be used in the Russia-Turkmenistan-Ukraine gas triangle and that Gazprom would start getting full commercial value from its activities in this sphere.

However, by as early as 2003, Rem Vyakhirev’s pet company Itera was merely replaced by another intermediary, EuralTransGas, which was registered in Hungary by four persons in 2002. In 2004, according to Vadim Kleiner {see note 11} of investment fund Hermitage Capital Management {see note 12}, a Gazprom shareholder that attempted to protest against the outflow of capital from the corporation, Gazprom gifted its intermediary EuralTransGas with $767 million profits from the resale of Turkmen gas to the Ukraine for subsequent re-export.

Starting 2005, EuralTransGas relinquished its role of intermediary in the Russia-Turkmenistan-Ukraine gas triangle to Swiss-registered Rosukrenergo which received the exclusive right to resell Turkmen gas to the Ukraine. Rosukrenergo founders were Gazprombank (which paradoxically has no gas interests) with a 50% holding and unknown persons. Suspicions were frequently voiced that big-time criminals were involved in Rosukrenergo and EuralTransGas. Later two businessmen, Dmitri Firtash and Ivan Fursin acknowledged their involvement. Despite the fact that Gazprom was now via Gazprombank receiving its share of the profits from the resale of Turkmen gas to the Ukraine and its subsequent re-export to Europe, a proportion of the profits were not going to Gazprom. In 2005, the amount that went to then then unknown co-owners of Rosukrenergo amounted to to $478 million.

It can therefore be seen that in 2004-2005, Gazprom simply gifted $1.25 billion of profit from its Turkmen gas trade with the Ukraine to some shady intermediaries.

Yet Rosukrenergo’s role in all this only grew. By an ill-famed agreement of 4 January 2006 between Russia and the Ukraine, Rosukrenergo was given the exclusive right to resell all Russian and Central Asian gas to the Ukraine. This agreement annulled direct contractual agreements between Gazprom and Naftogaz Ukrainy. As we shall show below, this scheme was not a commercial success for Gazprom.

In late 2006, just before Rossiya Bank gained control over Gazprombank, Gazprom bought a 50% share in Rosukrenergo from Gazprombank for €2.3 million (~$3.5 million). Furthermore, not long before that Gazprombank and private shareholders in Rosukrenergo had been paid $730 million in dividends. It therefore turns out that just before handing control of Gazprombank to Rossiya Bank, Gazprom further primed it with hundreds of millions of dollars that became Rossiya Bank’s.

Sibur

The 2008 story of the attempt to sell petrochemical concern Sibur to private individuals is perhaps the most insolent example of the asset stripping of Gazprom in recent years. Sibur is the country’s largest petrochemical corporation. It consists of 6 (out of the 8) Western Siberian plants for processing oil field gas; Tobolsk-Neftekhim, one of the countries largest petrochemical plants; 7 synthetic rubber production plants; 6 polymer production plants; 6 tyre factories; and 2 mineral fertiliser plants. Its turnover in 2007 was $6 billion and it made an operating profit of $1.2 billion.

In 2002-2003, the issue of regaining control of Sibur following the attempt by its former chairman Yakov Goldovsky to wrest it away from Gazprom was made one of the big themes of Putin’s propaganda campaign about returning assets lost to Gazprom under Rem Vyakhirev. Goldovsky was arrested in Gazprom head Aleksei Miller’s reception. Sibur was returned to Gazprom. Goldovsky had to flee abroad. Putin addressed the following threatening remark to Miller: “One needs to be more careful about questions of property. One day you may yawn a little too widely and lose more than Sibur.”

However, it would appear that Sibur was brought back into the fold only to be again handed to unknown private persons. AOnly a few years later, Gazprom once again finds itself losing its control over the company. First, through a series of manipulations Sibur finds itself no longer under direct Gazprom control and is owned by Gazprombank (70% – 1 share) and Gazfond (25% + 1 share). These two entities, of course, later pass from Gazprom into the hands of Rossiya Bank (as detailed above). In addition to all this, Gazprom wrote off 40 billion roubles of Sibur debt to it.

In April 2008 an attempt was made finally – and most hurriedly – to hand Sibur over to a group of private persons. On 22 April 2008 Sibur president Dmitri Konov and 4 other top managers informed Sibur’s board of directors of their intention to begin talks with Gazprombank regarding the purchase of a majority shareholding in Sibur by Hidron Holdings Limited, a Cypriot offshore company. A price and terms were agreed by the parties within a mere five days. According to Russian media sources, Hidron was to buy Gazprombank’s whole 70% holding in Sibur based on a preliminary valuation of the company at $3.8 billion.

Many analysts, however, estimated that $6.5 billion was a fairer valuation for Sibur.

Nearly half the amount Sibur’s managers were going to pay Gazprombank in accordance with the terms they had agreed (25 billion roubles out of a total of 53.5 billion roubles) was to be lent to them by Gazprombank for a three-year term. Gazprombank was in effect going to finance its purchasers in the deal! In addition to this, the new owners had negotiated for themselves the right to sell back to Gazprom the Sibur subsidiaries Sibur-Russkie-Shiny (Sibur Russian Tyres) and Sibur-Minodobreniya (Sibur-Mineral Fertilisers), evidently at a premium.

For what services five top managers who had only worked for a few years in the company were being given such a munificent present is a complete mystery. Why were they being allowed to rush-purchase a controlling share in Sibur on such unbelievably good terms? The company president Dmitri Konov had only been in place for four years, of which only 18 months in the top spot. None of the four other managers had worked in Sibur for more than 5 years. In addition, no one know who the ultimate beneficiary of Hidron Holdings Ltd, the buyer, is. Judging from the rush and the fantastic terms of the deal, there is every reason to believe that the object is to “reward” not Konov & Co. but some highly placed government figure “for all his good work”.

And of course Gazprom stands to lose no less than $3 billion in the matter.

Gazprom Asset Stripping Machinations: Conclusion

Over the last few years as a result of machinations to strip Gazprom of assets, the corporation has lost control of assets to a value exceeding $60 billion (6.4% of its own shares, shareholdings in Gazprombank, Sogaz, Sibur, Gazprom-media, and the assets of Gazfond, the largest non-state pension fund) plus cash amounting to almost $20 billion extracted from the corporation under the pretext of buying shares in Sibneft and machinations involving the trading company Rosukrenergo.

The value lost to Gazprom in these deals is, in our estimation, approximately equal to the cost of bringing the Shtokman, Bobanenkovo, and a number of other major new gas fields into production. These funds could have been used to develop new gas industries and ensure a reliable supply of gas for Russian consumers.

Instead, we have seen efforts devoted in the main to consolidating Rossiya Bank’s business empire by raiding Gazprom assets.

Rossiya Bank’s Empire built on assets stripped from Gazprom

Pipeline Machinations

In recent year Putin and Gazprom’s management have devoted a great deal of time and effort to a number of gas pipeline projects involving a lot of propaganda ballyhoo as well a serious foreign political gameplay. Many Russians have been led to believe that all these ‘Northern’, ‘Southern’, ‘Bluestream’ and other pipelines are the keystone of Russia’s national interests. Many therefore worry about the fate of these projects and accept that countries which are openly against the pipelines should be painted as enemies.

On closer examination, however, none of these ambitious projects for new export pipelines present anything like and open-and-shut case. In fact, these projects are no less machinations than the asset stripping of Gazprom.

First and foremost, it should be recalled that Russia has already had disappointing results from its machinations surrounding the implementation of large-scale international pipeline projects.

This is firstly the Bluestream gas pipeline running across the bed of the Black Sea from Russia to Turkey. In 1997, before the agreement to build it was concluded with Turkey, Gazprom asserted that this pipeline would be the linchpin of Russia’s strategic interests, the main point of which was to bypass Georgian territory. There is no doubt that such concerns as the need for it and questions of efficiency were swept away as ‘unprofessional’.

Bluestream has now been built. It is running at half its capacity and in its first 4 years ran at one-third capacity (because in 1997 Gazprom, as many experts foresaw – including the authors of this paper – overestimated Turkey’s potential demand for gas). The constructions of Gazprom’s section of the pipeline cost $3 million per kilometre, against a world average of $1-$1.5 million. The project was endowed with over a billion dollar’s worth of tax relief from the state, this at not the best of times – 1998-2002 – from the budget’s point of view.

Today, gas exported down Bluestream continues to enjoy relief from export duty in accordance with intergovernmental agreements ratified in 1999 when Putin was still premier. This is costing the state $600-$700 million a year at today’s gas prices {see note 13}.

As soon as Bluestream came online, there was a serious row with Turkey over its use. Turkey demanded – successfully – that the agreed price for the gas and its minimum guaranteed purchase quantities be reduced, thus reducing Gazprom income. Turkey next insisted on being appointed to resell surplus gas which Gazprom wanted to deliver down Bluestream to Europe in order to fill the pipeline. Cruel irony: there were even discussions about a potential branch pipeline through Georgia in order to make better use of capacity, even though, as we have noted, bypassing Georgia was the main ‘strategic’ region for the pipeline in the first place.

The result of all this was a decision to build a new pipeline – South Stream – under the Black Sea but now bypassing Turkey following the refusal announced the year before by president Putin to consider the building of a second phase of Bluestream.

The benefits to the state of another new ‘construction projects of the century’ were, to put it mildly, somewhat dubious.

Now we are being urged to become involved in yet more ‘construction projects of the century’, which it is argued are needed to protect our ‘strategic’ national interests. These are the Nordstream pipeline under the Baltic Sea, South Stream under the Black Sea, and the Altai pipeline to China.

Looking at our experiences with Bluestream, would it not be wise to think through how beneficial these new projects will be for Russia?

It is not at all clear that they will be. Let us take Nordstream first. Despite the fact that Gazprom has for years asserted that the cost of building this pipeline under the Baltic Sea will ‘not exceed’ $5 billion, the officially recognised figure already stands at $11.5 billion (€7.4 billion). We believe the maritime section of the pipeline will end up costing not less than $15 billion.

The alternative to Nordstream, which Gazprom rejected, would have been to add a second parallel pipe to the Yamal-Europe pipeline through Belarus and Poland at a cost of just $2.5 billion. This pipeline would have run parallel to the old one, through places with existing infrastructure and without the complexities of undersea construction. But this was rejected out of hand.

Gas will be transported down Nordstream on a ship or pay basis. This means Gazprom will have to pay the operating company for transport costs for 27.5 billion cubic metres from 2010 onwards regardless of whether it is carried or not and for 55 billion cubic metres from 2012 on the same basis. This ‘enhanced’ tariff, needed to help pay off the investment, will continue until 2032. It seems fair to say that transport costs such as these will certainly not result in any saving from what Belarus and Poland would have charged for transit. Gazprom is having to spend some serious money for the pleasure of bypassing these two countries.

That’s the price of having geopolitical ambitions.

It is furthermore not true to claim that Nordstream will enable Russia to bypass all transit countries. The pipeline will have to cross either Estonian or Finnish seabeds and then the Swedish one. Estonia has refused Russia its permission and both Finland and Sweden have objections to Gazprom’s pipeline plans.

The Nordstream pipeline is therefore nowhere near as clearly good for Russia as it is being made out to be. Nor is the situation with it particularly clear either. Gazprom’s capital and operational costs will be extremely high, the economic benefits are not obvious, the risks serious. Furthermore, despite that fact that the project has been talked up all through Putin’s terms, no start has been made on the construction of the maritime section of the line.

The situation is no better with the other pipeline megaprojects – South Stream and Altai. South Stream, which so far exists only as a concept (no detailed plans have been drawn up), is supposed to help correct the gross errors made on Bluestream and remove dependence on transiting Europe-destined gas via Turkey, which has proven to be a far less cosy partner than Gazprom had expected.

In principle, South Stream is supposed to travel across the Black Sea bed from Russia straight to Bulgaria and then on to other European countries. Not a bad idea. The Black Sea does not give rise to the same ecological problems as the Baltic. Unlike Nordstream, which is supposed to provide new delivery volumes to new markets (one purpose Nordstream does not have is that of bypassing Ukraine, since its intended market is North-West Europe, to which Ukraine does not send gas), South Stream does provide manoeuvring room against the Ukraine as it will supply gas to the South-West European countries currently served down the Ukrainian corridor. The scales differ, however: 130 billion cubic metres a year pass through the Ukraine and the proposed capacity of South Stream is 30 billion. Ukraine will retain its dominant position for many years to come.

On the other hand, there are obvious problems with the plan, namely it high cost and the inevitable need to agree the pipeline routing with either the Ukraine or Turkey as it will have to pass through one or the other country’s exclusive maritime economic zone.

Project costs have been estimated by Energy Minister Sergei Shmatko as running to up to $20 billion {see note 14}. Laying the pipe across the Black Sea bed will give rise to the same problems as Nordstream has in the Baltic. And we will need to get consent to lay the pipe in the exclusive maritime economic zones of either Turkey or the Ukraine, the very countries which the pipeline is being created to bypass!

Would it not work out cheaper to negotiate long-term and stable agreements with the Ukraine? In our view it would be far simpler to reach agreement with the Ukrainians than to spend billions on a pipeline that will reduce our dependence on gas transiting the Ukraine by just 25%. All that is needed to reach such an agreement is the ability to hold negotiations in which one is ready to find compromises and not just bully.

As regards the gas pipeline from Western Siberia to China, it is a case of pure adventurism. Despite Gazprom declaring that it will only cost $4-$5 billion to build, this is hard to believe since it will be 2800 kilometres long, much of that in mountainous regions of which Gazprom has little experience. One can safely assert that the project will cost no less than $10 billion (at $3 million per kilometre). The project represents a threat to the ecology of the Altai region and will involve doing damage to the Ukok high-mountain plateau, a unique wildlife reserve listed by UNESCO as a world heritage site.

However, the main thing to say about this project is that its economic prospects are incredibly dubious. This is because China is not prepared to pay high prices for Russian gas. Coal is the dominant power source in China and it is unlikely that the PRC, for whom energy self-sufficiency is the central aim of its energy policies, will agree to pay top dollar for imported gas if it can use its own coal more cheaply. Unlike oil, China does not now and will not in the future import large quantities of gas. It will prefer its own coal. In fact, the International Energy Agency predicts that China’s net imports of gas in 2015 will not exceed 30 billion cubic metres a year.

So it is that this factor traditionally has predicated that China has always been extremely inflexible in the matter of price when negotiating with Russian gas suppliers. When negotiations with China were held in 1999-2002 about supplying gas to China from the Kovykta gas field, the Chinese insisted that the price at the Russo-Chinese border should not exceed $40 per thousand cubic metres, less than the Ukraine was then being charged!

A Memorandum on the building of a gas pipeline to supply 30 billion cubic metres a year to China was signed by Putin in March 2006 but there have been no advances in the talks since then. It is said that the parties cannot find agreement on a price formula. Evidently, what the Chinese are offering is unacceptable to Gazprom.

What an acceptable level might be for them can be seen from the agreement between China and Turkmenistan for the delivery of 30 billion cubic metres starting 2010 down the newly-built Turkmenistan-China pipeline. As is not the case for the Russian ones, work on this pipeline is proceeding apace. A Memorandum on the building of the pipeline and delivery of 30 billion cubic metres was signed by the Chinese government and Turkmenistan’s former president S. Niyazov in early April 2006, 3 weeks after the Memorandum with Putin was signed. The Russian and Turkmen projects clearly compete with each other because, as stated above, China will not need to import more than 30 billion cubic metres for the foreseeable future and two pipelines are therefore unnecessary.

It would seem therefore that Turkmenistan was able to make China a better offer, one that included access to the gas fields and control over the pipeline. The price level, agreement on which was reached in November 2007, is $192 per 1000 cubic metres. This is lower than Gazprom’s prices – applicable until 2009 – to the Ukraine.

Question: why are we trying to get into the Chinese market, which promises worse deals that our deals with the Ukraine? All the more so since wer are clearly being outdone in the matter by Turkmenistan?

Doesn’t this whole story of pipelines to China reek of another machination?

And another big and even more important question marks hangs over all the pipeline megaprojects: where is Gazprom going to get the gas it proposes to send down these new pipelines? The total extra gas needed for the three projects – Nordstream, South Stream, and Altai, if they are built, is 115 billion cubic metres a year, a volume not available in the current gas accounts. We have already described the difficulties being encountered in the matter of gas extraction as a result of chronic underinvestment over the years. Gazprom has for a long time now been juggling names of new gas fields – Bobanenkovo, Shtokman – which could help fill the void in the gas balance resulting from the exhaustion of current gas fields. However, when it comes to developing new fields, there nothing to boast about.

The conclusion leaps to the eye: either all this hullaballoo about new gas projects is just a machination or we Russian consumers will have to pay for the increase in gas exports through reduced consumption of gas or its replacement by more expensive coal and atomic energy.

Gas conflicts in the CIS

The expanses of the former USSR have been shaken by loud conflicts over gas in recent years as a result of Gazprom pressurising our neighbours to accept higher prices for Russian gas. Everyone remembers the energy wars with the Ukraine and Belarus. Other countries were also severely pressured, in particular Georgia, Armenia, and Azerbaidzhan (which in 2007 actually decided to stop buying Russian gas at the higher prices demanded). We were assured that it was necessary to do this to ‘defend the country’s economic interests’.

There’s no arguing that the post-Soviet countries should not pay higher prices for their gas. The question is how one sets about achieving this and do the benefits from achieving this compensate for the damage done by Gazprom’s crude pressure tactics?

Let’s look at the figures. Gazprom income from gas sales to the CIS, as may be seen in their 2007 Annual Report prepared in accordance with international accounting standards amounted to $10.7 billion. Not bad money – about 11.5% of the total. One should ask, however, how much was gained from pressurising the CIS countries in this way and engendering political scandals and conflicts with the Ukraine, Belarus, Georgia and Azerbaidzhan.

It is worth recalling here that back in 2005, before all the gas wars, gas sales income from the CIS countries amounted to $4.6 billion. In other words, the series of loud gas scandals led in 2 years to an increase of $6 billion in Gazprom’s income. Is that a lot? It’s about 6.5% of its 2007 income.

In principle, that’s not a bad result. Still one should not forget how it was achieved. Crude political pressure, an atmosphere of constant aggravation in the media, harsh statements about neighbouring countries, the demonstrative turning off of the gas taps on 1 January 2006…

Now the whole world talks only about how Russia uses gas deliveries as a ‘political weapon’. Gazprom’s ‘aggressive ways and hostility’ tops the agenda of international seminars on energy security. Around the world, a large number of politicians with anti-Russian inclinations have jumped at the opportunity to use the example of Gazprom’s crude modus operandi with the CIS countries to talk up a picture of Gazprom and Russia as enemies.

The European Commission quite officially in September 2007 tabled a series of laws to reform electricity and gas markets that contained, as it was unofficially called, an ‘anti-Gazprom amendment’ – a proposal to limit the right of companies representing non-EU countries to purchase strategically important parts of Europe’s energy infrastructure. Gazprom’s energy wars with the CIS may end up leading it to a serious loss of investment opportunities in Europe.

And is that worth the $6 billion more extracted from the CIS countries in 2007 as compared to 2005?

It should also be remembered that Gazprom, while freely bandying about the concept of ‘transition to market prices’, for totally obscure reasons sets varying prices for different CIS countries, charging the Baltic countries and Georgia $230 and higher per 1000 cubic metres, Ukraine – $179.50, Moldova – $170, Belarus – $119 in the first half of 2008 and $127.90 in the second, while Armenia pays just $110. The political coincidence in this ‘geography of prices’ is too striking for words.

Of course, gas prices had to rise for our neighbours – but this should have been done through negotiations, compromise, and agreed stages without pressurising and aggression. The results obtained are not worth Gazprom’s loss of image worldwide as a result of how it got its way with the CIS countries.
Notwithstanding all this, Gazprom’s resale of Central Asian gas to the Ukraine (60% of Russia’s gas exports to the CIS countries) may not even make a profit: in 2007, for example, Gazprom bought Turkmen gas at the Turkmen-Uzbek border for $100 per 1000 cubic metres and sold it on to the Ukraine for $130. Transport costs, however, amount to close to $30. In 2008, the situation was much the same: the price agreed with the Ukraine was about $180 per 1000 cubic metres but by then the price to Turkmenistan had risen to $130 for the first half-year and $150 for the second. In 2009 prices are due to rise to $250-$300 per 1000 cubic metres but raising the prices paid by the Ukraine and Belarus will be problematic and no doubt give rise to sharp new political conflicts.

Why does Gazprom participate in profitless operations to resell gas to its CIS neighbours, creating problems for itself and reducing its own profitability?

Why did Gazprom need to create political scandals on the issue of gas deliveries to CIS countries for what amounts to modest improvements in the prices it charges while at the same time doing damage to its political reputation?

The Russian Consumer Pays the Price

Russians should have no illusions about who will end up paying for Gazprom’s inefficiency, underinvestment, and asset stripping.

We all will pay. In fact, we’re already having to – the price paid for gas by Russian consumers has risen sharply in recent years and the government plans to raise them still further and faster. In dollar terms, internal Russian prices have since 2001 risen nearly five-fold and now stand at nearly $64 per 1000 cubic metres (about the same as the gas price at the German border in 1999).

Average Russian consumer gas prices

But that is not all. On 28 May 2007, the Russian government – it was then the Mikhail Fradkov cabinet – passed Decree №333 approving a programme of staged increases in the internal price of gas based on the ‘principle of equal profitability’ with exported gas. In simple terms, Russian consumers were going to have to pay international prices. According to the government’s official prognostications, by 2011 prices would double to $125 per 1000 cubic metres and might rise still higher since prices were rising rapidly and unpredictably in Europe.

Vladimir Putin’s government confirmed its resolve to keep to the planned rises in internal prices with the aim of achieving parity with European ones.

Higher gas prices are a problem for Russians even if they do not themselves consume gas. This is because gas makes up nearly half of all the fuel used to produce electricity in Russia, and considerable more than that in European Russia. For example, gas is used to produce 95% of the electricity of the Moscow region (Mosenergo’s former territory).

It is no surprise, therefore that the regions inhabitants are already paying 8¢ KWh (~2 roubles) while in the US electricity costs on average 6¢. Muscovites pay more for their electricity generated using Gazprom gas than Americans do for theirs!!!

Yet in 2000-2003, when the Russian government was discussing ways to reform the gas industry and Gazprom, the Central Institute of Economics & Mathematics calculated that if competition were to be engendered by breaking Gazprom up into independent gas producing companies, the price of gas in Russia would not exceed a level of $60-$70 per 1000 cubic metres. This means that rises in the price of gas are not justified and have one main cause – the fact of Gazprom’s monopoly.

We Russians are paying for Gazprom to have a monopoly.

And we’re paying for it not just through higher gas prices but also through the ridiculously low profits that go from Gazprom to the state. The corporation gets immense hidden subsidies from the state in the form of reduced taxation: for example, in 2007 Gazprom paid into the budget just $7.3 per barrel of oil and gas equivalent as compared to the $40 per barrel paid by the large oil companies. In 2007, Gazprom’s taxes amount to only 30% of its income and yet the government keeps putting off to a later date the matter of raising its taxes.

The favours done to government-favourite Gazprom is costing the Russian budget no less than $20 billion a year (a minimum estimate based on Gazprom paying tax at 50%). And it’s not that they pay knock-out dividends into the budget either: in 2007,for example, the corporation paid the state dividends of $1.35 billion, a mere 1.4% of income. Dividends on Gazprom shares in 2005-2007 were just 1% of the average value of shares.

The Alternative

We have deliberately decided to examine Gazprom and its activities during Putin’s term of office in greater detail. Our professional experience means that the subject is one we know and understand as we have both been professionally involved in matters concerning the Russian gas industry and Gazprom.

We are some of the few experts in Russia who are not Gazprom insiders but independent yet who understand the internal peculiarities of this corporation and are prepared to put forward to the public alternative policy suggestions for the gas industry that could help it overcome its looming crises. The following is, in our view, what needs to be done about Gazprom in order to avert a crisis:

1. Russians need to recognise that Gazprom in its present form is a problem for Russia.

2. It needs to be understood that lack of competition in gas extraction is delaying the bringing on line of large new deposits not by years but by decades. If the new deposits, which belong to the state, were to be developed via the licensing of independent private companies, production would have started long ago and competition would have kept Russian gas prices down. For example, independent Russian gas producers outside of Gazprom have increased their production from 47 billion cubic metres a year in 1999 to 105 billion in 2007 (a doubling in less than 8 years), mostly as a result of bringing new deposits on line. Furthermore, if Gazprom’s production figures had not been increased as a result of its takeover of independent companies’ deposits (the Gubkinsk deposit from Itera, the North Urengoi deposit from Nortgaz), Gazprom’s production figures would actually have dropped 4.5% and stand at roughly the 2002 level.

3. We need to create independent gas extraction companies based on the licensing of deposits which Gazprom has up until now failed to develop. Shares in these companies should be sold at auction to private owners. This would enable a new private gas extraction industry to take shape in Russia with the potential for a total output of 300 billion cubic metres by 2015, this in addition to the current independent sector which could increase its production to 150-170 billion cubic metres in the same period.

4. These measures would make it possible to create a very competitive internal market in Russia (without doing away with the existing export monopoly) and thus potentially stabilise internal gas prices for Russian consumers at a level 20-25% lower than Putin’s government and Gazprom plan to achieve by 2011.

5. In order to ensure that independent gas companies enjoy fair access to the gas pipeline network, the same should be done for gas transportation as experience has shown to be the solution for the oil industry: gas transportation should be removed from Gazprom’s remit and made into a single entity independent of gas production. The state should directly control this company, as it does Transneft for the oil industry. Equal access needs to be ensured and a single tariff for gas transportation applied to all pipeline users.

6. Windfall profits from gas exports at today’s high prices should not be allowed into the hands of Gazprom’s managers and steps taken to ensure they are used to overcome the approaching collapse of pension system and pay higher pensions. At today’s European prices, the windfall profits on gas exports amount to $15-$20 billion a year and could be used to create a decent pension system.

7. In order to guarantee long-term export supplies, we need to conclude a number of long-term contracts for the purchase by Gazprom-export (whose name, we believe, should revert to its historical one of Gazexport) of gas for re-export from producers. These contracts should provide for the producers to enjoy equal access to the profits from export sales of gas, less tax and Gazexport’s commission.

8. Gazprom’s remaining assets – operational gas fields, processing plants, distribution pipelines – will enable it to carry out its function of providing the Russian consumer with a reliable gas supply.

9. A review of all the deals done over the last few years to strip assets from Gazprom need to be carried out and measures taken for their legally enforced return. At the same time, Gazprom’s non-gas assets, including shareholdings in oil, electric power generation, petrochemical, and financial companies, should be sold off at open auction. The funds generated should be spent on reducing Gazprom’s accumulated debt to external creditors and investing in gas extraction.

We believe that the ideas we have set out above (and any others that are tabled) should be widely discussed in the free media with a view to elaborating a national programme to pull the gas industry out of the deep crisis into which Putin and his team have mired it. This crisis is heavy with consequences for the national economy and presents a threat to Russia’s energy security.

Conclusions. The Bottom Line

Here is what the activities of Gazprom, the country’s largest energy corporation, have led to during president Putin’s term of office:

1. Against the background of a growing economy (between 2000 and 2008 GDP rose by over 70% and industrial production by 65%) Gazprom’s gas output has risen not at all. In 2007 Gazprom produced practically the same amount of gas as in 1999 – 548 billion cubic metres and 546 billllion cubic metres respectively. The absence of growth in gas production when internal demand is rising and new pipelines are being built has led Russia to have a shortage of gas.

2. Gazprom has burdened itself with immense debts. These have risen from $13.5 billion in late 2000 to $61.6 billion at end 2007, an amount equal to 2/3 of its annual income. Such a level of debt makes it impossible for the corporation to invest enough in gas extraction and puts it at risk of a default and of bankruptcy.

3. Gazprom is the state’s largest corporation yet pays a miserly amount of tax into the budget. While internal gas prices rise and world prices rocket, in 2007 the corporation paid a little over $7 tax per barrel of oil/gas while oil companies paid $40 per barrel.

4. As a result of machinations to strip assets from Gazprom, the corporation has lost control of assets worth over $60 billion (6.4% of its own shares, shareholdings in Gazprombank, Sogaz, Sibur, Gazprom-media, and in Gazfond, the country’s largest non-state pension fund) and cash funds to the tune of $20 billion under the pretext of purchasing shares in Sibneft and schemes with trader Rosukrnergo.

5. Gazprom’s largest ever acquisition – of oil company Sibneft – cost Gazprom $13.7 billion or the equivalent of 3 years investment in gas extraction yet has turned out to be a production failure. Average daily oil output at Sibneft has fallen by 11.5% in the less than three year since it was bought.

6. Gazprom’s management inefficiency is worse than anyone expected. Operating costs have tripled since 2003, going from $4.9 to $14.8 per barrel equivalent.

7. Gas shortages, Gazprom inefficiency, absence of competition in the gas industry, and the total subjugation of the government to Gazprom’s lobbying power has forced the government to take steps increase the rate of gas price rises for Russian consumers to match European prices; the cost of electricity and utilities will therefore rise too.

8. The giant gas pipeline projects – Nordstream, South Stream, and Altai – dreamed up by Gazprom are economically unjustifiable machinations. Their expected costs are beyond all reason. The pipelines, notwithstanding what is said in propaganda, do not solve the problem of transit countries (the throughput of the pipelines passing through the Ukraine and Belarus is about twice that of Nordstream and South Stream combined). Given the deep crisis in which Russia’s gas extraction industry finds itself, where the gas to fill these pipelines will come from is not at all clear.

The reason for Gazprom’s dismal results is the gross lack of professionalism and incompetence of its main ‘protector’, Russia’s second president, who over the last 7 years has to all intents and purposes personally run Gazprom.

Changes are needed in order to get Russia’s gas industry out of its crisis – structural and personnel changes in Gazprom and a cardinal change of approach for the corporation. It is not conceivable that there will be any positive changes in the gas industry if it is not brought out from under the pernicious ‘personal protection’ of Vladimir Putin, whose ‘efforts’ on its behalf have led to the profound crisis in the industry and to Gazprom’s many failures. We will only see a change for the better after Putin’s government has resigned.

About the Authors

Boris Nemtsov and Vladimir Milov are Russian democratic opposition politicians and the co-authors of Putin – The Bottom Line, published by Novaya Gazeta in February 2008.

Putin and Gazprom is a continuation of the February white paper and concentrates in greater detail on how Gazprom, Russia’s largest energy corporation, has performed during Putin’s term of office. B. Nemtsov and V. Milov have both been directly concerned with Gazprom’s problems in their professional capacities.

Boris Nemtsov, as first vice-premier of the Russian government and minister for fuel and energy in 1997 was the author of president Yeltsin’s Order №426 of 28 April 1997 ‘On the main directions of structural reforms of natural monopolies’, which envisaged liberalising the gas market and opening it up to independent producers. In 1997, a proposal of Nemtsov’s led to the establishment of a commission to ensure access to Gazprom’s gas transport system for independent producers. More gas from independent producers was able to flow down Gazprom’s pipelines and independent production more than doubled. Boris Nemtsov’s efforts managed to prevent a 38% government shareholding in Gazprom passing into the hands of the corporation’s previous managers led by Rem Vyakhirev and to restore the government’s direct influence in the corporation’s management through its board of directors.

Vladimir Milov was closely involved during his career in regulating Gazprom’s activities. In 1999-2001, while at the Russian Federal Energy Commission, he drafted the main points of what later became premier Mikhail Kasyanov’s Resolution №1021 of November 2000 for the regulation of prices in the gas industry and introduction of radical measures to ease access to Gazprom’s pipelines for independent producers. Later, in 2002, while he was deputy minister for energy, Milov drafted a concept for the development of the gas market in Russia which was presented to the government by the Ministry for Economic Development and Trade for approval. This approval was not given, however, as it was vetoed by president Putin because acceptance of the proposals would have led to an expansion of the role of independent gas producers on the Russian market and the restructuring of Gazprom, matters that did not accord with president Putin’s ideas about the future of the Russian gas industry.

NOTES:

(1) TN: economist and former Minister of Finance
(2) This statement comes from the website of the President of the Russian Federation
(3)Source: RAO UES Annual Report for 2006.
(4) Gas Rationing, article in Vremya Novestei, No. 7, January 2006
(5) Source: Gazprom: Explanatory note to Annual Report prepared according to international accounting standards.
(6) Source: Gazprom: Explanatory note to Annual Report prepared according to international accounting standards.
(7) Source: Gazprom: Explanatory note to Annual Report prepared according to international accounting standards.
(8) This includes the 0.9% holding of state-controlled of Rosgasifikatsiya
(9) Greater detail to be found in Rossiya Bank’s Helpers: How Yuri Kovalchuk Built Up His Empire, Vedomosti, 24 July 2008
(10) Interview with Rossiya Bank’s chairman, D. Lebedev, Keeping a Weather Eye Out For Freebies, Vedomosti, 17 June 2008
(11) Source: Presentation entitled How Should Gazprom Be Managed in Russia’s National Interests and the Interests of Its Shareholders, Vadim Kleiner, Gazprom Board Candidate, June 2005.
(12) Its head, William Browder, would later be refused Russian entry visas and its staff became the subjects of persecution.
(13) Source: Russian Ministry of Finance, Explanatory Note to draft federal budget for 2008-2010.
(14)Vedomosti, A Pipe for $20 Billion, 30 July 2008.