Nemtsov on Gazprom via Novaya Gazeta

Gazprom short-changes Russian consumers

Boris Nemtsov and Vladimir Milov, writing in Novaya Gazeta‘s English edition, offer the following analysis of the Gazprom empire (we have edited the orginal translation for linguistic issues and we have reproduced only one of the numerous tables offered by the authors; the others can be found by following the link). It is a continuation of the authors’ brilliant and courageous White Paper which we have previously translated and published through the good offices of columnist Dave Essel.

Putin and Gazprom

In February 2008 the authors of this paper published an independent expert report titled “Putin, the Bottom Line,” where we presented our vision of the results of the administration of of the second president of the Russian Federation. In that report we gave an uncomplimentary, though fair, assessment of Vladimir Putin’s work in various spheres of our life – the economy, the army, the pension system, the health care system, road infrastructure and other areas. The report was based on figures and facts concealed from Russian citizens by official propaganda.

Many readers noted that there was one issue upon we had touched too lightly, namely the Russian energy industry in general and Gazprom natural gas monopoly in particular.

That was not an accidental omission by us. We considered that the situation involving Gazprom required special consideration which would not be possible to fit in just a couple of paragraphs within our brief white paper. First, because Gazprom plays such a central role in pumping the lifeblood of our nation. Second, because we have first-hand knowledge of Gazprom’s problems, having had direct involvement with the company in our professional activities as a former fuel and energy minister and the deputy energy minister of Russia. Third, because Gazprom has been a kind of special and personal project of Mr. Putin. From the very beginning of his presidency he has cared for the company in a special way, appointing his closest confidants to the key posts in the company and looking into all the details carefully. Gazprom is one of few the projects where Putin can be considered personally responsible for the results, from the beginning of his tenure in office, and one of the projects to be taken as a central criterion for assessment of Putin’s presidential activities, a litmus test if you will.

In this present paper we intended to continue the method of analysis we began in our White Paper and to focus on what has been happening to Gazprom these past few years.

Putin’s Project, Step 1: Seize Control

Gazprom is a unique phenomenon in Russian political and business life. In 2007 its revenues amounted to over $93 billion, which was 7% of the Russian GDP. This is 2.5 times as much as our defense spending. Gazprom’s share of industrial production is over 12% and it accounts for rougly 16% of all Russian exports. The company accounts for about 43% of primary energy production and consumption. Gas supplies provided by Gazprom account for about 40% of all electric energy in the country. In fact, Gazprom is the energy core of the Russian economy. The stability and prospects of our economy depend greatly on its fortunes.

The Company is also a key player in the world energy market. The volume of oil and gas extraction by Gazprom takes an 8.3% share of world production of petroleum and gas. 50% of gas imported by Europe comes from Gazprom. It’s difficult to find another company of a similar scale and similar extent of political and economic influence in Russia. Significantly, Evgeny Yasin once called Gazprom the “purse” of the government, as the Company has no equals in terms of the degree of concentration of the financial assets readily available for state expenditures.

In the 1990s the authorities used this resource from time to time for solving political problems, for instance in 1997 when the government dealt with the task of paying off the arrearages of pensions. Then President Yeltsin diverted some $2 billion in Gazprom assets to finance the payments. Over the years of Putin’s presidency, Gazprom’s resources have been used for different purposes, and that is the subject of the present analysis.

Gazprom has become the most important personal project by President Putin. Right after coming to power, he began to keeping an eye on the company. Even over the course of the presidential election campaign of 2000 it was clear that energy issues and Gazprom were the key elements on the Putin’s political agenda. In June 2000, just a month after his inauguration, Putin managed to arrange the prompt replacement of Viktor Chernomyrdin with one of his closest assocaites, Dmitry Medvedev, in the post of chairman of the board. And in May 2001 the head of Gazprom, Rem Vyakhirev, who had managed the company since its foundation in 1992, was replaced by another Putin confidante, Alexei Miller.

“Gazprom is more than just a joint-stock company. The entire national economy is based to a significant extent on the gas industry.” These words by were spoken by Putin himself at a meeting held on 30 May 2001 in the Kremlin at which Miller’s appointment was announced, indicating the new president clearly understood the company’s significance from the word “go.”

Gazprom was the first business structure in which Putin began systematically seizing the key positions and appointing his own inner circle, ousting members of the old management team. The supreme leadership of Gazprom was soon filled with old acquaintances of Putin’s from his days in St. Petersburg. As of today, 11 out 18 members of the firm’s board directors (managing financial matters, property issues, corporate structure), are people who in the ‘90s worked either in St Petersburg administration or at the Sea Port of St Petersburg, or in some St Petersburg commercial structures, or in the FSB.

Such a practice is uncharacteristic of large global energy entities. Usually the leading positions there are taken by professionals having many years of experience working in high-ranking posts in different energy corporations. As a rule, former minor regional officials, employees of ports and construction companies are not appointed (particularly in such a big number) to fill the positions of top managers in leading oil and gas corporations. However Putin, who made personally decreed all the appointments, did not play by standard rules.

Putin’s Project, Step 2: Exercise Control

Having seized the reins of power, Putin moved on to step two in his plan, namely exercising that power. He dedicated a significant part of his first administration to reorgnizing the struture of the firm and lobbying on its behalf at international meetings, as if he were in truth the CEO.

As well, Putin forcefully guided all regulatory measures within his administration that had applicabilty to Gazprom. When, in 2002-2003, the cabinet of Mikhail Kasyanov attempted to include a question of reforming the gas industry and opening this sector for competition, Putin quashed the measure. More recently, as criticizm of Gazprom’s operating efficiency has increased, as well as questions about its tax burden, Putin has aggressively shielded the company, freezing its level of taxation through 2010.

With Putin’s approval, the government has adopted a program of sharp increases in gas prices for Russian consumers, making them correspond to European norms. Gazprom had been lobbying for this action for 15 years and got nowhere in the cabinets of Gaidar, Chernomyrdin, Kirienko, Primakov and Kasyanov. The program was finally accepted as Regulation #333 on 28 May 2007, signed by Mikhail Fradkov. In accordance with this program, the gas prices for the Russian consumers are to have double by 2011 compared to today’s level, and amount to at least $125 per 1,000 cubic meters (today’s price is about $64). Probably, in reality the prices will be even higher, as the gas prices in Europe have been going up rapidly and unpredictably.

So, over the years of his presidency Putin has proved to be a very effective lobbyist and advocate for Gazprom’s interests. And the question we must ask is this: Has the country benefited? Have the citizens of Russia reaped their rewards?

Putin Project Step 3: Gas resources are being choked off

Given that Putin has so directly controlled the staff and policy of Gazprom, it seems reasonable to hold him accountable for its performance during that time. And the results are rather poor. Above all, Gazprom management has failed in the main function of the company – that is, providing a reliable gas supply to Russian consumers. It could be said that it received a great many privileges from the State in exchange for fulfilling this vital task, not least of which is monopoly status.

But it has not done so. The volume of extraction by Gazprom has not grown over the Putin years, and it even decreased in 2007 back down to the level of 1999. Considering the exhaustion of the old gas fields, and the failure to develop replacements, we can expect this trend to continue. Given this, it’s hardly a surprise to learn that Gazprom’s deliveries to consumers have also failed to increase. In 2007 the volume of gas supplied to the home market amounted only 307 billion of cubic meters, which is only 2% higher than the figure it was in 2001. In the meanwhile, the home demand for gas has increased for 18% or almost 67 billion cubic meters per year! [The chart at the top of the page shows the shortfall in gas production by Gazprom compared to demand during the Putin years.]

Thus, the gap between demand and supply has grown from 72 billion cubic meters in 2001 up to almost 132 billion cubic meters in 2007. Today, Russia has to satisfy about one third of her need for domestic gas through non-Gazprom supplies. Such gaps have been traditionally closed with supplies from independent Russian gas producers and with imports of gas from the Central Asian countries. However, under Putin the operations of independent producers have been restricted, so that Russia becomes ever more dependent on imports from Central Asia, leading to sharp increases in Gazprom’s costs.

The problem of insufficient gas supplies in the domestic market owing to Gazprom’s increasing export obligations, is turning into a real threat. So far Gazprom has been lucky with favorable weather conditions: the last two winters have been relatively warm, which helped reduce the demand. But even in such periods, there is still an increase in demand which accompanies economic growth. This may be seen for example in the last winter season, 2007-2008, where gas was drawn from storage at a record level of 50.1 billion cubic meters, 20% more than the average for the prior three seasons. By the end of January, the underground gas storeage resources of Gazprom had been exhausted almost completely. Even though the relatively new Yuzno-Russkoe gas field came on line, daily output increased by only a meager 2-3% compared to the prior year. During the winter of 2007, 583.6 cubic meters of gas with drawn from storage each day — a record even compared to the much colder winter of 2005.

This shows how much the wintertime demand for gas has grown even under conditions of relatively mild winters, and one may project from this an emergency situation arising should the next winter be an unusually cold one. Large scale service failures could result, such as the one that occurred during the winter of 2005-2006; at that time, restrictions on gas supplies to electric power stations were 12.5% and up to 83% at key regional centers. In other words, at some urgent moments during that winter there was a nearly complete failure of gas delivery in some European parts of Russia (gas is the leading source of energy in electricity supply).

At the same time, there were serious issues concerning gas exports. The media reported that on January 18th Gazprom unilaterally decreased transit through Ukraine from 390 to 350 million cubic meters per day due to shortage of the gas. On the same day Gazprom informed its Italian partner, the ENI Concern, of its inability to guarantee the gas supplies at the planned volume due to extremely cold temperatures, after which restrictions of Gazprom supplies were reported by Serbia (25%), Croatia (6-10%) and Hungary (20%).

The reason for stagnation of the gas supplies in the home market against the background of the growing demand is a systemic shortage of investments into extraction capacity. Russia possesses sufficient stocks of the proven reserves of gas, which should be enough for the next 80 years with today’s level of extraction. However, many of those fields are not explored. A significant part of the reserves is concentrated in fields in new unexplored areas where there is no developed infrastructure, and this is why those areas are so difficult for exploration.

For example, to explore the fields in the peninsula of Yamal situated at a distance of 500-600 km to the north of the existing extraction regions would require construction of a 540 km long railroad through areas of permafrost and those which are 50-60% waterlogged, bedecked with small rivers and streams. To deliver the gas from the peninsula of Yamal it is necessary to build a gas pipeline with a length of 1,100 km, part of which would need to be under water.

According to licenses issued by the government, Gazprom was to put those fields in operation in the late 1990s. However, nothing real has been done to achieve that goal. In 2000 the former head of Gazprom Rem Vyakhirev asked for extension of the licenses. He was refused at first, however after appointment of Alexei Miller as head of the company the license terms were postponed for 8-12 years in a quiet way and without any explanations being given. And now then their terms will clearly not be satisfied.

As a result of declining volumes of extraction at the old gas fields, put into operation as far back as 1980s, Russia is going to face a threatening problem of gas deficit. The Yuzhno-Russkoe field is the last relatively large field remaining in the standing area of the extraction where the infrastructure is rather well developed and conditions of extraction are more favorable. The “new gas” will have to be taken from unexplored fields, one of the most complicated in the world, where exploration and infrastructure will require vast investments. According to latest estimation by Gazprom itself, the cost of the construction of the Bovanenkovo-Ukhta pipeline alone will be $80-90 billion, while the entire project of exploration of the Yamal may take an amount of up to $200 billion, which is more than the entire Stabilization Fund!

Why haven’t those investments already been made? The problem is that Gazprom has intentionally spent only relatively minor sums on investments into its profile business, i.e. gas extraction. The vast majority of its profits, gained out of the rapid growth of export and domestic gas prices, Gazprom has spent on buying up assets and on financing rapidly growing internal expenses. Thus, in the period from 2001-2007, only slightly over $27 billion has been spent by the company on capital investment in its main business, gas extraction. By contrast, from 2003-2007 Gazprom spent $44.6 billion on asset acquisition, with over $30 billion of that amount having no relation to the gas industry at all, but involved instead with the oil and electricity sectors. If those sums had been spent on exploration of new gas fields and infrastructure, Russia would not be facing a threat of gas shortages today.

Rather then exploiting the Yamal fields in Russia, Gazprom has become addicted to Central Asian supplies. If in 2002 their share was 4% of Gazprom’s total, now it has doubled to 8%. The price rise has been substantial, too. In 2003 1,000 cubic meters of Turkmen gas cost Gazprom $30. Today, the price stands ats $150, a fivefold increase. By 2009, the price may reach $250 or more.

Little wonder, then, that Gazprom’s 2007 annual report shows a paradoxical result: With revenues on gase sales up 8%, profits were down 11%. And this figure appeared against the background of steady growth of gas sales in 2007, including 22.5% for the Russian consumers and on average 25.2% for the CIS countries.

How can Gazprom have falling profits when prices are rising? The company’s management makes no secret of the the fact that the reason is the rise in its internal costs, including the purchase of gas from third-party suppliers (which practice increased 36% last year). In 2003 such expenses totaled less than $1 billion; today they stand at $15 billion or more than a quarter of the operating expenses of the company. Gazprom spent just over $1 billion buying gas from Central Asia in 2003, $7.5 billion in 2006 and $11.7 billion last year.

In March 2008 the heads of the state petroleum companies from Kazakhstan, Uzbekistan and Turkmenistan advised Gazprom that beginning in January 2009 they are going adopt a new tariff structure on the gas supplies, making it proportionate to the European counterpart. That means the purchase prices may reach $250-300 per one thousand cubic meters. Thus, Gazprom’s costs for buying Central Asian gas will increase to $17-21 billion per year.

Another serious problem affecting Gazprom’s performance is its chronic inefficiency. It’s operating costs have increased threefold compared to 2003, from $4.49 to $14.8 per unit. Wage payments have escalated from $3.7 billion in 2003 to $9.7 billion in 2007, again a threefold increase. It’s employee base has increased from 391,000 in 2003 to 445,000 in 2007.

Yet another problem is debt, which Gazprom incurs in order to finance its acquisitions and expenses. The company’s debt was $13.5 billion in 2000 and had reached $61.6 billion (or 66% of annual revenues — the normal figure for foreign petroleum companies is more like 10-15%) by last year. The company carries a massive burden of debt service, which could impel a bankruptcy under sufficiently sharp market conditions. Prior to that, one would expect rapidly rising prices for consumers and a dire lapse in exploration investments.

So it turns out that the gas resources lying in the depths of the Russian lands and allegedly belonging to nation’s people are in reality are disposed of by a narrow circle of persons who are close to the country’s leadership.