The Kremlin’s Wins Abroad Yield Little Reward for Gazprom

Despite the international outcry over a range of social and political controversies, 2013 has really gone Vladimir Putin's way. While other leaders in the West like President Obama and Prime Minister Cameron appear besieged after several foreign and domestic policy missteps, the Kremlin stands vindicated on issues ranging from Syria's chemical weapons to Iran's nuclear program. Most recently, even as thousands gathered in Kiev's central square in protest, Ukrainian President Viktor Yanukovych opted to enhance his country's partnership with Russia rather than take the first step to joining the European Union via the EU Associations Agreement.

Given these major foreign policy achievements, one would think that the mood in the Kremlin this Christmas is upbeat and celebratory. Quite on the contrary, in his address to the Federal Assembly on December 12, President Putin lamented the country's languishing economy and underscored the corrosive effect of corruption and technological stagnation on growth and development. In case his fellow statesmen and citizens were not clear on what he was talking about, Putin declared that he would not extend tax exemptions to energy companies in his newly proposed special advanced economic development zones because they were already in a profitable sector. It was a bold call for diversification and a troubling sign for Gazprom (NASDAQOTH: OGZPY  ) .

Gazprom's misadventures in the east
Putin's speech came days after Gazprom's longtime monopoly over natural gas export was officially terminated by the Kremlin. This did not come as a shock to Gazprom. The legislative effort to increase the country's share in the global energy market by allowing other energy producers to export abroad had been in motion for quite a while. Anticipating this loss of privilege, Gazprom has been highlighting the progress of its pipeline negotiations with Beijing. This was meant to calm concerns from investors as a long-term deal to supply the voracious Chinese market would allow Gazprom to continue dominating the export market.

A big breakthrough in talks came in September when Gazprom and China National Petroleum Corporation finally agreed on basic terms. However, Russian news agency Itar-Tass recently reported that the Russian energy giant has yet to budget for the gas pipeline, delaying the finalization of the long-disputed agreement on the price of natural gas.

A major part of the problem is Gazprom's refusal to connect its price formula to U.S. Henry Hub prices, which stand substantially lower than prices elsewhere in the world. So far, Gazprom has been championing the regional oil-linked benchmark, Japanese Crude Cocktail, for assessing the price of natural gas in East Asia. However, with the shale gas boom in North Dakota, China is looking to get a better deal from Gazprom as cheaper gas from the United States becomes available in the market.

While Gazprom is promising the conclusion of a pipeline gas deal by January or February of 2013, there are other factors that might prevent any long-term deals from going forward. According to estimates from the Peterson Institute for International Economics in Washington, Gazprom loses around $40 billion a year, equivalent to nearly 40% of its total revenues, to corruption and waste. This is a major liability for any partner. Furthermore, while China's demand for natural gas is certainly increasing to substitute its coal consumption, Gazprom and its fields in Siberia are far from being the only potential source for China. From newly discovered gas fields in Tajikistan to advances in liquefied natural gas, Beijing has reasons to stay its hand for now.  

The crumbling shares in the European market
While Gazprom faces uncertainty in Asia, the European market is looking no better despite Moscow's recent diplomatic successes.

On the surface, it seemed as though Moscow's deal with Kiev would create avenues for Gazprom to increase its share in the European gas market. On December 17, Ukraine accepted a $15 billion aid package and discounted energy prices from Russia. While it is true that Gazprom will now receive less money for the gas it delivers, some see the new deal as an opportunity to bolster falling gas exports to Ukraine.  In addition, many observers have suggested that Moscow is now closer to controlling the transit pipelines going through Ukraine to the European market, the center of many disputes between the two countries.

Nonetheless, Putin's victory failed to reverse the winds of change that are sweeping the region. On the same day that Kiev accepted the aid package from Moscow, Ukraine's energy ministry announced that recent diplomatic developments will not affect the agreements made between Kiev and Western energy companies -- in particular with those developing the country's shale gas deposits.

This is good news for Chevon (NYSE: CVX  ) , which had signed a $10 billion shale gas production-sharing agreement with Ukraine in November. This deal, alongside the U.S. energy giant's more recent partnership with Poland to explore shale gas in the southeastern part of the country, promises big returns for Chevron as Europe's recovering demand for natural gas imports increase in lockstep with its political desire to diversify the source of its energy.  

The same goes for BP (NYSE: BP  ) , which leads a consortium developing the Shah Deniz gas field in Azerbaijan and recently purchased a larger share of the project. Signing on $28 billion, the consortium intends to not only increase gas condensate from 55,000 barrels per day to 120,000 barrels per day but also construct a pipeline connecting the field to Italy. With full backing of Brussels, BP-led consortium's development of the gas field constitutes the core of Europe's energy security policy, aimed at reducing the EU's dependence on Russian gas. Even if Gazprom's gas prices become suppressed in the short term to coax Ukraine, the project in Azerbaijan carries political momentum, making it difficult to derail. As a result, it promises to be a robust long-term investment.

Russia plays a losing game
Chevron's and BP's moves in Eastern Europe and the Caucasus do not bode well for Gazprom or Russia's export-dependent economy. Putin was right to point out that corruption and stagnation were weighing down the Russian economy. Ending Gazprom's export monopoly was definitely a step in the right direction. However, it is unclear whether Moscow can really act on the rhetoric to make substantial changes to the domestic economic environment. Even as Putin lauded the virtues of efficiency and entrepreneurship before the Federal Assembly, the Russian state was taking measures to freeze utility prices in an ill-conceived and costly bid to win over the public. The Russian economy clearly suffers from a fundamental weakness: its own corrupt interventionist state.

It is said that a wise man learns more from his enemies than a fool from his friends; as Russia watches Western energy companies prosper, we shall soon find out if Moscow will develop a greater impetus for change. So far, it doesn't look too good.

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  • Report this Comment On December 31, 2013, at 5:01 AM, amvet wrote:

    What a worthless article. Mr. Kwon is incensed that the Russian government would provide fuel to the Russian people at an affordable price. (The WTO is also incensed that the Indian government wants to help poor people buy food.)

    Meanwhile, the western governments continue to manage the interest rates to almost zero to damage any person with bank savings.

  • Report this Comment On December 31, 2013, at 10:35 AM, kwony wrote:

    I am not incensed by Putin's populist policies - rather, I am suggesting that this bodes badly for the economic environment. Who will want to invest in infrastructure in Primorski Krai if their profits are going to be dictated by Moscow? This will simply increase the burden on Gazprom.

    If affordability was the only index, why not engage in deflationary policy? Shouldn't short term consumer gains be balanced with long-term sustainability of welfare?

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