Russia Is Losing Its Leverage

Geography blessed Russia with energy-starved industrial economies to its east and west. However, after decades of favorable energy exports, the ground beneath Russian energy giants like Gazprom is shifting.

Feb 19, 2014 at 11:24AM

Compared to other emerging markets struggling in the recent bout of instability, Moscow appears to be in an enviable financial position. The country is not heavily dependent on foreign loans, and earnings from energy exports have bolstered the state's fiscal health. In fact, some analysts suggest that the decline of the ruble to record levels against the dollar-euro basket in the last few weeks might further boost oil and gas exports, facilitating a current account surplus.

However, the long-term outlook for the Russian state could not be more precarious. The lack of diversity in the Russian economy means that even small fluctuations in its energy exports will seriously impact the fiscal health of the state as a whole. While this had not been a serious problem for Russian energy exporters in the last two decades, events in the past few months show that Russia's long-standing commercial ties with its resource-scarce clients in Europe and Asia are shifting.

The European front
The European Union has been taking significant steps toward diversifying its energy suppliers in the last few years, hoping that the reduced dependence on Russia's natural gas will also diminish Moscow's leverage over key political issues in Eastern Europe. Pursuant of this goal, a consortium of energy companies led by BP (NYSE:BP) is spearheading development of natural gas in Azerbaijan's Shah Deniz gas field along with a pipeline to deliver the output through Turkey. With full blessings from Russophobe European states, this project is undoubtedly going to be facilitated by both finances and political capital.

This is bad news for Gazprom (NASDAQOTH:OGZPY), which supplies Russian natural gas to the European Union. Internal corruption and waste abetted by ties to President Vladimir Putin aside, the very identity of Gazprom as a supplier of Russian gas is now playing to the benefit of its rival developers in Western Europe.

Further weakening the company's position as the preeminent regional supplier, the ongoing civil unrest in Ukraine has become a major obstacle to Gazprom's ability to deliver gas. With the anti-government protests preventing Kiev from collecting taxes or the utility bill from its citizens, Ukrainian energy firm Naftogas has been left unable to pay Gazprom. As the single-largest importer of Russian natural gas, Ukraine's default has a huge impact on Gazprom's operations. For now, Moscow is forcing Gazprom to accept deferments in the import bill, but this cannot last forever. While Moscow's financial assistance package to Kiev could resolve payment problems, if Ukrainian President Yanukovich accepts help from the Kremlin, it could prolong protests and further disrupt Naftogas' ability to service imports.

Meanwhile, signs of disruptions in Gazprom's key transit state will only further accelerate Western European energy firms' drive to supply the region with alternative supplies.

With the resolution of the crisis in Ukraine unforeseeable in the near future, Gazprom's short-term prospects look increasingly fragile; and with European energy firms pursuing diversification by tapping reserves in the Eastern Mediterranean and elsewhere, the company's long-term prospects in Europe are under serious threat.  

The Asian front
Adding to Gazprom's headaches, the critical pipeline deal with China remains stalled. Late last year, the company announced that it expected a deal with China to be finalized by January 2014. Now, both Gazprom and China National Petroleum Corp. have agreed to push back the negotiations to May when President Vladimir Putin is expected to visit China.

Beijing continues to delay finalizing the deal because it feels Russia's natural gas prices could go lower, especially given how shale gas production in the United States is boosting global supply. But from Gazprom's perspective, with net earnings down, its export prices are already at their lower limit. Unfortunately for Gazprom, with China exploring natural gas options in Central Asia and West Africa, the company's leverage will only grow weaker as negotiations drag on.

To make matters worse, Japan may be cutting its imports as early as this summer. Yoichi Masuzoe, who strongly advocated for the reopening of the country's nuclear power plants, won the election for Tokyo governor. The controversial power plants, which provided nearly 30% of Japan's electricity needs prior to 2011, were closed down due to safety concerns following the meltdown at the Fukushima Daiichi Nuclear Power Plant. Since their closures, Japan had been increasing the import of natural gas from Russia to supplement energy production. However, the new governor is expected to restore operations to ten nuclear power plants by this summer, exercising the Tokyo metropolitan government's stake in Tokyo Electric Power.

With demand in Europe guaranteed to fall, Gazprom must establish long-term export contracts in East Asia soon to make itself viable. Unfortunately, that appears less and less likely as time goes on.

The prognosis
There was hope in 2013 that Moscow's abrogation of Gazprom's monopoly of natural gas exports would make the company more efficient. However, the events in Ukraine reveal how Gazprom is still intrinsically tied to Moscow's foreign policy aims. This not only diminishes the urgency within the company to eliminate its crippling waste and corruption, but also leaves clients deeply suspicious of Gazprom's intentions. As a consequence, Gazprom's European clients are actively seeking to diversify their supply of gas while Beijing believes that Moscow can lower Gazprom's gas prices for diplomatic capital. Neither of these outcomes are favorable for Gazprom.  

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Yong Kwon has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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