How Much Will Gazprom Benefit From the China Deal?

This past week, Russian gas giant Gazprom (OGZPY) signed a historic deal with China to supply pipeline gas through the eastern route. The deal, which materialized after more than a decade of negotiations between Russia and China, comes at a time when Russia is facing isolation from the West following its actions in Ukraine. The deal makes a lot of sense for Russia, but the key question is whether it benefits Gazprom.

Finally a deal
Russia and China had been negotiating a gas deal for over a decade. The fact that China is not a major consumer of Russian gas comes as a surprise given the country's energy needs and its proximity to Russia. The major obstacle to a potential deal over these years has been price. However, this past week, in the presence of the Russian President, Gazprom finally signed a deal with China National Petroleum Corporation (CNPC), the parent company of PetroChina Company (PTR).

Under the 30-year contract, Gazprom will supply 38 billion cubic meters of Russian gas annually to China. The deal requires Gazprom to develop gas fields in eastern Siberia. Gazprom said that $55 billion will be invested in the construction of production and transmission facilities in Russia. CNPC has agreed in principle on $25 billion advance payment on the gas contract, according to Gazprom Export CEO Alexander Medvedev. While Gazprom initially did not disclose the price China will pay for the Russian gas, Russian Economic Development Minister Alexei Ulyukayev told Bloomberg TV on Thursday that he estimates the price to be around $350 per 1,000 cubic meters.

Deal crucial for Russia
The deal comes at a crucial time for Russia. The country is facing isolation from the West following its actions in Ukraine over the past few months. Europe, which still accounts for majority of Russian gas exports, has been exploring alternatives to Russian gas. If Europe does decide to cut its dependence on Russian gas, it could have a significant impact on the country's finances. The deal with China shows that Russia has alternative markets for its natural resources in case Europe decides to take some action. While the deal serves Russia's geopolitical interests, the key question is whether it serves Gazprom's business interests.

What does the deal mean for Gazprom?
I have noted in previous articles that Gazprom needs to reduce its dependence on Europe. In 2013, gas sales to Europe and Turkey accounted for 32% of Gazprom's total revenue. Although Europe will always remain a key market for Gazprom, the deal with CNPC allows the Russian company to diversify its revenue sources. Gazprom sees diversification to the Asian market as a priority in 2014. From a diversification perspective, the deal definitely makes a lot of sense for Gazprom.

However, it is likely that Gazprom has agreed to a lower price for gas supplies to China. If the price estimate of $350 per 1,000 cubic meters given by the Russian Economic Development Minister is correct then Russia is charging less than the $380 it charges European customers. The deal will therefore have a negative impact on Gazprom's profitability. Bloomberg, citing Sberbank CIB analyst Oleg Maximov, said in a report that the price implies a very sub-prime return for Gazprom.

In addition, Gazprom will be required to make huge investments in order to develop gas fields in eastern Siberia and build the infrastructure to transport gas to China. At $43.9 billion, Gazprom already had one of the highest capital expenditures among the world's biggest oil and gas companies in 2013. According to data from Bloomberg, only Brazil's Petrobras (PBR 0.12%) and CNPC had higher capital expenditures than Gazprom. The investments required to develop eastern gas fields and build the transport infrastructure will likely result in a further increase in Gazprom's capital spending, hurting cash flows. 

The deal doesn't make a great deal of business sense, given its likely impact on Gazprom's profitability and cash flows. Using state-owned oil and gas companies as a political tool tends to hurt the involved companies in the long run. In Brazil, Petrobras has been used to subsidize petroleum products, which has hurt the company's financial performance and forced it to take on huge debt. It seems Gazprom is also headed in the same direction.