The past few months have been hard on shares of most energy companies, with small and big players both taking hits. A collapse in oil prices has made some producers unprofitable and forced others to lower guidance and/or dividend payments.
But while the value of a barrel of oil is the primary concern for at-risk North American companies, Russian energy giant Gazprom (OTC:OGZPY) continues to carry major government risks as well -- ones that could be increased by the slide in oil prices, geopolitical tensions, and a slowing Russian economy.
When I look for an investment, I strongly prefer companies where it's in management's best interests to build shareholder value. Of course, investors will argue over how to best build value, but the general principle lies in the idea that if a company is owned by its shareholders, then management, being paid by the company, should at least act in the shareholders' best interests.
However, Gazprom is no ordinary company. Majority owned by the Russian government, this oil and natural gas producer acts in the interests of the government first and private foreign shareholders later.
Gazprom has declined to buy back stock even as shares traded at less than four times earnings for most of 2014, well below the industry average. Investors looking for a bright spot in Gazprom may point to its massive dividend, which yielded about 5% at the time of its announcement in May. However, the dividend is also a way for the Russian government to collect the energy profits it needs to continue operating. As such, the dividend alone does not make a case for a shareholder-friendly company.
Is Gazprom in trouble?
Excluding geopolitical risks and potential shareholder value-destructive action by the Russian government, Gazprom does not appear to be on the brink of collapse, but it will see lower profits because of falling energy prices. Being an energy producer of such a tremendous size, the company has economies of scale that give it an advantage over start-up drilling companies. Additionally, data from Morgan Stanley shows about half of Russian oil as having a cost of production below $50 per barrel.
But Gazprom investors should not ignore political risks, as a company with strong influence from the Russian government. Let's look at a few potential government actions that could be taken as Russia's economy slows and oil prices remain low.
Although the Russian government does enjoy a stream of Gazprom dividends, it may call for a dividend cut at the energy giant in light of lower oil prices and significant upcoming pipeline investments.
If the Russian government is playing the long game, it would be better off if Gazprom can survive the recent troubles rather than being drained of cash through dividends, leaving it to require a bailout so as not to threaten the Russian markets.
A cut to the dividend was already discussed in July 2014, when oil was trading near $100 per barrel on the idea that Gazprom would need the capital to complete its pipeline construction, although a dividend cut was not officially confirmed. With oil down about 50% since then, the current oil market could put more pressure on Gazprom to cut its dividend.
Back in June, Russian president Vladimir Putin floated the idea to recapitalize Gazprom with state funds. The intent would have been to strengthen the energy giant's capital base as the company embarks on new pipeline construction projects.
But a share issuance plan like Putin discusses would almost certainly be damaging to current private shareholders. With shares now trading at less than three times earnings, the valuation on Gazprom is so low that current shareholders would see significant dilution in exchange for the capital injection.
For now, such a proposal has been set aside, but it does give a glimpse into how Putin sees Gazprom as a national champion to benefit Russia rather than as a corporation seeking out maximum returns for its shareholders.
Retaliation against sanctions?
Russia's economy appears to be feeling the pain, as it reported a contraction for November and the Russian central bank was forced to push rates up to 17% to stabilize the ruble.
It's unclear how much of the economic damage to Russia is due to economic sanctions and how much comes from the drop in oil prices. However, while Putin's not in a good position to start an oil price war, he may take other actions to retaliate against the sanctions.
If Putin were to turn more aggressive in confronting the sanctions, he may move to freeze or seize Western assets in Russia. Although this scenario seems less likely than the previous two, it may be the most costly for Western shareholders of Gazprom.
To deprive these Gazprom shareholders of access to the company's profits, the government could, among many things:
- Cancel shares of Gazprom held by investors in countries with sanctions on Russia.
- Recapitalize Gazprom on unfavorable terms to dilute out Western shareholders.
- Create a special security senior to the common stock that diverts Gazprom's profits to the government.
Taking this option would probably startle foreign investors in Russia and cause a run for the exits, as investors would fear for their own investments. And the long-term picture wouldn't look much better, as fears of government seizure would still linger in investors' minds.
Going with such an upfront action mostly to spite the West would probably have severe negative effects in both the short and long term; however, this is not a possibility that investors should ignore, since none of us really knows how far Putin will go to try to show Russia's strength against Western powers.
Despite being one of the world's largest energy companies, Gazprom has a set of risks that differentiates it from the Western oil majors. And as oil prices have fallen, the chances of unfavorable government action increase, since the government may feel it needs to recapitalize the company.
At this point, I don't hold Gazprom in my portfolio, but I could see how some investors may find it attractive as a speculative value pick. For these investors, it's important to remember that lower oil prices could cause more damage to Gazprom shares than just a short-term profit downturn and that this risk should be considered before making an investment.