by Nicholas Watt
After years of monopolizing the European gas market, Gazprom now finds itself on the defensive. Developments such as the highly publicized arbitration cases and billion-dollar rebates have the Russian gas giant sweating and its critics reveling. Such critics proclaim that the end is in sight for Gazprom’s age of dominance and that its strong-arm tactics and inflexible contracts have become incompatible with the liberalized European gas market. While these proclamations are just predictions, raw data show that Gazprom’s European sales are indeed dropping. Naturally, Gazprom is doing all it can to avoid the doom its critics envision and is fighting to regain its lost market share. This war, however, has two fronts, and the domestic front is often overlooked. If Gazprom’s market share in Europe does not hold up, it may not have its domestic customers to fall back on. Russia has the world’s largest gas reserves and other Russian energy companies, not named Gazprom, are cashing in on this natural resource advantage. Russian law precludes these NGPs (non-Gazprom producers— a term used by James Henderson of the Oxford Institute of Energy) from selling abroad and so this gas stays in Russia, sold on the Russian market. With NGP gas production on the rise and the increasing liberalization of the domestic market, Gazprom’s quasi-monopoly is at risk at home.
In 2012 Gazprom held 73.9% of the domestic market—a far cry from its 2000 mark of 90.5%
Russia boasts the second largest gas market in the world behind the US and has burned an average of 467 bcm (billion cubic meters) per year from 2008 to 2012. Roughly half of Russia’s total gas consumption is accounted for by the industrial and power sectors and it is in these two sectors that the market has experienced the most significant shakeup. Of the yearly 225 bcm consumed by the industrial and power sectors, 65 bcma is contracted out to NGPs by 2015 and an additional 89 bcma will be up for grabs after the expiration of nearly half of Gazprom’s contracts with these customers. This means that in the unlikely event that all of these customers decline to renew their Gazprom contracts in 2013, 69% of Russia’s premium gas consumers will be supplied by NGPs. The industrial and power sectors are premium gas buyers because they pay more frequently and at higher prices than their residential counterparts.
How has this happened and which NGPs are doing it?
The Federal Tariff Service sets the price at which Gazprom sells to the domestic market. The process of raising this regulated price has been under way since the mid 2000s, but only after 2009 did Gazprom finally turn a profit on domestic sales. This trend of higher prices served as an impetus for NGPs to increase production; and the two that have capitalized most on this opportunity are privately owned Novatek and state-owned energy giant Rosneft. By 2010 Novatek was producing double the amount of gas it had four years prior. 2011 data show that Novatek’s production was 53.5 bcm, with Rosneft trailing slightly behind at around 45 bcm. After those, the drop-off is steep: Lukoil produced 15 bcm, Surgutneftegaz 10 bcm, and Gazpromneft 7 bcm. The remaining gas production amounts to approximately 30 bcma produced by other oil companies both Russian and international, none of which is significant enough to note here. Of all domestic production in 2011, NGPs accounted for around 160 bcm compared to Gazprom’s 513 bcm. In 2012 Gazprom held 73.9% of the domestic market – a far cry from its 2000 mark of 90.5%.
It would be a mistake to assume these figures spell complete doom for the gas giant. Gazprom still remains Putin’s favorite son and deeply protected within the womb of the Russian government. All children, however, must grow up. One of Gazprom’s most prized toys is the Unified Gas Supply System (UGSS), the domestic pipeline system over which Gazprom enjoys full control. Despite 1999 legislation mandating the allowance of third party use of the UGSS, Gazprom has repeatedly refused these other suppliers pipeline capacity, failed to deliver contracted gas, and declined to divulge data concerning the system. In a speech to German television audiences in 2009 Putin supported greater liberalization: “we are seeing it as our goal to provide our gas producers with more liberal access to Gazprom’s pipeline system.” These words were backed by action with the order of a presidential commission to investigate claims that Gazprom was blocking independent access to its pipelines. Within a year of his speech on German television, Putin issued another statement on the issue, this time as a reproach: “Gazprom must treat the development of the infrastructure that helps provide the energy sector with gas as responsibly as possible… if [Gazprom] proves unable to cope with all of these tasks it means we will have to involve other companies.” Putin’s public sentiment created a domino effect by which many in the political elite, including former Energy Minister Sergei Shmatko, fell in line with similar statements. The courts soon followed suit. In a 2012 case brought by the FAS (Federal Anti-monopoly Service) against Gazprom involving the refused access to already agreed upon capacity, a Moscow arbitration court upheld the FAS’s decision that Gazprom was “abusing its dominant market position”. The FAS has received so many similar complaints against Gazprom that it submitted a bill proposal to the Duma addressing the issue. The level of support for this bill is still unclear.
Gazprom, Novatek, and Rosneft currently relate to each other with a fickle combination of competition and cooperation
The loosening of Gazprom’s grip over the UGSS has been one of the reasons for NGP success. Another reason is that these companies offer more flexible contracts than Gazprom. After power company E.ON replaced Gazprom with Novatek in a $22 billion deal, company spokesperson Anna Martynova said simply that Novatek “offered better terms” than Gazprom and its competitors. Novatek has reported that its contracts use a pricing mechanism that makes adjustments based on monthly consumption and does not penalize for dropping below a prescribed annual consumption mark. Rosneft, in its own right, has been successful at wooing new customers with lower prices. Upon completion of deals with E.ON and Fortum, Rosneft reportedly agreed to terms to sell gas below the regulated price with discounts amounting to 11% to 2% of Gazprom’s price. Rosneft’s prices were so favorable that it stole one of Novatek’s largest clients, INTER-RAO, a state-owned power generation company, in a 25-year deal worth over $80 billion.
There is, however, an additional factor whose effect is more difficult to quantify—the political connections of these NGPs. Two billionaires, Leonid Mikhelson and Gennady Timchenko together own over 50% of Novatek and represent a controlling interest in the company. Timchenko and Putin worked together in the 1990s and opened judo club, Yawara-Neva, in St. Petersburg in 1998. Amid widespread speculation, both men vehemently deny all allegations of corruption in the amassment of their respective fortunes. Putin’s administration granted Novatek massive tax exemptions without which the capital intensive Yamal LNG project would not be economical. It would be cynical to assume these tax breaks were a result of cronyism, but naïve to believe these breaks came without strings attached. In a Nov. 19th 2012 announcement Putin publicly called on Novatek to team up with Gazprom in the Yamal LNG project. Less than two months later, Gazprom announced that a joint venture between the two gas producers was to be established in the Yamal peninsula. Cooperation is further explained by the fact that Gazprom owns a 10% share in Novatek.
Rosneft’s political clout has a different structure; it is state-owned and its CEO is Igor Sechin. When Putin was deputy mayor of St. Petersburg, Sechin served as his first chief of staff in 1994 and has held various posts under him ever since. Sechin is widely considered one of Putin’s closest allies. Moreover, as a state-owned company, Rosneft would naturally have competitive advantages over private companies.
At the moment, Gazprom, Novatek, and Rosneft currently relate to each other with a fickle combination of competition and cooperation and it is unclear by what mechanism their interaction is governed. It is because of this ambiguity of leadership that “NGP” is an appropriate designation for Novatek and Rosneft. The term “independent gas producer”, which is often used in the press, implies each of these companies possesses sovereignty in its decision-making. Such an implication would be misleading: Novatek is partially owned by Gazprom and appears to act in cooperation with it while Rosneft is owned by the same entity that controls Gazprom, the Russian state. Amidst this uncertainty two indisputable facts are at our disposal: these companies produce gas and are not named Gazprom, so we have the term “non-Gazprom producer”.
The recent trend of consumers switching to NGPs suggests that competition does exist, and the NGPs’ respective production forecasts indicate they are gearing up for more. Novatek projects that by 2020, NGPs will roughly double their production to 300 bcma and by that same year, Gazprom projects its own production will increase to 660. If you consider that 2012 gas production in Russia was slightly below 700 bcma, and juxtapose that with the prediction that Russian and European demand will remain roughly the same, then where will all of this extra gas go?
President Putin has said that by 2017 domestic gas prices will reach the European netback level, which is defined as the amount European customers pay after adjusting for transportation costs, transit tariffs, and export taxes. Though netback parity has yet to be achieved, Russian prices have been steadily increasing and importantly for gas producers, have become profitable. In 2009, the same year
Gazprom made its first profit off the domestic market, Novatek boasted a 30% net profit margin selling at prices that were significantly below European netback. If Gazprom and Novatek produce nearly the amount of gas they project, the market will be flooded, which in a free market would have the effect of pushing the price down. The Russian gas market, however, cannot be considered free, despite experiencing considerable liberalization. As such, the direction the price goes will go a long way in telling us the extent of this process and more specifically about the level of actual competition among Russian gas producers.
There are two scenarios: the price goes up or down. If the price continues to climb, then the NGPs, which are not bound to the FTS’ regulated price, will undercut Gazprom every time and continue to steal market share. If not, then it will be a sign these gas suppliers are colluding, holding the domestic market hostage to unnecessarily high prices. On the other hand, if the price starts to fall, then it will be the result of competition. Novatek has already proven that selling gas at well below European netback levels can yield handsome profits; is it unthinkable to expect a similar level of efficiency from Gazprom?
This question has already in part been answered by the FTS’ announcement in March 2013 that for the first time in years, the quarterly gas tariff will go down. It remains to be seen whether or not this price drop is temporary. In all likelihood, the news was not well received by Gazprom managers, who will see this as another sign that it is time for some serious company-wide belt-tightening.
Nicholas Watt is an MA candidate in the ENERPO program at European University at St. Petersburg.
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