January 16, 2003

Russian Business Monopoly Gazprom’s Great Need

Why solving the gas concern’s debt problem will lead to higher domestic gas prices

Yulia Novosyolova and Dmitri Sivakov

We have examined Gazprom’s finances. But before we go any further into what we found, we need to state our reasons for doing so. A couple of years ago, we began to wonder about the company after comparing two figures – Gazprom’s revenue and its accumulated debt. At that time, these figures were $12.4 billion and about $12 billion, respectively. A question immediately came to mind: wasn’t Gazprom right on the edge of default and bankruptcy? Based on Gazprom’s annual reports from 1995 to 1999 (information not easy to obtain back then), it turned out that debt didn’t threaten Gazprom’s solvency as long as annual payments didn’t exceed $7 billion. The general information about Gazprom’s proceeds, net profits, and accumulated debt implied that everything was financially all right. However, to judge the company’s financial health accurately, we would have needed detailed information on the company’s debt structure, long-term borrowing programs, refinancing, and current cash on hand.

Many things have changed over the past two years. Gazprom has become a more open company: it started sharing more comprehensive data on its activities with the public. In particular, Gazprom released information about its debts due in 2002 totaling $7.5 billion. This figure alone, as we have already mentioned, should set off alarms. But there were more than enough other reasons to prick up our ears. Since then, the gas monopoly’s leaders have been changed fundamentally: Alexei Miller’s team replaced Rem Vyakhirev’s team. The new people were not from the so-called gas gang, which meant that Gazprom’s finances began to face additional risks. In the past year, these risks have come to the surface: Gazprom appears to be digging through the market in search of cash, borrowing from many lenders in relatively small amounts (for Gazprom of course). Previously, Gazprom had little trouble borrowing practically any amount (up to $3 billion) for its investment needs. Naturally, the former leadership’s departure might provoke a wary, conservative reaction from the world gas community, more used to lending to concrete people for concrete projects, not to the company in general. When these people were replaced with unfamiliar faces, creditors, well aware of the company’s business, recalled old political risks and prior conservatism. In short, they stopped lending large amounts to Mr. Miller and his team. This is only a hypothetical version of events, but considering other facts and factors, it is plausible enough to make us seriously afraid for Gazprom’s finances.

But this is not the whole story. The company’s increasing transparency has given observers new food for thought, the details of Gazprom’s investments projects and investments needs. Gas production at the leading Gazprom’s deposits in the Nadym-Pur-Tazovsky area is swiftly falling. Meanwhile, gas supplies to Western Europe are growing under current contracts that don’t expire until 2030. This means a gas shortage will hit Russia before long. As for investment resources required to develop large deposits on the Yamal Peninsula, the price tag is shocking – up to $140 billion. Even given that Yamal will be developed over the next twenty years, Gazprom will have to set aside (or borrow!) another $7 billion a year for its investment needs.

If you put all these pieces together, the situation is frightening in earnest. Gazprom is obviously in no position to set aside $14 billion a year ($7 billion for old debt plus $7 billion for investments) from its revenues (a “mere” $27 billion) or to borrow this amount for the long term.

And finally, a last remark. Having realized the gravity of the problem, we tried to find out about how Gazprom and the Russian government are attempting to solve it. We discovered that using gas mains as collateral for securing Western investment loans was being discussed seriously as an option. If the government and Gazprom officials are discussing this approach, then things really look grim.

Deep in debt

The proposed $100-billion loan using gas mains as collateral, of course, has never been discussed in full. Nevertheless, the monopoly’s need for a regular cash injection has become frightening clear. Early this summer, the company turned to the Central Bank requesting permission to borrow from Sberbank and Vneshtorgbank several hundred millions of dollars over the Central Bank’s loan per borrower regulations. The Central Bank declined the request, after which the monopoly had to double its borrowing on the domestic market.

Gazprom has had to pay $7.5 billion on debts this year. Without refinancing, these payments could become a greater burden than Gazprom can bear, leaving the company on the verge of default. In order to avoid trouble, the company had to borrow at least $6 billion in 2002, with at least $3 billion as short-term loans and bonds. And in order to reduce the pressure of short-term debts (See Graphics 1 and 2), the monopoly made an attempt to expand its list of creditors and long-term loans. However, this is no easy task. The company has already put up 70% of its export revenues as collateral by now, while according to EBRD and other banks’ recommendations, this figure shouldn’t exceed 60%. This is why the gas giant has had to resort to overactive borrowing on the Russian market and Western unsecured loans.

In Russia, one of the monopoly’s largest creditors is Mezhprombank, which has lent $100 million. In September, the company and the bank signed an cooperation agreement for 2002-2005. But Russian banks cannot make large loans to Gazprom, since they exceed the official lending limits. Gazprom tried to borrow in the West, which offers lower rates and longer terms. The only problem was that the company couldn’t use its revenue as collateral and had get unsecured loans, which is much more difficult. Nonetheless, Gazprom succeeded (See Table 1). The monopoly’s troubles don’t end there, though. Next year, the concern is due to pay $7.95 billion: $2.9 billion for long-term loans, $2.8 billion for short-term loans, and $800 million on bonds (the rest consists of other kinds of debt). Refinancing will cost $3.56 billion, a considerable part of which Gazprom intends to raise by selling eurobonds. However, the Ministry of Finance, which has stayed away from foreign markets since the 1998 crisis, is trying to impose restrictions on corporate loans. It is anxious about international corporate debt, now out of its control. The Ministry considers 60% of the GDP as the critical level for state and corporate debt. According to figures for 2002, state debt is expected to decline from over 50% to 40% of the GDP, and corporate loans are expected to total 13%. This makes 53%, but as early as 2003, this figure could increase, mostly because Gazprom plans to issue at least $1.2 billion in eurobonds.

Throughout this year, Gazprom has managed to increase the gas rates on the domestic market considerably by lobbying the FEC and the Ministry of Economic Development. At a meeting on December 11, the government decided to increase gas prices by 20%. We are haunted by the persistent feeling that Gazprom cannot cope with its debt on its own and is sorting it out at our expense.

Looking for explanations, we turned to Gazprom directly and spoke with Boris Orlov, the company’s CFO (see interview). We were convinced that Russia shouldn’t be anxious about the gas company’s finances for the present despite its difficulties. Gazprom’s main problems, it turns out, are production and investment, not debt.

Negative production

Over the last decade, the level of gas production at Gazprom has been declining. While in 1991 it produced 600 billion m3, in 2001 it produced only 512 billion m3 (See Graphic 3). Gazprom has many deposits in production, but the overwhelming majority of its gas comes from three deposits, Yamburg, Urengoi and Medvezhie. They all are located in Yamal-Nenetsky District, Nadym-Pur-Tazovsky Area. These deposits, some of the largest in the world, came into service almost thirty years ago. They all are on the verge of depletion.

According to Gazprom Deputy Chairman Alexander Ananenkov, the company “receives 20-25 billion m3 of gas less than its target every year because of the depletion of traditional deposits.” By 2015, gas production will have fallen to half, and the Russian market will plunge into a severe gas shortage.

The very large Zapolyarnoye gas deposit could prevent this grim outcome, and Gazprom managed to start developing it in 2001. It sits near the deposits of Nadym-Pur-Tazovsky area, not far from existing gas pipelines. The planned production capacity at the Zapolyarnoye deposit is 100 billion m3 of gas a year. This target will supposedly be reached by 2005, thereby saving us from gas shortage. But are such rates realistic?

In mid-October, Ananenkov made a business trip to Novy Urengoy, Zapolyarnoye, and Yamburg. As a tour at Urengoygazprom showed, there are more than enough problems at the newly opened deposit areas. The main problem is the shortage of financial resources. At the meeting, Mr. Ananenkov demanded that production speed up. Representatives from Urengoygazprom responsible for developing the Urengoy deposit, from Gazprom Engineering responsible for design and cost estimates, and from Gazkomplektimpex responsible for logistics made their reports to the high official. Though the reports started off in the spirit of “we’re on top of the world,” they invariably concluded with the phrase: “If we only had some money….” During the course of the meeting, it became clear that contractors were about to quit, there was no money for workers’ wages, no pipes, and no design estimates for some projects. The Zapolyarnoye deposit, Gazprom’s principal hope for the next few years, faces even greater financial problems. Its development will cost $7 billion, $7 billion Gazprom doesn’t have. Last year, the first plant with a 35 billion m3 annual capacity began to operate at the Zapolyarnoye deposit (there will be a total of three). A second plant of the same capacity was supposed to start operating in the end of September. Its opening was postponed to December because of a shortage of funds. Over the last two months, the company has extracted 6 billion m3 less than its targets, and it will have to make deliveries using other resources.

But even solving these current difficulties would not prevent a Russian gas shortage. The Zapolyarnoye deposit will only delay its coming. Estimates show that by 2008, increased production at Zapolyarnoye will not compensate for reduced production at Urengoy, Yamburg and Medvezhie. Gazprom needs to develop new large gas deposits now.

New deposits

Gazprom’s options are limited. There is the large Shtokmanskoye deposit on the shelf of Barents Sea. Then there are several very large gas deposits on Yamal Peninsula.

Both areas are located far from Gazprom’s present transportation and residential infrastructures and in even harsher environmental conditions than the deposits of Nadym-Pur-Tazovsky area. Their development will require astronomically more funds than Zapolyarnoye.

Take, for example, the Shtokmanovskoye gas deposit. It will have to be developed underwater, a thousand km away from main gas pipelines. A gas main will have to be laid, most of it along the floor of the Barents Sea. Gazprom lacks the experience and technology, making the development of the Shtokmanskoye deposit without the help of foreigners and Russian oil companies practically hopeless. This means Gazprom will have to share the profits. This fact alone reduces the site’s appeal, although the monopoly has already almost found enough Western partners and investors to develop the Shtokmanovskoye deposit. The price will run from $12 to 25 billion.

The Yamal Peninsula deposits are more attractive. They are larger and a bit closer. They will require no “maritime” technology whatsoever. Yamal’s reserves can ensure high and stable production of the “blue fuel,” but $50 to 70 billion will be required to this end. To make matters worse, more than half the funds will be needed in the next few years to develop the Bovanenkovskoye deposit that will “open” the peninsula in 2007. Developing Yamal is expensive because the deposits are over 500 km away from the gas transport systems, and they won’t produce until this infrastructure is set up. So, a new gas-transport network at Yamal alone will require $25 to 30 billion. About another $7 billion will go toward a new Yamal-Europe pipeline. Renovating existing gas mains will require more than $5 billion.

In total, Gazprom needs to invest around $100 billion in the next twenty years. Some sources put this figure as high as $140 billion. Today, Gazprom is in no position to attract this sum of money from the market or to save it on its own. This problem cannot be put off until tomorrow, since license agreements are pressing (See Table 2). Should Gazprom fall behind in putting new deposits into production, these licenses could be revoked, and the company could lose over 22% of gas reserves with relatively low production cost located close to the existing infrastructure.

How to rescue Gazprom

In Gazprom’s opinion, it’s as easy as pie. For a start, Russian customers should pay more for gas. The Federal Energy Committee agrees. According to government specialists, gas production and delivery costs an estimated $18 per 1,000 m3 on average, practically equal to its price (See Table 3). Therefore, at the FEC they are confident that Gazprom needs to raise the consumer price of gas to pursue a normal investment policy. According Gazprom, in order to increase annual gas production to 530 billion m3 and maintain this level, the company needs to invest $500 million a year, and increase the price of gas by 40-50%. Gazprom estimates that 1,000 m3 of gas costs 126.8 rubles ($4.09) to produce, 382.9 rubles ($12.35) to transport, and 773 rubles ($24.93) to sell and deliver to consumers. Thus, the total sales costs are estimated at twice the production costs.

As domestic demand for gas is growing, the government and the company propose encouraging gas production by independent producers and give them access to the gas pipeline system in order to prevent a shortage. However, industrial consumers will receive this gas already at market prices. These will surely be higher than the FEC’s new prices, since gas market liberalization will exclusively benefit Gazprom. There have been more than enough state proposals in the past aimed at reforming the gas industry. The company was not happy with many of them. Some recommended Chubais’ favorite strategy: split up Gazprom and to sell the parts. Now, the FEC is proposing a new Federal Wholesale Gas Market (FWGM) with a regulated and non-regulated sector. The situation is clear as far as the regulated sector is concerned: the FEC sets the rates for gas going to private customers, public organizations, and communally heated housing. Everyone else will buy gas on the open market. A non-commercial organization founded by Gazprom jointly with gas suppliers and consumers (the only question is in what proportion) will act as an administrator. Gas distribution and sale in both sectors will be carried out by organizations authorized by Gazprom. However, the company will have to engage independent sale agents on the non-regulated market. Full liberalization of the market will happened in 2008 at the very earliest.

How Gazprom can save itself

It looks as if Gazprom has heard the voice of reason and began to cut costs. The giant’s top executives now proclaim that the company will reduce costs almost by $1 billion in 2003.

Apart from loans, the company’s diverse joint projects could help stop the decline in gas production. For example, in a joint venture with Kazakhstan, Kazmunaigaz owns 50%, Gazprom – 30%, and Rosneft – 20%. In 2001, Kazakhstan produced 12 billion m3 of gas, a quarter of which was simply burnt when they failed to sell it. After the joint venture, Kazakhstan could increase production up to 50 billion m3 a year. Recently Gazprom signed agreements with Surgutneftgaz to cooperate in the deep development of existing deposits (so-called Achimovsky gas condensate fields) and with LUKoil to develop Yamal and the North Caspian Sea. More opportunities lie in granting independent gas producers access to the pipe. However, Gazprom insists that these very independent producers sell their gas in Russia, not abroad.

Getting used to expensive gas

A sad picture is taking shape. As long as Gazprom struggles to sort out its debt and to ensure at least a minimum of capital investment to keep up the current level of gas production, we will not see the development of new deposits. It’s clear that Gazprom cannot overcome this situation without a dramatic increase in domestic gas prices.

We could escape basically unscathed by increasing unreasonably low gas prices (see Table 3) for the former Soviet republics. This does not seem likely to happen, however, in the foreseeable future. The government is intent on using Gazprom as a stick or carrot in its dialogue on gas prices with our neighbors. The problem of money owed to Gazprom, especially from state customers, will hardly be solved within the next few years. The company will have a hard time making use of these obvious sources of additional income.

Industrial customers are also against big price increases. Their main argument is that gas gives Russian manufacturers a competitive advantage. There is a way to deal with both Gazprom’s problems and industrialists’ reasonable objections. Gas prices should be indexed not to Gazprom’s schemes but to the average standard of living in Russia. Only this way can Russia’s gas monopoly be converted to a normal commercial enterprise, where business problems are solved not by lobbying for price hikes but by reducing costs and improving service.