In September, the Russian State Duma will review legislation that aims to liberalize liquefied natural gas exports, a move that would end Gazprom's long-standing monopoly in the field. One of the companies that have lobbied for this strategic move is Rosneft, which has been actively expanding into the gas sector. IMR Advisor Olga Khvostunova analyzes the recent shifts in the energy market and their consequences for Gazprom.

 

Igor Sechin (left) and Alexei Miller.

 

Turning to Asia

According to the April 2013 Global and Russian Energy Outlook up to 2040, a major analytical report developed by the Energy Research Institute (ERI) of the Russian Academy of Sciences and the Analytical Center of the Russian Government, the next 30 years may rightly be called “the era of gas.” But Russia may lose its chance to take advantage of new opportunities caused by these developments, despite its enormous gas reserves.

In the general scenario, over the next 10 to 15 years, Russian exports of oil and gas would drop by more than 20 percent, with their share of the country's GDP decreasing by one-third. This might lead to a deceleration of economic growth equal to 1 percent of GDP (approximately $20 billion). But considering such factors as the deceleration of economic growth and consumption in developed countries, and revolutionary changes in the world energy market (including the “shale gas revolution,” the global transition to gas-based transportation, and technological breakthroughs in the production of liquid fuels and gas hydrates), ERI experts see no reason for such an extreme forecast for Russia. They anticipate that a “moderately non-optimistic” scenario is most likely.

By the most optimistic forecasts, it will take Russia at least 10 years to catch up with the leaders of the new energy markets.

The report alerted Russian officials. By the end of April, the Energy Ministry had openly acknowledged that Russia is facing the real threat of losing its competitive advantage in the world energy market. In the last few years, the global share of tight oil production increased from 1 to 19 percent, the offshore production share reached 30 percent, and the share of liquefied natural gas (LNG) production will shortly surpass 40 percent. But the structure of the Russian energy industry prevents the country from meeting the technological challenges of these trends. By the most optimistic forecasts, it will take Russia at least 10 years to catch up with the leaders of the new energy markets.

 

The signing of the Azerbaijan agreement.

 

To overcome this gap, the Russian authorities made a strategic decision—to develop offshore and LNG production and direct LNG exports to Asian markets. This new shift in Russia’s energy strategy has been unofficially called the “Asian turn.”

 

A Defeat for the Monopoly

According to the 2006 law on gas export, the exclusive right to export gas from Russia belongs to the owner of the unified system of gas supply, namely, Gazprom. All Russian companies that would like to export gas are obliged to do so through this monopolist—but even most energetic managers are often brought to the point of exhaustion in negotiating with it. Gazprom’s export monopoly creates a bottleneck for further development in Russia’s turn toward Asia. Despite the fact that this shift has great strategic value for the Russian energy industry, it has taken time to resolve this bottleneck.

In the late 2000s, even though Gazprom's position was still strong, Vladimir Putin (who is undoubtedly the key decision-maker in the company) began encouraging other gas producers to develop. As some analysts pointed out, this was intended to stimulate diversification of the gas market and to spur Gazprom’s own production, since its performance had started to raise questions.

All Russian companies that would like to export gas are obliged to do so through Gazprom—but even most energetic managers are often brought to the point of exhaustion in negotiating with it.

Under this strategy, in 2009, Gennady Timchenko, owner of the commodity-trading company Gunvor and Putin’s close friend, acquired a 23 percent stake in NOVATEK, the second-largest gas producer in Russia. (In 2006, 19.9 percent of this company was acquired by Gazprom.) With Timchenko’s participation, NOVATEK started to develop fast, and in just two years, it had acquired stakes in several prospective companies, including Yamal LNG, SeverEnergiya, and Sibneftegaz. By the end of 2012, NOVATEK had increased its market share of Russia’s overall gas production to 9 percent and its share of the domestic supply to 16 percent.

For a long time, independent gas companies in Russia have been fighting for the chance to sell gas abroad. Finally, in July 2012, NOVATEK celebrated the first victory in this fight when it signed a 6 billion euro ($8 billion) contract to export gas to Germany. This export agreement was the first of its kind in the corporate history of Russia.

Another development of 2012 was the increase in the mineral extraction tax for independent gas producers. Since Gazprom used to justify its monopoly by arguing that it faced a higher tax rate, this created a new argument in favor of liberalization, which NOVATEK used in its pursuit of export opportunities. In response to this argument, the government began discussing the issue. In the fall of 2012, NOVATEK officially appealed to the Energy Ministry to request liberalization of LNG exports.

 

Igor Sechin (left) with Vladimir Putin

 

This appeal became real at the end of 2012, when Rosneft joined NOVATEK in lobbying for LNG exports. There is no doubt that this move of the oil corporation had been previously approved by the head of state. Early in 2013, the issue of export liberalization received official support from the Energy Ministry and Putin himself. But liberalization was supposed to happen only for LNG exports. The repeal of Gazprom’s pipeline monopoly was not on the agenda.

At the time, the Energy Ministry promised that the final decision on liberalizing LNG exports would be made by the end of this year. In September, the amendments to the law on gas export will be reviewed by the State Duma and will most likely be passed. The only question to which the answer remains unclear is which companies will have access to the global LNG market: Will the independent producers be allowed to export only to the markets of the Asia-Pacific region, will their exports be limited by certain quotas, or will they be allowed to compete with Gazprom all over the world, including in Europe?

 

Rosneft’s Maneuvers

Rosneft’s entry into the LNG export market triggered a public discussion of the possibility of the company competing with Gazprom. This possibility has officially been denied: it is assumed that each company will work in its own niche and will not get in the other’s way. Such a scenario seems logical, since the state holds a stake in both corporations. Should there be a conflict, the key owner—the government—will have the last word.

But in terms of changes in the global energy market and the weakening position of Gazprom, it is safe to assume that some competition between Rosneft and Gazprom will be unavoidable. This conclusion stems from both Rosneft’s development strategy and the hard-driving ambitions of its head, Igor Sechin, who over the last year has turned from the Kremlin’s éminence grise into an influential public figure. Immediately after his appointment as Rosneft’s president last May, Sechin announced plans to expand the company’s gas business. And then he began to methodically implement them.

In terms of changes in the global energy market, it is safe to assume that some competition between Rosneft and Gazprom will be unavoidable.

Rosneft’s purchase of TNK-BP in the fall of 2012 not only made it the largest oil company in the world, but also enlarged its gas assets. For example, a part of TNK-BP is Rospan—a company that develops large gas fields in the Yamal Peninsula, including the East Urengoy and New Urengoy deposits, which produce 3.5 billion cubic meters of gas per year.

The acquired TNK-BP gas assets were transferred to the management of Itera. Rosneft acquired the majority stake in Itera in February 2012, and in May 2013 increased its stake to 100 percent. Before Rosneft developed interest in the company, Itera was the only large independent gas producer in Russia. Upon consolidation of its gas assets, Rosneft increased its gas production by one-third and became one of the top three largest gas producers in the country, behind only Gazprom and NOVATEK. By 2020, the company plans to increase its gas production by 2.5 times, up to 100 billion cubic meters.

In the context of the “Asian turn” in the Russian energy industry, Rosneft views the Asian-Pacific market as the baseline. First of all, the company is counting on the development on Sakhalin. Since 2005, Rosneft has participated in the Sakhalin-1 offshore development project as part of a production-sharing agreement: Rosneft has a 20 percent stake in the project, as do the Indian ONGC and the Japanese SODECO; ExxonMobil holds a 30 percent stake. Early this year, Rosneft also reached an agreement with ExxonMobil to build an LNG plant in the Far East. Construction costs are estimated at $7 billion, and the plant should be finished in 2018–19.

 

The Chayanda gas field.

 

In July, Rosneft signed an LNG supply agreement with two Japanese companies—Marubeni Corporation and Sakhalin Oil and Gas Development—and the oil trader Vitol. Thus, the only thing that Russian oil corporations have left to do is to wait for the liberalization of LNG exports.

Another direction in which Rosneft’s ambitions are expanding is Arctic offshore development, which, according to the U.S. Energy Information Administration, has reserves equivalent to 400 billion tons of crude oil (about 22 percent of the world’s hydrocarbon reserves). Gas accounts for up to 80 percent of these reserves. For now, Rosneft has been able to receive 43 licenses for developing offshore blocks, but the company’s actual work there is an issue for the distant future. Rosneft’s appetite can be explained by its general strategy—to claim as many stakes as it can and deal with them later.

Rosneft’s plans are not limited by its participation in Russian offshore development—the company is also looking into joining similar projects all over the world. Earlier this year, Rosneft negotiated the development of the offshore gas deposit Mariscal Sucre with the government of Venezuela. The development of this deposit will be carried out in partnership with the Venezuelan state oil and natural gas company PDVSA. Among other major players that were seeking to get into the Venezuelan offshore market was Gazprom, but the parties were not able to reach an agreement. Rosneft showed more flexibility, and in July 2013 it signed a formal agreement with PDVSA. Here it must be said that Rosneft’s interests in the region are conditioned more by political considerations than by real economic benefits.

Rosneft is trying to take an early lead: when other major energy players eventually come to Iran, Rosneft will have already established itself in the market.

In the same month, Sechin managed to meet with Rostam Kasemi, Iran’s petroleum minister, to discuss bilateral energy efforts and LNG production (today, according to BP’s Statistical Review of World Energy 2013, Iran is the world’s largest holder of proven gas reserves, surpassing Russia). Considering Iran’s complicated relations with the West and the existing oil embargo imposed by the United States and the European Union, Rosneft is trying to take an early lead in strengthening the political connections between Iran and Russia: when other major energy players eventually come to Iran, Rosneft will have already established itself in the market.

Rosneft’s latest move was Sechin’s visit to Azerbaijan and the signing of an agreement of cooperation with the State Oil Company of Azerbaijan (SOCAR). The two companies are planning to create a joint enterprise on a parity basis for the purpose of oil production and exports. But Rosneft’s interests in the nation are not limited by the oil business: the company may also join Azerbaijan’s largest gas projects—Absheron and Shah-Deniz-2.

 

The Sakhalin-1 project.

 

This move by Rosneft is also strategic. Since 2006, Azerbaijan has been developing offshore production at the Shah-Deniz gas field through an international consortium whose operations are overseen by BP. In June, the members of the consortium (besides BP, these include Statoil, Total, NICO, Turkish Petroleum Overseas, SOCAR, and Lukoil) decided that they would supply gas through the Trans-Adriatic Pipeline, which will run through Azerbaijan, Georgia, Turkey, Greece, Albania, and Italy. TAP is also a direct competitor of the South Stream—Gazprom’s pipeline, constructed in partnership with the Italian energy company ENI. In about five years, these two pipelines will have to compete for the markets of the Balkans and Southern Europe.

In the nearest future, Azerbaijan is likely to experience an energy boom, and Rosneft wants a piece of the pie. The second stage of the Shah-Deniz development (Shah-Deniz-2) will start in 2016–17, and Rosneft will have the opportunity to join it. The fact that both Putin and Azerbaijani President Ilham Aliyev were present at the signing of the agreement shows that Rosneft's ambitions have support at the highest levels. Azerbaijani gas will sooner or later become a direct competitor of Gazprom's gas in Europe, and it is therefore crucial to Putin to insert Rosneft into this country's energy projects, which will let him exert a certain amount of control in this strategic region.

 

Gazprom's Concessions

For the last 10 years, Gazprom has been both a backbone and a sacred cow of the political regime created by Vladimir Putin. After he came to power, Putin quickly changed the company's management and appointed his friend and former colleague Alexei Miller as CEO, despite the fact that Miller’s name had hardly been heard of before. Putin relied on Gazprom’s resources in building the so-called “vertical of power.” Until recently, any criticism of the corporation sparked the “Teflon effect” from the Kremlin: Putin constantly defended it from tax increases, antimonopoly investigations, and attacks by the European Commission and members of the Russian government and business community.

Meanwhile, in the last 5 years, Gazprom’s capitalization dropped by almost four times and is continuing to decline. Its financial productivity is also being questioned: according to financial reports of the first six months of 2013, the company’s profits decreased by one-third. Its share of the European market (the 27 member-countries of the EU) went down from 47 percent in 2003 to 34 percent in 2012. The company’s management is regularly accused of inertia and a lack of strategic vision for the development of the gas industry.

Today, it is getting harder for Putin to deny Gazprom's failures, and perhaps in the near future the company will lose its “untouchable” status. One of the signs of such a shift is that last fall Putin announced that law enforcement agencies would check the company’s pipeline business for corruption schemes—or, to be more specific, for overpricing. This May, head of the Russian Accounts Chamber Sergei Stepashin noted that for the first time in the last 5 years, he would audit Gazprom. He also promised that the results that will be published in November of this year will be “quite interesting.”

It is getting harder for Putin to deny Gazprom's failures, and perhaps in the near future the company will lose its “untouchable” status.

Still, Gazprom is being given special opportunities to develop its domestic operations. For example, in May, Prime Minister Dmitri Medvedev announced that 50 percent of Russian transportation would be gas-based by 2020. This idea was originally voiced by Vladimir Putin two years ago, but bureaucratic delays played their part.

The “gas-engine revolution” will let Gazprom compensate for its losses in foreign markets. A separate company has already been founded to develop the new business—Gazprom Gas-Engine Fuel—that is headed by former president of the Russian Football Union Sergei Fursenko, who is also Putin’s close friend and former neighbor in the Ozero dacha cooperative. The chairman and CEO is Viktor Zubkov, former prime minister and another close friend of Putin’s. The new company has already announced its plans to open 17 gas-fuel stations by the end of the year.

But even here, Rosneft is breathing down Gazprom’s neck. As Igor Sechin publicly claimed, his company fully supports the idea of transitioning to gas fuel and by 2020 will have invested $2 billion in opening 1,000 gas-filling stations. Some analysts explain that participation in the “gas-engine revolution” was one of the terms of Rosneft gaining access to the LNG export market.

As a result, Gazprom, which had been passively watching Rosneft's successful moves, finally decided to join the public argument. This summer, Miller and Sechin took a few punches at each other, trying to prove which company is more important to Russia. First, they clashed on the issue of who is the largest taxpayer. Then Gazprom went on the offensive, claiming that no other Russian company has enough capacity and necessary experience to successfully develop offshore projects. It should be noted that the first Russian company that started to develop offshore projects was actually Lukoil—back in 2004, the company launched an operation in Kravtsovskoye oil field in the Baltic Sea. Somehow, Gazprom forgot about this.

 

The Yamal LNG project.

 

Rosneft was not left abashed. Meeting with Putin at the sea platform Orlan, Igor Sechin spoke of the success of Sakhalin-1—the first offshore project with a Russian stake that has reached the extraction stage. Still, Sechin also played with the facts a little bit, since it is ExxonMobil that should actually take credit for the success of this offshore project.

The verbal back-and-forth between the two companies is hardly evidence of the beginning of a serious confrontation. But in the future, competition might become feasible in the Far East. Rosneft has already taken a lead in this region: as mentioned previously, the Sakhalin-1 project is moving forward well, there are plans for construction of an LNG plant; and agreements have been made for delivering LNG to Asian-Pacific markets. Gazprom is lagging in conquering Asia. After its largest gas project—Shtokman—was put on hold (the plan was to deliver LNG from Shtokman to the U.S. market, which has become irrelevant because of the shale gas revolution), the company decided to accelerate its Eastern Gas Program.

Some of this program’s key points are the development of the Chayandinskoye gas field in Yakutia, the construction of the Siberian Force Pipeline (from Yakutia to Khabarovsk to Vladivostok), and the construction of an LNG plant in the Far East. The program is scheduled to be finished in 2017–18. In Gazprom’s estimates, it will cost $45 billion, but analysts point out that this figure is understated, claiming $60 billion as a more adequate estimation. For the moment, this program is still one of the most expensive projects in the world and therefore raises questions of cost-efficiency and viability.

Changes in the economic situation of Europe have weakened Gazprom’s position, forcing the company to exhibit more flexibility in its price policy.

According to energy analyst Vladimir Milov, “there is a high concentration of special interests in the Russian gas industry, people who gain from making decisions on certain large-scale projects of dubious economic quality. It often happens that the decision is made, the project is implemented, money is invested in it, and later it stands idle, unclaimed.” The decision to invest in the Eastern Gas Program was made, but for now, Gazprom hasn’t reached any concrete agreements with future buyers. Negotiations with China on gas supplies have been going on for several years, but it is still not clear what price can satisfy both parties.

 

NOVATEK co-owners Leonid Mikhelson (left) and Gennady Timchenko

 

Changes in the economic situation of Europe have also weakened Gazprom’s position, forcing the company to exhibit more flexibility in its price policy. Earlier this summer, for the first time, Gazprom excluded the “take or pay” condition, which made clients purchase a certain amount of gas or pay a penalty, from its long-term contracts. The largest French energy company, GDF Suez, was the first contractor that managed to negotiate new, more favorable terms with Gazprom. Other European companies, including Econgas, Wingas, and ENI, have requested similar conditions.

Implementation of the provisions of the EU’s Third Energy Package has not made Gazprom more optimistic. As Kommersant newspaper reported, the Russian Energy Ministry is developing recommendations for restructuring the supply of Russian gas to Europe, in case Gazprom’s new pipelines (the North Stream and the South Stream) continue to be subjected to these provisions. According to unconfirmed information, the Ministry is seriously considering bringing Gazprom’s direct competitors into the gas transportation market.

 

The Stalemate

In April, Gennady Timchenko, co-owner of NOVATEK, met with Vladimir Putin to discuss the prospects of gas industry development. As Timchenko later told Neue Zurcher Zeitung, Gazprom wants to retain its monopoly and not change anything: “They have long-term contracts with European consumers. But we would also be eager to work [with these countries] if we could impose the same extra charges as Gazprom.” Moreover, the issue of dividing the company’s production and transportation assets was also brought up in Timchenko’s conversation with Putin. This idea was first suggested by the IMF in the late 1990s and was supported by the Russian Economic Development Ministry. A plan for restructuring the company by 2004 was developed, but it encountered powerful resistance from Gazprom CEO Alexei Miller. By 2006, the idea of dividing the company had been shelved.

If Rosneft acts with excessive vigor, it can destabilize the industry—as can the game of “strategy and politics,” if Sechin continues to play it.

Today, because of the combined efforts of Timchenko and Sechin and thanks to Gazprom's inertia, the scenario of dividing Gazprom's assets is being discussed once again “at high levels,” according to Kommersant's sources. In this context, rumors of Miller's resignation have started surfacing again, but so far, they have not been confirmed. One thing is clear: the reform of the gas industry cannot be avoided in the near future. Global shifts in the world gas market and the necessity of raising taxes on the Russian gas industry to cover the growing infrastructural and social expenditures of the government make such reform inevitable.

The question is, who is going to lobby for the reform? For the moment, perhaps, the only person who is well positioned to do so is Igor Sechin, head of the world’s largest oil corporation, who has gained significant political weight and administrative leverage. The way Rosneft chooses to act will have an effect on the Russian energy sector and may stand to change the system of checks and balances.

If Rosneft acts with excessive vigor, it can destabilize the industry—as can the game of “strategy and politics,” if Igor Sechin continues to play it. Considering the rise in Rosneft’s debts after its acquisition of TNK-BP, the company will be generating a lot of risk if it continues its intervention in the gas sector and its greedy usurpation of offshore fields. Rosneft, let alone the sagging Gazprom, will most likely postpone the development of the Arctic offshore fields for decades. With the state companies’ monopoly on offshore development, there is nothing else for the independent companies to do other than struggle with declining production at their old fields without a chance to expand their resource base. In the end, everyone may lose.

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