May 16, 2013

How Gazprom Snoozed through the “Shale Gas Revolution”

The “shale gas revolution” in the United States is changing the world’s energy map. The International Energy Agency’s latest predictions suggest that by 2035 America will have become the world’s largest gas producer, outpacing Russia. Until recently, Gazprom, Russia’s natural gas monopoly, has been skeptical about such forecasts. But Gazprom’s lack of long-term vision can have negative implications both for the company and for the country.

Foie Gras or Steak?
In late December 2012, analysts from Rusenergy, one of the leading consulting companies of the Russian oil and gas industry, reported on the past year’s major trends, producing findings of great interest. According to Rusenergy, Russia’s gas monopoly Gazprom has become the “Loser of 2012.” As the largest company in the world in terms of gas reserves, Gazprom is criticized for its inefficient management, investments in projects of questionable profitability, reputation as a “gas terrorist,” and so on. But until recently, these criticisms have not prevented the company from maintaining its position as a global leader in terms of net profits, or its CEO, Alexei Miller, from being listed among Harvard Business Review’s top 100 most effective managers in the world.
In 2012, Gazprom’s internal problems suddenly surfaced. In its report, Rusenergy ranked the company in the first place in such categories as “Failure of the Year” for the collapse of Shtokman Development AG, a consortium set up for developing the Shtokman field; and “Disappointment of the Year” for its decision to launch the construction of South Stream before all necessary permissions had been acquired, and before demand for energy in Europe, where Gazprom exports two-thirds of its produced gas, had stabilized. In addition, Gazprom initiated costly projects to develop the Chayanda field and construct the Yakutia– Vladivostok gas pipeline.
The slow recovery of demand for Russian gas in the European Union can be attributed to a range of reasons, but one of the main factors is the “shale gas revolution” in the United States. This “revolution” is a phenomenon caused by new technological developments in shale gas and oil production. Even though the existence of tremendous reserves of shale gas and oil has been known since the 19th century, their production was previously considered unprofitable. This situation changed when oil and gas prices reached a high enough level, and new technologies for hydraulic fracturing and horizontal drilling were sufficiently developed, encouraging investments to flow into shale projects. The “shale gas revolution” caused price-cuts in the U.S. market, and today, American gas on the local markets is cheaper than gas in Russia.
Nevertheless, Gazprom’s management was skeptical about the new developments in the U.S. energy market. In June 2010, while delivering a speech at the European Business Congress in Cannes, France, Gazprom CEO Alexei Miller tried to debunk what he called “the shale myth,” claiming that shale gas is nothing more than a local natural resource that can only be used to compensate for shortages of conventional gas in the regional markets. He also sarcastically remarked that “if you like foie gras, it doesn’t mean that you don’t need steaks anymore.” Despite sagging demand in the European gas markets during the 2008–2009 global financial crisis, Miller assured the forum’s delegates that energy industries in these countries would recover by 2012, and that Gazprom would continue to fill the European Union’s growing demand.
In 2011, in another speech, Miller continued to elaborate on his point by arguing that “shale gas is a well-planned propaganda campaign, similar to those for global warming or biofuels.” He made this statement regardless of the fact that in 2010, shale gas production in Europe had already grown to 138 billion cubic meters per year. Miller made his argument by pointing out that nonconventional gas, including shale gas and liquefied natural gas (LNG), is prohibitively expensive to produce, and that, despite the stir that it had caused in the media, it could not become a game changer for the global energy market. Alexander Medvedev, Miller’s deputy at Gazprom, made a public claim that the company was ready to increase its share in the U.S. gas market by 50 percent through exports of LNG from the Shtokman field (although in that case, Gazprom’s share would still not be more than 1 percent of the market). Medvedev called the hike in U.S. shale gas production “a bubble,” similar to the “dot com bubble” in the IT market that caused a collapse in the industry.
All Not Quiet on the Western Front
Gazprom’s confidence that European demand will continue growing has been based on the assumption that the financial crisis will make European governments sober up and stop talking about energy security, decreasing their energy consumption, and switching to renewable energy sources. Miller labeled such aspirations “morally invalid,” especially in the face of EU countries’ ongoing efforts “to balance their budgets.”
But according to BP’s 2011 Statistical Review of World Energy, demand for gas in Europe decreased by 9.9 percent over the past year. This dip was caused not just by the economic crisis, high gas prices, and the continuing growth of renewable fuel consumption, but also by a shift in consumption toward cheap coal.
Meanwhile, Gazprom has continued to reinforce its export policy in Europe. In October 2012, the second stretch of the Nord Stream gas pipeline was opened, which increased its capacity from 27 billion to 55 billion cubic meters per year. The company’s management claimed that the construction of a third and a fourth stretch was being considered as well.
At the same time, in mid-2012, when oil prices were rising, the difference between spot prices and contract prices went up to $150 for a thousand cubic meters (Gazprom ties its gas prices to the price of the oil basket, with a time lag of six to nine months). Over that period, Gazprom’s European partners incurred losses because they had to resell Russian gas at lower prices. At times, the spot price was as low as $300 for a thousand cubic meters, while the contract price was $450. The increase in Gazprom’s contract gas prices seemed especially inadequate given the stability of the spot market prices.
Gazprom’s awkward attempts to strengthen its position went against the prevailing trend on the European market, which was changing as a result of the influence of global fluctuations in LNG supplies from Qatar and Norway. The “shale gas revolution” redirected export flows to the European market. As a result, by the end of 2012, LNG’s share of the EU energy market had increased to 20 percent—compared to 12 percent in 2008.
Under these conditions, which were unfavorable for Gazprom, the European Union lobbied for the passage of the Third Energy Package, a bundle of laws that set a goal of liberalizing the EU energy and gas markets. The key provision of the Package is to split the production of electricity from its transmission in terms of the companies operating in the EU market. This provision works against Gazprom, which produces, transports, and eventually sells gas (through affiliated companies). The Russian government’s attempts to negotiate an exception for Gazprom were unsuccessful.
On top of that, in September 2012, the European Commission initiated an antitrust investigation against Gazprom on the basis of allegations that the company was restricting competition and abusing its dominant position in Central and Eastern European markets (including Poland, the Czech Republic, Slovakia, Hungary, Bulgaria, Estonia, Latvia, and Lithuania). News of this investigation caused the company’s stocks to drop in value, and the overall capitalization of its holdings to decrease by $2 billion.
The investigation is based on the results of office searches of Gazprom’s subsidiaries and its European partners, and is being undertaken by the European Commission’s General Directorate for Competition, which has not lost a case in similar court trials since 1958. European officials won comparable cases against Microsoft and Intel, so it is logical to conclude that sanctions against Gazprom are inevitable. If found guilty of the current charges, Gazprom will have to pay a fine of $14 billion.
Shtokman Is Still There
Today, 40 to 60 percent of oil demand in the United States is satisfied by imports, but that situation may change fast as a result of the “shale oil revolution.” Meanwhile, the “shale gas revolution” has already brought America to the threshold of energy independence. In 2000, the share of shale gas in the U.S. gas production structure did not exceed 1 percent. In 2011, this share reached 34 percent (214 billion cubic meters). Thus, over the last decade, U.S. dependence on gas imports has decreased by 45 percent, with LNG imports dropping by 19 percent. As the International Energy Agency forecasts, the shale gas share in the U.S. energy structure will reach 43 percent by 2015, and 60 percent by 2035.
These shifts in the American market have had a negative impact on Gazprom’s plans. First, anticipating a growth in demand for gas in the United States in the early 2000s, Gazprom started to actively explore opportunities to develop the Shtokman field, the largest known gas field in the world. The plan was to produce LNG from natural gas extracted at Shtokman and to export it to the United States.
But while Gazprom’s management was choosing foreign partners to join the consortium for developing Shtokman, the world energy market began to change. As a result, at the end of August 2012, Gazprom and its partners in Shtokman Development AG (France’s Total and Norway’s HydroStatoil) made a decision to put the project on hold because of excessive costs for the development and the “emergence of new projects of shale gas production.”
It is worth mentioning that at a meeting of the Russian government’s fuel and energy commission in October 2012, Vladimir Putin finally admitted that the shale gas revolution might be real—several years after it had actually started: “I have to note that more countries have launched new technologies for shale gas production and refining. For example, in the U.S. [these technologies] have helped to produce shale profitably. […]Politicians, experts, and businesspeople have started talking about a real shale gas revolution.” Putin also called Gazprom to pay attention to such changes in the global energy market and to reassess its export policies.
Even if Gazprom prefers not to discuss the “shale gas threat,” it did listen to the Russian president’s advice—although it chose to pay attention not to shale gas, but to shale oil. At the end of October, the board of directors of Gazprom Neft, a subsidiary of the Russian energy monopoly, announced that the company would start producing shale gas at the Verkhny Salym oilfield in partnership with Shell. As Alexei Miller noted, unlike shale gas production, which is not “relevant” for Russia, shale oil could present “a noticeable interest” for his company.
A Vague Future
In late September, Sergei Aleksashenko, a Russian economist and head of the analytical group Development Center, published an interesting diagram that illustrated the dynamics of major energy companies’ stock prices during 2008–2012 (2008 was taken as a zero mark). As a comment to the diagram, Aleksashenko added: “Not a single company performed as badly as Gazprom. No one managed to lose more than one half of its value (53 percent). Not even BP, which had to deal with the largest catastrophe in the Mexican Gulf that cost the company more than $20 billion in fines only. Not even Surgutneftegaz, whose ownership structure remains a mystery to many analysts and whose quality of corporate management is the lowest of the low. Not even ENI and Total, which are controlled by their countries’ governments. All companies have a much better stocks dynamic than that of our ‘national treasure.’ ExxonMobil, a leader of this diagram, practically matches the S&P 500 index, while Chevron (not shown on the diagram so as not to embarrass Gazprom) has improved its position by 25 percent since 2008.”
On January 17, 2013, Gazprom published its financial report (conducted in accordance with International Accounting Standards) for nine months of 2012. Even though some of the figures have improved in the third quarter, the data for these nine months do not look promising in comparison with the previous year. For example, the company’s net profits have decreased by 11 percent (compared to the same period of the previous year), operational costs have increased by 18 percent, total supply volume has dropped by 8 percent in annual terms, and the income from gas sales has only increased by 1.6 percent. At the end of the year, Gazprom recorded an overall drop in production. All of these factors will probably have a negative impact on how investors view the company, and will prevent its stock quotes from growing.
When world gas prices were rising, Gazprom could feel at ease. Today, when the global environment has changed, the company’s internal problems have become visible. These include strategic management mistakes, aggressive marketing policies, high levels of bureaucracy and corruption, and vague prospects for financial prosperity in the long run.
On July 1, 2013, domestic gas tariffs in Russia will increase by 15 percent. Gazprom plans to achieve net back parity by 2014, which means that gas prices for Russian consumers will grow 2.5 times. Such a hike runs the risk of causing additional social tensions inside the country.
All of these factors can lead to serious problems for Gazprom. Considering the fact that the company provides one-fifth of Russia’s federal budget revenues, Gazprom’s destabilization can cause risks for society as a whole. If Gazprom does not begin to adjust its long-term strategy and change the model of its relationships with its partners in the European Union and the Commonwealth of Independent States, Russian citizens will quite soon have to pay for the company’s errors.

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