Russian Energy Strategy in Natural Gas Sector By Vlad Ivanenko1 December 2006

Abstract: Gazprom, one of the least reformed and most successful Russian companies, is largely responsible for defining national energy strategy. The consumers of Russian gas – the EU and post-Soviet countries – pay increasing attentions to the ways this company operates. This paper outlines the constraints faced by the Russian government and Gazprom management and lists options that these two players can employ transforming Russian energy might into economic benefits.

PhD economics (University of Western Ontario) and senior trade analyst (Ottawa). E-mail: ivanenko60@yahoo.com

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Introduction The natural gas sector is the least reformed and, apparently, the most successful industry in the Russian economy. Unlike the oil extraction sector –which was broken up and privatized in the early 1990s – natural gas production and distribution networks were preserved, with few exceptions, in the state-controlled monopoly Gazprom. Correspondingly, the Russian gas industry avoided ruinous warfare that the oil barons – former insiders and well-connected newcomers – waged fighting for control, ownership, and export quotas. Likewise, the natural gas sector was largely spared the troubles that befell on some oil majors (e.g. on YuKOS) which did not fall in line after the state changed its policy on energy resources in 2003. It is unsurprising that Gazprom is at the spearhead of the current Russian search for a decent place in the global division of labor. Russians appear to have come to a firm consensus that their country needs to be integrated into the world economy but they are less certain about what economic activities Russia should focus on. Exploring comparative advantages related to natural endowments of energy resources seems to be the right choice given prevalence of energy resources in Russian export. In this respect, the oil extraction sector is a better candidate because it dominates Russian export and it is more reformed than Gazprom. However, the sector is still consolidating and there is no Russian oil major capable of competing on the global scale. Moreover, and this factor is a key, the Russian state and private businesses are highly suspicious of one another. Owners are uncertain about the state’s commitment to respect their property rights obtained through dubious privatization deals. In turn, the Kremlin doubts that the owners of private companies will not fly to safety with their ill-gotten gains (capital flight) after it helps them to secure a place abroad. Gazprom – managed by Kremlin-trusted loyalists installed during the restoration of state control in 2001 – is the perfect trailblazer in this respect. To understand what place the Russian government envisions for Gazprom internationally and what strategy it pursues, it is necessary to dwell on domestic constraints that the Kremlin faces.

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Kremlin Conditioning in Natural Gas Sector Gazprom has not been fully privatized and restructured due to historical accidents. Early in the transition to capitalism, the Russian government recognized that providing natural gas to households and power plants – regardless of customers’ ability to pay – was a key to social stability. Since the state was deeply in debt and could not subsidize Gazprom directly, a method of indirect subsidization was employed. The company was allowed to subsidize its domestic (loss-making) deliveries out of export revenue. This arrangement required the state to retain control over Gazprom. Occasionally, Gazprom was also used as the “lender of last resort” to the Federal Government like in May 1997 when it had to cough up several billion dollars in “tax arrears” accumulated for unpaid domestic deliveries. Due to historical circumstances, Gazprom enjoys a special status within the Kremlin’s hierarchy of domestic monopolies. First, the latter continues to see Gazprom’s money as not being fully separated from the federal budget. For example, the Ministry of Finance believes that Gazprom should contribute to the Stabilization Fund like oil companies do. Gazprom hints that if it pays more in taxes, it should be relieved of social responsibility to subsidize its domestic operations (imposed through state-regulated prices) or be eligible for state subsidization. The latter proposition is under review but unlikely to be implemented before the next presidential election in 2008. Second, because Gazprom enjoys strong economic clout in many ex-Soviet states, the Kremlin is occasionally tempted to use the company as a tool to advance Russian political objectives abroad. Some Western observers find that this blend of economic and political goals is a part of the master plan that the Kremlin pursues promoting Gazprom abroad. For example, many see the price scuffle with Ukraine in January 2006 as an example of new Russian policy to project its power abroad using energy trade. A closer look suggests that economic considerations take prevalence over political agenda whose objectives are reflected, at best, in the timing of energy deals. Third, as a globally important company Gazprom is a potential engine of national growth. The Russian government understands that the country needs to diversify its export base moving towards products with the value-added higher than that of raw materials. Given that natural gas is the key input in the production of organic chemicals,

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metals and electricity; the abundance and cheapness of natural gas in Russia suggests preferential development of these sectors. However, neither Gazprom nor the government shows persistent interest in exploring this possibility, especially after 2004 when Russian export revenue surged in the wake of energy price growth worldwide. Still, the issue of export diversification is a factor that affects, tangentially, energy strategy that the Kremlin may pursue. Fourth, being an unreformed Soviet organization, Gazprom serves as the benchmark against which the excesses of privatization in energy sector are highlighted. The company preserved the bulk of Soviet gas facilities but some dilution of assets still took place. Virtually all independent (and rather small) gas producers – Novatek, Itera, Nortgas, or Sibur – are Gazprom’s spin-offs that were born out of shady deals struck with former Gazprom management in the early 1990s. The new team – Alexey Miller and Dmitry Medvedev – which came to the board in 2001 has gradually re-asserted control over many spin-offs, often under the threat of criminal investigation. The remaining two examples of privatization in the gas sector that went awry involve foreign companies that enjoy protection under the foreign law. The first is British Petroleum, which acquired control over the Kovykta gas field in Eastern Siberia through a backdoor deal with local oligarchs. The second involves the Sakhalin II project controlled by Shell under the terms of a production-sharing agreement highly disadvantageous to Russia. Otherwise, the Russian gas sector is relatively free from conflicts between domestic producers and the state ripe in other energy sectors. Gazprom is firmly under the state control and it is wellpositioned to become the “model” transnational company with Russian roots that the Kremlin plans to support. If it happens the latter can resort to restructuring and privatizing Gazprom on terms incomparably better for the state than backdoor deals of 1990s.

Implications for Russian Energy Policy The Russian government is aware of the limitations that it faces dealing with Gazprom and, at least, is looking for ways to mitigate some of the problems. Judging by the dynamics, the role of Gazprom as a commercial vehicle appears to become primary while its role as the guarantor of social stability is in steady decline.

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The objective to relieve Gazprom of social responsibilities normally associated with the state has been present since the day Russia turned into a market economy. It was obvious that providers of communal services had to become self-sustainable financially if the state wanted to release itself from this burdening obligation. However, the reform was consistently postponed due to abject poverty of Russian households. The importance of this factor appears to go away as the Russian economy has entered eighth consecutive year of growth. Increase in household disposable income was so noticeable that the government deemed timely to introduce a wide-ranging reform of communal services in 2005. Following spontaneous mass protests by retirees and other poorly protected social groups, the reform was scaled down but not abandoned altogether. As a result of reform, domestic gas providers have become – for the first time in a decade – profitable in several regions and the number of such regions continues to grow. This development allows the state to relieve Gazprom of the necessity of cross-subsidization and to concentrate predominantly on raising the efficiency of its export operations. Greater profitability of the domestic market benefits Gazprom in another way. It attracts independent gas producers that are content on utilizing small fields that have missed Gazprom’s attention. Oil companies that argue constantly with Gazprom over oilwell gas access to the monopolist’s pipelines are becoming interested in serving domestic markets. Sensing a possibility to earn extra money, Gazprom takes a more accommodative stance on pipeline access as well. Additional deliveries of gas free its resources – previously supplied to domestic consumers – for export and allow earning on transit fees. In general, Gazprom searches for ways to expand its export capacities. For example, it seeks control over key electricity generating companies such as Mosenergo with the tentative objective to restructure their fuel basket in favor of fuels alternative to gas that is heating oil and coal. Using the argument of energy-efficient consumption, Gazprom is successfully pushing state regulators to increase domestic gas prices above the inflation rate – thus, weighing against the state objective to keep inflation at bay – arguing that it is up to the markets to keep inflation minimal. Finally, Gazprom is looking for ways to tighten its grip on Central Asian and other countries’ natural gas reserves for potential re-sale to European consumers.

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The attempts to acquire downstream gas assets in Europe are consistent with the new Gazprom strategy of turning itself into a purely commercial entity. It should be noted that the Russian government lobbies Gazprom interests actively abroad and protects its export monopoly legislatively. This fuels Western fears of Russian political meddling in European affairs. By and large, such fears are unfounded. The Kremlin does not gain political dividends if Gazprom manages to get control over, say, gas distribution networks or power plants in Germany. It is predominantly Gazprom shareholders – the Russian government being one of them – who benefit and mostly commercially. The main advantage that the Kremlin realizes if Gazprom establishes itself firmly in Europe lies elsewhere. With European distributors committed to Russian gas, the government can relax export rules and proceed with a project which now is politically unfeasible but which is nonetheless unavoidable – the task of breaking Gazprom up. The reasons for this move are obvious. Many in the Russian government and among politicians resent Gazprom’s clout and lament potentially corrupting influence that it spreads around. Gazprom is a state within the state which wields political power unrivalled by other companies. It sets the rules of the game in the Duma (the Russian parliament) and fends off attempts to change the way it is taxed – to the great resentment of other, less powerful, lobbies. It goes not unnoticed that Gazprom controls a significant media empire which can be used to promote political agendas, which may not coincide with what the Kremlin wants. To reduce the weight that Gazprom carries in Russian politics, the Kremlin may find expedient to re-focus the company on purely commercial enterprises abroad while undercutting its political might at home. The domestic situation is favorable to this plan. Many Russian policy-makers believe that local economic heavyweights are discriminated in the West. If Gazprom breaks through, supposedly hostile, regulatory barriers abroad and after the bout of national pride withers away, the company will lose the support of nationalists. Instead, the attention will shift to unmatched power and glaring inefficiencies that Gazprom exposes at home. Today, the company refuses to let independent gas producers export gas via its pipelines because it can claim that a greater competition reduces the overall value of Russian gas abroad. If it controls end-user deliveries in the West, this argument becomes irrelevant. Second, after capturing new

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markets Gazprom may find no longer possible to lobby for lenient tax treatment. The argument that it needs to build a “war chest” comparable with that of its rivals overseas will lose appeal. Finally, the excessively privileged status of Gazprom employees who get wages five times higher than the average Russian will come to the fore – much to the detriment of Gazprom’s positive image at home. It is conceivable that as Gazprom strengthens its position abroad, the company becomes a political liability domestically. The perception that Gazprom is “too big” to be allowed in its current form grows among foreigners and domestic constituencies alike. Eventually, the company may be broken into an export trading branch – which is what, essentially, Gazprom whose shares are traded today is – and a host of regional operators that buy gas from independent suppliers to be delivered by a separate pipeline monopoly similar to the oil transportation monopoly Transneft.

Gazprom in “Near Abroad” In the 1990s, Gazprom provided gas to Ukraine and other former Soviet republics at subsidized prices with the same objective of maintaining social stability in neighboring countries. This objective has become less demanding following gradual increase in household incomes in the Russian neighborhood since 1999. Correspondingly, the political pressure on Gazprom to keep prices artificially low has gradually rescinded. From the beginning, the Gazprom tried to raise prices for gas supplied to post-Soviet republics but with little success. It encountered strong resistance from transit countries – such as Ukraine – that threatened to block the transit of Gazprom gas to Europe. In the end, facing high political uncertainty and pressure at home, the company subcontracted intermediaries – often of shady origin with links to political elites of the importing countries – that became responsible for handling deliveries in Ukraine, Azerbaijan, and Moldova; see Table 1. At the same time, Gazprom pressed gas producers in the Central Asia that lacked alternative routes of transportation to sell gas cheaply to such subcontractors. In this way, Gazprom managed to share the burden of gas subsidies with Kazakhstan, Uzbekistan, and Turkmenistan. The situation changed when Ukraine, on Western prodding, tried to “diversify” gas routes by arranging direct deliveries from Turkmenistan in 2005. This move prompted

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Gazprom to agree at a higher price for Central Asian gas. Steep price increase of the latter unsettled the system of intermediaries that Gazprom developed in the Near Abroad. At the same time, having convinced the Kremlin that the old system of subsidization was unsustainable, the company got permission to charge post-Soviet republics more competitive prices. The intermediaries were left behind struggling for survival.

CIS Armenia Azerbaijan Belarus Georgia Kazakhstan Moldova Ukraine

Import of natural gas (mil $) 91 277 950 86 372 108 3,946

Share of Russian gas (in %) 100 9 100 100 46 44 31

Average price of Russian gas ($/m3) 67 45 48 73 33 80 52

Table 1: Total import and import of Russian natural gas (HS 271121) by CIS countries, in 2005. Source: Comtrade (UNSD, 2006)

European Optimal Policy on Natural Gas Security The issue of gas security comprises two items important for consumers. First, they are interested in a reliable (uninterrupted) and predictable supply of gas for current needs and for foreseeable investment projects. Second, consumers want to cut the price of natural gas down to its production and transportation costs. The two objectives are contradictory, particularly because gas production requires significant investments in exploration and development of gas fields and in pipelines. High entry cost limits the number of producers while the complexity of transportation network and management of underground storage facilities reduces the number of traders. In this respect, reliability of supply favors long-term relationship between dedicated suppliers and consumers. Thus, consumers should be ready to trade reliability – or longterm stability – for more volatile and presumably cheaper “spot” prices hoping that competition will bring enough sellers in due time. The strategic choice between these extremes is difficult because it depends on multiple considerations. The “spot” market is preferable because it is less expensive and

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more efficient due to market competition. However, it is also more difficult to develop. Gas wells have to be maintained irrespective of their capacity utilization. Gas delivery is costly, be it via a pipeline equipped with compressor stations or with LNG (liquefied natural gas) tankers that require special terminals and reprocessing plants to operate. Historically, disjoint small gas operators (who are model price takers) have been unable to build and maintain such capital-intensive infrastructure. Thus, if the EU chooses to focus on cost reduction instead of security, it should be prepared to allocate significant public expenditures for investments in gas infrastructure. This option may be politically unfeasible because the risk of failure is high and the return on such investments will disproportionately benefit large gas importers. A less extreme option is to aim at developing oligopolistic market of gas. This is essentially the policy that the EU is pursuing and Gazprom is resisting. One should note that the end result of this implicit confrontation depends heavily on who bears the cost of potential over-investment. To ensure competition, the EU considers financing the construction of gas pipelines – the Nabucco project to export Iranian gas comes first to mind – and LNG plants in Africa and the Middle East. Gazprom responds by buying up Central Asian resources – thus, making Trans-Caucasian gas pipeline uneconomical – or proposing to establish a price cartel (dubbed “gas OPEC”) to prevent EU’s agreement with alternative suppliers. It also realizes that investments in LNG plants are more costly than pipeline deliveries, which gives Gazprom a competitive edge. Therefore, the EU goal of reducing gas prices through greater competitiveness is confronted by Gazprom attempts to thwart European plans. At the moment, Gazprom has a better position as what the EU can do at most imposes a cap on Gazprom gas price. Gazprom management weighs in the EU debate stressing the importance of stability on another front. It talks about “diversification of supplies” suggesting, first of all, Russian shift towards Asian markets and, to a lesser extend, markets served with LNG. Future growth of domestic prices on Russian gas is also a factor that limits EU bargaining power: if Russian consumers will be able to pay competitive price, the allure of European market for Gazprom will wane.

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EU Former socialist Czech Rep. Estonia Hungary Latvia Lithuania Poland Slovakia Slovenia Western Europe Austria Belgium Finland France Germany Greece Italy Netherlands United Kingdom

Import of natural gas (mil $) 1,793 91 2,431 151 264 1,801 1,323 273 2,101 10,551 676 8,899 17,612 563 8,035 3,800 2,927

Share of Russian gas (in %) 70.8 100.0 73.4 100.0 100.0 64.0 89.1 48.7 61.3 0.4 100.0 24.7 32.8 81.2 47.6 20.0 9.0

Average price of Russian gas ($/m3) 188 95 202 95 90 172 180 165 203 183 148 183 197 191 196 195 172

Table 2: Total import and import of Russian natural gas (HS 271121) by EU countries, in 2005. Source: Comtrade (UNSD, 2006)

Accommodating Gazprom demands is the last option that the European Commission wants to consider. The main objection lies with the persistent suspicion that Russian control over European gas deliveries will lead to political demands from the Russian side. What these demands might be is hard to explain. Russian conditioning indicates that Gazprom turns steadily into a commercial entity, which – in full accordance with market principles – cares only about its market power and net profit. Potentially, European fears relate to growing Kremlin authoritarianism and the power that Gazprom, a foreign monopoly, will exercise in Europe. These are concerns that Russia needs to address in earnest. The issue of authoritarianism lies beyond the scope of this paper but the subject of monopoly is relevant. Being a monopoly, the behavior of Gazprom is limited by public supervision both at home and abroad. The EU may request the Kremlin to provide guarantees that Gazprom will not violate local rules. In principle, if Gazprom is broken along technological lines into production, transportation and trading branches; the last

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unit becomes a predominantly European legal entity and subject to EU anti-trust rules while being a generator of profit for Russian owners.

Conclusion This paper provides a brief outline of the problems that need to be resolved in gas sector for EU-Russian partnership to go ahead. It describes historical conditioning that affects the structure of Russian gas monopoly, Gazprom, after the collapse of communism. Gazprom, a vertically integrated company, lacks significant downstream actives in its main market – Europe – and experience problems with transit countries, predominantly Ukraine. Having significant political clout at home, Gazprom enjoys political support of the Kremlin, which it does not shun of solving its commercial problems abroad. The EU and Ukraine pursue their own commercial and political interests. The EU aims at curbing the power of foreign monopolists, first of all Gazprom, within the common market. Its objective is twofold. First, Brussels wants to reorganize gas market following the example of electricity deregulation. It hopes that deregulated market will benefit consumers, disproportionably residing in the EU, at expense of producers, who turned out to be mostly foreigners. Second, the EU resists attempts of foreign monopolies to penetrate its markets in general because if fears political repercussions. On its part, Ukraine wants to capitalize on its geographic advantage of being a bridge between the top supplier of gas – Russia – and the top consumer – the EU – with the objective to maximize transportation fees. The paper has concluded that the current confrontation between the three players is likely to be won by Gazprom due to its comparative strengths. At the same time, it has indicated that the EU can reduce the risk of foreign volatility if it conditions Gazprom’s acquisition of local downstream assets on its divestiture of production assets at home.

References United Nations Statistics Division (UNSD, 2006). United Nations Commodity Trade Statistics Database (URL: http://unstats.un.org/unsd/comtrade/default.aspx)

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