Checkmate - Novatek Deal Strengthens Gazprom's Gas Position in Russia and Beyond

Growing at Home

Gazprom's announcement on Monday (26 June) that it had reached a preliminary deal to acquire a 20% stake in Novatek should - in theory at least - have sparked more controversy than it has. Yet, considering the Kremlin (the presidential administration)'s unrelenting and unyielding strategy of bringing the Russian oil and gas sector under greater state control, the deal under which the state-owned gas giant is set to purchase a minority stake in the country's number-two gas producer caused nary an eyebrow to raise, even though - in theory, once again - the deal is clearly in violation of Russia's own anti-monopoly regulations.

Less than one year ago, Russia's Federal Anti-Monopoly Service (FAS) had ruled that Gazprom, in the wake of its takeover of Northgaz, could not make any further gas acquisitions in Russia. The ruling appeared to force Gazprom to look abroad for additional gas assets and/or focus on diversifying its Russian business operations into oil and electricity. While Gazprom has duly sought to expand its empire by shifting gears more into the oil and power sectors, the gas giant's deal to acquire a minority stake in Russia's largest independent gas producer appears to fly directly in the face of the FAS ruling.

Then again, if the FAS truly had any teeth in Russia, Gazprom would not already be in control of 95% of Russia's massive gas assets, produce 90% of the country's gas output, operate Russia's entire domestic gas pipeline network, and hold a soon-to-be-legally-official monopoly on the export of Russian gas. Gazprom had already crafted something of a "gentleman's agreement" with Novatek - the upstart independent that conducted a highly successful initial public offering (IPO) last July in spite of its inability to export gas from Russia - under which Gazprom agreed to co-operate with Novatek and provide it with access to the Gazprom pipeline system to supply domestic consumers. Now it appears that agreement has been expanded to allow Gazprom to acquire a minority stake in Novatek and thus boost the gas giant's overall control of Russia's gas resources.

The Gazprom-Novatek deal will no doubt be sanctioned by the Kremlin - the move almost certainly cleared at the highest reaches of the presidential administration before it was announced - in spite of the nominal FAS position against allowing Gazprom to expand further in Russia. After all, as Gazprom is now majority state-owned, the company's reputation as a "state within a state" is no longer accurate - Gazprom is the state, and as such the company plays by its own rules…or at least according to those set down by President Vladimir Putin. And if Putin wants to move the goalposts and allow Gazprom to further cement its hold on the Russian gas sector, then so be it.

Increasing Leverage Abroad

With Novatek predicting that it will double its gas production - from 25 Bcm at present to 50 Bcm by 2010 - the addition of a stake in the fast-growing independent certainly improves Gazprom's production outlook. For its part, Gazprom is expecting to produce 548 Bcm in 2006, barely higher than the 545 Bcm the company extracted in 2004. Gazprom has forecast relatively flat production growth for the next 20 years, with the company increasingly turning to imports of Central Asian gas to make up for declining output from Gazprom's "Big Three" fields at Yamburg, Medvezhye, and Urengoy.

Gazprom has signed several gas purchase deals with Kazakhstan, Uzbekistan, and Turkmenistan that are geared to allow the Russian gas giant to meet its export commitments while forestalling more expensive upstream investments in the Yamal Peninsula that would allow the company to boost its own production. While Gazprom has done well to make good use of its geographic position in negotiations with Kazakhstan and Uzbekistan to lock in supplies, Turkmenistan - which in 2003 signed a 25-year, 1.8-Tcm gas supply deal with Gazprom - is forcing Gazprom's hand with a threat to cut off supplies unless Russia complies with the Central Asian country's own demands to raise gas prices from US$65 per 1,000 cm at present to US$100 per 1,000 cm.

Since Turkmen gas accounts for the bulk of Russia's Central Asian gas imports, Turkmenistan's price demands carry more weight and have the potential to upset Gazprom's delicate balance of meeting its own domestic supply commitments while fulfilling its export commitments. Gazprom has been reluctant to see the Russian government open up its domestic pipeline system to third-party producers (such as Novatek and Russia's oil companies), a move which would reduce the need for Central Asian gas as a supplement to Gazprom's own production but also cost the gas giant its jealously guarded monopoly on the domestic Russian pipeline system. Thus, the decision to turn around and acquire a stake in Novatek - and thus secure access to existing production from the independent, as well as its planned future production increases - is a masterstroke by Gazprom in boosting its leverage in price negotiations with Central Asian producers, in particular Turkmenistan.

Outlook and Implications

By solidifying its position in the Russian gas sector (one finds it hard to suggest that Gazprom is "eliminating the competition", as that suggests that there was at some point some actual competition in the Gazprom-dominated Russian gas industry), the company is also increasing its leverage on the international front for the coming gas price wars, both with Turkmenistan and with Ukraine (and, by extension, the European Union). Access to Novatek's existing gas reserves, and its future production, gives Gazprom the ability to cut back on its Central Asian imports, thus reducing Turkmenistan's leverage in calling for its healthy price increase. Instead of needing Turkmen gas to supplement its own production, Gazprom can (at least in part) turn to output from Novatek to fill the gap between the gas giant's own production and its supply commitments.

In turn, any price increases that Turkmenistan foists upon Russia will either be rebuffed or passed along to Ukraine, which is likely to bear the brunt of higher gas import prices - be they from Russia or Turkmenistan - as early as next week, when prices under the January Russia-Ukraine gas supply agreement expire. Adding part of Novatek's output to Gazprom's portfolio has the added bonus of improving the gas giant's ability to withstand a backlash from Ukraine over higher prices, as - under a scenario in which Ukraine siphons Russian gas intended for Europe following a unilateral price increase - Gazprom could conceivably draw upon additional gas supplies to pump to Europe via Ukraine. Gazprom could then pin the blame for any new disruption in gas supplies to Europe squarely on Ukraine.

A potential interruption in Russian gas supplies to Europe via Ukraine would surely be met with further howls against Gazprom's monopoly position, however, limiting the upside potential in the gas giant's use of Novatek as a "swing producer". Still, the acquisition of the minority stake in Novatek gives Gazprom an undeniable dominant position in Russia and strengthens the gas giant's hand in negotiating prices and supplies with Central Asian producers. Gazprom's leverage in dealing with Ukraine and the European Union will likely be put to the test shortly, but the gas giant is clearly in sight of declaring "checkmate".