Betting on a Gusher

Vladimir Putin is betting big on oil and gas. for the first time in its 40-year history, the state gas giant Gazprom plans to allow foreign investors to buy its stock directly, perhaps as early as the end of January, on the St. Petersburg Stock Exchange.

This month's offer was to be the first step in a campaign to make Gazprom the ExxonMobil of Russia, one of the world's great energy companies. Indeed, Putin had installed his old friend Alexey Miller,

43, as CEO of Gazprom in 2001, with a mandate to rid the former state monopoly of the privateering, corruption and cronyism that had overtaken it after the fall of the Soviet Union. And Miller and his new lieutenants have vowed to make Gazprom "the largest energy business in the world" by 2010.

It certainly has the potential. Gazprom is the top global supplier of natural gas, controlling 16 percent of the known reserves, and a top-20 oil company. It's aggressively expanding into lucrative new markets in Western Europe with a $5 billion new pipeline project under the Baltic, and eying schemes to export liquid gas to the United States. Just two weeks ago Gazprom shares rose 23 percent, on news of rising world energy prices. Yet even so, its market capitalization is just $1.3 million per billion barrels of proven reserves (compared with $17 million at ExxonMobil), making it one of the cheapest energy stocks in the world.

The Gazprom discount is a function of politics and Putin. Investors will remain wary so long as he treats Gazprom above all as a tool for enforcing his political will, rather than a real private company, in the Western sense. For all Putin's efforts to reform Gazprom, a recent spat with Ukraine demonstrated that the company is still run as a branch of the Kremlin. On New Year's --Day, in an attempt to force Ukraine to pay full European market prices for its gas--and, diplomats say, to punish the Orange Revolution that brought an anti-Russian team to power in Kiev--Gazprom shut off Ukraine's gas supplies. European customers farther down the pipeline immediately felt the pressure drop and complained loudly. Within days a complex deal with Ukraine restored pressure, and though both sides claimed victory, the damage was done.

Russia's reputation as a reliable energy partner was shaken--and with it, Gazprom's ambition to become the country's first brand-name multinational in good global standing. U.S. Secretary of State Condoleezza Rice criticized Russia for the "politically motivated" cutoff and warned that if Moscow wants to be "a part of the international economy" it should "play by its rules." Gazprom says that's unfair. "It would be naive to think that economic issues can be separate from politics," says Alexandr Medvedev, Gazprom's deputy CEO. "Lenin used to say that politics is a concentrated expression of economics."

Perhaps. But most investors hardly see Lenin, the late father of Soviet communism, as a guiding light for modern multinationals. "Can you imagine ExxonMobil or Chevron switching off the pump to Canada or Mexico because these countries disagreed with Bush on Iraq?" asks Karina Litvack, head of governance at F&C Asset Management in London. Gazprom is about to go on worldwide sale at a time when its senior managers seem sharply at odds with the free-market world view that dominates global financial markets.

Putin has been trying to have it both ways, pushing Gazprom to attract foreign money without loosening Kremlin control. Miller, an economics Ph.D., worked alongside Putin in the early 1990s in the office of leading reformer Anatoly Sobchak, then the mayor of St. Petersburg. Ever since, say investors, Miller's been doing a good job of cleaning up the monopoly's endemic corruption and inefficiency, stamping out the kind of asset stripping that placed Gazprom execs among Russia's richest men. And Miller is popular among the new generation of Westernized young managers he brought in with him--several have framed beer ads on the walls of their offices in Gazprom's giant skyscraper on the outskirts of Moscow, proclaiming it's miller time!

But according to a source close to the Gazprom senior management, who did not wish to speak on the record, Miller couldn't have tackled the old Gazprom regime on his own; Putin also had a hands-on role in the makeover: "Putin runs Gazprom in critical situations, and makes many of the day-to-day decisions too." All top managers have been personally appointed by Putin, and all major projects, especially those involving negotiations with Europe, are Kremlin-approved.

Putin has also begun to seek out famous Western names to help make over the image of Russian energy businesses: former U.S. Commerce secretary Donald Evans turned down an offer, but former German chancellor Gerhard Schroder now heads a Baltic pipeline project for Gazprom. According to a source close to Gazprom, Schroder was in regular touch with Putin through the Ukraine crisis, and even placed calls to Polish President Aleksander Kwasniewski and Ukrainian President Viktor Yushchenko to urge a speedy resolution. To Vadim Kleiner of Hermitage Capital Management, the biggest current foreign investor in Gazprom, the Kremlin role is both perfectly legit, since the state remains the largest shareholder, and an improvement over the old Gazprom regime, which managed the company "as a private vehicle for benefits and assets divestitures to the relatives of management."

Now, reckons Eric Kraus, the American chief strategist at Moscow-based SovlinkSecurities, Gazprom "is increasingly being run as a for-profit operation." Miller has launched a legal campaign to regain gas fields lost by Gazprom in dodgy sell-offs between 1997 and 2001; so far, nearly three quarters of the lost assets have been recovered. And gas supplies to international clients (other than Ukraine) are now delivered directly by Gazprom, rather than by shady middlemen as in the past. Overall, the company is "speeding up the move toward getting full market value for its gas in the former Soviet markets," says Anatoly Romanovsky, Hermitage's investment director.

Russian investors certainly agree--corporate Moscow is rolling in oil dividends, and a lot of those rubles have been pouring into Gazprom. The company's shares have risen from 51 cents to $8.44 since 2000, and spiked recently due in part to Russia-based investors' buying the stock in anticipation of the first broad sales to foreigners, says Pharos Russia Fund president Peter Halloran. Mainly, says Halloran, "everyone wants to be in energy stocks now." Gazprom stock is now available to foreigners through special American Depository Receipts issued by the Bank of New York, but will soon go on sale through St. Petersburg and ultimately on international exchanges such as London.

Not so long ago Gazprom seemed an unlikely candidate for foreign sales of any kind. Considered a Russian national treasure and strategic asset, it was defended by a "ring fence" of protectionist barriers, backed by the increasingly nationalist regime of President Putin (who reportedly aspires to lead Gazprom when he retires). Yet the ring fence was recently ripped down, out of necessity. Though Gazprom has begun to talk of charging market rates, less than a quarter of its gas is now sold at the market price of about $230 per thousand cubic meters. The rest is sold cheaply inside Russia and former Soviet republics, and Gazprom needs money. Simply to maintain current output, Gazprom officials say, they will need foreign investment of $173 billion to $203 billion over the next 15 years.

It's still not clear how much foreign money will be forthcoming. There are plenty of doubters. Roland Nash, chief strategist at Renaissance Capital in Moscow, says the market has priced in the "ring-fence removal," leaving Gazprom poised for a fall: "The company has a lot of issues, such as huge cost overheads which it has been unable to cut." Jerome Guillet, a banker who worked with Gazprom in the 1990s, says the deal with Ukraine "is obviously shady" because Ukraine will buy not from Gazprom but from RusUkrEnergo, the last in a line of shell companies that traded on the difference between low gas prices in the former Soviet Union and the higher European price. "What is obvious is that these deals are not driven by the best interests of Gazprom or of Russia, but by the interests of people in power in both" Russia and Ukraine, says Guillet.

Those doubts are mirrored by Western governments. European energy officials are rethinking their growing reliance on natural gas, and Russia as their gas supplier of choice. Many Europeans note that Putin, the 2006 chairman of the G8 group of industrialized nations, wants energy security to top this year's G8 agenda. But energy markets won't be more secure if Gazprom remains a political cudgel for the Kremlin. Gazprom officials complain that their embargo on Ukraine was misunderstood--all they wanted was a fair market price--but even investors who are buying the stock don't buy that argument. How can they, when Putin still calls the final shots?

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