Hoping For A Gusher

Gazprom's bosses expected to make headlines this month--not because of Russia's gas war with Ukraine, but because of a stock offer that could hail the emergence of a new leader in the world energy market. For the first time in the gas giant's 40-year history, Gazprom is allowing foreigners to buy a hefty 49 percent of its stock--possibly as early as the end of January on the St. Petersburg Stock Exchange. The move is to be the first step in a campaign to make Gazprom one of the world's great energy majors; in fact, CEO Alexei Miller expects Gazprom to be "the largest energy business in the world within five years." That may sound grandiose, but it's not impossible for a company with more assets than most major oil companies.

In other circumstances, the opportunity to buy into some of the world's largest and most undervalued oil and gas reserves would trigger a gusher of interest. Not so with Gazprom. The Ukraine fiasco exposed the company as, first and foremost, a tool for enforcing the Kremlin's will rather than a private enterprise. On New Year's Day, in an attempt to force Ukraine to pay full European prices--and, in no small part, to punish the country for its pro-Western Orange Revolution--Russia 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 allowed both sides to claim victory.

But Russia's reputation as a reliable energy partner was deeply shaken--and with it, Gazprom's long-term prospects of becoming Russia's first brand-name multinational in good global standing. U.S. Secretary of State Condoleezza Rice warned that if Moscow wants to be "a part of the international economy" it should "play by its rules." Potential investors, as well as potential customers, were worried. "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. Not the best atmosphere, then, to open Gazprom to world financial markets.

Too bad. Gazprom's been working hard to clean up its act since President Vladimir Putin's ally Miller took over in 2003. The company has "made great progress" in maximizing its revenues, according to Vadim Kleiner of Moscow-based Hermitage Capital Management, the biggest current foreign investor in Gazprom. Gas supplies to all international clients (other than Ukraine) are now delivered directly by Gazprom, rather than by shady middlemen as in the past. Miller has also launched legal challenges to regain gas fields lost by Gazprom in dodgy share dilutions between 1997 and 2001; so far, nearly three quarters of the lost assets have been recovered. The company is demonstrating that "it's speeding up the move toward getting full market value of its gas in the former Soviet Union markets. That's good news for investors," says Anatoly Romanovsky, Hermitage's investment director.

Gazprom's vast reserves are the key attraction for investors. Gazprom controls 16 percent of the world's known natural-gas reserves, and is the top global supplier of gas, as well as a top-20 oil company. Its market capitalization is just $1.3 million per billion barrels of proven reserves--by comparison, ExxonMobil's is more than $17 million--making it one of the cheapest energy stocks in the world. This is true even though Gazprom shares have risen from 51 cents to $7.90 in just five years, and 12 percent just in the last month, as Russia-based buyers snapped up the stock in anticipation of the first free share sales to foreigners.

As Russia's largest company, Gazprom was protected until recently by a "ring fence" of protectionist barriers and seemed unlikely to go on foreign sale under the increasingly nationalist regime of President Putin, who, rumor has it, aspires to lead Gazprom when he retires. But the ring fence was removed for a simple reason: gross inefficiency. For all its recent talk of charging full market rates, less than a quarter of Gazprom's production is actually sold at world prices--the rest is distributed cheaply inside Russia and to loyal states inside the former Soviet Union such as Belarus, which pays just $47 per thousand cubic meters. Simply to maintain infrastructure and keep up current production levels, says Gazprom's head of strategic development, the company will need foreign investments of between $173 and $203 billion over the next 15 years. It's not clear that money will be forthcoming. Roland Nash, chief strategist at Moscow-based Renaissance Capital, says the market has already 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."

Indeed, the Gazprom that emerges from last week's Ukraine tussle looks less like a new Russian oil major than a new arm of the post-Soviet kleptocracy. On the face of it, the Russian-Ukrainian deal was a victory for market logic, upping the price Ukraine pays for Russian gas to $230 per thousand cubic meters (though mixed with far cheaper gas from Turkmenistan, Ukraine will ultimately pay an average of $90 for its gas, about double what it paid last year). That's at least a step toward the European market. However, says Jerome Guillet, a banker who worked with Gazprom in the 1990s, "the deal is obviously shady," because Ukraine will buy not directly from Gazprom, but from a recently created firm, RosUkrEnergo, the latest in a line of shell companies that trade 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.

Persistent accusations of corruption are raising alarm bells among investors, and not only about Gazprom. Major London fund managers have begun calling for tighter regulations on foreign firms listing in the U.K. F & C's Litvack says that firms from Russia and other former Soviet republics are of particular concern because of lax governance standards and questionable motives. "For some, these listings seem to be a matter of gaining prestige, rather than money," says Litvack. "If a company really needs capital, then they'll be careful about the concerns of the shareholders," Gazprom now sells stock internationally only through special American Depository Receipts issued by the Bank of New York. But soon the shares themselves will be available to foreign buyers, first in St. Petersburg and ultimately on international exchanges such as London.

Even if Gazprom does, in time, improve its standing with investors, it has a new problem with governments. The Ukraine spat has inspired many European energy officials to rethink their rapidly growing reliance on natural gas as a clean and relatively cheap fuel--and on Russia as their natural-gas supplier of choice. Moscow's shut-down has given a new fillip to plans to build alternative pipelines from other suppliers, including Azerbaijan. Italian Industry Minister Claudio Scajola announced that "a nuclear option is back on the agenda," despite a post-Chernobyl national referendum rejecting nuclear power. Even Germany, which is already committed to Gazprom's new Baltic pipeline, is wary--"Gas supplies can only be increased if we know that deliveries from the east are dependable," warned Economy Minister Michael Glos.

It's a rich irony that Putin, who assumed the chairmanship of the G8 group of industrialized nations on January 1, wants energy security to top this year's G8 agenda. World energy markets will hardly be more secure if Russia continues to use Gazprom as a political weapon. And that tactic would squander the value of a national asset. The Ukraine embargo reminded investors of the risks in Russia, and that's likely to raise the discount they demand on Gazprom stock.