Letting Loose the Giant: Gazprom Remains at the Center of Reform and Deregulation Talk

Most outside observers have agreed that from its very formation Gazprom, the giant monopoly producer and distributor born out of the Soviet Gas Ministry in the early 1990s and owner of around one fifth of the world’s proven gas reserves, was in need of thorough reform.

This might seem paradoxical, since Gazprom is highly profitable, earning large amounts of hard currency from exporting gas to Europe, supplying a quarter of the continent’s homes and businesses. Moreover, this percentage is almost certain to increase in coming years as Europe’s oil reserves in the North Sea run out and the continent turns more and more to natural gas because of its better environmental properties compared to oil.

But Gazprom is burdened with heavy and increasing levels of debt, and suffers from rapidly rising operational and capital expenditure, all of which are eating into its profits. So, although gas prices are linked to oil prices, albeit with a lag, Gazprom has failed to benefit from the high crude prices in recent years.

And on the domestic front, Gazprom says it will lose over $1 billion this year on its operations in Russia, where gas prices are capped for social, political and economic reasons.

Besides, monopolies are an unfortunate part of reality that conflict with the theory of economic liberalism and competition and therefore, according to many of its critics, simply have to go. So, the case for change now looks stronger than ever.

The suggestion to allow the company to sell its gas within Russia, in most cases, at the world market rate that was put forward by Gazprom CEO Alexei Miller in March might therefore seem a logical step forward.

“We propose to use, beginning in 2006, market methods for fixing gas prices to industrial consumers and to retain regulated gas prices only for housing and utilities, budget-sector consumers and the population at large,” Miller said. “At the present time, natural gas is the only primary source of energy whose price is regulated by historical values, rather than by real supply and demand.”

The result is that, as Miller pointed out, under the current price system, “the gas sector has long subsidized almost all other sectors of the economy, including highly-profitable and export-oriented branches.”

Miller’s idea of deregulating prices might seem in line with the current Western orthodoxy of economic liberalism and thus likely to meet with approval among economists, especially after receiving the apparent backing of President Vladimir Putin.

In fact, his proposal provoked widespread opposition. If Miller gets his way, gas prices would, according to Gazprom, rise by 15 to 20 percent in 2006, even though the government has only sanctioned an increase of 11 percent in those sectors where it is responsible for approving price rises. In any event, higher prices would indeed hit the “export-oriented branches” Miller mentioned, such as aluminium, where energy accounts for some 90 percent of production costs due to the prodigious amounts of gas required to generate the very high temperatures needed for smelting. Industrial producers argue that these higher prices would inevitably reduce the competitiveness of Russia’s exports.

Economists also noted that inflation, which is already rising this year, would receive a further boost if industrial gas prices rise, which would, of course, then have knock-on effects throughout the whole economy, thus putting at risk the governments inflation and broader economic targets.

But many analysts are sceptical for other reasons about whether the proposed increase in gas prices can work. The EU and the United States have long since accorded Russia “market status,” but this was more for political reasons after Russia’s support following the Sept. 11 terrorist attacks on the United States, and does not reflect the true state of the Russian economy, which is dominated by huge companies and lacks the thriving small and medium-sized enterprises that form the backbone of Western, developed countries.

Gazprom, like Russian Railways and United Energy Systems (UES), the Russian electricity monopoly, is the successor of the Soviet or Russian ministry that used to run the industry, and these companies are dominant in their particular sectors, a situation that stands in marked contrast to the Russian oil majors which were separated from the ministry in the early 1990s.

So while observers and investors have long been criticizing the failure of Gazprom and the government, which holds a 38-percent stake in the company, to embrace real market reform, Gazprom remains a monopoly with almost total dominance of the Russian gas sector.

And it is this situation that explains the stance that has been taken by Economic Development and Trade Minister German Gref, whom the Russian daily newspaper Kommersant quoted as saying: “I view [the cancelling of the state laws on regulation] as positive, but this is possible only if there is no Gazprom monopoly.”

But this is where the difficulty lies. Such a scenario is unlikely in the foreseeable future, requiring as it would major structural reforms that in turn require tremendous political will. But, as with the broader strategy of Russia’s economic policy, there also appear to be divisions within the government on the issue of deregulation of gas prices. The business newspaper Vedomosti reported that Putin had told Prime Minister Mikhail Fradkov and Industry and Energy Minister Viktor Khristenko to prepare specific proposals on gas price deregulation, while the news agency Prime-Tass reported that a source within the presidential administration said there was no point in liberalizing prices for a natural monopoly – precisely because it was a natural monopoly.

In view of the various other issues facing Gazprom, the price of liberalization is arguably the least of the company’s worries. Ever since the Kremlin floated the idea of a Russian energy “supergiant” in 2004 that could compete with global majors, the idea of a linkup between Gazprom and the state-owned oil company Rosneft has been in the cards. But, in December 2004, Rosneft acquired Yuganskeneftegaz, the main production unit of beleaguered oil major Yukos, accounting for some 60 percent of its oil output. Judging by their actions since summer 2004, Group Menatep’s shareholders seem set on embroiling the Russian state in litigation abroad to redress what they see as the illegal expropriation of Yuganskneftegaz for as long as possible. However, Khristenko said recently that he sees no reason why the merger between the two companies should not be completed by summer, although it remains to be seen how this will work out.

Quite apart from the questions surrounding Yuganskneftegaz, the merger also raises, again, the issue of further reform at Gazprom, which is urgently needed to improve the company’s efficiency and bring down its costs. Most observers argue that the Russian economy would benefit from the increased competition that would result if production and transmission were separated into different legal entities, for instance.

If the merger between Gazprom and Rosneft goes through as planned, the Russian government’s current 38-percent stake in Gazprom would jump above the 50-percent mark. So, with the state holding a majority stake in a combined Gazprom-Rosneft company, the prospects for reform may be bleak in view of the government’s past failure to push through with market reforms at the gas giant.

One benefit of the merger, however, should be the final abolition of the so-called “ring-fence” that limits foreign ownership of Gazprom shares to 20 percent. The result of the ring fence is that the price for the ADRs and ASDs that are used to place them on foreign markets is significantly higher than their value on the Russian exchange, so foreign investors have been hoping for years that the ring-fence would go, something that Russian-based investment banks now expect to happen sometime this year.

Special to Russia Profile, an online and monthly print magazine dedicated to Russia and published jointly by RIA-Novosti and Independent Media, Moscow.

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