Gazprom has more to worry about than just Western sanctions and lower oil prices – there’s also an influx of new domestic competitors, the threat of an LNG revolution in Europe and continued concerns about the payoff from the company’s Asian pivot.

The head of Russia's largest oil company Rosneft, Igor Sechin (left), and the head of Russia's state-controlled gas company Gazprom, Alexei Miller (right), during a ceremony of the Nord Stream gas pipeline in Portovaya Bay in 2011. Photo: AP / TASS

As a sign of shifting trends in global oil and gas markets, Gazprom, the state-run energy giant, recently lost its status as Russia’s most valuable company in terms of market capitalization. That distinction now belongs to Rosneft, Russia’s largest oil producer.

In early trading on Apr. 11, Rosneft shares rose 4.8 percent in London, boosting the value of Russia’s largest oil producer to $52 billion. Gazprom gained 0.3 percent, raising its market capitalization to $51 billion. The market capitalization of Rosneft is now higher than that of Gazprom for the first time since Gazprom’s shares began trading in 2006.

Indeed, Gazprom has been under considerable stress lately. Its export revenues fell by 23 percent in 2015 due to volume reduction and currency volatility. Cash flow has turned negative as natural gas prices in Europe remain below $200 per 1,000 cubic meters and access to international finance markets has been limited by U.S. sanctions that were introduced in September 2014.

Faced with the vigorous growth of domestic competitors and a myriad of external challenges, Gazprom’s prospects and the health of its wide-ranging strategic ambitions are increasingly being called into question.

Also read Russia Direct Report: "Russian Energy Sector: Beyond Sanctions"

Challenge #1: Domestic competition

Gazprom’s gas production reached a record low of 418.47 billion cubic meters (bcm) – roughly 65 percent of aggregate Russian production – in 2015, with the first months of 2016 signaling a continuation of its production decline.

However, in no way does this trend represent a downgrade of Gazprom’s production capabilities, as its spare capacity hovers around 150 bcm per year and might even grow in the upcoming decade.

Rather, the problem lies in the complex and multi-layered challenges emanating from the current state of the European and global gas markets, as well as from slowing domestic consumption in Russia.

Current economic hardships notwithstanding, production plant modernizations and the adoption of energy-efficient technologies have paved the way to lower gas consumption per unit.

Gazprom’s domestic market share is under considerable pressure, as it has seen a steady annual decline of 2 percent between 2008 and 2015 (from 82.2 percent in 2008 to 65 percent in 2015) against the background of other producers’ expansion. These alternative producers currently account for 35 percent of the aggregate production.

NOVATEK, Russia’s largest independent natural gas producer, leads the pack with an annual production of 51.9 bcm, predominantly from the Yamalo-Nenets Autonomous District in Siberia. Other gas producers include Rosneft (42.3 bcm in 2015), LUKOIL (18.8 bcm in 2015), Gazprom Neft (12.5 bcm in 2015) and Surgutneftegaz (9.6 bcm in 2015).

Since only Gazprom has the legal right to export natural gas by pipeline, these companies had to wrest away domestic market share within Russia, taking advantage of the peculiarities of Russian regulations, namely Gazprom’s inability to sell gas at a discount. As a consequence, these gas producers managed to lure away a plethora of attractive clients, while Gazprom is, in many cases, forced to deal with the least profitable sectors of the economy.

Challenge #2: LNG revolution

Apart from domestic concerns, numerous external challenges lie ahead for Gazprom.

The new liquefied natural gas (LNG) revolution might upset Gazprom’s plans, too. According to the International Energy Agency (IEA), LNG export capacities will grow 40 percent worldwide by 2020, driven mostly by Australia and the United States.

Regular U.S. exports to Europe will not materialize until 2018, when most of the new capacities were scheduled to be put into operation.

In the same manner that Saudi Arabia’s exports have been threatened by a powerful shale revolution in the United States, Russia’s gas market share in Europe might be jeopardized by U.S. LNG imports, all the more so given the current fraught political atmosphere between Russia and the West.

However, the net back costs of Russian gas are significantly lower than those of American or Australian LNG. According to IHS, a consultancy company headquartered in Colorado, U.S., Gazprom’s costs of production, including export taxes and transit tariffs, are still lower than $100 per 1,000 cubic meters. With the help of preferential tax rates this might be brought even lower.

Thus, in theory the emergence of overseas LNG should prompt Russia to attempt to block it from gaining share in the European market by lowering prices, thus rendering rival production economically impractical.

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Challenge #3: Western sanctions and low oil prices

Sanctions continue to complicate matters for Gazprom, effectively blocking it from the U.S. credit market and placing strict limits on its acquisitions of offshore, deep-water and unconventional shale gas technologies.

Although it was oil production that had been put under sanctions by the U.S. government, the overall ban on export of goods, services and technology is applied to Gazprom, too, since most gas fields contain some form of oil or condensate.

For instance, Washington has specifically targeted the Yuzhno-Kirinskoye gas field, earmarked for the Sakhalin-3 project, alleging it also has oil resources.

As most of Russia’s large banks remain barred from long-term dollar-denominated credit lending, Gazprom must look for financing elsewhere. Luckily, Chinese banks are stepping in to fill the void created by Western banks.  

However, the impact of low oil prices dwarfs that of Western sanctions, to the extent that Gazprom has demonstrated a 1 billion-ruble loss in the third quarter of 2015 (around $15 million at current exchange rate).

Although Gazprom has enough reserves to keep the company’s operations safe and sound for at least three more years, it is the oil price and the Russian currency rate that will ultimately shape its market behavior.

Russian President Vladimir Putin, left, speaks to Russia's natural gas giant Gazprom's CEO Alexei Miller after their talks with British Prime Minister David Cameron at the G-20 Summit in Antalya, Turkey, Nov. 16, 2015. Photo: AP
New opportunities for Gazprom within Europe

Despite these challenges, Gazprom has a chance to capitalize on full-fledged resource depletion in European countries.

For example, Norway, one of EU’s traditional gas suppliers, saw its gas output and exports peak in 2015. Its export volumes are likely to drop to 105-110 bcm per year in the next five years, followed by a precipitous fall to half its current level in the following decade.

The Netherlands, home to the Slochteren gas field, the largest natural gas field in Europe, is confronted with an even steeper decline in output. Its production, currently at 27 bcm per year (a third of its output compared to its peak in the 1970s), will be gradually phased out in the next two decades in the face of thorough reservoir depletion.

The Dutch gas grid operator Gasunie is already building a conversion facility to process Russian and Norwegian gas in order to safeguard the country’s transition from domestic production to exports. British gas production peaked in 2000 and will struggle to reach double-digit bcm levels in the long term.

The inevitable nature of an increasing reliance on gas imports constitutes the underlying rationale behind the European Commission’s drive against Gazprom. It is control over prices and markets, not an ultimate shutting down of the Russian monopoly, that appears to be the quintessential aim of the EU’s anti-trust probe into Gazprom’s alleged abuse of dominance in Central and Eastern European countries.

Russia exported 159 bcm of natural gas to Europe in 2015 and, despite political tensions, is expected to continue supplying 150-160 bcm annually through 2020.

Annual volumes might be contingent on climate conditions: for example, the winter season in 2015 turned out to be the mildest since records began, pulling down the continent’s gas needs.

Gazprom’s numerous European pipeline projects are dependent on the political will on both sides. To date, it seems only the pipeline project Nord Stream 2 has backing solid enough to withstand the ire of the European Commission, acting on behalf of Central and Eastern European countries loath to see their transit income brought to naught.

Turkish Stream, once deemed the most likely to be realized, will not materialize as long as Turkish President Recep Tayyip Erdogan remains in power.

Ukraine remains the largest impediment to the smoothing of relations between Gazprom and the European Union. The Russian monopoly’s plan to reduce Ukrainian transit to a minimum by 2019 as a result of a long-standing gas price dispute and Kiev’s regular payment arrears have led to an unprecedented freeze between Gazprom and Naftogaz, the Ukrainian state-run gas company.

Since it was Ukrainian Prime Minister Arseniy Yatsenyuk government’s decision to avoid Russian gas imports as long as it is possible, combined with a 50 percent transit fee increase for 2016, Gazprom might find it easier to push forward the Nord Stream 2 agenda.

The pivot to Asia

Considering the abovementioned factors, a certain normalization of relations with Europe, even at the cost of concessions, might be valuable to Gazprom as its much-debated pivot to Asia looks increasingly risky.

Gazprom’s 30-year contract with the China National Petroleum Corporation (CNPC), stipulating an annual gas supply of 38 bcm, remains the biggest contract in the company’s history, representing a huge step towards cementing its share in what is currently the most attractive gas market.

However, the $55 billion deal comes with an oil price linkage that might render production economically questionable in the current conditions. Gazprom has been in talks to conclude an additional deal that would see it supply Western Siberian gas to China, so further deliberations will be necessary to revalidate the oil price link.

Eventually, keeping in mind that a slow yet firm increase in oil prices is inevitable, Gazprom might stick to its traditional pricing scheme, all the more so that it is not until 2019 that the Power of Siberia pipeline will be launched.

As China is bound to become the world’s leading gas consumer by 2040, Gazprom’s Asian pivot makes economic sense. According to IEA estimates, global gas demand will increase to 5.1 trillion cubic meters, leaving plenty of market opportunities for Gazprom, the spare production capacity of which will likely rise even further to 200 bcm per year in the next decade.

The three main factors in Gazprom’s long-term development strategy – secure at least a 30 percent European market share, stave off a LNG revolution by lowering prices, consolidate its positions in Asia – are not antithetical and, given a certain degree of flexibility and responsiveness, remain completely feasible.

The opinion of the author may not necessarily reflect the position of Russia Direct or its staff.