Russia's state owned energy giant OAO Gazprom (OGZPY), which holds the world's largest natural gas reserves, recently released its third quarter results in which its net income nearly doubled to $10.1 billion versus analysts' estimate of $9.6 billion while revenues increased by 18% to $37 billion. Gazprom will need to make serious changes to maintain this level of performance as there are shifts coming to the European gas market that seek to drag down prices and profits.
It wouldn't be hyperbole to say that Gazprom's performance is heavily dependent on foreign exchange issues. The outperformance, despite the 40% rise in operating costs to $28.64 billion, was because of foreign currency gains of $2.59 billion. In the same quarter last year, it incurred a foreign currency loss of $4.67 billion, a net positive $7.26 billion swing year-over-year. The ruble has been very volatile in the past year, going through a volatile but bearish period in Q4 2011 which was followed by a 17% devaluation in April 2012, but has recovered most of that move.
The Ruble's strength may have at least something to do with the nearly 100 tons of gold (GLD) the Russian Central Bank added to its reserves in 2012. Latest data has the Russian stash at just under 900 tons according to the data it has given the World Gold Council.
The year's total revenue may reach $150 billion while EBIT could touch $55 billion. Most of Gazprom's sales growth in FY Q3 came from oil, not natural gas. The company's CFO Andrey Kruglov has also said in the conference call that Gazprom ended up spending $4 billion more than its actual plan in 2012, which caused a significant increase in annual cap-ex spending now at $44 billion. I expect the price of Brent crude (BNO) to rise this year into Q2 where the markets will make the decision to embrace a new round of credit growth - fueling a new commodity price boom - or reverse and demand higher returns on invested capital than central bank interest rates would indicate, in which case strategic commodities like oil and natural gas will be range bound. Like oil, gold prices will be buoyed by worldwide quantitative easing measures and increasing demand. Either conditions - either a credit-fueled expansion or a slide into stagflation - will be beneficial for gold and with it the Ruble.
Markets Abhor a Monopoly
Gazprom holds the monopoly in the Russian natural gas export sector and is one of the key suppliers to the debt ridden continent of Europe which accounts for almost half of the company's total sales. Europe needs Russia as much as Russia needs Europe and it is an important relationship to consider as the currency wars play themselves out. The falling levels of demand in 2012 forced Gazprom to sell natural gas at discounts to some of its main customers. In the first six months of its fiscal year, Gazprom's gas shipments to Russia, former Soviet Union states and Europe all fell. During this period, European sales dropped by 10% while shipments to FSU dropped by an enormous 29%. Total European exports in the first nine months dipped by 8% to 138 billion cubic meters. On the other hand, average European gas prices have remained fairly flat from last year at $379 per thousand cubic meters.
But the real problems begin later in the year. Gazprom's supply contract terms with a number of clients are up for review in 2013. The Germany based Wingas GmbH and WIEH, French GDF Suez S.A (GDFZY.PK) and the Austrian Econgas have already asked for a renegotiation of their supply terms. This is coming at a time when, according to Fitch, European natural gas demand is anticipated to fall further in 2013. Kruglov has shied away from giving any predictions on the results of these negotiations. It would be prudent to assume a drop in price. The consensus could be for an 8% drop in negotiated terms for long-run contracts.
The litigation costs related to the European probe into price fixing and unfair competition from Gazprom in the Eastern and Central European markets will put another dent in the company's income statement. Put two and two together on this. How likely do you think it will be for Gazprom to play hardball in contract negotiations with litigation like this hanging over its head? What is one on the one hand can easily be extracted from the other. Meanwhile, Gazprom's strategy to shift its gas shipments from Ukraine to the Nord Stream pipeline is creating a cost blowout as the price of transferring gas from both locations - Ukraine and Nord Stream jumped by 20% in just the first half of 2012.
The Norwegian Threat
Adding to Gazprom's struggles is that Statoil (STO) has reported record levels of natural gas exports to Europe in 2012 - 107.6 billion cubic meters - which is creating serious pricing issues for Gazprom.
As Russia Today noted, "The Scandinavian rival has what Gazprom can't afford - lower prices." Like so many state monopolies the very threat of real competition renders them uncompetitive in the market. What it is facing in Europe is a kind of triple witching hour:
- Falling European demand coupled with falling wages and stagnant economy.
- Sincere competition from Statoil
- No pricing leverage in long-term contract negotiation
Gazprom's position as the only Russian exporter gas will have to come to an end at some point. Although Russia has "independent" gas producers with substantial reserves they can only sell the gas to local consumers or to Gazprom. The Russian administration seems to have realized this. Novatek, which is co-owned by Gennady Timchenko, an influential figure in Russia's power circles, has asked President Putin to grant his company an exception to Gazprom's legal monopoly which, in turn, is asking them to collaborate. It's an untenable situation that will eventually resolve in the opening up of the industry.
This may be an inflection point in Europe's history and with it Gazprom and Russia's. Lower real energy costs will help the Eurozone weather some its marginal economic problems. This is fundamentally different than what is happening in the U.S. where the shale boom has yet to have the domestic infrastructure built to take proper advantage of it. Whereas in Europe the opening up of the Russian gas market, hastened by Statoil and Norway's rise, will be felt immediately. Gazprom has noteworthy representation in PowerShares FTSE RAFI Emerging Markets ETF (PXI), 3.37% of AUM and the Market Vectors Russia ETF (RSX), 8.16% of AUM. Because of these troubles brewing for the Russian giant the more diversified PXH would make more sense for investors wanting exposure to what is sure to be a continued long-term bull market in energy commodities. But in the near to midterm Gazprom will be under pressure to make changes that will weigh heavily on earnings.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.