Gazprom: Look Beyond Its Recent Woes And You May Find Great Opportunity

Jun.25.13 | About: PJSC Gazprom (OGZPY)

Gazprom's (OTCPK:OGZPY) problems seem to keep on coming. It is seeing demand for its natural gas to Europe decline and its market share fall. Earnings per share (EPS) have fallen by 37% for 2012; and the dividend has been cut by 33%. Western European importers of natural gas are renegotiating their long-term contracts with are indexed, perhaps "unfairly", to oil prices. Increasing LNG supply from Australia, East Africa and the West Coast of the U.S. is expected to harm Gazprom's ambitions to expand into the Asia-Pacific Region. Furthermore, the European Union (EU) is investigating Gazprom for hindering competition and its unfair business practices, which could affect force the company to divest its electricity production assets within the EU.

Gazprom and the natural gas market outlook

Gazprom is truly an enormous company: it was created in 1989 to control all gas assets in Russia formerly owned by the old Soviet Ministry of Gas, and today it employs over 390,000 people. Gazprom is the largest producer of natural gas in the world; with a share of 14% of global production, and 18% of the world's natural gas reserves. It holds a monopoly over all exports of natural gas from Russia; and operates a huge gas transportation and storage network. Furthermore, we must not forget about that Gazprom also operates an oil company. With such tremendous scale over production, significant vertical integration and a monopoly over exports, Gazprom had made enormous profits over the past decade. However, with the shares price over five years having fallen by 68%, Gazprom's shareholders will certainly be disappointed.

The outlook for Gazprom's future has certainly become gloomier for its exports of gas to the rest of Europe; with demand falling, renegotiation over lower gas prices on long-term contracts, and increasing production from Norway. This has been caused by decreasing industrial production in Europe, increasing supply of natural gas, the increasing economic advantage of using coal, and higher renewable energy capacity. Despite Gazprom's huge reserves of natural gas, Gazprom has failed to increase production of gas.

With massive profits flowing in from a decade of increasing demand in Europe, and rising commodity prices up to 2008, Gazprom's management had been lured into a sense of misguided reassurance that the good times will never end. As a result, it had let its operations become more and more inefficient, and made poor investment decisions. It believed the "shale revolution" was a myth, which led Gazprom to pursue the project in the Barents Sea to supply the U.S. market with gas - they have finally shelved that idea, at considerable expense. Despite a huge resource base and significant capital expenditure and investments, totaling $6 billion in 2012 alone, production of hydrocarbons is 3% lower in 2012 than a decade ago. Now, Gazprom has to realize this mistake and its management needs to cut costs and take a more prudent approach to making sound investment decisions.

Russian government is both its best friend and worst enemy

Gazprom and the Russian government often appear to share an unusual symbiotic relationship. Both rely on each other for survival in a mutualistic relationship but that does not prevent them from making decisions in their self interest. Gazprom is majority owned by the government and the government has shown a protective attitude to its business interests, such as granting Gazprom the legal status as a gas export monopoly in 2006 and through political interference with foreign governments' investigations into Gazprom's anti-competitive practices. In turn, Gazprom's 25% market share of Europe's gas supply gives the government significant political leverage over European nations, especially those former Soviet Union members. Furthermore, Gazprom's huge profits over the past decade have made a significant contribution to the government's public finances through the payments of dividends to its majority shareholder.

This does not mean that the Russian government had acted completely within Gazprom's business interests. Because of political interference, Gazprom has focused on expanding its market share in Europe where demand has been slowing and prices are beginning to ease. Gazprom had thus squandered the opportunity to more towards Asia where there is far greater opportunity. It had failed to reinvest its profits into developing new fields in the east and expand into the Asian market. Asia is gas poor and so the cost of gas in Asia is significantly higher than in Europe -- even more so than in the U.S.

Gazprom's profitability is in the government's interest. It is the majority shareholder and receives the bulk of its dividend for its public finances. This does not mean, however, that it has not acted against Gazprom's business interests. It has increased the mineral extraction tax (MET), which has already affected Gazprom's profitability. The MET hike directly benefits public finances but economic "rents" on gas have been typically higher than oil. Gazprom suffers from massive corruption and has engaged in plenty of projects of questionable value, such as extracting gas from Shtokman and possibly South Stream (another gas pipeline to Western Europe).

Gazprom's monopoly over exports of gas may soon come to an end. Novatek (OTC:NOVKY), a Russian gas company, and Rosneft (OTC:RNFTF), a majority state-owned oil company, plans to build LNG plants in the Russian Far East to supply Asian consumers, including Japan, South Korea, and China. The Russian government is likely to grant them licenses to export LNG, effectively ending Gazprom's legal monopoly over all natural gas exports. Gazprom is however likely to maintain its monopoly over exports of natural gas over pipelines, which means that its pricing power in Europe could be maintained as Europe's imports of gas from Russia come primarily from pipelines. But this means that Gazprom cannot exploit this advantage in Asia. However, this does not mean that Gazprom does not have plenty of opportunities in Asia and in particular, China.

Look to the East

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Source: Annual Report 2012

Asia is gas poor and thus North-East Asian importers have been paying about a one-third premium more than their European counterparts. The economies there are growing more strongly and the outlook for natural gas is promising. China, in particular, is looking to increase its share of natural gas in electricity generation to reduce air pollution, and together with increasing energy demand and China's geographic proximity, Gazprom has a significant opportunity to offset falling demand in Europe with strong demand and higher prices in Asia. It intends to expand into this region by developing production in Eastern Siberia and the Yamal Peninsula and start supplying LNG from Vladivostok by 2018.

Russia's geographic proximity to key demand market in Asia, including Japan, South Korea, and China, offers Gazprom a competitive advantage over the competing supply of LNG coming from the Middle East and Australia. These markets have huge potential, and these economies are going to continue to demand huge imports of gas and oil. Gazprom expects to conclude a deal by the end of this year to supply China via the construction of a gas pipeline with the capacity of carrying 2.9 bcf a day. Understanding this and together with an increasingly cloudy outlook over Europe's gas needs, Gazprom is looking to expand its operations in Asia.

Diversifying exports of natural gas to both Europe and Asia would reduce Gazprom's susceptibility to changing regional factors affecting demand for natural gas and offer greater stability to Gazprom's profitability. Pessimists claim that the Russian government would seek to expand its political influence over Europe by "forcing" Gazprom to expand its market share in Europe at whatever cost to Gazprom. But this may not turn out to be correct. After all, Russia's influence is decreasing despite its intentions and a weaker Gazprom would not serve its influence well. Russia would not squander the opportunity to expand its influence in the Asia-Pacific region and seek closer ties with countries such as China, Japan and South Korea. China and South Korea are potentially going to become more politically relevant globally as their economies continue to grow significantly. Closer ties with Asia would in turn expand Russia's influence over Europe and a stronger Gazprom would be in Russia's interest in maintaining global political strength. Would Russia really decide to "kill its golden goose"?

Conclusion

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OGZPY data by YCharts

The outlook on the natural gas industry despite developments in the horizontal drilling and hydraulic fracturing (fracking), remains promising. Gas is a significantly cleaner fuel than coal or oil and increasing the composition of natural gas in power generation is the most realistic method of reducing greenhouse gas emissions. With increasing supply of exports of gas to Asia, and Gazprom's enormous resource base, there is plenty of potential for Gazprom to expand its share of the global gas market. With the recent profit fall serving as a wake-up call for Gazprom's management, Gazprom may finally realize that it must operate efficiently and move to refocus its attention towards growth opportunities in Asia. Trading at a P/E of 4.59 and at less than a third of net assets; Gazprom's potential appears to be grossly undervalued.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.