- Gazprom's earnings were operationally very strong.
- Pipeline projects have survived most political risks.
- Gazprom's future is very bright as major projects will not hit the balance sheet until 2019.
- The ruble exchange rate is the biggest short-term risk for U.S. investors.
The political risk surrounding Gazprom (OTCPK:OGZPY) has always been high. But it's never been higher than it is right now. With three major pipeline projects in various stages of completion, the company is at its most vulnerable to changes in the political landscape.
This vulnerability is reflected in the firm's year-end earnings report where, in broad strokes, revenue, gas deliveries, oil production, and gross margins were up, and bottom-line profit was down.
The main reasons for this were the Stockholm arbitration award to Naftogaz that, while still under dispute, has to be reflected on the earnings report and squaring of capex allocations versus deployment. Gazprom, according to the earnings call, under-deployed its 2016 capex budget and spent it in 2017, thereby shifting numbers around on the earnings report.
Net debt rose by nearly $7.5 billion, mostly associated with the financing deal for Nord Stream 2. The board recommended holding the annual dividend payout the same as last year at RUB8.04 per share, which translates to a 5.6% yield at a current price of RUB144 per share.
And, that is the major part of the story with the company. There are three major growth drivers for the company under construction that will not begin adding to the top or bottom line until 2019 and that is what makes this report, in effect, unremarkable.
So, how has this company beaten the odds? Simple. It has successfully navigated the geopolitical and legal challenges to two of its major growth vectors into the European gas market, reducing the probability of these projects not becoming reality in the near future.
Nord Stream 2 was just granted the last of the environmental permits necessary to begin construction from Finland. Gazprom also just announced that the first deepwater train to Turkey for the Turkstream pipeline was completed on time. Each of 2 trains will provide 15.75 bcm of natural gas. The first, and the one just completed, is for the Turkish market. The second is for the Southern European market.
That pipeline is still a potential political football. The gas is demanded by countries such as Greece, Bulgaria, and Hungary, but the European Commission is under tremendous pressure by the U.S. to not approve it for 'energy security' reasons.
Nord Stream 2 is a similar problem for the U.S. The roadblocks put up in front of it have been legion.
Poland's opposition forced the current deal structure where Gazprom had to borrow the money that would have been put into the project by its partners - Wintershall, Engie, OMV, Royal Dutch Shell (RDS.A), and Uniper (OTCPK:UNPRF) - as part of a joint venture.
The European Commission even went so far as to try and extend EU energy market rules to offshore projects. This was shot down by the courts earlier this year. After that, European Council President Donald Tusk of Poland simply wanted to change the rules to effectively outlaw Nord Stream 2 by applying rules, The Third Gas Package, which forbids wholly-owned foreign companies from providing gas to the European Union. These rules were adopted and applied to South Stream back in 2014 which ended that project, costing Gazprom millions.
The ending of South Stream gave rise to the current Turkstream project where much of the initial engineering work was salvaged, re-routing the destination from Bulgaria to Turkey.
Nord Stream 2 is wholly owned by Gazprom, created out of necessity by Poland's original nixing of the Nord Stream 2 Joint Venture with the five companies listed above, which was designed to satisfy the Third Gas Package rules it didn't, in the end, need to comply with.
The Way Forward
Where things stand for Gazprom today are fraught with obstacles, but most of the difficult ones have been overcome. Nord Stream 2 will happen. The first train of Turkstream is done and will begin generating revenue soon. Power of Siberia, the first in a potential series of pipelines to China is more than 75% complete and ahead of schedule.
It is still on course for a Q4 2019 opening, along with Nord Stream 2.
China and Russia continue to talk about Power of Siberia 2 which would bring gas in from the = Altai pipeline which could be extended to China's western border with Russia. Reports in February of the unreliability of gas shipments from Uzbekistan and Turkmenistan, I felt, played into this negotiation.
A report noted some frustration from China over the irregular liquefied natural gas (LNG) supplies coming from its contract partners in Uzbekistan and Turkmenistan.
It seems the Turkemi and Uzbek governments are shaking down China for better prices because gas demand in Western China's autonomous regions is growing rapidly. Complicating matters is the tough winter in Europe which spiked LNG demand there as well.
So, expect Power of Siberia 2 talks to become more concrete in the coming months as winter continues to stretch into May. Reports of it affecting Russia's wheat crop this year support this thesis.
The big question hanging over Gazprom right now is U.S. belligerence to Russia and the latest round of sanctions that has caused upheaval in the Russian corporate and sovereign bond markets. These current projects are funded as long as the company has adequate access to working capital to get them completed.
Power of Siberia and Turkstream won't have any issues as they are both being built by Russian crews likely paid in rubles through Russian banks.
The bigger questions arise over Nord Stream. The final hurdle Nord Stream 2 faces is a complete shutout of Russian companies from the European banking system. This has already been hinted at by U.K. Prime Minister Theresa May.
What investors need to take from this is that Nord Stream 2 is a litmus test for U.S. political power in Europe. To this point, it has always gotten its way in the quest to limit Russian expansion of its energy business into Europe. Failure to stop Nord Stream 2 will be a watershed event politically.
The amount of political capital expended thus far to stop it has been enormous. For that to fail would make it difficult to stop the second train of the Turkstream pipeline. Looking ahead, as Russian Prime Minister Dmitri Medvedev, suggested this week, Europe will need Nord Stream 3 if output from the Netherlands and the North Sea keep falling.
Gazprom's reserves are strong, rising 1.2% in barrels of oil equivalent in 2017. Its balance sheet is as well. Debt to EBITDA is just 1.4 and debt to equity just 0.27. It is uniquely positioned, regardless of Europe to be the primary supplier of gas and electricity to a central Asia as China's Belt and Road Initiative moves forward.
For U.S. investors the biggest concern, however, is the USD/RUB exchange rate. The new sanctions policy is creating havoc in the bond markets as sellers have dried up due to pending compliance rules.
The U.S dollar (UUP) has finally bottomed and is moving higher. But, since Gazprom has very little U.S. dollar denominated debt, the dollar exchange rate is mostly irrelevant to its operations. Investors' returns, however, are tied to the exchange rate.
Where there has been weakness in the firm's economic model is its reliance on issuing euro-denominated debt. Specifically, the Nord Stream 2 loans were all made in euros. And, today, the euro is 5% higher than it was when those deals closed.
The floating Ruble insulates the company from any operational worries, and a weaker euro makes servicing its euro-debt easier. If we've reached a cycle low in the dollar and a concomitant high in the euro, which April's closing prices suggest, then Gazprom's 2018 earnings will get a foreign-exchange tailwind versus 2017's.
As a U.S. investor, I would continue to keep Gazprom on my radar for a potential spike bottom in price based on current foreign exchange weakness and then buy with both fists for the long term. It would not be untoward to see the price of the ADR pull back towards $4.25 as we approach the May 7th deadline for divestiture of Russian bonds per new sanctions policy and, with it, a spike in the USD/RUB exchange rate.
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