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August 30, 2005

Russia: Tightening The Screws With Gazprom

by Roman Kupchinsky

Recent reports that Gazprom is negotiating to purchase oligarch Roman Abramovich's 72 percent stake in the Russian oil company Sibneft have renewed speculation about the state's objectives at home and abroad.
Recent reports that Gazprom is negotiating to purchase oligarch Roman Abramovich's 72 percent stake in the Russian oil company Sibneft have renewed speculation about the state's objectives at home and abroad.

The news came amid reports that the state-controlled gas monopoly had successfully obtained a 3 percent stake in Sibneft on the open market, which could bolster the purchase by preventing a rival oil company from a obtaining a 25 percent-plus-one-share blocking stake.

Gazprom is reportedly trying to secure a $10 billion loan to purchase Sibneft, a trivial price for the Kremlin to pay in its apparent quest to convert Gazprom into a unified, vertically structured, gas and oil monopoly and to tighten the state's grip on Russian energy exports.

The "Dow Jones Newsletter" of 8 August described the deal as an unusual one: "For the first time in history, a company controlled by the government is going to hand over billions of dollars in cash to an oligarch [Abramovich] who paid a fraction of the true value for the asset in question, and who paid precious little in tax on the income it generated."

Sibneft is the fifth-largest private Russian oil company, with a market capitalization of $16.5 billion, according to "The Moscow Times." Yukos owns a 20 percent stake in Sibneft, leaving a 5 percent stake on the open market -- if Gazprom did indeed successfully garner 3 percent of Sibneft shares in open trading. Rosneft has expressed interest in obtaining Yukos's 20 percent Sibneft stake, which has been frozen, in payment for debts.

RIA-Novosti reported on 27 July that Sibneft owner Abramovich "appears keen to deliver Sibneft to Gazprom," adding that he stands to benefit from a significant pre-sale payoff.


Meanwhile, Ronald Smith, head of research at ING Group in Moscow, told the "International Herald Tribune" of 18 August that "[President Vladimir Putin seems to have blessed this deal.... Nothing this big can happen without Kremlin approval."

However, presidential spokesman Dmitrii Peskov denied that the state has any involvement in the deal, telling the newspaper that the "Kremlin's permission isn't necessary."

Despite the Kremlin's assurances, recent experience has shown that the Putin administration has played its hand to ensure that -- in the energy sector at least -- it gets what it wants, and that it is intent on consolidating Russian energy business into one state-owned energy powerhouse.

This is evidenced by the government's purchase in June of a 10.74 percent stake in Gazprom for which it paid $7.1 billion in order to secure a majority stake in the company. Other recent maneuvers by the state were the creation of a shell company, BaikalFinance, to gain control of Yukos assets, and the reported transfer of state funds to enable the wholly state-owned oil company Rosneft to buy Yuganskneftegaz.

Such moves, and Putin's apparent choice of Gazprom to be the nucleus of a state-controlled energy giant, is raising serious concerns among investors as to the president's agenda.

Breaking Out Of The CIS
Russia is intent on expanding into Europe's increasingly more liberal energy markets, and obviously depends on Gazprom -- the only Russian company that exports gas to countries outside the CIS -- to lead the way in obtaining direct access to European consumers.

On 7 October 2004 the "International Herald Tribune" reported that since the incorporation of Gazprom as an open-share company in 1993, the company has pursued a policy of expansion by actively buying shares in foreign gas- and energy-transportation related companies in Europe, where its exports grew 11 percent in the first seven months of 2005.

Germany, the largest importer of Russian gas, has emerged as the prime target for Gazprom purchases. By the end of 2001, Gazprom owned 35 percent of Wingas, 50 percent of Wintershall Erdgas, 49 percent of Ditgaz, 100 percent of Zarubezgas Erdgashandel, and 5.3 percent of Verbundnetz Gas., according to the "International Herald Tribune."

The Russian gas monopoly is also making a strong overtures in Italy. During a meeting in Sochi on 29 August, President Putin asked Italian Prime Minister Silvio Berlusconi to allow Gazprom to invest more heavily in his country, saying: "It is in our interest that our companies, including Gazprom, be allowed to invest extra money in Italy's energy sector, including in gas-distribution network," RIA-Novosti reported.

Gazprom also owns up to 50 percent of the shares of gas companies in Poland, France, Hungary, Slovakia, Greece, and Bulgaria. The "International Herald Tribune" estimated the cost of these worldwide investments at $2.6 billion.

While it is not unusual for major oil and gas companies to own shares in other such companies around the world, the difference lies in the fact that the notoriously nontransparent Gazprom is now controlled by the Russian state which, in the past, has often used Gazprom as a lever for its foreign-policy goals in the CIS.

This reputation has apparently preceded Russia in Germany, leading Putin to respond on 29 August to allegations in the Russian media that the timing of the signing of a major pipeline deal between a Russian-German consortium is intended to boost Chancellor Gerhard Schroeder's reelection chances, RIA-Novosti reported.

The signing of an agreement on the construction of the Northern European pipeline -- which will run 1,200 kilometers along the floor of the Baltic Sea and 1,000 kilometers overland to connect the German city of Greifswald to Russia's Vyborg -- was originally planned for October. However, the date of the ceremony has been moved up to a take place during Putin and Schroeder's summit in Berlin in early September -- just ahead of Germany's 18 September parliamentary elections.

Putin denied that the Russian government has any intention of interfering in Germany's domestic situation, or that his trip is designed to help Schroeder, saying: "If you keep turning [your head] [to hear] what other people say, you may end up headless."

Shadow Foreign Affairs/Defense Ministry?
With global oil and gas prices showing no signs of abating, the temptation to use energy as a political weapon will no doubt increasingly cross the minds of Russian leaders.

CIS member states are well familiar with the powerful influence Russia can have on their domestic political situations by threatening or implementing gas cutoffs and price hikes.

Foreign Minister Sergei Lavrov provided the most recent example of such machinations when -- in commenting on an unidentified senior Kremlin official's reported statement that Russia plans to punish Western-leaning states by halting the provision of discounted gas and oil -- he said Russia will "abandon its tacit agreements with its neighbors in favor of relations based on international standards," "The Moscow Times" reported on 24 August. The move was viewed by the daily as an "apparent attempt to prevent more former Soviet republics from slipping from Russia's orbit of influence."

The newspaper further quoted the unidentified official as saying that among the topics Russia planned to address at the recent CIS summit in Kazan would be that "Russia will not tolerate an arrangement in which it does not receive economic nor political benefits for selling oil and gas at a discount."

Considering Putin's criticism of Gazprom last year for selling gas to its Western European partners at one-third of retail prices, is there any reason believe Russia won't also use Gazprom as a means of implementing its foreign policy outside the CIS?

Speaking to German Chancellor Schroeder in October 2003, President Putin made clear the special role Gazprom plays in Russia's relations with the European Union as its borders approached Russia's. "We intend to retain state control over the gas-transportation system and over Gazprom," Putin said. "We are not going to divide Gazprom. The European Commission had better forget about its illusions. As far as the gas is concerned, they will have to deal with the Russian state," "Novaya gazeta" quoted him as saying in October 2003.

The construction of the Northern European pipeline is one example a project taken on by Gazprom solely for political purposes," according to "Stratfor Commentary" on 24 August. Stratfor described the pipeline as a "white elephant" that is being constructed purely in order to bypass the present trunk gas pipeline that transits Ukraine on the way to Europe.

Stratfor's analysts believe that Russian policy makers prefer to cut out all intermediaries in the transport corridor of Russian gas to Germany and thus have the benefit of dealing directly with the Germans. The fear is that sooner or later, Gazprom will tell Germany what they are telling Ukraine and others -- "we want the political benefits from this deal."

The costs of the Northern European pipeline project are said to range from $2 billion to $12 billion and will have to be borne by Gazprom alone. "The Baltic line is not about money; it is about strategic alignment -- and with some help from the government, Gazprom is going to find itself with the cash to build it.... Ultimately, the Russian government sees Gazprom as not just a cash cow, but a tool of foreign policy," "Stratfor Commentary" wrote.

Image Problem
A report released in June by the Moscow-based Hermitage Capital Management describes Gazprom's opaque financial practices and makes serious charges of mismanagement on the part of the company's CEO, Aleksei Miller, and his management team, which many Kremlin watchers believe is very closely allied to Putin.

The report, titled "How Should Gazprom Be Managed In Russia's National Interests And The Interests Of Its Shareholders?" was written by analyst Vadim Kleiner. It alleges that Gazprom has been mismanaged for more than a decade, has engaged in dubious practices, and that enormous amounts of money are unaccounted for and have been misspent. "Gazprom's debt burden has made it the most leveraged company in the Russian oil and gas sector," the report adds.

As an example of Gazprom's cost inefficient practices, Kleiner cites Gazprom's reported plans to spend over $9 billion on the 2,700-kilometer North Tyumen-Torzhok gas pipeline. At an estimated $3.3 million per kilometer, the question arises as to whether such a cost is reasonable -- and Kleiner himself provides the answer. "It would appear not!" he writes. "The cost per kilometer is 3.4 times the cost of building a similar pipeline in the rest of the world, including the U.S."

Kleiner further makes a comparison of the costs incurred by Gazprom and Botas, the Turkish state construction company, in jointly constructing the Blue Stream gas pipeline under the Black Sea. Gazprom spent $2.95 million per kilometer for construction costs, while Botas only spent $1.35 million per kilometer. "Although very modest compared to Russia," Kleiner states, "the Turkish government was outraged by the high costs its company incurred" and sentenced the head of the company and four of his accomplices to prison on charges of graft in May 2004.

The report attributes some of the dramatic costs incurred from Gazprom construction projects to the use of unknown middlemen in the purchase of such items as large-diameter pipes.

Beginning in November 2002, three firms of unknown origin were registered in Russia to act as middlemen for the purchase of Ukrainian pipes for Gazprom. These firms increased the price charged to Gazprom by 35 percent, although the price charged by Ukrainian pipe manufacturers had only increased by 1 percent, according to the Hermitage report.

The report also describes the use of the Switzerland-registered company RosUkrEnergo, which was set up as an intermediary between Gazprom and the Ukrainian state oil and gas company Naftohaz, in the alleged sale of Turkmen gas to Ukraine. Kleiner claims that RosUkrEnergo earns a profit of $478 million annually for what he sees as its unjustified and murky role.

For unknown reasons, the Kremlin has apparently decided to turn a blind eye to these activities. They have have never been investigated by the Russian Prosecutor-General's Office, although they appear to be bleeding Gazprom and the Russian state of needed capital.

When seen in this light, Gazprom's -- and thus the state's -- possible control of Sibneft, which in 2004 produced nearly 39 million tons of crude, could prove to be a very significant move to consolidate power in the hands of Putin's closest associates. And while the deal is contingent on financing from Western banks, Russia is not having any difficulties in finding willing institutions -- both ABN-AMRO and Dresdner Kleinwort Wasserstein are reportedly involved in negotiations to provide a loan to Gazprom for the purchase.

This scenario leads some observers to hope that Lenin's saying, "We shall hang the capitalists with the rope they sell us," will not apply in this case.
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