Russia's power broker

The largest gas producer in the world, Gazprom is something of a sleeping giant, but it is on the point of waking up to its huge potential. When the Russian state-controlled gas company Gazprom decided to cut supplies to Ukraine on New Year's Day, it did so with the maximum amount of fanfare. The technicians turning down the flow of gas at a compressor station near the border were filmed in the act and the pictures transmitted live by, among others, the national broadcaster NTV.

by Dominic Midgley

We can be sure that Gazprom executives will have had very little trouble persuading the television executives to run with the story. Why? Because NTV is one of the gas giant's many subsidiaries. This is a neat illustration of Gazprom's role as geopolitical power broker: sparking a global energy crisis and simultaneously giving it the oxygen of publicity.

When the UK privatised its state-owned gas company, British Gas, in the 1990s, the technocratic incumbent Cedric Brown stayed in his post. In Russia, however, a familiarity with the corridors of power is more important than a working knowledge of flow stations and pipeline costs per km. And so the chairman of the board, Dmitri Medvedev, fulfils that role in addition to acting as Russia's first deputy prime minister, and the chief executive, Alexei Miller, owes his position not so much to a couple of years working in the energy sector, but his status as a trusted protege of President Vladimir Putin.

Although Miller may run Gazprom on a day-to-day basis, no one is in any doubt about who wields the real power. "Generally, in the Russian government, no one makes policy apart from Putin," says Bill Browder, chief executive of Moscow-based Hermitage Capital Management, which has $4 billion of Russian funds under management, including a significant stake in Gazprom.

"Medvedev is a trusted implementer of his policies, but Putin makes all the decisions."

To understand why the head of state of a superpower should want to take such a hands-on role in the administration of a utility in which the state holds a majority stake, it is important to appreciate just how substantial a national asset Gazprom is. The company that produced 547 billion cubic metres (bcm) of gas last year, employs 330,000 people and accounts for about 8% of Russia's GDP. Apart from owning 60% of the country's gas reserves, it produces a fifth of the world's gas and accounted for a quarter of Europe's supplies in 2004.

Prospects for growth are so good that Gazprom's deputy chairman Alexander Medvedev recently told the BBC that it is targeting a market capitalisation of between $250 billion and $300 billion "in the next five to seven years".

This compares with a market cap of $370 billion at Exxon Mobil.

The company that has been described as "a state within a state" is now the cornerstone of Russia's foreign policy. "Russia wants to be a superpower, but it can't be a military superpower," says Browder. "Nor can it be an economic superpower, but it can be an energy superpower. By being good at what it does in the energy field, Gazprom has a big seat at the table and it is not going to exploit it in a negative way because the positive way has its own economic benefits."

And the key to exploiting Russia's energy might in a positive way is to control the channels of distribution. This has been the government's aim ever since Gazprom was carved out of the old Gas Ministry by Viktor Chernomyrdin in 1991. The company he inherited became something of a conglomerate.

Apart from gas reserves and pipelines, Gazprom built up its own fleet of planes, a shipping line and a rail network, and retained stakes in dozens of financial institutions, including Gazprombank, the National Reserve Bank, Inkom, Olympisky and Promstroibank.

When he was made prime minister by Yeltsin in 1992, Chernomyrdin handed over control of Gazprom to a colleague named Rem Vyakhirev, who combined a certain amount of vision with an eagerness to line his own pockets.

Vyakhirev's aim was to model Gazprom on Western success stories such as Germany's Ruhrgas and France's Gaz de France, but with Chernomyrdin's indulgence, he turned what should have been a national champion into something of a personal fiefdom.

One of Vyakhirev's most intriguing creations was a gas trading company called Itera, based in Jacksonville, Florida. Hugely profitable, it turned over billions of dollars by procuring cheap gas from Gazprom and reselling it at world market prices. Unfortunately, from the point of view of the national coffers, it was run by Vyakhirev's nephew.

It was a similar story with Stroitransgaz, a pipeline construction company, with which Gazprom carried out $1 billion of business a year. Its shareholders included not only Vyakhirev's daughter, but Chernomyrdin's two sons and Arngolt Bekker, then a Gazprom board member, and his three children. Meanwhile, one of its import-procurement companies, Interprocom, included among its shareholders one Vitaly Chernomyrdin, son of the prime minister.

Gazprom prospered under the protection of Chernomyrdin senior, who exempted it from taxes and shielded it from competition in exchange for it supplying domestic gas at heavily subsidised prices. The day of reckoning came in 1998 when oil prices fell to first $11 a barrel and then $8. Asia plunged into a financial crisis, and a run on the rouble took the exchange rate from R6/dollars to R25 in a matter of months. Not only were there insufficient funds to pay teachers, miners and pensioners, but in August Russia defaulted on its foreign debt repayments.

Chernomyrdin had been sacked as prime minister at the onset of the crisis and so the way was clear for a newly appointed energetic young tax minister called Boris Fyodorov to attempt to claw back some of the estimated $6 billion in back taxes owed by Gazprom. Fyodorov sent tax officials up and down the country to probe Gazprom's operations and set up a 15-strong co-ordinating team in Moscow to squeeze payments from the company. As he said later: "Gazprom made up to 20% of the money coming into the coffers of the state. You cannot ignore such a thing, especially when you know it should have been at twice as much."

Fyodorov had insufficient political backing for such an aggressive campaign, however; he was sacked after less than a year in the post. But the impetus for reform proved unstoppable and, when Putin became president in January 2000, he moved swiftly to impose his authority. At Gazprom's AGM in June 2000, the Kremlin asserted its right to appoint five directors. Chernomyrdin left the board and was replaced by Dmitri Medvedev, then a 35-year-old lawyer. Yet another Putin crony, he is described as "extremely practical".

A well-dressed man, whose only outward sign of ostentation is an expensive watch, Medvedev is not conspicuously charismatic. Asked to sum him up, one associate says: "He is a serious guy, very intense, not a backslapper. He's not someone who makes people feel warm and fuzzy, but he's not dealing with warm and fuzzy issues." Under his watch, however, Gazprom's fortunes have been transformed.

At the same AGM, the old guard received a rude shock. Aware that their old adversary Fyodorov was agitating for a seat on the board - something that required the support of 8% of the shareholders - Vyakhirev and his friends threw money at the problem. They secured the support of US-based financiers such as George Soros and Kenneth Dart by converting their domestically traded shares into American Depositary Receipts (ADRs).

It was to no avail. "Vyakhirev was visibly agitated as the results were read out and there was a gasp when Fyodorov's score came up," says one observer. With the board now weighted 7-4 in favour of outside interests, Vyakhirev's reign was nearing its end and, a month before the following year's AGM, he was gone. His baby-faced replacement, Miller, cut his teeth working as Putin's deputy on the St Petersburg foreign economic relations committee when Putin was deputy mayor of the city in the early 1990s.

Miller went on to gain expertise in the energy sector through heading up the Baltic Pipeline system in 1999, and in his subsequent role as deputy energy minister in Putin's first Cabinet.

By now, Gazprom's leading role in the implementation of Russian foreign policy under its politically dominated new-look board was becoming increasingly clear. The first example of this came in the winter of 2000 when gas to Georgia was turned off for 'technical reasons'. This was widely interpreted as a means of forcing Georgia to backtrack on its stated aim of closing the Russian military bases on its soil that had taken on renewed significance since the start of the Chechen conflict.

The region's politicians were beginning to learn that subsidised Russian gas came at a price. But the most naked display of Gazprom's might was yet to come. In 2005, Ukraine witnessed an unprecedented display of people power following the re-election of the sitting president amid widespread allegations of vote-rigging. The protest, which came to be known as the Orange Revolution, succeeded in forcing a re-run of the country's elections and brought President Viktor Yushchenko to power. The election of a West-leaning leader in a country that had traditionally allied itself with Russia was bound to have commercial consequences, according to Browder.

He likens the supply of heavily subsidised gas to countries such as Ukraine to the sort of bilateral foreign aid that the US gives to strategically important friends such as Israel and Egypt.

"It worked very nicely until the Orange Revolution when the new government made a clear decision, based on 53% of the vote, to align itself with the West rather than the East," he says. "Russia said: 'In that case, there is no need for the $3 billion a year of foreign aid.' In response, Ukraine said: 'You supply Europe through our territory; we will sabotage that. Just watch us.' It all blew up on 1 January and Ukraine realised that it had very little leverage apart from PR."

By now, Gazprom - and the Kremlin - had come to the conclusion that pipelines that ran through foreign lands would never be seen as purely commercial assets that they could acquire and control. The centralised authority of Moscow was ended by the break-up of the Soviet Union, and Gazprom realised that the only way to avoid being periodically held to ransom by transit nations was to avoid them altogether.

Hence the superficially eccentric route of the 1,200km North European pipeline. The shortest and cheapest gas delivery route between Russia and Germany entails a land-based pipeline running via Poland and the Baltic states. But when former German Chancellor Gerhard Shroeder, President Putin, and Miller met in Berlin to unveil the $5 billion deal that would link Germany's Baltic coast to Gazprom's huge gas fields in north-west Russia, the route ran not overland but under the Baltic Sea.

"The Germans proposed the new route because of the unreliability of the transport countries," says Browder. "It's three times more expensive to sink a pipeline underwater and that decision added $2.7 billion to the cost. Ukraine said it was outrageous. The Poles said they couldn't do it. And the Estonian government tried to pass a law extending its territorial waters to encompass the route of the pipeline."

None of this sabre-rattling had the slightest effect and Gazprom can look forward to significantly enhanced revenues in future. In the first half of 2005, the company made $5.9 billion of its $22 billion revenue from domestic sales, with another $1.9 billion coming from sales to former Soviet countries, such as Ukraine and Belarus. By far the biggest customer, however, was Europe, which brought in sales of $14.2 billion.

The key factor here is the differing prices paid by the various customers.

While Germany and Spain pay $230 per thousand cubic metres, the Baltic states pay $170, Poland $120, Ukraine $50 (pre-dispute) and Belarus $47.

With the completion of the pipeline in 2010, Gazprom can expect substantially higher sales at a premium price, adding up to $9 billion a year to its turnover.

Domestic revenues are set to rise steeply too. When EU and US trade representatives sat down with their counterparts in Moscow three years ago to discuss Russia's entry into the World Trade Organisation, the biggest bone of contention was the scale of the energy subsidy afforded to Russian industry.

At the time, Germany was paying $120 per thousand cubic metres, while Russian users were paying $20. Big Western users of electricity, such as steel, aluminium and fertiliser producers, were particularly exercised by the issue.

With the Western powers refusing to endorse Russia's application to join the WTO without movement on the energy tariff question, the Russians finally relented and agreed to raise the domestic gas price to $60 by 2010. Such a move could boost Gazprom's revenues by a further $7 billion a year.

Not surprisingly, China is likely to prove another big market. During Putin's visit last March, the two countries signed an agreement to pipe large quantities of gas from fields in Siberia to China. Officials claimed the pipelines could begin within five years and would deliver up to 80bcm of gas annually. Miller told reporters that while the timeframe and scale of the deal had been agreed with China's oil and gas company China National Petroleum Corporation, the details were still to be negotiated.

"China is price-insensitive on energy and is gazumping all countries in all deals," says Browder. "It needs to raise 900 million people above the poverty line and to do that it needs to grow at 8%-12% a year for the foreseeable future, and so you can be sure that it will agree to a pipeline and that the price it pays for gas will be acceptable to Russia."

But the most radical option open to Gazprom in its drive for growth and profits is to make the move from wholesaler to retailer. One Gazprom watcher points out that when Russia was selling gas to Germany for $100 per thousand cubic metres, the German consumer was paying the equivalent of $575.

The temptation to acquire customer-facing businesses in western Europe must be great and, sure enough, Gazprom has already made its first move in this direction with the acquisition of 35% of Wingas, a German gas distribution company controlled by BASF, which, along with E.ON, is one of the Russian company's partners in the North European pipeline. Gazprom intends to take its stake in Wingas to 50% and, in return, the Kremlin will grant BASF the right to acquire a 25% share in the development of a large gas field in north Russia.

Gazprom executives have also gone public over their interest in the UK's Centrica, and there are even rumours that they would like to extend their gas pipeline network to mainland Britain. Whether a British government would be willing to allow such a strategically important price-setting company to pass into the hands of a state-controlled Russian energy giant remains to be seen, however.

For all their shrewdness in the arena of realpolitik, Gazprom's management are no exemplars of commercial competence. Vladimir Milov, head of the Institute for Energy Policy, a Moscow think-tank, says the company is still managed as "a Soviet enterprise". Although its market value is on the rise, he argues this is largely a function of external factors: namely, rising gas prices and the stability lent to it by the support of the Kremlin, which reassumed its control of the company by taking its shareholding to 50% plus one share in September last year.

Fundamental shortcomings persist in the shape of stagnant production levels, a decaying infrastructure and rising costs. There are also murky areas in the accounts and none is murkier than the resolution of the Ukraine issue.

Under the terms of the agreement reached following the New Year's Day shutdown, Russia sells gas to a Swiss-registered company, RusUkrEnergo, for $230 per thousand cubic metres. The company, which then sells a combination of the Russian gas and much cheaper Asian gas to Ukraine for $95, is a 50-50 joint venture between Gazprom and another, so far unidentified, entity. Gazprom's stake in the company is represented by Konstantin Chuichenko, head of its legal department, and said to be a former KGB man from Putin's power base of St Petersburg.

RusUkrEnergo has twice attracted the attention of the Ukrainian prosecutor's office, which recently investigated allegations of links between its management and organised crime. This probe was discontinued after the change of government last September, but Browder's Hermitage - which has a record of uncovering corporate malpractice at the gas giant - has promised to carry out an investigation of its own.

However, Gazprom remains something of a sleeping giant. As Eric Kraus, managing director of Moscow-based investment bank Sovlink, observes: "Gazprom is Russia's first $100 billion company and may even become its first $1 trillion company. It's the largest gas producer in the world; its resources are poorly explored and in very challenging geographical locations, and so there's very substantial value to be realised."

There are even those who say the individual best equipped to exploit Gazprom's potential is the man who will be rendered unemployed by the constitutional obligation to give up power at the end of his second term: Putin.

THE GAZPROM BOARD Dmitri Medvedev chairman, Gazprom, and first deputy prime minister Alexei Miller CEO, Gazprom Alexander Ananenekov deputy CEO, Gazprom Burckhard Bergmann chairman, Ruhrgas; president, Dresdner Bank Russia Farit Gazizullin director, Gazprom German Gref economic development and trade minister Elena Karpel head of Gazprom's economic expertise and pricing department Mikhail Sereda deputy chairman, Gazprom's management committee and head of administration Boris Fyodorov director, United Financial Group Viktor Khristenko industry and energy minister Igor Yusufov Putin's special envoy for international affairs CANDIDATES FOR THE NEXT GAZPROM BOARD (TO BE ELECTED ON 30 JUNE 2006) The board nominated 26 candidates for 11 seats on the next board of directors - a record number of candidates - including all those on the current board listed above. Andrei Akimov CEO, Gazprombank Kirill Androsov deputy economic development and trade minister Matthias Warnig chairman, Dresdner Kleinwort Wasserstein's management committee for Russia and CIS Sergei Glazer director, Vostok Nafta Investment Vadim Kleyiner director, corporate research, Hermitage Capital Management Vladimir Kuznetsov deputy head, Federal Energy Agency Yuri Medvedev deputy head, Federal Property Management Agency Yuri Neyolov governor, Yamal-Nenets Autonomous District Sergei Naryshkin minister and government office director Sergei Oganesian head, Federal Energy Agency Charles Ryan chairman and CEO, United Financial Group Alexander Ryazanov deputy CEO, Gazprom Bob Foresman head of investment banking, Russia, Dresdner Kleinwort Wasserstein Alexander Shokhin chairman, Renaissance Capital Supervisory Board Ilya Scherbovich president, United Financial Group COMPANY WORTH BY MARKET CAP AT 27 MARCH 2006 (dollars BN) Gazprom 220 ExxonMobil Corp 370 BP 236 Royal Dutch Shell 199 Source: Hermitage Capital Management.

Dominic Midgley is co-author of Abramovich: the billionaire from nowhere and associate editor of City A.M.

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