There has been a recent spate of articles once again implying that Russia’s gas deals with China are uneconomic and bad for Russia and for Gazprom.
These articles tend to link to the separate question of Gazprom’s market valuation. The insinuation is that Gazprom’s low current valuation is somehow related to these deals.
To assess these claims some background is needed.
Before the 2008 financial crash, Gazprom had an estimated market value of $360 billion - leading to a reckless prediction from its chairman Aleksey Miller that it would rise to $1 trillion.
In the event, Gazprom’s market value fell sharply during the financial crisis. It then recovered on the back of higher oil prices, though not to the level it enjoyed before 2008.
The collapse in oil prices has dragged Gazprom’s value back down again. It presently stands at no more than $50 billion.
This contraction in Gazprom’s value is commonly blamed on Putin, who supposedly misuses Gazprom as a political tool to serve Russia’s geopolitical interests.
It is insinuated that the two pipeline deals to China are both uneconomic projects foisted by Putin on Gazprom. This supposedly is also true of Gazprom’s various European pipeline projects: North Stream, the now cancelled South Stream and Turk Stream (which has replaced South Stream).
Most Western articles on the subject say that instead of investing in these European pipelines Gazprom should continue to send the bulk of the gas it exports to Europe through the existing Ukrainian pipelines, as it has up to now being doing.
As for the pipeline deals to China, it is said that the fall in the price of oil has rendered them uneconomic, the implication being that Gazprom should pull out of them.
These claims do not just appear in the western media. They are widely repeated in the Russian liberal media as well.
What however is the truth of these claims?
Turning first to Gazprom and its market value, the initial collapse in Gazprom’s market value - from which it has never really recovered - took place in 2008, well before the two Chinese pipeline deals were agreed.
North Stream was first discussed in 1997 and was formally launched in 2002, well before Gazprom’s value peaked.
South Stream was launched in 2007 - as Gazprom’s market value was climbing and approaching its peak - which it did some months later.
Preliminary agreement for Turk Stream happened in autumn 2014 - long after the peak in Gazprom’s market value had passed.
It is impossible to see any direct correlation between any of these projects and the rise or fall of Gazprom’s market value or share price.
By contrast - and as one would expect given that it is an energy exporter - Gazprom’s share price has closely tracked the price of its product, which is natural gas.
Since the price of gas is linked to the oil price, that means that Gazprom’s value has moved in line with the oil price.
Until the first half of 2008 oil prices were spiralling upwards. They peaked at $150 a barrel in 2008, with Miller predicting they would reach $250 a barrel. Gazprom’s market value zoomed up in unison, with its share price peaking at around $30 a share
Expectations of further indefinite oil price increases undoubtedly added to the sentiment and influenced the level of Gazprom’s share price. It was in this euphoric atmosphere that Miller made his prediction of Gazprom’s value reaching £1 trillion.
In 2008 the oil price collapsed and Gazprom’s share price collapsed with it, falling to $6.50 a share.
It then recovered with the oil price.
Oil prices have however never recovered to the level they hit in the first half of 2008, and with sentiment about oil prices being much more negative after 2008, Gazprom’s share price never recovered to its pre-crisis level, peaking at $16.80 a share in April 2011.
Subsequently, the oil price has fallen again, and Gazprom’s value has gone down with it, with its share price falling to just $6 a share.
The point is sometimes made that Western energy companies do not suffer from anything like the same falls in value when the oil price falls.
That however says less about Gazprom than it does about the state of Russia’s financial system, which - as we have discussed many times - is too small. This means that Gazprom does not have the great mass of small and institutional Russian shareholders to support its share price in bad times that western energy companies typically do.
If we put aside the question the size of Gazprom’s market value - something that ultimately depends heavily on sentiment - and look at how well Gazprom actually is doing, then the picture becomes far more favourable. It turns out that Gazprom is profitable, has an exceptionally strong asset basis, and that its financial position is also strong.
The instability in Gazprom’s market value and its small size relative to the giant scale of its operations is not therefore ultimately a comment on Gazprom - still less on Putin. It is a comment on the small size of Russia’s financial system, which is too small for Russia’s economy causing it to struggle to cope with a company the size of Gazprom’s.
The result is that the Russian financial system finds it impossible to price an energy giant of Gazprom’s size properly, which is why Gazprom’s market value is so much smaller than - based on its profitability, financial solvency, asset base and the scale of its operations - it should be.
What then about the economic viability of the two Chinese pipeline projects?
Basically, the two points made by critics are (1) that the fall in the gas price no longer justifies the investment in these projects, with the implication that Gazprom cannot really afford these projects; and (2) that the projects do not make economic sense because Gazprom could sell the gas at a higher price in Europe.
The dollar price of gas has indeed fallen dramatically over the last year. However what critics of the two pipeline projects fail to mention is that as the projects are being built in Russia their cost will be mainly in roubles not dollars.
The devaluation of the rouble in lockstep with the fall in the dollar price of oil has mitigated the effect on Gazprom’s profit in roubles of its sale of gas priced in dollars. Gazprom’s reported profit in roubles in the first half of 2015 in fact surged.
Of course some of the equipment that will be used for the pipelines is imported. However most of the cost - including critically the cost of labour - will be in roubles.
The rouble’s devaluation therefore means that the cost-benefit dynamic of the two projects has been far less affected by the oil price fall than the critics seem to realise, whilst the level of Gazprom’s profit in roubles means that its ability to fund these projects is not unduly affected.
What of the argument that the projects do not make economic sense because Gazprom can sell its gas instead to Europe for a higher price?
The price the Chinese have agreed to pay for the gas for the first project is not in fact significantly out of line with the price the Europeans pay for their gas.
However this argument misses the point. Even if the Europeans were paying much more for their gas than the Chinese are prepared to do, that would still not necessarily make the two Chinese projects a bad bargain.
As I have said many times, price is only one factor in a commercial relationship.
Gazprom is choosing to work with a new partner (China) with which it has a civil if tough-minded relationship, in place of an old partner (Europe) which has imposed sanctions on it, is busy bringing an anti-trust claim against it and which is constantly looking for alternative suppliers.
It is not surprising that Gazprom prefers its new partner to its old one, even if the new partner will pay a lower price.
What much of the hostile commentary about these two projects anyway misses is any real appreciation of what Gazprom actually is.
Gazprom is not just an energy company. It is the gas export arm of the Russian state, with a legally enshrined monopoly on the export of natural gas from Russia.
The Russian government is Gazprom’s majority shareholder. Government officials - including Alexander Novak - the country’s Energy Minister - sit on its board. Gazprom itself was originally a government ministry - the USSR’s Ministry of Gas Industry - a fact confirmed by its name: a contraction of “Gazovaya Promyshlennost” - “gas industry”.
Gas supply agreements made between Gazprom and its customers - including those agreed with China - are not therefore just contracts. They are agreements the Russian government often has a hand in making. They therefore have the status of interstate agreements.
A contract between Gazprom and China to supply China with gas is not just a commercial contract. It is an agreement between Russia and China agreed at the highest level of their governments as part of the strategic relationship they have forged between them.
That does not of course mean that negotiations between Russia and China always happen smoothly or easily.
Both the Russians and the Chinese are tough hard-headed negotiators who aim for the best possible deal for their countries.
Neither side will allow itself in negotiating such complex agreements to be boxed in by arbitrary deadlines or by artificial determinations of price intended to benefit disproportionately one side at the expense of the other.
If nonetheless the two sides decide that it is in their countries’ national interest to come to an agreement, then an agreement will be reached, and the pipelines will be built.
The terms of the first pipeline deal from Russia to China have been agreed, and unless there is a fundamental change in their relationship or a total transformation of the world energy market, it will almost certainty be built. In fact work has already started.
The terms of the second pipeline deal have not yet been fully agreed. The Russians - in what looks like an opening bid - apparently asked for a very high price for the gas from this pipeline, justified by the supposedly high cost of building it. The Chinese are expected to refuse, and will no doubt in time make a counter-offer.
It is likely that because of the ongoing oil price fall final agreement on this issue will be put back until oil prices have settled so that a proper price formula can be agreed based on actual data - though it is just possible that agreement could be reached during Putin’s forthcoming visit to Beijing in September. In either case it is unlikely that final agreement will be reached without the two countries’ political leaders becoming involved.
The mere fact that oil prices are currently low will not however stop the two countries from going ahead with the projects.
As the Russians and the Chinese know - but Western critics of the projects apparently don’t - oil prices that go down one day are certain to go up again some other day.
Projects of this scale are for the long term. The Russians and the Chinese are not going to be put off building them simply because of short-term fluctuations in the oil price.
Ultimately what Gazprom’s critics and the critics of Gazprom’s Chinese pipeline projects are saying is that Gazprom should content itself with the way things are.
It should continue to pump nearly all its gas to Europe even as the Europeans sanction it and bring legal proceedings against it and look to replace it with alternative suppliers.
It should also continue to send its gas to Europe through Ukraine, despite Ukraine having twice interrupted supplies - in 2006 and 2009 - and having threatened to do so again during the gas talks last year.
It is understandable why - writing from a purely Western point of view - Western commentators want this.
It is equally understandable why the Russians and Gazprom don’t want it and won’t accept it and why they are forging ahead instead with their Chinese and other projects.
If the Europeans feel they have a right to look for alternative suppliers at a higher cost than the Russians will charge, then the Russians have an equal right to look for alternative customers at a lower price than the Europeans will pay.
That this is happening is a consequence of the breakdown in the relationship between Europe and Russia. Ultimately it was the Europeans who - by dragging Gazprom into their disputes with Russia - brought this about. If the Europeans are unhappy with the result, then they have no one to blame for it but themselves.
In the meantime mendacious commentary that says it is in Russia’s and Gazprom’s interests to act in Europe’s - and Ukraine’s - interests should be seen for the straightforward propaganda masquerading as business analysis that it actually is.
via Marshall Horn, CFTC Why Criticism of Gazprom and the Chinese Pipeline Deals Is Wrong
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