The rise of the gas independents: a game changer for Russia

The rise of independent gas producers in Russia marks a paradigm-shift for the domestic market, and could ultimately challenge Gazprom's dominant position in the export market, according to Danila Bochkarev, Senior Fellow at the EastWest Institute in Brussels. For the EU's drive towards diversification of gas supplies, the emergence of new suppliers could be welcome news.

Russia's President Vladimir Putin (right) meets with Gazprom's Chief Executive Alexei Miller, October 29, 2012 (c) Reuters
In 2012, two key Russian gas market "independents" - Novatek and Rosneft - took important steps to consolidate their position both within Russia and abroad. The two companies have significant ambitions, which look set to alter the dynamics of the domestic gas market and which, in the long run, could challenge Gazprom's dominant position in the export market. Novatek and Rosneft last year announced their plans to increase annual gas production to 112 and 100 billion cubic metres, respectively, by 2020.

The decline of Gazprom's output, a result of of the domestic gas glut, gave these two independent producers an even higher profile in 2012. According to data released by the central dispatch unit of the Russian Ministry of Energy, national gas production dropped by 2.3% to 655 bcm, and Gazprom's output decreased by 5.4%  to 478.8 bcm, while virtually all independents increased their production. For example, Novatek's output grew by 7.1% to 57.3 bcm per year, while oil companies' production increased by an estimated 5.7 % to 67.5 bcm/y.

Political connections

So what is behind this change, and what will be its impact on gas exports? The rise of independent gas producers is partly explained by their ability to secure new supply contracts in Russia and to efficiently control lifting costs. A governmental decision to limit gas flaring to 5% of production from 1 January 2012 also contributed to an increase in gas production among Russian oil companies.

Political connections have also played a role. The ability to lobby for tax breaks and state aid have contributed to the success of energy companies such as Novatek. Yamal LNG would have been unthinkable without important tax incentives. The favorable tax regime was also a key factor in Total's decision to partner with Novatek in the Arctic LNG project.  

Both Novatek and Rosneft have conducted aggressive merger and acquisition (M&A) policies, focused on the extension of their reserves and client base. By the end of 2010, Novatek had acquired a 25.5 % stake in SeverEnergia (proven reserves of 1.3 trillion cubic metres of gas and 155 million tons of condensate) and purchased 51% in Sibneftegaz (proven reserves of 290 bcm of gas).  In August 2011, Novatek received state licenses to develop the Geofizichenskoye, Salmanovskoye, Severo-Obskoye and Vostochno-Tambeiskoye gas fields on the Yamal Peninsula and, in November 2012, the company bought a 49% stake in the independent gas producer Nortgaz,  adding a further 2 bcm/y of natural gas supplies.

Novatek's expansion has included pipeline and petrochemical companies. Novatek purchased Mezhrigiongaz Chelyabinsk, a network company, giving direct access to downstream for RUB 1.55

The emergence of the independents has dramatically changed the Russian gas market, creating an oversupply of natural gas in the domestic market

billion (US$50 million), which provided access to a client base, expected to consume about 16.4 bcm/y by 2015. In 2011, the companies owned by Leonid Mikhelson and Gennadi Timchenko - Novatek's key Russian shareholders -  took full control over Russia's largest petrochemical conglomerate, Sibur. In December, Novatek agreed to supply Sibur with 36 million tons (mt) of light hydrocarbons and 8 mt of LPG, for a total value of RUB 510 billion, during the contractual period 2014-2034, setting Sibur on the path of becoming one of Novatek's largest customers.

Potash producer

Last year also brought important new German and Russian clients for Novatek. In August, the company concluded two supply contracts with Eon Russia (RUB 702 billion) and Fortum's Russian power plants (RUB 145.9 billion), and will provide these two companies with 180 bcm of gas during the period 2013 - 2027. In October 2012, Novatek started the implementation of its 10-year long supply contract with German utility EnBW, with total volumes expected to reach 20 bcm. Novatek will be buying this gas on the market via its Swiss-based trader. In December 2012, the company signed a contract with Mosenergo for the delivery of 27 bcm of gas in the period 2013 - 2015 and became the exclusive supplier of Russian potash producer Uralkali. In most cases, Novatek was replacing old Gazprom's contracts.

The nomination of Igor Sechin as Rosneft's Chief Executive favored the company's expansion. In August 2012, Rosneft purchased 51% of independent gas producer Itera (annual production in 2011 was 12.6 bcm) and the high-profile acquisition of a 100% stake in TNK-BP, which has important gas assets both in Russia (Rospan) and abroad, is planned to be completed in H1 2013. TNK-BP produced 11.6 bcm in 2011 and its output is expected to reach 28 bcm in 2017.

Russia's largest oil company also managed to expand its presence on the domestic gas market by signing two supply contracts in November 2012. Rosneft will supply InterRAO with 875 bcm during the period 2016-40. The company also signed a supply contract with Fortum and will ‘inherit' the recent TNK-BP contract with KES Holding.

Novatek's ambitions are not limited to the domestic market. In November 2012, it requested an exemption from the export monopoly enjoyed by Gazprom for its Yamal LNG project, although the company's Chief Executive Leonid Mikhelson has emphasized Novatek is not questioning the pipeline export monopoly itself. The company has justified the exemption request by pointing out its current "agency contract" with Gazprom Export for the sale of Yamal LNG gas does not allow using future supply contracts as bank loans' guarantees.

The emergence of the independents has dramatically changed the Russian gas market, creating an oversupply of natural gas in the domestic market, which Gazprom claimed had reached 30 bcm in 2012. The internal gas glut has also led to increased competition between independent gas producers. Rosneft, for example, is projected to replace Novatek as the key gas supplier of InterRAO in 2016, which accounted for up to 30% of Novatek's domestic gas sales in 2011.

Impact

How will this internal gas glut influence Russia's internal gas market and Gazprom's position abroad, primarily in Europe?

Inside Russia, the key impact has been that Gazprom, the traditional supplier, has lost market share. The story has been similar to when Qatari LNG first started to compete in Europe: traditional suppliers lost market share because of the competitive pricing policy of the newcomers.

Independent gas producers have increased their market share in Russia from 9.5% (55.5 bcm/y) in 2000 to 14.6% (96 bcm/y) in 2006 and 26.9% (176.2 bcm/y) in 2012.

Functioning internal market mechanisms are, however, still poorly developed in Russia, and

All these trends will lead to a "smaller" Gazprom, which will have to increase its operational efficiency and will need to review some of its upstream projects

independent gas producers are still vulnerable to price, regulatory and fiscal fluctuations. They are also dependent on their ability to secure long-term supply contracts with large utilities. Independent gas producers without significant oil production are also very sensitive to taxation policies such as the Mineral Extraction Tax. 

Despite that, Gazprom feels threatened by the independents and the internal gas market liberalization in Russia. In September 2012, the Russian gas conglomerate unsuccessfully attempted to reduce the intake of non-Gazprom gas in its pipeline system. Gazprom has also suggested Russian domestic production and distribution should be regulated to avoid oversupply and a sharp decrease in domestic gas prices.

In 2006-2008, natural gas was (experimentally) traded on the electronic trading platform of Gazprom's Mezhregiongaz. The trading activity stopped after the formal completion of the ‘experiment' but, in reality, the economic crisis also had an impact. The crisis was followed by the contraction of internal consumption and this led to a drastic decrease in spot prices to below the level of fixed tariffs, making trading activity unprofitable both for Gazprom and the independents.

Monopoly

Currently, gas trade is regulated by the Federal Tariffs Service, which sets maximum and minimum prices. While Gazprom has to respect both upper and lower limits, independents have the right to sell below the minimum price, allowing independent gas producers to gain market share from Gazprom by proposing more attractive supply conditions.

The emergence of the independents will also have an impact on Gazprom's gas monopoly. While the monopoly may formally remain intact - in particular for the pipeline gas exports - the independents may be allowed to bid for specific export quotas, for instance for LNG supplies. The future pricing mechanisms to be used by the independents are yet to be determined. Preliminary analysis on the EnBW contract suggests Novatek is most likely using a mixed pricing system (petroleum indexation plus a spot component, linked to North European gas hubs).

If implemented, such a measure would presumably fit in with the EU's drive towards a competitive internal market and the diversification of gas imports. It may also improve the image and market positioning of "Russian gas" in Europe. When the South Stream project was launched in Brussels in May 2011, EU Energy Commissioner Gunther Oettinger said: "I would like to see Novatek in Europe."

In the long term, Gazprom will still remain Russia's largest gas company, but it is likely to have to abandon some of its global ambitions and focus on internal reforms.  All these trends will lead to a "smaller" Gazprom, which will have to increase its operational efficiency and will need to review some of its upstream projects.

 

This article was first published in Global Gas Analytics, a new monthly analytical publication by Interfax covering the global gas markets. For publication details please email: analytics@interfax.co.uk