Russia's Gazprom forced to soften its touch amid perfect storm of weak demand, rising supply

By Gary Peach

Just a year ago, Gazprom seemed all-powerful. The Russian gas producer was the third-largest corporation in the world, sat on a hoard of cash and had single-handedly blocked gas to a large part of Europe in the middle of winter without fear of losing business.

A lot has changed since -- with both Gazprom and its customers strapped for cash amid the global downturn, the Russian behemoth is now under pressure to lighten its heavy-handed touch and become more accommodating with them.

The main market force reshaping the Russian monopoly's attitude has clearly been the economic crisis, which has slashed energy demand from Europe's massive industrial sector. But while the recession has hit businesses everywhere, Gazprom is also a victim of its own rigid practices.

Because the company pegs its prices to the oil market, its customers are paying 50 percent more than those buying on the spot market, which means new customers have no incentive to sign a deal. Furthermore, Gazprom has so far insisted on an inflexible contract system called "take-or-pay" which risks driving demand away.

Under these contracts, Gazprom's European customers must buy a fixed amount of natural gas at a price pegged to crude oil for a duration of 20 to 30 years. The take-or-pay clause means that even if customers take less -- which is exactly the case amid the downturn -- they still have to pay.

Such contracts were conceived to give producers long-term financial stability to invest in production, but when the market becomes as volatile as the in the past year, they can become a huge strain.

The U.S. and Britain, by contrast, no longer make take-or-pay gas contracts since they liberalized their energy markets two decades ago.

Sergei Chelpanov, deputy director of Gazprom's export arm, has said there would likely be 8-9 billion cubic meters of undelivered gas on take-or-pay contracts by the end of the year.

At this year's average export price, this means Gazprom will have the right to claim up to $2.5 billion from its customers -- for gas they never used.

Alexander Nazarov, an analyst at the Metropol investment bank in Moscow, says this amounts to nearly 5 percent of the company's pretax earnings. "It's a nice sum of money for Gazprom," he said.

The company has made it clear it wants full payment. "These are contractual obligations, and they should be carried out. There won't be any cancellation," Chelpanov said Nov. 9.

But Gazprom is starting to cave in.

Just this week, it revised a deal with Ukraine, lowering the amount of gas the cash-strapped country is required to import and forgoing fines on gas not used. Because it was price disputes between Russia and Ukraine that had caused a major gas cutoff in January, the move is particularly telling.

Gazprom realizes it can't push too hard, said Mikhail Korchemkin, director of East European Gas Analysis, a Pennsylvania-based firm. "If Gazprom is persistent, it could kill its client base in Europe. Many of its clients are in trouble," he said.

Because Gazprom pegs its gas price to a basket of oil prices, it is currently charging approximately $300 per thousand cubic meters to West European customers -- 50 percent more than the spot market price of about $200.

So while older players with long-term contracts with Gazprom are locked into buying "expense Gazprom" gas, newer players who can procure more gas on the spot market will come out ahead, explained Korchemkin.

This is why some European customers appear ready to fight. Turkish Energy Minister Taner Yildiz was reported in Russian media as saying that Turkey intended to discuss with Russia the possibility of freezing the take-or-pay clause.

Several European gas importers -- such as Germany's E.ON and Poland's PGNiG -- refused to comment their contractual obligations with Gazprom.

Failure by Gazprom to loosen its terms with customers could have far-reaching implications and come back to haunt it in the future. Not only could it lead to a larger role for spot trading but, with Gazprom's development of new gas sources threatened by the recession, the market may boost investment into shale gas, a new natural gas source under development in North America.

This is why, together with the global recession, some analysts believe there will be a glut of natural gas -- a dire forecast for Gazprom.

"The boom in North American unconventional (shale) gas production, together with the recession's impact on demand, is expected to prolong the glut of gas supply for the next few years," Nobuo Tanaka, director of the International Energy Agency, said Nov. 10 in London.

It is a scenario eerily reminiscent of the oil markets in the 1970s and 1980s. Pinched by OPEC's policy of reducing supply, Western energy companies at the time scrambled to find new fields.

They succeeded, so by the mid-1980s crude oil prices hit a historic low -- a situation that, among other consequences, facilitated the collapse of the Soviet Union, which desperately relied on oil exports for foreign currency revenues.

As Tanaka said, a future natural gas oversupply "could have far-reaching consequences for the structure of gas markets, with suppliers to Europe and Asia-Pacific coming under pressure to modify pricing terms under long-term contracts, to de-link gas prices from oil prices, sell more gas on a spot basis and to cut prices to stimulate demand."

Kari Liuhto, a professor at the Turku School of Economics in Finland, downplays that possibility and rather expects a shortage in 10-15 years.

Part of the problem is that Gazprom's major fields are aging and won't be able to meet demand 15 years from now, he said.

The Russian company is trying hard to keep apace with its ambitious investment program -- which includes two expensive pipelines -- the Nord Stream to Germany and the South Stream to Austria and Italy.

But its financial position is weakening and some question its strategy.

"Nord Stream is a pipeline that they don't need -- it will probably cost $15 billion. And South Stream makes no commercial sense whatsoever," said Anders Aslund, senior fellow at the Peterson Institute for International Economics in Washington, D.C. "Gazprom just wastes enormous amounts of money."

As it sits on nearly one-fifth of the world's natural gas, Gazprom is and will remain an indispensable player in the gas market, particularly in Europe. But the shock waves from the economic crisis have contributed to create a perfect storm large enough to rock even the largest boats.

"Compared with the years 2000-2007, when everything was growing -- energy prices, gas prices -- the situation is unprecedented," said Simon Pirani, senior research fellow at the Oxford Institute for Energy Studies.