Write 2 pages summary of the main points of the case

TB0005-PDF-ENG.PDF

Home >English homework help >Article writing homework help >Write 2 pages summary of the main points of the case

TB0005

Copyright © 2009 Thunderbird School of Global Management. All rights reserved. This case was prepared by Professor Kannan Ramaswamy for the purpose of classroom discussion only, and not to indicate either effective or ineffective management.

Kannan Ramaswamy

Gazprom: The Evolution of a Giant in the Global Oil and Gas Industry

Today Gazprom is a modern, open, dynamic company. In just the last five years, the amount of tax it pays has more than doubled, and it accounts for nearly 20 percent of the country’s budget. Gazprom’s capitalisation has reached a new historic high, surpassing the 350 billion dollar mark. It is one of the largest companies in the world. Obviously, the success of the company has been in large part due to intelligent and flexible poli- cies, not only Gazprom’s but also those of the government and the state. Such close cooperation is in full accord with the current trends in the global oil and gas industry. Moreover, it provides the company, the industry, and the entire economy with additional opportunities for long-term develop- ment. Given Gazprom’s strategic importance for Russia, the state will continue to keep the situation under its direct control.

Vladimir Putin, then-president of Russia, Speech Commemorating 15th Anniversary of Gazprom,

www.gazprom.ru/eng/articles/article27020.shtml.

Alexei Miller had been a key architect in the emergence of Gazprom as a global player. In seven short years, he had been largely responsible for engineering the global rise of the Russian gas superpower that was sure to domi- nate the industry for decades to come. Gazprom had been launched as a joint stock company in 1993 when the Russian government decided to spin off the administrative arm that was managing gas assets in the country. By early 2008, the company had increased gas reserves to some 4.3 tcm (trillion cubic meters), the largest in the world, had about 22,000 km of gas trunk lines reaching out into Eastern and Central Europe, as well as points along the Caspian Sea, and a market capitalization that had grown 200-fold since inception. Western Europe was increasingly dependent on gas supplied by Gazprom, as were other former Soviet Union countries such as Ukraine and Belarus. It was the largest employer in Russia, the largest exporter, and accounted for roughly 20 percent of the country’s tax base—a leviathan by all accounts. Despite Gazprom’s dominant position, especially at a time when the world’s energy resources were becoming scarce, there were some critical challenges that cast a long shadow over its future. (See Appendix 1 for key statistics on Gazprom, and Appendix 2 for comparisons with competitors.)

The company had been unable to increase its production significantly despite its command over vast reserves. Many Russian analysts believed that without substantial investments in new projects, Gazprom could soon find itself unable to honor its mandatory commitments even to the domestic market. However, many of Gazprom’s reserves were located in very challenging environments such as the Arctic shelf and Siberia. These projects required fairly sophisticated levels of technical expertise and huge amounts of capital. In the recent past, the company had, surprisingly, spent much of its capital budget on large acquisitions of new reserves and forays into unrelated sectors of the economy, such as media and banking. It remained to be seen whether the company would have the skills and resources to execute these crucial projects.

This document is authorized for use only by sefik sakar ([email protected]). Copying or posting is an infringement of copyright. Please contact [email protected] or 800-988-0886 for additional copies.

2 TB0005

In the global arena, Gazprom was still dependent on western European sales for much of its lucrative overseas revenues. It realized roughly five to ten times the price for its gas in Western Europe compared to its domestic market. However, in the next decade, Europe seemed likely to welcome other suppliers from North Africa, Central Asia, and the Middle East. The competition was also bound to intensify with rapid changes wrought by LNG technology, a technically complex field where Gazprom did not have much experience. These nettlesome issues were sure to undermine the unassailable image that Gazprom was projecting.

The Genesis of Gazprom Gazprom is a mutant. People need to be aware of what kind of animal it is. It doesn’t follow business logic or political logic. It’s a mixture of a business empire and a presidential administration.

Russian Analyst Pavel Baev, “How Gazprom Turned Up the Heat on the West,” The Independent,

September 3, 2007.

Gazprom traced its origins to the USSR Ministry of Oil and Gas Industry. In 1989, the Soviet government, under Victor Chernomyrdin, reorganized this administrative arm and named it Gazprom. In 1993, Gazprom was given further autonomy and constituted as a joint stock company by the Boris Yeltsin government.

Russia had chosen to adopt completely different approaches to its assets in the oil sector and gas sector. While it had encouraged foreign investors to participate in the privatization of oil assets, no such invitation was extended with respect to gas assets. The privatization of oil occurred at a particularly trying economic period for Russia and seemed to be a quick way to overcome some of the financial distress. At the end of this process, Russia was left with effective control over the main arterial pipelines that were used to export oil, but the base assets themselves had been sold to Russian and foreign interests. This process allowed those close to the Kremlin to make enormous profits. Many Russian oligarchs, such as Oleg Deripaska, Vladimir Potanin, Roman Abram- ovich, Mikhail Friedman, and others, built huge empires almost overnight.

In contrast, when it came time to set forth a strategy for gas assets, Russia retained effective control over vast reserves by using Gazprom as the entity responsible for the majority of the country’s gas assets. The company was listed on European and U.S. stock exchanges via GDRs (Global Depository Receipts) and ADRs (American Depository Receipts) in 1996. However, the Russian government always held significant control in the com- pany, either financially or politically, alongside private and institutional investors. The chairman of the board had traditionally been a government appointee with management control vested in the hands of a handpicked technocrat. For example, Victor Zubkov, the current chairman of Gazprom, was originally the prime minister of Russia under Vladimir Putin. He relinquished his post to make way for Putin when Putin’s term of office as president of Russia expired. Alexei Medvedev, who was elected to succeed Putin as president, was the previous chairman of Gazprom. The nexus between the government and Gazprom had been a source of some advantage for the company both at home and abroad.

Gazprom had managed to marshal very significant land tracts all across Russia bearing rich deposits of gas, and government patronage surely helped it along the way. Combined with a far-reaching network of gas transportation pipelines, Gazprom evolved to become the largest and most widely known Russian company and its most widely known globally. It had the rather unique distinction of being perhaps the only gas company in the world that was permitted to maintain its own standing army, ostensibly for defending its vast reserves and production assets.1 It employed more than 430,000 people, making it the country’s largest single employer in the industrial sector. Representing 20 percent of tax inflows into the Russian exchequer, it was also no doubt one of the Russian government’s most favored companies.2 Over the years, Gazprom had diversified into a host of related and unrelated areas, both of its own volition and also at the prodding of the Russian government. This unwieldy portfolio included significant assets in AB Gazprombank, a significant power in domestic banking; NPF Gazfund, Russia’s biggest nongovernmental pension fund; insurance company Sogaz; and a media giant, Gazprom Media.3

TB0005 3

Organized along global functional lines, by 2008 Gazprom had moved from a geographic approach to managing its assets to a more functional approach. This structure, it was believed, offered the potential for le- veraging knowledge assets, especially in the areas of prospecting and development. It also offered the prospect of leveraging some scale economies. Gazprom had developed a two-stage plan to reorganize the company’s seven subsidiaries, spread over 11 geographic regions, into six business divisions overseeing production, maintenance, and transportation.

Starting with a stronghold in gas, Gazprom had expanded to other areas within the realm of energy. In 2005, it acquired most of Sibneft, the country’s fifth largest oil company, in a buyout that was then the biggest ever in Russian history. Gazprom also had a 10 percent interest in RAO UES, Russia’s largest electricity provider, and 25 percent of Mosenergo, Moscow’s utility services company. These holdings cemented Gazprom’s position as the leading energy company in the country. It was this dominant position combined with opaque relationships with the power brokers in the Kremlin that worried competitors and customers both within and outside Russia. (Appendix 3 shows the holdings portfolio of Gazprom.)

The Domestic Market for Gas in Russia Price controls and government supply mandates were two of the most crucial features that had come to charac- terize the market for energy in Russia. Although Russia was adopting a more modern approach to its enterprises by encouraging their globalization, allowing their listing on foreign exchanges, and helping them forge alliances and joint ventures with western firms, it still had to contend with its legacy under communism when collective good outweighed all else. In the energy sector, this translated into crippling controls on pricing. For example, Gazprom was able to earn only about 20 percent of the revenues in its home market of what it could earn in foreign markets. Russian law mandated that Gazprom sell gas domestically at a controlled price, about $50/thou- sand cubic meters (including taxes and excise duties), although the government, despite widespread discontent, was committed to raising the floor prices. The Russian government had committed to wholesale deregulation of gas prices by 2011 when Gazprom would be permitted to charge market-based prices to its industrial customers. However, prices for domestic consumers, who constituted 15.7 percent of Gazprom’s sales in 2007, were not expected to be deregulated.

Domestic consumption in Russia was increasing significantly at a time when production was declining in three of Gazprom’s biggest fields. The West Siberian fields of Urengoy, Yamburg, and Medvezhye had all fallen close to 50 percent below their original production levels. To compensate for these aging fields, Gazprom had set forth a plan to accelerate development of many smaller fields, but it was believed that even with these new fields coming online, there would still be a supply shortfall. Domestic consumption growth was partly attributed to the overall growth of the economy itself. This growth pressure was also accentuated by some of the realities of the local gas distribution system. For example, most buildings designed during the Soviet era did not have the necessary infrastructure to monitor gas usage. Individual meters for customers were unheard of and retro- fits almost impossible. Thus, customers did not know how much gas they were using, making it impossible to institute any energy savings plans. To complicate matters further, it was even difficult to get a clear idea of how much they were paying for gas on an individual basis. Payments were possible in a wide range of options from cash to barter arrangements.4 It was widely believed that Russia was the only country in the world where gas was cheaper than coal, making it difficult to rein in consumption. In keeping with national plans for both rural and urban development, more and more parts of the country were coming under the gas infrastructure. Roughly 62 percent of the homes in Russia had begun to use gas, a 20 percent increase since 1993 when Gazprom was privatized. This trend was expected to continue with the government’s ambitious plan to bring the eastern regions of the country under a gas infrastructure.

Gazprom’s Gas Fields—The Crown Jewels Gazprom controlled the vast majority of Russia’s gas resources, a pre-eminent position considering the fact that Russia was also the single largest holder of gas reserves worldwide. Many of the reserves were located in the chal- lenging Siberian regions of the country that were characterized by very short periods that allowed for exploration, followed by long periods of harsh winter conditions. The largest remaining untapped fields were in the Yamal-

4 TB0005

Nenets region, onshore as well as offshore. These fields included Shtokman and Bovanenkov, both of which were considered gas giants. Much of the production, about 70 percent of Gazprom’s total output, was occurring in the Urengoy, Yamburg, and Medvezhye fields, all of which had seen brighter days with respect to yields.

In the near term, Gazprom’s four largest fields were expected to suffer production declines of around 50.4 bcm/y.5 Although there were new fields awaiting investments for commercialization, Gazprom had competing priorities. The last field to come online was the huge Zapolyarnoe field with a yield of about 100 bcm/y. The Yuzhno-Russkoye field was also brought online in late December of 2007. A joint venture with BASF, this field was expected to reach its designed production capacity of 25 bcm by 2011. Despite these new additions, the amount of new gas being brought online was believed to be incapable of stemming Gazprom’s production declines. It is worth noting that prior to the Zapolyarnoe and Yuzhno fields coming online, the last previous addition to the capacity had occurred in 1991.

In addition to the new fields, there were three more that had come under Gazprom’s sphere of influence. At the behest of the Russian government, Gazprom had obtained a controlling interest in the Sakhalin II project, developed by Shell and its consortium of Japanese partners in 2007. One of the largest of its kind in the world, this project was expected to yield 643 bcm of gas and 173.4 million tons of oil and condensate. The project was in advanced stages of commissioning when Gazprom bought a controlling interest for $7.45 billion. (Appendix 4 provides a brief history of Sakhalin II and the assumption of control by Gazprom.)

The second major field awaiting development was the massive Shtokman field in the Barents Sea. Gazprom had originally intended to use a consortium of contractors to develop the field instead of partnering with IOCs, who were clamoring for the opportunity. Subsequently, a partnership deal was struck between Gazprom, Total of France, and StatoilHydro of Norway. In a departure from the standard practice of offering the IOC partners an equity stake in the field, Gazprom constituted a wholly owned subsidiary that would hold the lease and title to Shtokman. Total and StatoilHydro would function as contractors to the company and own 25 percent and 24 percent, respectively, of the company’s equity, albeit one step removed from the title holder.

The third major field that had emerged was Kovykta, originally discovered in 1987. BP and its partner had held it for a considerable period of time. Alleging production delays at the field, BP and its partner, TNK, were sidelined to make way for Gazprom to take it over. TNK-BP agreed to sell the field to Gazprom in 2007 for between $700-$900 million. Analysts had estimated the value of the property at $3 billion, making the deal a very good one for Gazprom. Kovykta was thought to contain 2 tcm of gas, making it one of the largest fields in the world. However, as of October 2008, the transaction had not been completed. Given the very long-term development horizon and the cost involved, Gazprom had even observed that the property was “worthless.”6

A confluence of likely scenarios included spiraling domestic demand, a decline in domestic production, ever-increasing costs to bring new capacity on stream, and an increase in prices demanded by FSU (Former Soviet

Exhibit 1. Gazprom’s Supply v. Sales (data in billion cubic meters—bcm)

Source: Gazprom

TB0005 5

Union) suppliers that fell within the Gazprom sphere of influence. In assuaging some of the fears expressed by foreign buyers in Western Europe, Alexei Miller had observed, “Our international business ties and our joint projects have turned Gazprom into a global company. We will rigorously abide by all of our long-term contract obligations. The size of our reserves permits us to confidently state that Gazprom is able to meet any solvent consumers’ demand for gas, in domestic and foreign markets alike.”7

The Power of the Pipeline There was perhaps no bigger asset that Gazprom inherited at its creation than the network of pipelines to trans- port gas. Called the Unified Gas Supply System of Russia (UGSS), the network was the largest in the world, built to withstand challenging environments. It spanned 157,000 km (97,500 miles), enough to circle the world more than 24 times. Although it had achieved a throughput of 717 bcm by 2007, it was already far below the capacity needed. Of this capacity, roughly 22 percent was used to carry gas produced by independent produc- ers, both within and outside Russia—for example, from fields in Central Asia. This network provided Gazprom significant power to dictate the strategy of many independent producers, both local and foreign. Exhibit 3 shows a map of Gazprom’s UGSS network.

In the face of rocketing demand and declining gas yields, Gazprom had resorted to importing gas from friendly FSU countries, such as Turkmenistan. While some of the domestic oil producers did indeed have the ability to produce gas from their operations, there was little incentive for them to do so since Gazprom virtually controlled the entire domestic transmission system. The company had been very careful in allowing transmission from other producers, sometimes claiming that specifications of their production were not within the tolerances allowed by its network or that no spare capacity was available. However, it did stand to benefit significantly by tapping other independent producers to transport gas to locations where it could make a trading gain. Most independent producers had to sell to Gazprom at wellhead prices that were below even domestic prices. For example, Lukoil was selling gas under long-term contract from its Yamal-Nenets field to Gazprom at $22 per thousand cubic meters, when Gazprom itself was charging more than $36 even in nearby domestic markets. This also had the important benefit of strengthening its supply position by augmenting its own production and making it even more powerful.

The UGSS infrastructure was also a tool of political influence used by the Russian government. This was illustrated most notably in 2006 when Gazprom decided to shut off gas supplies to Ukraine. The shutdown was ostensibly meant to force Ukraine to settle its bills for the gas it had already received, and also to enforce a higher

Exhibit 2. Production in Major Russian Gas Fields 2001-2011

Source: “Russia,” Country Analysis Brief, Energy Information Administration, 2008. 2008-2011 are estimates.

6 TB0005

price for future supplies. Russia had always provided subsidized gas to the FSU republics, but the cost of such a subsidy had risen significantly. The closure of the pipeline coincided with the Orange Revolution in Ukraine when the newly elected democratic government there started moving closer to Western powers. Thus, it was unclear whether political priorities superseded business interests, or vice versa. The effects of this closure continued to linger in the EU countries that were importing Russian gas. Many of these countries were aggressively pursuing alternatives so that they could reduce their dependence on Gazprom supplies.8 (Appendix 5 provides data on the proportion of market shares controlled by Gazprom in Europe.)

By 2008, there were many serious questions about the continued viability of the transmission network. First, there was the issue of increasing demand on the one hand, and the pipeline capacity bottleneck on the other. It was estimated that by 2020 the network would need additional capacity of 170 bcm, an increase of roughly 24 percent over its installed capacity as of 2008. Second, it was believed that much of the UGSS infrastructure had to be significantly upgraded. It was reported that roughly 60 percent of the pipelines were more than 20 years old,9 and about 14 percent were being operated well beyond their expected life.10 Upgrading these assets required very significant investment—around $2 bn annually. Gazprom was in the process of strengthening the network, although most of its focus was on international transmission. There was feverish activity to build new trunk lines that would enable Gazprom to reach deeper into Europe and ports along the Caspian Sea to tap into export markets.

The Foray into the Oil Business The purchase of Sibneft in 2005 was Gazprom’s most significant oil investment. While some, including Dmitri Medvedev, the current president of Russia, then chairman of Gazprom, presented the Sibneft acquisition as a fairly common one that occurred in all free markets globally, others believed that there was much more to it. This was seen as a vital piece of Russia’s strategy to bring back oil resources that had been privatized. Rosneft, the Russian oil giant, had already acquired Yukos, originally one of Russia’s leading oil producers. Yukos had been decimated by a tax charge that many believed was payback for Yukos CEO Mikhail Khodorkhovsky’s political

Exhibit 3. The Unified Gas Supply System of Russia

Source: Gazprom.

TB0005 7

ambitions that crossed Putin’s path. Thus, the acquisition of Sibneft by Gazprom, a friendly ally of the govern- ment, was considered a good step to effectively rein in a significant part of Russia’s oil assets.

Describing the Sibneft acquisition, Russian Natural Resources Minister Yuri Trutnev said, “On the one hand, this makes Gazprom the world’s largest energy company, which positively influences the investment at- tractiveness of both the firm and also of Russia. On the other hand, the transaction arouses certain fears as to the efficiency of managing the new oil assets and the possibility of monopolizing the market.”11

Roman Abramovich, who bought the company via a privatization plan in 1995, paid $100 million for Sibneft. Barely ten years later, Gazprom paid $13 billion to acquire the company from Abramovich. At the time, Sibneft was the fifth largest oil company in Russia with a production of 650,000 barrels (88,400 tons) a day. The company came with healthy reserves estimated at four billion barrels. It also had a very large refining capacity in Omsk, believed to be among the biggest in Russia. This was indeed a crucial piece of Gazprom’s vertical integration strategy in oil, given that the refinery was linked to all its major fields via pipeline networks. The company leveraged this close proximity to its Siberian fields as a source of significant cost advantage over other producers.

Gazprom’s oil interests were also consolidated through a joint venture with TNK-BP for a 50 percent inter- est in Slavneft. Through this venture, Gazprom had access to more refining capacity. There had been rumors of a forced sell-off of TNK-BP’s interests in the venture to Gazprom, but this had not materialized. The company also owned a retail network that was strong in Western Siberia, where many of its oil fields were located.

Gazprom intended to leverage its position in the oil business and expand operations to cover parts of Central Asia and beyond. By 2008, it was already operating a small network of retail outlets in Kyrgyzstan. The immediate priorities, however, were related to bringing more of its fields online and increasing its prospecting activities so that it could book more reserves. Its reserves to production ratio stood at 23 years. A significant proportion of the company’s projects were considered to be early in the cycle of production development, however. Although mostly limited to Russia, Sibneft’s portfolio of exploration leases was quite large. The service operations of its oil business were carried out by 17 service affiliates, all owned by Gazprom. These companies alone employed 20,000 people. They carried out the basic service functions, such as seismic surveys, drilling rigs construction, well drilling, and other related activities. The oil interests ensured synergies in strategic thinking and execution. The service companies were managed as a consolidated entity named Gazprom Neft–Neft’eservice.

Gazprom had built an advantageous position in the petrochemicals segment as well by moving quickly to capitalize on an opportunity that emerged in 2001. Through its banking arm Gazprombank, it was able to gain control of 70 percent of SIBUR Holding, Russia’s largest petrochemical company. Gazfond, Russia’s larg- est pension fund, controlled 25 percent, and the rest were in the hands of company management. This move proved to be a crucial one in that it cemented Gazprom’s position as a fully integrated company spanning both upstream and downstream segments, including the lucrative petrochemicals segments. Of particular relevance was the dry gas processing facilities that SIBUR operated. Between Gazprom’s own gas refineries and those of SIBUR, Gazprom essentially controlled almost the entire gas processing market in the country.

Exhibit 4. Prospects in Oil for Gazprom Neft’

R/P Ratio (Reserves to Production—years)

21 21.5 22 22.5 23

2004 2005 2006 2007

R/P Ratio (Reserves to production)

R/P Ratio (Reserves to Production—years)

21 21.5 22 22.5 23

2004 2005 2006 2007

R/P Ratio (Reserves to production) Source: Gazprom Neft.

8 TB0005

Global Ambitions: “Near” Abroad and “Far” Abroad Global challenges require global efforts for their resolution. For this reason, the sphere of our inter- ests is not limited to the European continent. It is well known that gas production has been steadily dropping in the United States in recent years (by more than 30 billion cubic meters between 2001 and 2006), while Russia over the same period has been able to boost production by 70 billion cubic meters. Gazprom has unique experience, know-how, and modern technologies, and is the world’s most advanced company in the field of gas transmission via high-pressure gas pipelines.

Alexei Miller, Chairman, OAO Gazprom, XII St. Petersburg International Economic Forum, June 2008.

Gazprom was conceived within an international context. The breakup of the Soviet Union resulted in a set of self-governing republics that became independent countries in their own right. Although they parted ways with centralized Soviet control, the gas infrastructure that was built to supply many of these former republics was still very much in use. Countries like Turkmenistan, Kazakhstan, and others along the Caspian Sea who were produc- ers used the UGSS operated by Gazprom. Countries such as Belarus and Ukraine were dependent on Russian gas carried through Gazprom pipelines. Referred to as the “near abroad” by Russians, these countries belonged to the Soviet Union. Near abroad also signified close links that had been fostered over the decades when they were politically connected to the Soviet Union’s sphere of influence. Leveraging these connections was indeed a natural avenue for Gazprom to capitalize on as it set its sights on crafting a global strategy. The first step was essentially to entrench itself in the near abroad so that it could retain crucial transit rights for its pipelines that would eventually target Western European markets while at the same time help monetize gas production in the former Soviet Union countries.

Gazprom also exerted significant influence over those near abroad countries that either did not have energy reserves or were otherwise unable to access them. Countries such as Armenia, Belarus, Moldova, to name a few, were supplied fully by Russia through Gazprom pipelines. These relationships were also a throwback to the Soviet days. The pricing structure for many of these countries was a fraction of free-market prices, thus ensuring that their governments were indeed beholden to Russia in a variety of foreign policy matters.

Although the near abroad had become Gazprom’s fiefdom, there were periodic difficulties in enforcing control over its pipeline networks, especially when the republics involved were being wooed by Western pow- ers that had their own designs. The Baku-Tbilisi-Ceyhan pipeline, from Baku in Azerbaijan to Ceyhan on the Turkish Mediterranean coast, was a prime example of the jostling for influence by major political powers. While Russia wanted to ensure continued control over the near-abroad countries, far-abroad powers were exploring ways in which they could create alternatives to Russian dominance in the region. With the patronage of the Rus- sian government, Gazprom had managed to navigate these choppy waters and maintain its position as either a premier supplier of gas or a partner of choice for producing countries in the region. Many of the countries, such as Macedonia and Belarus, were dependent on Russian supplies for almost 100 percent of their needs. In 2007, Russia exported 191 bcm (billion cubic meters) of natural gas, of which roughly 37 bcm went to the near-abroad countries. Although these countries constituted only 22 percent of Russian gas exports, their importance was far more strategic when it came to ensuring transit access to the more lucrative European markets to the west. For

Exhibit 5. Russian Gas Supply Prices for Near-Abroad Countries (2008)

Destination Price in $ per thousand cubic meters Lithuania 280.00 Latvia 280.00 Estonia 280.00 Georgia 230.00 Moldova 191.25 Ukraine 179.50 Belarus 119.00 Armenia 110.00 Western Europe 370.00

Source: “Russia,” Country Analysis Brief, Energy Information Administration, 2008.

TB0005 9

example, 80 percent of all Russian gas exports had to flow through pipelines located in Ukraine. Thus, while Ukraine itself had no natural gas deposits, its position on the transit route gave it unique leverage that had been used to keep gas prices low in that country.

First, producer countries in the near-abroad region—such as Turkmenistan—did not have alternative routes to monetize their energy reserves. Gazprom, under the auspices of the Russian government, was able to persuade these countries to link to its extensive network as a means of commercializing the gas that they produced. These deals were inked at very low prices, giving Gazprom the ability to sell the same gas to Western European buyers at much higher prices. For example, Turkmenistan signed a 25-year deal with Gazprom at $44 per thousand cubic meters to be paid in cash and commodities. Gazprom was selling the same gas to Western Europe at three times the price,12 making an easy transactional profit that would continue for years to come. Second, the augmentation of supplies from the near abroad ensured not just continued Russian control, but also offered Gazprom an easy way to overcome the supply shortfalls it had in its domestic and/or export markets. Within Russia, the govern- ment had decreed that Gazprom would be the only legal channel for gas exports, thus giving it a wide berth to articulate a global approach to its business.

Gazprom in Western Europe Gazprom was able to leverage the export channels to reach customer markets in countries such as Germany, Italy, France, and Austria. Gazprom’s predecessor (the Ministry of Oil and Gas Industry) had been exporting gas to Austria since 1968. By 2008, Gazprom was supplying roughly one third of total gas consumed in Western Europe. For example, Germany was dependent on Russian gas for nearly 39 percent of its consumption, and Italy was dependent to the tune of 31 percent. Starting with an approach of selling gas only at the border of its customer countries, Gazprom had become a participant in the entire delivery chain at the local level in some places. One of the key examples of such vertical integration was the joint venture forged with Wintershall, a German oil and gas company owned by BASF, to create a new venture named Wingas in 1993. Gazprom held 50 percent minus one share in the enterprise. Wingas owned 2,000 km of distribution pipelines in Germany, and Europe’s largest underground storage facility. The venture offered Gazprom its first local access in a Western European market. (Appendix 6 shows a schematic of Gazprom pipelines in Europe.)

Gazprom sold its gas primarily on long-term contracts, typically over a 25-year period. These contracts also contained “take-or-pay” clauses that reduced the risks that Gazprom would otherwise have to carry. Going

Exhibit 6. Major Destinations for Russian Gas

Sources: “Domestic Consumption,” EIA International Energy Annual, 2007; “Exports 2006 and 2007,” Gazexport as cited by Energy Intelligence, March 2008.

10 TB0005

forward, these contracts seemed to be crucial to Gazprom because Western European buyers were evaluating potential alternatives that had appeared over the horizon. North Africa and the Middle East seemed to be two viable provider regions, but it was premature to determine their viability in the near term. Many of the European oil and gas companies were engaged in alliances and joint ventures with Gazprom as a possible foil to the per- ceived imbalance in the relationship between the provider and buyers. Companies such as Eni of Italy, E.ON of Germany, and Gaz de France (GDF) were all associated with Gazprom on a range of projects from exploration to pipeline construction. Besides the obvious benefits of an assured market for its gas, Gazprom was focused on Western Europe because of the higher prices it was able to realize there. Three major projects were in various stages of approvals and execution to cement these links. The Blue Stream, Nord Stream, and South Stream proj- ects were primarily pipeline projects that were targeted to carry gas to markets in Western Europe. The company expected to grow its Western European market faster than its domestic and near-abroad markets.

Gazprom had set up operations in the U.K. in 2006 at a time when the relationship between Russia and the U.K. was at a low point following allegations of espionage and murder involving KGB agents and Russian oligarchs domiciled in the U.K. Gazprom had bought a fairly small British gas supply business, Pennine Natu- ral Gas, a company that supplied gas mostly to small-and medium-scale enterprises. By 2008, it had grown its customer base to about 5,000. However, these moves were being watched very closely. The Wall Street Journal reported that the EU was seriously contemplating how such moves could be stopped. “Gazprom embodies ev- erything the EU is trying to change—vertically integrated national champion with a monopoly on exports and that owns gas fields and pipelines. In a preemptive move against Gazprom, the EU is mulling a plan to stop such companies from controlling EU distribution networks.”13 The company did point out that much of the gas that it was selling in the U.K. came from swaps and not from its fields in Siberia, more than 7,000 miles away.

Gazprom also did have its supporters. Reflecting a widespread sentiment among U.K. brokers who had done business with Gazprom, Michael Abbot of Inenco, an energy consulting company, observed, “Gazprom is new to the market, so they’re fleet of foot and innovative.”14 Building on this U.K. experience, Gazprom intended to move into France, although it believed that the legislative barriers could be more formidable there.

Going to America: The Very Far Abroad The promise of America was indeed a strong pull on Gazprom’s global intentions. In 2005, the company had delivered LNG to the Cove Point regasification terminal in Maryland under contract with British Gas and Shell. Although there had been some talk about shipping LNG from its Sakhalin II project with Shell to Baja California, it was unclear whether the plans for exports to the U.S. market would ever take flight. The U.S. was one of the largest consumers of gas by a wide margin, and Gazprom was keen to establish a foothold there. The company was examining several possible avenues to achieve this goal, including acquisitions. Vitaly Vasiliev, the CEO of Gazprom marketing and trading, observed, “We can build organically; we can do it with a partnership to build an outlet for us in the U.S., or the third option would be acquisition.”15 Gazprom had already signed a deal with a consortium of French and Canadian partners to set up an LNG regasification terminal in Quebec, Canada. The intent was to bring gas from Gazprom’s Shtokman field to North America. It was also in discussions with BP and ConocoPhillips on participating in the Alaskan gas pipeline that had been planned. “It is important that we have a position in the most liquid gas market, which is in Houston for Henry Hub,” said Vasiliev, in describing Gazprom’s desire to anchor its U.S. operations in America’s oil country.16

The more Gazprom had pushed into Western markets, the more it realized that it would have to go beyond its delivery-at-the-border approach. Many of the buyers, it found, were trading its gas in markets where price margins were a lot higher, distributing themselves, converting it to electricity, and in general making a lot more money than Gazprom did. In capturing additional value for itself, Gazprom had sought to bolster its own mar- keting and trading operations. It was with that end in mind that it targeted Houston. It had already captured 8 percent of the wholesale market in the U.K. and 1.5 percent of the retail market as well. Its customer base had doubled in a year. Similar results were expected in France. Success in the U.S. would complete that strategy of capturing value for itself.

TB0005 11

Looking at the Future: An Ambitious Project Portfolio Because you are Gazprom, everybody wants to talk to you. There are so many opportunities; the idea is to choose the best.

Vitaly Vasiliev, quoted in “Russian Unit Heads in New Direction,” Financial Times, June 11, 2008.

Gazprom appeared to be in an enviable position in mid-2008. However, it was also very apparent that it would have to move quickly to address some strategic priorities methodically. Hostilities had broken out between Russia and Georgia in the disputed region of South Ossetia. The fighting had also spread to Abkhazia, another nearby disputed region on the Black Sea. Although a hasty ceasefire had been called, there was a real danger that the Baku-Tbilisi-Ceyhan (BTC) pipeline could be damaged. The BTC represented the first tangible achievement of Western Europe’s desire to seek alternatives to Russian gas. It brought Azeri gas from Baku to the Turkish port city of Ceyhan and well into the sphere of EU influence. Apart from a gentle condemnation of the conflict, Western Europe did not appear to have much to say about Russia’s role. Gazprom had won friends through the pipeline after all. Of course, it was also in Gazprom’s best interests to help keep those friends.

While the key components of Gazprom’s global strategy had focused largely on Europe, eyeing the rise of India and China, Gazprom had started looking East. It had already entered into a joint exploration program with the Gas Authority of India Ltd. (GAIL). It was also prospecting in Vietnam in some of the prime targets for gas deposits. It had cast its net quite wide to also include Venezuela, where it held prospecting licenses. Libya and Nigeria were possibilities as well, and some high-level talks had been conducted at an intergovernmental level. Gazprom had set out an agenda to first capture gas that was being flared in Nigeria, and had also made a statement that it could easily replace Shell in that country should there be a meeting of the minds. These were indeed ominous signs that created concern among EU countries and U.S. IOCs that were among the first to commercialize Nigeria’s energy resources. Gazprom had also signed exploration deals with Libya and, in 2007, struck a downstream deal as well. Under terms of the agreement, Libya’s National Oil Corporation (NOC) would form an alliance with Gazprom to set up a refining plant in Libya. Gazprom had also offered to buy all Libyan oil and gas exports, an offer that was reportedly well received by the Libyan government.17 U.S. officials, who feared a loss of control and influence over future energy supplies, also did not welcome this move. U.S. Deputy Assistant Secretary of Eurasian Affairs Matthew Bryza observed, “The monopolist Gazprom is behaving like a monopolist does. It tries to gain control of the market as much as possible and to stifle competition. And that’s clearly what’s going on.”18

Gazprom had risen on the wave of success in exploiting gas resources within its own borders and the near- abroad countries. Its future, at least in part, seemed to be tied to that of Central Asia. A significant portion of Gazprom’s gas exports came from supplies that it had contracted for in Turkmenistan, Uzbekistan, and Kazakhstan. These three countries accounted for roughly 54.4 bcm/y against Russia’s exports of 191 bcm/y. Turkmenistan and Uzbekistan were already exploring other routes to commercialize their gas outside the Central Asia center pipeline that Gazprom operated. Gazprom was developing projects in Tajikistan and Kazakhstan, countries that seemed friendlier than some others. Access and transit rights depended on pricing and the ability to lock in long-term contracts. It remained to be seen whether some of these markets would turn liquid and favor spot trading with the advent of more transportation options. The pricing for gas from these countries had already started to trend upwards.

At home, Gazprom was looking to become far more active in the Yamal-Nenets region, where several new finds had been made. The region comprised 26 fields that had not yet been harnessed, a process that would considerably ease the strains and stresses of declining yields in Russian fields. However, it was estimated that this process would cost roughly $160 billion to accomplish.19 It was toward this end that the company had an- nounced its intent to increase capital expenditure by 40 percent in 2009, to $65 billion. Although this appeared like a fairly steep increase, some analysts opined that the figures were inflated largely by rising service costs rather than true investments. Gazprom planned to spend $20.4 billion in natural gas production and transportation, of which $8.7 billion had been earmarked for production in 2008.

12 TB0005

On the anvil for Gazprom were some large-scale pipeline projects that had the ability to either solidify its reach or weaken it beyond repair. The Nord Stream and the South Stream projects were two that seemed to have both a strong economic and political dimension. The Nord Stream pipeline was a joint partnership between Gazprom (51 percent), BASF (24.5 percent), and E.ON (24.5 percent). It planned to link production from the Russian gas main at Gyrasovez to the Baltic Sea at Vyborg, and with the gas distribution system of Germany, without transiting any other countries. More than 1,200 km of the pipeline would run under the Baltic Sea. While the first segment was expected to become operational in 2010, it would reach its capacity by 2016. It was estimated to cost around $7.4 billion. By mid-2008, the project had been delayed by Sweden, a Baltic neighbor, as the government did not appear satisfied with the environmental impact assessment of the project. While this project would certainly help German consumers, it did pose a challenge to the EU because it wanted to speak with one voice regarding gas distribution among EU member states and relationships with Gazprom. The South Stream was a similar venture seeking to establish a direct line between Russia and Italy.

There were additional projects on the drawing board to connect Russia with China via the Eastern route from Sakhalin, and via a Western route from Western Siberia. Gazprom had been exploring the feasibility of these lines with China National Petroleum Corporation (CNPC). The ambitious projects would drain much of Gazprom’s capital budgets, leaving very little for augmenting production. Many of its customers felt that while the pipelines to carry the gas might eventually become a reality, there was less certainty about Gazprom’s abil- ity to increase its gas production in parallel to keep the pipeline stocked and flowing. This greatly influenced Gazprom’s perceptions of energy security.

Storm Clouds over the Horizon Gazprom had indeed become a major force to contend with on the world scene by 2008. It seemed to be poised to become a premier player in some areas, but in many ways these were both the best of times and the worst of times. There were several critical issues that had to be sorted out, both internally and externally.

In late 2007, Gazprom had clearly signaled its intent to use the production of gas from the Sakhalin I project owned by a consortium of partners that included ExxonMobil, Russia’s Rosneft, Japan’s Sakhalin Oil and Gas Development Company, and India’s ONGC Videsh. Gazprom had unveiled its Eastern Strategy calling for gas fields in that region to contribute 30 percent of all Russian energy exports, a ten-fold increase, by 2030. The major point of concern was the mandate that Gazprom had been given by the Russian government to gasify the Russian Far East. Gazprom expected help to come from two sources: Kovytka and Sakhalin. Under the watch- ful eyes of the Russian government, TNK-BP was engulfed in a crisis over its Kovytka fields. The government alleged that the project was set back because of undue delays, thus limiting the prospects of a fair return to the Russians anytime soon. This gave the government the leverage to inject Gazprom into the equation as a potential buyout partner for Kovykta. TNK-BP appeared willing to go along, although progress was slow and protracted. BP contended that the fields had become uneconomical because the government had decreed that it could sell its output only in the domestic market where prices were controlled. Along similar lines, it was quite possible that ExxonMobil and its partners in the Sakhalin I project would also be called upon to sell gas domestically. It appeared that ExxonMobil would not entertain such a stipulation because the economics of the project would be in jeopardy, given the paltry prices that prevailed in the Russian Far East.

The EU was unhappy over the turn of events over the last decade that had seen the rise of Gazprom as the key gas supplier to Western Europe. The precarious dependence seemed to be accentuated by the fact that Gazprom seemed able to strike separate deals with EU countries and also venture forward with integration into distribution systems in some of these countries. The EU wanted to bring Russia under the rules of its energy charter so that Gazprom would not exercise undue leverage, given its pre-eminent position as a supplier to Western Europe. Fifty-one countries had signed the charter in 1990 as a prelude to energy cooperation in Europe. Russia had refused to sign on given obvious differences.

Gazprom had become quite dependent on its European portfolio just as its customers had become reli- ant on Gazprom for stable supplies. (See Appendix 7 for an analysis of Gazprom sales and destinations.) Thus, diversifying away its dependence seemed an urgent priority. Money for expansion and diversification projects

TB0005 13

was sure to be in short supply. By early October 2008, the global financial crisis that was rocking key markets had begun impacting Russia as well. The price of oil had dropped from its highs of $146 per barrel to below $70 dollars, drying up potential sources of capital funds for many of the energy companies such as Gazprom. In 2007, Gazprom already had a debt load of $61 billion, of which $21 billion was short term. (See Appendices VIII to XI for data on Gazprom’s finances.) With local sources of capital drying up, it appeared that Gazprom would be forced to seek capital in foreign markets, a proposition that would be far more expensive.

The stance with European and U.S. IOCs had also become quite hardened. Medvedev, in an interview with the Financial Times, had remarked, “Gazprom’s strategy calls for the formation of complete-cycle ‘production-sales’ transnational chains. Therefore, while discussing the possibility of access for foreign partners to the development of our reserves, we want to understand what the deal will give Gazprom from the point of view of the develop- ment of our production chain abroad. We do not need assets as such; we need a synergy with existing business and enhanced positions of a global player in the energy market.”20 Eni of Italy had been a notable partner for Gazprom, and had shown a willingness to join hands with the company under these terms of complementary access to reserves and markets. It had signed on as a key partner on the South Stream project to carry Russian gas to Italy. Gazprom had also been promised downstream participation in the domestic Italian market, plus a variety of other projects under the aegis of Eni, such as in Libya and, jointly, in Venezuela.

In the middle of a frigid winter in early 2009, Gazprom once again shut off gas supplies to Ukraine. Cit- ing the very same reasons of low prices and unpaid bills, Prime Minister Putin personally ordered the shutoff. Western European nations were up in arms because of the uncertainty surrounding continued supplies of gas, especially because of the importance of Ukraine in the transit routes. This once again demonstrated the unreli- ability of Russia as a supplier, they said. Buyers who argued that Gazprom had violated their contracts were contemplating legal action. In turn, Gazprom used the occasion to underscore the need for immediate action on the Nord Stream pipeline that would bypass Ukraine. Tensions flared on all sides before a resolution was hast- ily crafted. Ukraine would pay off unpaid bills and agree to higher gas prices. The effect of this sudden closure left Western European buyers deeply disturbed because they believed this could happen all over again, and they might eventually suffer the consequences of a loss in supply.

Would Gazprom ever be a reliable partner? Would it ever be able to realize its full potential in the global gas business? With declining prices on the horizon, the once rosy future now seemed a bit hazy. Alexei Miller had much to contemplate as he thought about the challenges ahead. He did appear positively ebullient despite the formidable tasks that lay ahead. In an interview with the Financial Times, Miller had observed, “We think the price of oil will reach $250 per barrel in 2009. The competition for resources is growing and the tendency is very noticeable.”21 Whether this was indeed a realistic possibility or just wishful thinking, only time would tell.

14 TB0005

Notes 1 Mortished, Carl, “Gazprom to Raise Its Own Private Army to Protect Oil Installations,” The Times, July 5, 2007. 2 Kramer, Andrew, “As Gazprom Goes, So Goes Russia,” The New York Times, May 11, 2008. 3 Victor, Nadejda Makarova, “Gazprom: Gas Giant under Strain,” Working Paper 71, Program on Energy and Sustainable Development, Stanford University, 2008. 4 Ibid. 5 “Russia,” Country Analysis Brief, U.S Energy Information Administration, www.eia.doe.gov/emeu/cabs/Russia/NaturalGas. html, 2008. 6 Crooks, E., and Belton, C., “Stake in TNK-BP Labeled ‘Worthless,’ ” Financial Times, October 17, 2008. 7 Miller, Alexei, “Energy—Global Players and Referees (Interdependence, Partnership and Competition),” XII St Petersburg International Economic Forum, St Petersburg, Russia, June 6-9, 2008. 8 Mitrova, T., “Gazprom’s Perspective on International markets,” Russian Analytical Digest, Vol 42, pp 2-16. 9 http://eng.gazpromquestions.ru/index.php?id=6. 10 Fredholm, M., “Strategy and Energy Policy: Pipeline Diplomacy or Mutual Dependence?” Conflict Studies Research Centre, UK Defence Academy, Russian Series, 05/41, 2005. 11 “Gazprom-Sibneft: A Transaction with Many Dimensions,” Hermitage Capital Management, November 8, 2005, pp 10-16. 12 Smith, K C., “Russian Energy Politics in the Baltics, Poland, and Ukraine,” Center for Strategic and International Studies, Washington, D.C., 2004. 13 Chazan, Guy, “Gazprom Eyes UK as Foothold into Consumer Market,” Wall Street Journal, January 28, 2008. 14 Ibid. 15 Crooks, E., and Politi, J., “Gazprom Looks at Acquisitions for US Toehold,” Financial Times, June 11, 2008. 16 Ibid. 17 Murina, E., and Pedersen, J., “Gazprom, Libya to Form Refining JV,” www.downstreamtoday.com/News/Articles/200807/ gazprom_Libya_To_Form_Refining_JV_11786.aspx, 2008. 18 “Gazprom Libya bid Imperils Moves to Curb Russia’s Energy Clout,” Tehran Times, July 12, 2008. 19 “Russia Gazprom Investment,” Oxford Analytics, International Herald Tribune, April 23, 2008. 20 Belton, C., Hoyos, C., and Crooks, E., “Transcript: Interview with Gazprom Chief,” Financial Times, www.ft.com, June 26, 2008. 21 Hoyos, C., and Blas, J., “Gazprom Predicts Oil Will Reach $250,” Financial Times, June 10, 2008.

TB0005 15

Appendix 2. Gazprom and Competitors—Financial Comparisons

Company Country Market Cap.

Mn $ P/E ratio ROE% ROA% ROIC%

Gazprom Russia 317,462 11.60 15.30 9.70 13.20 Lukoil Russia 77,869 6.66 25.67 17.63 22.46 Gazprom Neft Russia 35,607 9.55 40.69 26.98 33.44 Surgutneftegas Russia 41,176 10.86 9.83 9.15 9.71 TNK-BP Russia 33.912 5.01 73.96 31.86 60.87 Rosneft Russia 112,447 14.03 51.13 21.16 29.45 Novatek Russia 26,112 24.18 25.04 19.90 23.62 PetroChina China 389,842 10.75 22.06 15.07 20.44 Petrobras Brazil 250,332 14.66 20.35 9.74 16.07 BP UK 200,450 8.53 23.39 9.19 18.64 Chevron Texaco USA 194,242 10.30 25.60 13.28 23.11 ConocoPhillips USA 135,273 8.34 13.86 6.94 11.33 ExxonMobil USA 445.468 10.96 34.47 17.61 32.47 Royal Dutch Shell Netherlands 238,571 7.20 27.28 12.41 23.75 GLOBAL MEAN 9.26 27.98 13.15 24.38

Source: “Gazprom: What is the Nature of Monopoly’s Income Growth?” Bloomberg and Veles Capital, July 11, 2008.

Appendix 1. Gazprom Key Statistics

2007 2006 2005 2004 2003 Share of global natural gas proved reserves % 16.30 16.02 16.10 15.77 15.93 Share of Russian national gas reserves % 62.3 62.4 61.0 60.5 58.3 Share of global natural gas production % 17.37 18.05 18.52 18.59 19.02 Share of Russian national natural gas production % 84.27 84.72 86.61 87.33 88.29 Pipeline infrastructure (‘000 Km) 545 514 485 463 428 Size of retail customer network (million homes) 25.9 26.1 25.6 25.1 22.8 Total Natural Gas Reserves tcm 20.82 20.73 20.66 20.9 18.5 Gas condensate reserves (million tons) 686.1 658.99 692.60 654.4 588.2 Crude oil (million tons) 1132.5 1066.48 1231.7 235.96 132.5

Source: “Gazprom: What is the Nature of Monopoly’s Income Growth?” Bloomberg and Veles Capital, July 11, 2008.

16 TB0005

Appendix 3. The Portfolio of Ownership and Holdings of OAO Gazprom

Source: “OAO Gazprom: Taming the Lion,” Bear Stearns, March 13, 2007.

TB0005 17

Appendix 4. The Sakhalin II Saga

The Sakhalin fields in the Russian Far East were opened for development through PSA arrangements in the early 1990s to reach the booming economies in the Asia Pacific region. There were six different Sakhalin projects created for this purpose. Much of the gas in this region is found under deep water several miles beyond the Sakhalin Island coast. Thus, Russia did not have either the technology or the capital outlays needed to bring the gas to market. Realizing these critical shortcomings, the country opened bids for allotting acreages to international oil companies such as ExxonMobil, Shell, and others.

In May 1991, just before the collapse of the Soviet Union, Marathon, McDermott, and Mitsui were awarded a contract to examine the feasibility of producing gas and crude oil from two fields off the Northeastern coast of Sakhalin. In 1992, Royal Dutch Shell and Mitsubishi joined the consortium as partners to establish the Sakhalin Energy Investment Company (SEIC), and signed a Production Sharing Agreement (PSA) with the Russian government in 1994 to produce both crude oil and gas from the fields they had leased. It was then estimated that the region comprised 4.6 billion barrels of crude and 24 tcf of natural gas. This marked the point at which Shell played out a series of strategies to gain a stronger foothold in the project and consolidate its ownership interests. McDermott sold out its share (20 percent) to Shell, and subsequently Shell was able to convince Marathon to also sell them its share. These negotiations were protracted but did serve Shell’s intent to gain a majority position in SEIC. By December 2000, Shell had a 55 percent share of the project with Mitsui and Mitsubishi evenly splitting the remaining equity. The Sakhalin II projects were covered by a PSA that established the following broad conditions:

• SEIC would have the right to 100 percent cost recovery before allocating profits to the federal and provincial governments

• Best effort to achieve 70 percent Russian content measured in labor and materials • 6 percent royalty on oil and gas produced for the life of the project • Exemption from VAT, customs duties, and certain road taxes • Title on assets held by SEIC until full cost recovery has been obtained, after which it would be transferred to the

Russian government. SEIC would retain the rights to exclusive use for as long as it is viable.

The first phase, Russia’s first offshore oil project, involved development of the Piltun oil field. This $1.9 billion project came online in 1999 and produced oil for six months of the year. The other half of the year, the platforms were frozen solid and hence could not produce. The second phase of the project was by far more expensive and complex. Expected to cost $10 billion, the project was expected to bring gas from the Lunskoe field off the northeastern coast of the island, which would be piped to land and then delivered by a pipeline running the entire length of the island to an LNG terminal at the southern end.

The project ran into trouble almost from the beginning. The political climate in the country had changed, and the Russian parliament was unwilling to resolve conflicting laws that impacted the project. Public sentiment had also turned against foreign investors. The Putin government was recentralizing power at the federal level with distinct nationalistic overtones. Four of the Sakhalin projects were mothballed, and future PSAs became almost impossible to obtain. Around this time, Gazprom appeared keenly interested in joining the consortium, a prospect that it had not found very appealing when Shell had approached the company earlier. The Russian government also filed charges of environmental non-compliance, and a failure to follow local content and employment guidelines. By that time, project costs had doubled to $20 billion. The project was also faced with external pressures since ExxonMobil and partners appeared to be ahead of the race in their Sakhalin I venture close by. Long-term contracts with Japanese and Korean buyers were delayed because of the uncertainties surrounding the project, thus making it difficult for SEIC to capture the value of its first mover advantage over Sakhalin I.

In 2005, Shell and its partners agreed to a new deal that allowed Gazprom to take a majority stake in the project. Shell agreed to continue as the operator. Gazprom paid roughly $7.5 billion for a 50 percent stake plus one share in the project. The Russian government decided to drop all charges. As of early 2008, the project had yet to come online.

18 TB0005

Appendix 5. Gazprom’s Share of Domestic Consumption in European Markets

Sources: “Domestic Consumption,” EIA International Energy Annual, 2007; “Exports 2006 and 2007,” Gazexport as cited by Energy Intelligence, March 2008.

TB0005 19

Appendix 6. Russia’s European Network Access

Source: U.S. Department of Energy, Energy Information Administration, “Russia,” Country Analysis Brief, April 2007, p. 11, www.eia.doe.gov/emeu/cabs/Russia/pdf.pdf (August 20, 2007).

20 TB0005

Appendix 7. Gazprom’s Sales Structure 2003-2007 (in Million Russian Rubles)

2007 2006 2005 2004 2003 Gas Sales

Russian Federation 399,452 357,274 311,336 252,552 207,056 Former Soviet Union 273,550 243,133 131,393 88,440 58,945 Far Abroad 1,161,549 1,149,582 850,017 607,695 567,855

Gross Sales of Gas 1,834,551 1749,989 1,292,746 948,687 833,856 Refined Products

Russian Federation 268,278 233,044 123,565 Former Soviet Union 42,181 29,776 14,414 Far Abroad 181,979 172,165 64,891

Total Sales of Refined Products 492,438 434,985 202,870 Crude Oil and Condensate

Russian Federation 31,024 26,737 17,376 Former Soviet Union 19,586 19,213 4,793 Far Abroad 117,148 125,759 30,422

Total Crude oil and condensate sales 167,758 171,709 52,591 122,248 92,180 Gas Transportation

Russian Federation 41,252 34,468 Former Soviet Union 488 32

Total Transportation Revenues 41,740 34,500 65,559 29,027 28,226 TOTAL SALES 2,390,467 2,152,111 1,383,545 976,776 954,262

Gas 76.74% 81.31% 93.43% 97.12% 87.38% Refined Products 20.60% 20.21% 14.66% Crude oil & Condensate 7.01% 7.98% 3.80% 12.50% 9.65% Gas Transportation 1.75% 1.60% 4.73% 2.97% 2.96%

Source: Gazprom Annual Reports, 2003-2007.

Destination Analysis

2007 2006 2005 2004 2003 Gas Sales

Russian Federation % 21.77 20.42 24.08 26.62 24.83 Former Soviet Union % 14.91 13.89 10.16 9.32 7.07 Far Abroad % 63.32 65.69 65.75 64.06 68.10

Refined Products Russian Federation % 54.48 53.58 60.91 Former Soviet Union % 8.57 6.85 7.11 Far Abroad % 36.95 39.58 31.99

Crude Oil and Condensate Russian Federation % 18.49 15.57 33.04 Former Soviet Union % 11.68 11.19 9.11 Far Abroad % 69.83 73.24 57.85

Source: Author’s analysis.

TB0005 21

Appendix 8. Gazprom’s Balance Sheet 2003-2007 (in Million Russian rubles)

2003 2004 2005 2006 2007 Current Assets Cash and cash equivalents 71396 106157 146866 269224 279109 Restricted Cash 33743 16861 18040 12356 12025 Short term financial assets 57069 40428 79001 106574 113911 A/c receivables and prepayments 234929 316709 394659 662040 697464 Inventories 111330 130400 169121 207459 245406 VAT recoverable 85909 94863 145484 140305 122558 Other current assets 6086 21262 48282 84347 95944

485159 726680 1001453 1482305 1566417 Non-Current Assets Property, plant and Equipment 1973781 2183084 2791011 3034968 3490477 Investment in associated firms 58939 81783 233782 318142 670403 Long term accounts receivables 93769 6302 179187 251123 402382 Available For-Sale long term financial assets 8178 28710 67847 150874 256210 Other non-current assets 28958 39230 65814 72513 406667

2163625 2479109 3337641 3827620 5226139 Total Assets 2764087 3205789 4339094 5309925 6792556

Current Liabilities Accounts payables and accrued charges 124273 174433 219983 398126 485466 Taxes payable 103799 84977 104817 68380 73563 Short-term borrowings 170622 156172 180959 290705 504070 Short-term promissory notes payable 27433 20845 20710 102859 21455

426127 436427 526469 860070 1084554 Non-Current Liabilities Long term borrowings 303755 427086 741849 668343 981406 Long term promissory notes payable 13715 11640 10639 17186 3555 Restructured tax liabilities 6111 1829 1128 822 0 Provisions for liabilities and charges 34880 44275 83794 119578 79213 Deferred tax liabilities 96823 137062 251868 275508 308353 Other non-current liabilities 12573 9446 4613 18598 22376

468037 631338 1093891 1100035 1394905 Total Liabilities 894164 1067765 1620360 1960105 2479459

Equity Share capital 325194 325194 325194 325194 325194 Treasury Shares -33889 -41586 -19504 -41801 -20801 Retained earnings and reserves 1563825 1808865 2270277 2905065 3646396

1855130 2092473 2576417 3188458 3950789 Minority interest 14793 45551 142317 161362 362308 Total Equity 1869923 2138024 2718734 3349820 4313097 Total Liability and Equity 2764087 3205789 4339094 5309925 6792556

Source: Gazprom’s IFRS Consolidated Financial Statements, 2003-2007.

22 TB0005

Appendix 9. Gazprom’s Income Statement, 2003-2007 (in Million Russian Rubles)

2003 2004 2005 2006 2007 Sales 819753 976776 1383545 2152111 2390467 Less Operating Expenses 563415 714165 929561 1363923 1688689 Operating Profit 226338 262611 453984 788188 701778 Gain from sale of interest in a subsidiary .. .. .. .. 50853 Gain from change in fair value of call option .. .. .. .. 50738 Deconsolidation of NPF-Gazfund .. .. .. .. 44692 Finance Income 74866 69332 53890 97923 159380 Less Finance Expense 72725 53482 69926 65220 132573 Share of income from jointly controlled entities 3478 8151 11782 26363 24234 Gains from sale of available for sale financial assets 5017 5018 385 8811 25102 Profit before profit tax 236974 291630 450115 856065 924204 Current profit tax expense 42368 57949 118028 213844 218266 Deferred profit tax expense 32449 21939 16156 5760 10953 Profit tax expense 74817 79888 134184 219604 229219 Profit for the period 162157 211742 315931 636461 694985 Attributable to Equity holders of OAO Gazprom 159095 209449 311125 613345 658038 Minority Interests 3062 2293 4806 23116 36947

162157 211742 315931 636461 694985 Diluted earnings per share of OAO Gazprom (Russian Rubles)

8.02 10.44 14.55 26.90 28.07

Source: Gazprom’s IFRS Consolidated Financial Statements from 2003 to 2007.

Appendix 10. Operating Expenses Structure (Selected elements only. In Million Russian Rubles)

2003 2004 2005 2006 2007 Purchased Oil and Gas 25,666 66,546 87,723 280,062 382,054 Staff Costs 100,122 122,853 168,076 199,588 248,894 Transit Fees for Gas and Refined Products 108,711 103,853 110,863 156,489 152,093 Social Expenses 11,724 13,335 15,674 18,563 16.343 Research and Development 6,083 5,845 6,544 13,123 15,486

Source: Gazprom Annual Reports, 2003-2007.Appendix 11. Gazprom’s Financial Ratios 2003-2007.

Appendix 11. Gazprom’s Financial Ratios 2003-2007

2003 2004 2005 2006 2007 Return on equity % 7.60 8.70 6.08 9.40 9.11 Return on assets % 5.65 6.41 4.79 7.55 6.90 Return on sales % 26.59 23.85 29.09 30.87 27.41 Debt to capital ratio % 22.40 23.70 20.23 16.90 23.39 P/E for domestic market 6.30 11.29 22.65 20.83 23.61 P/E for external market 12.67 14.49 24.06 20.83 23.61 Market capitalization $ billion 26.99 54.24 91.13 239.33 259.00

Source: Gazprom in figures, 2003-2007.