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Executive Summary
“We must also take action to make our energy consumption radically more
efficient. This demand is not just a whim for a country rich in energy resources,
but is an issue for our competitiveness in the context of integration into the
world economy… I believe that only in this way can we ensure that Russia
maintains a leading and stable position on energy markets in the long term. And
in this way, Russia will be able to play a positive part in forming a common
European energy strategy.”
President Vladimir Putin, Annual address to the Federal Assembly, May 10,
2006.
Russia’s gas market and export supplies are at an inflection point, headed for
dramatic change with far-reaching consequences. The scale at which these
trends are developing and affecting the sector are being largely underestimated,
in our view.
The Russian gas supply picture looks increasingly tight. With Gazprom’s output
on three “super-giants” continuing to decline by 6%–7% pa, the company can do
little to change its effectively flat production profile over the next ten years. The
Russian gas monopoly has both reserves and now the financial resources to
develop them; however, long lead times, technical and management challenges
mean that the massive fields, such as Shtokman in the Barents Sea and
Bovanenskoye on the Yamal Peninsula, will have little part to play in the
Russian gas balance until 2015. While the development of smaller fields and
acquisitions could offset the decline in core production, they would be
insufficient to meet the growing demand. We forecast Gazprom’s production to
increase from 547 bcm in 2005 to its targeted 560 bcm in 2010, with no growth
(and perhaps even some annual declines) through 2015.
Chart 1: Gazprom’s production breakdown, bcm
Growth in Russian gas demand is largely misunderstood and underestimated, in
our view. Gazprom has been and continues to be conservative in its projections,
anticipating less than 1% annual growth for the next three years. Furthermore,
the forecasts in Russia’s long-term energy strategy, approved in 2003 and
implying 0.7% pa growth, effectively became obsolete in two years, already
reaching its 2020 consumption target in 2005.
We forecast that total Russian demand will grow by 105 bcm over the next
decade to reach 546 bcm in 2015—24% of total growth or 2.5% CAGR. This is
expected to be driven by strong economic expansion, thermal capacity additions
and increased gasification activities. Moreover, the forecast has a risk to the
upside, in our view, as future GDP growth is likely to be more investment-led,
than recovery-based, creating a larger need for energy.
The tight domestic gas market has five, significant implications, in our view:
■ Firstly, for European exports, it means that Gazprom would be unable to
significantly boost its market share from the current 27%, increasing
deliveries to 180 bcm by 2010 and to 215 bcm by 2015. Growing LNG
imports and security of supply concerns are likely to take their toll to put a
ceiling on the Russian market share in Europe and even contain the size of
the market.
■ Secondly, despite stepping up its efforts to build a new pipeline through
Altai to China, Gazprom is unlikely to deliver any West Siberian gas to Asia
in the next ten years. The attractive Chinese market may be tapped with
volumes from East Siberian and Far Eastern fields. However, without
significant output from Yamal, which we do not expect until 2015, Western
Russia will have no gas for China in the next decade, in our view.
■ Thirdly, Russian oil companies and independent gas producers will become
larger players in the gas industry. In 2005 they accounted for 94 bcm, or just
under 15% of the country’s total gas output. At the same time, an estimated
40% of Russia’s gas reserves, amounting to 21 tcm of gas, are outside
Gazprom’s portfolio, with 11 tcm already being controlled by independent
suppliers. The implied reserve life for “non-Gazprom” reserves of over 200
years demonstrates the huge production potential from independent gas
producers in Russia. We forecast their output will increase to 209 bcm for
western markets by 2015, accounting for a 27% share in total production and
a 43% share of the domestic market.
■ Fourthly, and perhaps most importantly, tight supply is likely to change the
pricing environment in Russia. Today, at $42/mcm1, natural gas is the most
mis-priced product in the country, totaling only 17% of the European gas
price and 29% of its netback. The government’s recently announced tariff
hikes will bring the price to $65/mcm by 2009. Under our base case, we
estimate export netback convergence at $84/mcm already in 2011—the
netback level, which is based on our normalized long-term oil price of
$41/bbl Brent. And netback parity means it is equally attractive to sell gas
domestically as it is to export it—a sea change for the industry.
However, the domestic gas price could move higher in the event of a supply
shortage and the continuation of higher energy prices internationally. At
$50/bbl and $60/bbl long-term oil price, export netbacks would be
$111/mcm and $137/mcm, respectively, putting significant upward pressure
on domestic gas prices. Our estimate of current net-back parity (based
around the c$65/bbl oil price) is $146/mcm. Moreover, a “Ukrainian-type”
scenario, under which the government moves to or is forced to a one time
price adjustment or price shock cannot be excluded towards 2010. Net-back
parity, for a good while the norm in domestic oil and oil-product markets,
looks set to become the case in the gas market sometime soon after 2010, in
all likelihood.
We do not think that the authorities would allow the domestic price to rise as
far as $140/mcm, the current net-back price, in the mid-term, though it is
possible. However, they could cap the net-back parity price rises under
higher oil-price scenarios by raising the export tariff on gas, at high prices,
up from the current $0.30 per marginal dollar (high-grade oil product has an
export tariff of $0.44 and crude one of $0.65). This can readily be done
without injuring Gazprom’s profitability—both since they will benefit more
from the domestic price rises than they will lose from a capping of the export
tariff, and because the amount it is adjusted by can be small and only at
higher oil prices (a new band could be set for, say, gas prices above the
equivalent of $40/bbl oil). In sum, $120/mcm domestic prices, under higher
world oil price scenarios than our central forecast of $41/bbl from 2009, are
quite possible in the 2010-2015 period.
The Russian economy can afford to take a hit, in our view. The average gas
bill for households in Russia is low even when compared relative to
disposable income. Moreover, at our central case of an $84/mcm gas price in
2010, we see even a decline in the average gas bill as a portion of disposable
income. We argue that as Russia gets wealthier and income distribution—
more even, higher gas prices would be substantially more acceptable
politically.
Chart 2: Gas bill, % of disposable income vs GDP per capita
Fifth and finally, as Russian gas prices approach the export netback, and
because non-Gazprom supply will, we estimate, account for up to 40% of the
market, the government may take steps to liberalize the domestic gas market.
Although the argument may look stretched at this stage, it is the logical way
to go, given the price rises, the importance of independents, the need for
more pipelines, the demands of the West and the likely increasing demands
of domestic industry for secure and predictable supplies. Whether it will be
quite full liberalization or some partial version of it remains to be seen—and
a partial version is hardly far-flung: already UES purchases a third of its
needed gas at non-regulated prices, which are above the agreed limits with
Gazprom. But the advantages of a liberalization are clear domestically.
Furthermore, since a liberalized market would mean domestic gas prices at
or around net-back parity, the ability to keep a lid on that price (through
possible marginal export-tariff increases as noted above) means resistance to
it should be limited.
In turn, these significant changes in the gas market have potentially far-reaching
consequences for other energy sectors, the domestic economy in general,
economic relations with the West and geopolitics in the region. We note them
briefly here:
■ Below c$80/mcm we see the drive to increase energy efficiency in gas
users—from electricity generators, to petrochemical producers, to cementmakers,
to households—as limited. Above that number, the economics of
upgrading the capital stock become compelling. We see a massive
restructuring of the domestic capital stock as likely to truly kick in over the
2010-2015 period.
■ One part of this will be an increasing move to alternative fuels domestically
to fire electricity generation. Hydro, nuclear, and coal all look set to be key
beneficiaries. Russia currently consumes 15% of the world’s gas, but only
6% of the world’s primary energy.
■
The change in the capital stock will mean substantial demand for modern
new generators and other capital goods. These are likely to come from both
domestic producers and foreign capital goods makers.
■ A move to net-back parity for domestic prices, and a potential liberalization
(whether partial or not) of the domestic gas market, both in an environment
of a booming Russia getting more integrated into the global and European
economy—the recent renewal of the suggestion of a free-trade zone between
Russia and the EU is tantalizing in this regard—suggest the makings of a
“grand bargain” between the EU and Russia: Russia allows foreign oil and
gas companies into the upstream in return for Russian companies (Gazprom,
mostly) being allowed into European downstream. This could well be on a
50+1% basis only, but the outlines of a mutually beneficial deal are clear.
■ Central Asia’s role in the gas market becomes increasingly important in the
scenario we see above. If it were to either decide on selling gas to the
Chinese, or get involved in a possible Iran-India pipeline, or simply play
politics and demand unacceptable prices for its gas from the Russians, or
some combination of these, there could be trouble. It would necessarily
increase the tightness of the supply/demand balance, thereby putting more
pressure on independents to ramp production, as well as prices etc. This
could even lead to a “crisis”. It also might make Russia think about simply
“passing through” Central Asian gas in its pipeline system to final users, and
taking a transportation tariff for it, rather than buying and then reselling
supplies as it does now.
■
Tightness means “crisis risk” is real
Our bottom up demand/supply model works just enough to balance. We believe
that there are substantial risks in our assumptions, which if they materialize,
could create a crisis scenario—a significant shortage of gas that would lead to
some form of rationing for some consumers and generate either a de facto spike
in gas prices where markets exist, or a de jure jump in tariffs.
The first conclusion of our analysis is that the supply/demand equation looks
tight, particularly over the next five years. Meeting the 90 bcm increase in total
call on Russian gas by 2010 will require 100% of Gazprom’s targeted 560 bcm
of output, 100% of Central Asian 70 bcm export potential and just below 90%
of what we estimate Russian independent gas producers can technically produce
by the end of decade—148 bcm. By 2015 this picture eases, but only very
marginally: independent suppliers will have 13% notional spare capacity in
2015 versus 11% in 2010.
The three most significant negative shocks are identified below:
Underlying Russian demand growth being higher than 2.5% pa. This is
quite likely given that Russia is moving from “recovery growth”—i.e. that
which comes largely from a re-working of the existing capital stock—to
“investment-led growth”—i.e. that which comes from significant increases in
the capital stock. In fact, thus far we have seen 5% electricity demand
growth this year which is not purely related to the cold winter, and is not
slowing down mid-year, pushing gas consumption up by an estimated 4.3%.
■
Our demand model assumes the continuation of the historical electricity-toGDP growth ratio at 0.35. In comparison, China during its investment-led
expansion had this ratio well above 1—electricity growth over the past
decade has been more than 15% pa, compared to real GDP growth of
c10% pa. We do not see Russia’s electricity demand elasticity being so
high—there is still notable over-use of electricity, and higher prices will lead
to further economizing and efficiency gains. But the risk of faster-thananticipated
domestic demand growth is clear.
■ Significant Central Asian exports are not exploited or go east or south.
There are interrelated political, pricing and infrastructure risks associated
with the increasing supplies from Turkmenistan. The 20 bcm incremental
deliveries from the region we model will require concerted efforts by the
Turkmen and Russian sides in order to commit to $2-3 bn pipeline expansion
the next five years. If substantial amounts of this gas were to go east to
China, or south to India through Iran—both of which have been touted as
possible—western markets in Russia would feel the pressure. Also, there is
the risk of politics playing a role—an “errant” Central Asian leader could use
brinkmanship to achieve better pricing.
■ A lack of transport infrastructure from West Siberia. The supply
tightness is compounded by the fact that independent producers have yet to
be truly incentivized to produce their gas, and also because the existing
transport system from West Siberia may not be able to move around
690 bcm by 2010 and 725 bcm by 2015 to the European part of Russia. The
fact that it is owned and operated by Gazprom creates issues too.
On the other hand, the potential positive shocks that appear less plausible are, in
our view:
■ Imports from Central Asia rising to full capacity of an upgraded Central
Asia-Centre pipeline which would also need significant exploration success
in the region.
■ 100% utilization of the independent gas production capacity.
■ Acceleration of the developments of the Yamal fields by Gazprom. This
cannot realistically influence the balance by 2010, but could add an
additional 50 bcm of supply by 2015. However, a decision on this would
need to be taken by next year for Gazprom to see meaningful production in
Yamal towards the end of the next decade.
Ironically, the high oil price may itself be the key determinant of whether a
crisis or something akin to one occurs. Not only do the resulting high export
revenues fuel the domestic economic growth that is driving local demand up, but
the high oil price also boosts the implicit Russian gas subsidy, making energy
consumers relatively more competitive on the international markets, pushing
domestic gas demand up further for producers in mid-stream processing sectors
(petro-chemicals, fertilizers, metals and electricity itself for export).
How the Russian government would respond to such a crisis scenario is an
interesting question. Almost certainly, the two tools at its disposal—rationing
and sharp price increases—would be used in combination (it would almost
certainly lead to a de facto increase in prices, as potential rationing forces
consumers into paying more, just like UES does now and Ukrainian industrial
consumers did before the gas price hike in January). Higher prices create the
right economic incentives for higher gas production and improving energy
efficiency and are, quite possibly with more liberalization of the sector, likely to
be the only long-term solution to any shortage. The former could only address
the issue in the short-term, unless of course one assumes that the Russian
economic growth can be constrained on a sustainable basis because of lack of
Energy!
Will a crisis happen? In the end, many of Russia’s significant policy changes
have historically come on the back of some form of crisis. Improving the
country’s long-term energy efficiency may not be an exception.
Key stock calls
Novatek, the only pure play on the domestic gas market, is fully geared to
the higher prices and increasing share of non-Gazprom supply. At our price
forecasts in 2010, the company would have an estimated 80% of its
operating earnings coming from the Russian gas business, while the same
figure would be 29% for Gazprom, and 14% for Lukoil.
■ We are upgrading our forecast for Novatek’s long-term production, raising
2010E output by 6% to 50.5 bcm. The company’s potential is higher—
65 bcm, leaving significant volume and pricing upside after 2010. We are
upgrading our Price Target on the stock by 12% to $6,200/share, making it
our key call in the sector.
■ Despite essentially a flat production profile, Gazprom is also a beneficiary
from the higher supplies from independents and Central Asia and higher
prices domestically. While domestic transportation tariffs continue to be
regulated, as a natural monopoly, Gazprom is likely to make a sizable margin
on the amount of total gas moved.
■ Gazprom’s decision on “transport or trade” will depend on the company’s
political influence and its choice whether it would want to dominate the
natural gas trading in the region. The control over the gas flows comes with
the responsibility to secure supplies and this may be an increasingly
challenging task in the environment of tight supply. Still, the company as the
holder of the largest gas assets in the region will benefit from the expected
re-rating: we reiterate our Buy 2 rating and Price Target of $52.7/share.
■ Convergence of the natural gas price to export netback parity, if achieved,
together with the oil-to-gas price link in Europe will massively boost
sensitivity of Russian gas producers to the international energy markets. Our
model suggests that at a normalized $60/bbl oil price and domestic gas price
at netback parity, Novatek’s and Gazprom Price Targets would see upside
potential (to an estimated $15,144/share and $104/ADR).
■