GAZPROM FACING TOUGH FINANCIAL TIMES AHEAD

UNCLAS SECTION 01 OF 04 MOSCOW 000367 SENSITIVE SIPDIS DEPT FOR EUR/RUS, FOR EEB/ESC/IEC GALLOGLY AND WRIGHT EUR/CARC, SCA (GALLAGHER, SUMAR) DOE FOR HEGBURG, EKIMOFF DOC FOR JBROUGHER E.O. 12958: N/A TAGS: EPET ENRG ECON PREL RS SUBJECT: GAZPROM FACING TOUGH FINANCIAL TIMES AHEAD REF: MOSCOW 153 SENSITIVE BUT UNCLASSIFIED. PLEASE PROTECT ACCORDINGLY. NOT FOR INTERNET DISTRIBUTION. -------------- SUMMARY -------------- ¶1. (SBU) Gazprom's financial outlook for 2009 is increasingly bleak. The company's revenues from exports to Europe are set to decline dramatically as gas prices to Europe, which lag oil prices by about six months, head to one-third their peak price. Unfortunately for Gazprom -- and the GOR, which depends heavily on Gazprom for its budget -- this trend will be amplified and prolonged by reduced European demand due to recession and pricing pressure from massive new volumes of LNG. Domestically, hopes for higher revenues from liberalized prices are fading as the GOR will find it politically difficult to raise gas prices during an economic downturn. Furthermore, Gazprom is facing substantial debt repayments in 2009, yet continues to talk of new multi-billion dollar investments. The markets have rightly punished the company, driving down its stock price by over 70% from its peak, giving the company little hope of achieving its long-sought goal of becoming the "most valuable company in the world." End summary. -------------- LOW PRICES TO HIT GAZPROM HARD IN 2009... -------------- ¶2. (SBU) Gazprom's revenues from European gas sales are dropping fast. In a February 6 presentation to investors, Gazprom predicted an average gas price to Europe of $280 per thousand cubic meters (mcm) in 2009, down from an average price of $409 per mcm in 208. Considering the European market alone, Gazprom's price estimate combined with its expected decline in the volume of sales, from 179 billion cubic meters (bcm) to 170 bcm, would result in decreased revenues of approximately $26 billion for Gazprom in 2009, compared to 2008. ¶3. (SBU) The financial hit of reduced gas sales to Europe is amplified by Gazprom's relative dependence on those sales. Gazprom's figures indicate that revenues from Europe were $73 billion in 2008, while revenues from the former Soviet Union (FSU) states and from the domestic market combined were approximately $31 billion -- meaning European sales account for over 70% of Gazprom's revenues from gas sales. ¶4. (SBU) Ron Smith, chief strategist at Alfa Bank, told us on February 9 that he expected Gazprom's quarterly revenues from Europe to drop steadily from a peak of $26 billion in the fourth quarter of 2008, to just $7 billion in the third quarter of 2009. The price of Russian gas sold to European customers is based on formula tied to oil and lags the oil price trend by 6 to 9 months. The precipitous drop in oil prices from the summer 2008 peak will thus cause gas prices to Europe to drop similarly from the first quarter of 2009 to the third quarter. Smith estimated the average price to Europe would drop from $512 per mcm in the fourth quarter of 2008 to just $170 per mcm in the third quarter of 2009. -------------- ...AND BEYOND -------------- ¶5. (SBU) Unfortunately for Gazprom, there does not seem to be much hope for a rebound in the prices it can charge European customers. Wood Mackenzie, a global energy consulting firm, predicts continued downward pressure on European gas prices for the next few years. Tim Lambert, Vice-President at Wood Mackenzie, told the AmCham Energy Committee on February 5 that his company has significantly lowered its forecast for European gas demand in the coming years as the effects of the recession take hold. ¶6. (SBU) Lambert noted that reduced European demand will coincide with large increases in global volumes of LNG, largely from Qatar, coming online in 2009 and 2010. Lambert MOSCOW 00000367 002 OF 004 explained that most of this LNG would find itself in Europe, over-supplying the market and driving spot-market gas prices lower for the foreseeable future. Lambert went on to explain that Gazprom would not be able to completely isolate itself from the lower spot market prices, even though its contracts with European customers are long-term and indexed to oil. According to Lambert, the contracts have enough flexibility in them that Gazprom would have a difficult time maintaining a strict link to oil prices. Thus, even an unlikely rebound in oil prices may not relieve the price pressure on Gazprom in the near-term. -------------- NO RELIEF FROM DOMESTIC, FSU MARKETS -------------- ¶7. (SBU) By volume, Gazprom sells more than twice as much gas to domestic consumers and the former Soviet Union (FSU) than it does to Europe. The company expects some of its lost revenues from Europe to be offset by price increases for FSU and domestic consumers. However, this expectation seems overly optimistic. Price increases to the FSU will be partially offset by lower volumes and higher prices paid by Gazprom to Central Asian suppliers. Domestic price increases are only planned, and will be politically very difficult to implement during a recession. ¶8. (SBU) In its presentation, Gazprom publicly predicted the gas price to FSU customers would rise from $159 per mcm in 2008 to $198 per mcm in 2009. However, Gazprom also expects sales to the FSU to drop in volume from 88 bcm in 2008 to 75 bcm in 2009. Using those figures, Gazprom would only realize a net increase of less than $1 billion in revenue from the FSU. The true figure is likely to be even be lower as the majority of gas volumes sold the to FSU originate in Turkmenistan, to which Gazprom reportedly will pay a fixed $150 per mcm, leaving little room for a substantial mark-up. Furthermore, by the company's own admission, the gas shutoff to Europe and Ukraine in early January (reftel) cost Gazprom $2 billion in sales -- sales lost during a period of record high prices. ¶9. (SBU) Accepting the GOR's planned increases in domestic gas tariffs as a given, Gazprom's message to investors and analysts has been that its domestic revenues should see robust growth in coming years. Under the existing GOR plan, domestic prices, currently averaging approximately $62 per mcm, are set to rise to "netback parity" (export price minus transportation and taxes) by 2011. For that to happen, according to Gazprom's presentation, domestic prices would have to rise 210% by 2011. ¶10. (SBU) Most investment analysts are generally cautious, however, about planned future domestic gas price increases. Raising prices at that rate during a recession would likely be nearly impossible from a political standpoint. Slower-than-expected domestic price rises, coupled with an expected drop in domestic demand -- as Gazprom's Chief Financial Officer Andrey Kruglov reportedly advised was likely in a February 11 conference call with investors -- would result in a relatively minor increase in overall domestic revenues. -------------- RUBLE DEPRECIATION A BRIGHT SPOT -------------- ¶11. (SBU) The one bright spot for Gazprom's finances is the weakening ruble. With most of its revenues in dollars or euros and most of its operating expenses in rubles, the company stands to benefit substantially from a weak ruble. In its presentation, Gazprom estimated that each 1% decline in the value of the ruble would result in about $500 million of benefit to the company. -------------- YET GAZPROM EQUIVOCATES ON COST-CUTTING... -------------- ¶12. (SBU) Gazprom, as currently structured, will have a tough time turning its finances around. It is not just a company, MOSCOW 00000367 003 OF 004 but a political enterprise. With its most senior executives and the most senior leaders of the GOR pledging to push ahead on expensive and politically motivated projects such as the South Stream pipeline, the company will have a tough time finding major savings in project cancellations and delays. Furthermore, second only to its mission of providing gas to Russian consumers is its non-commercial mission of providing a variety of social welfare programs. ¶13. (SBU) However, Gazprom will face tremendous political pressure to avoid cost-cutting measures that would result in massive job losses or big reductions in procurement or social expenditures. That is likely why the company has been unclear about how it will meet its expenses and what proposed investments it plans to delay or cut. In its investor day presentation, Gazprom maintained that it was moving ahead with its 2009 investment budget of $29 billion, including "priority" production and transportation projects, most of which would be financed in dollar or euro terms. These priorities include development of the Shtokman field in the Barents Sea and the Nord Stream pipeline across the Baltic to Europe. (N.B. In a February 13 meeting with the Ambassador, Gazprom CEO Alexey Miller affirmed that his company has not changed its investment plans. Septel.) ¶14. (SBU) The company said in its February 6 presentation to investors that it planned for Nord Stream phase 1 to be complete by 2011 and for the South Stream pipeline under the Black Sea to southern Europe to be complete by 2015. It estimated the total cost of Nord Stream (both phases) at 7.4 billion euros and of South Stream at "24 " billion euros. The company also announced that it planned to complete its $5 billion purchase of a 20% stake in Gazpromneft (Gazprom's oil subsidiary) that is owned by Italian company ENI. ¶15. (SBU) In Kruglov's February 11 conference call, however, he was more equivocal, saying the company planned to review its 2009 investment program for possible delays or cuts. Doug Busvine, Russia analyst for Medley Global Advisors, a strategic advisory firm, told us February 9 he couldn't see how Gazprom would find the money to move ahead with its investment plans. Various analysts have expressed the same doubts in investment newsletters over the last several weeks -- in a period of substantially lower revenues and with external credit markets virtually closed to Russian companies, it would be very difficult for Gazprom to stay on its intended course. ¶16. (SBU) Even if it cut back on planned investments, however, Gazprom would still need to take tough and specific actions to reduce operating expenses to effectively weather the tough financial times ahead. To that end, the company has said it planned to cut overhead expenses by 29% at the parent company and by 24% at its subsidiaries. However, the company did not provide any details on those cuts except to note that about 40% of those cost reductions would be due to the weak ruble. It has not announced any cuts in its 436,000 staff, other than a reduction of about 600 employees at headquarters announced months ago. There have been press reports that the GOR may allow state-owned companies like Gazprom to withhold dividends to save cash, but Gazprom has not confirmed that it would do so. A February 11 press report indicated Gazprom would hold back on payments to suppliers as a way of "managing" its working capital. (N.B. This supports anecdotal evidence we have been hearing for months that Gazprom's debts to suppliers are increasing). -------------- ... WHILE LOOKING TO ROLLOVER DEBT -------------- ¶17. (SBU) While Gazprom's operating expenses are in rubles, its very substantial debts, much of which is short-term, are almost entirely in dollars and euros, complicating its efforts to reschedule or rollover debt. According to Gazprom's figures, as of June 30, 2008 (the latest available figures),the company's total outstanding debt stood at $47.6 billion, of which 90% was in dollars and euros and only 4% of which was in rubles. As of June 30, 2008, almost 39% of Gazprom's debt had a maturity of less than 2 years, and another 22% had a maturity of 2-5 years. That would mean the MOSCOW 00000367 004 OF 004 company would need to retire or refinance over $18 billion between July, 2008 and the first half of 2010. In its investor day presentation, the company said it planned to repay $9.2 billion of debt in 2009, but did not provide details. -------------- HARSH MARKET REACTION -------------- ¶18. (SBU) As with Russian companies as a whole, the markets have been tough on Gazprom in the face of its looming financial problems and its inability or unwillingness to deal with them. On February 4, Fitch ratings lowered its outlook for the company to negative from stable. According to Bloomberg news, the yields on Gazprom debt have skyrocketed, with the yield on the company's 10-year notes due in 2018 reaching 1053 basis points above U.S. Treasuries at the end of January, up from 383 basis points in April, when the notes first traded. The company's stock price is down more than 70% from its peak in May 2008 and its market capitalization is down from about $365 billion to about $85 billion on February 11. -------------- COMMENT -------------- ¶19. (SBU) As of mid-year 2008, Gazprom was still confidently predicting that it would become the "most valuable company in the world" and the first company to reach a market capitalization of $1 trillion. The failure of Gazprom's out-sized ambitions is bad news for the GOR. Not long ago, a company representative told us Gazprom alone is responsible for contributing 40% of the GOR budget. That could partly explain recent upward revisions by the GOR of its expected 2009 and 2010 budget deficits. Like the Russian economy as a whole, the company's problems are deeper than the immediate financial difficulties it faces. Gazprom is perhaps the most prominent example of the flawed economic model in Russia -- giant, inefficient, politically directed companies that destroy wealth and stifle dynamism. BEYRLE