Troubled Gas Giant

By Akram Esanov, RWI Senior Economist

In April, a pipeline explosion disrupted natural gas supplies from Turkmenistan to Russia. Though official investigation results have not yet been released, the media has speculated that shrinking demand from Europe prompted the state-controlled Russian gas company, Gazprom, to shut down the pipeline without advanced warning to Turkmen officials. The resulting pressure buildup apparently caused a blast along the Turkmen section of the pipeline, and now some in Turkmenistan are accusing Gazprom of deliberate negligence, and are threatening to seek damages in the international courts.

The tension between the Gazprom and Turkmenistan stretches back several months. The accident didn't just create a raucous diplomatic clash between Russia and Turkmenistan; it also underscored the massive financial challenges facing Gazprom.

Recently-released data on natural gas production and consumption reveal that Gazprom, whose taxes used to provide 20 percent of the country's budget revenues, is going through tough times. In the first four months of 2009, natural gas exports from Russia to Europe plunged 57 percent from the same period in 2008. Among the causes of this dramatic slump is a slight decline—about five percent—in European demand for natural gas, which is likely due to the availability of small Norwegian natural gas supplies and a European market tentative about Russian gas after last winter's Ukrainian gas crisis.  Observers indicated that Gazprom was less flexible than its competitors in negotiating gas prices with European gas importers, largely because Gazprom's pricing decisions are highly centralized and politicized. This practice discouraged European importers from purchasing Russian gas. Furthermore, since natural gas prices are pegged to oil prices, following a six- to nine-month lag, most European countries postponed Russian gas imports, expecting lower prices would follow the drop in oil rates in 2008. Finally, lower GDP growth forecasts across Europe and limited credit also contributed to a decline in natural gas consumption in Europe.

These developments had far reaching implications for Gazprom's business plans and Russia's energy policy for Europe. Facing a decreasing demand for its product, Gazprom slashed its export forecast for 2009 by about 18 percent, from 170 billion cubic meters to 140 billion cubic meters. Falling gas prices are also having a withering effect on Gazprom's revenue forecasts. In May, Gazprom reduced its forecast for the average export price by seven percent, from $280 per 1,000 cubic meters to $260. This revised average export price may itself prove optimistic if European gas demand continues to fall. New market conditions in Europe are forcing Gazprom to take defensive measures, such as cutting production and attempting to pass the revenue losses on to its Central Asian suppliers. Gazprom recently announced that its production volumes for 2009 will be reduced by about 20 percent, and the company is expected to further scale back its $27 billion investment program.

It was amid this tumult and uncertainty that, on April 9, Gazprom unilaterally and without warning, cut off 90 percent of gas flowing from Turkmenistan, presumably causing the pipeline explosion near the Turkmen-Uzbek border.

In response, the government of Turkmenistan indicated that it would find other supply routes to diversify its natural gas export market. At present, the Central Asian state exports 50 billion cubic meters of natural gas to Russia annually. In the wake of the pipeline blast, however, Turkmenistan intensified negotiations with China,  intending to increase the transit capacity of its new pipeline, which is currently under construction and is expected to be operational in 2010. This pipeline will connect Turkmenistan with China through Uzbekistan and Kazakhstan and has the capacity to transmit 30 billion cubic meters of natural gas per year.  In addition, the Chinese government agreed to lend Turkmenistan $3 billion to develop its vast South Yolotan natural gas field, and China is the only foreign country to sign a production sharing agreement with Turkmenistan in the natural gas sector.

The growing tension between Turkmenistan and Russia over the pipeline blast may also bring about new opportunities for the European Union to advance its Nabucco pipeline project, which hopes to bypass Russia by bringing Central Asian gas directly to Europe through Azerbaijan and Turkey. If Turkmenistan stops selling its gas to Russia, it could supplant that lost income by becoming an EU Nabucco project supplier, while still maintaining its Chinese market.

Meanwhile, Gazprom asked Turkmenistan either to slash its gas supplies to Russia or cut its export prices, since its existing contract with Turkmenistan was signed before the energy market weakened substantially. Even with rising Chinese demand, Turkmenistan remains dependent on Russia for exporting its gas, and any diversification attempts will take years, if not decades. Gazprom is likely to succeed in its demands to cut prices unless European demand recovers soon, and Russia needs additional gas to meet that demand. Meanwhile, Turkmen gas output has not fully recovered to pre-explosion levels, providing Gazprom a much needed respite while it negotiates lower imports or costs for Turkmen gas.

Gazprom is falling victim to its own boom period policies. The company benefited enormously from recent high energy prices,  and generated colossal net profits. Yet its investment strategy failed to take into account the reality that international prices for hydrocarbons fluctuate sharply in the short run. Gazprom invested heavily in acquisitions, such as television channels and newspapers, rather than in improvements to technology, exploration and maintenance. As a result, Gazprom's production capacity declined while its liabilities increased.

Under new market conditions, natural gas contracts signed with energy-rich Central Asian countries also appear to work against Gazprom's interests. Not long ago, when the price of natural gas was rising, Gazprom promised to pay "European" prices to its suppliers in Kazakhstan, Turkmenistan and Uzbekistan. This decision was partly political and partly a necessity in the era of rising hydrocarbon prices, as Central Asian countries demanded full market value for their resources, threatening to seek other export routes if Russia exercised its gas transit monopoly. Growing European demand for Russian gas further pushed Gazprom to pay Central Asian suppliers richly. But with the collapse of world energy prices, these deals are no longer as attractive as they were a year ago, and the income they bring in is substantially less, if any. 

The Russian government, which sees Gazprom an instrument to implement its foreign policy and doesn't hesitate to shelter it from foreign and domestic competitors, has been trying to resolve the company's financial crisis. In the short term, Russia can help Gazprom recover some of its previous glory by privileging the company and disfavoring its domestic rivals. But in the long run, Gazprom is bound to fail as a global energy market leader unless it enhances its production capacity through investments in exploration and technology and makes dramatic improvements to its governance structure and overall efficiency.

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