Is the Russian Gas Sector the Next to Rebound?

Russian gas production dropped 17 percent YoY in the first four months of 2009. With us expecting the industrial output to decline 9.5 percent in 2009 and the electricity demand to contract 5 percent, we see the Russian gas balance shrinking 12.6 percent this year. We forecast that Gazprom's gas production will go down 12.8 percent but that Novatek's output will remain flat in 2009, in line with the recent guidance from the company's CEO.

In our view, the revival of the Russian oil and gas sector is underway, and while short-term volatility is imminent, we expect sector valuations to re-rate massively over the next two-three years. While Russian oil majors have shown the first signs of a sustained recovery (crude output in Russia was up 1.3 percent YoY in April), the gas sector is still on its knees (gas output in April dropped 23 percent YoY). Coupled with the lag in European gas prices, as compared with oil, this tells us that a recovery in gas sector fundamentals is something to look for during the second half of 2009.

We pinpoint two fundamental concerns over the gas sector, which add uncertainty (but also upside potential) to Gazprom and Novatek, who are major players on the market. The first concern is that gas pricing looks volatile and hard to predict in 2009-10. European prices might surprise on the downside, since the bulk of Russian gas exports this year will be skewed towards the second half of 2009, when we forecast contract prices will hit the bottom. Domestic price reform in 2010 might also be revised to adopt a more gradual increase. Novatek's deteriorating price premium (as indicated by the first quarter results) is another negative factor.

As for the second concern, with no firm guidance on 2009 production levels yet, we expect both, Gazprom and Novatek, to see a major shortfall in output this year, with forward-looking production levels also revised down. While Gazprom's recent guidance of a potential 18 percent decline in output in 2009 is probably a worst-case scenario (no demand recovery and zero flexibility on Central Asian imports), Novatek's 5.5 percent growth so far this year (well reflected in the price performance) suggests some room for disappointment later on this year.

We stick to the following considerations when addressing these concerns. We expect the recent oil market rally to smooth gas price trends in Europe in 2H09. There are to be two more quarterly gas price hikes, raising domestic prices 16.3 percent between the start and the end of the year, and we believe the government is unlikely to set back gas price reforms. However, the quarterly revision schedule does not change much in terms of overall price momentum.

Meanwhile, alongside the decline in gas volumes, particularly with the forward demand curve shifting down, we are likely to see major capex reductions and the bulk of the pre-crisis capex being targeted towards new capacity additions (at both Gazprom and Novatek). As a result, we expect the two companies to see strong FCF momentum in 2009 (a year when sector profitability might well hit its lows), with FCF yields averaging 9 percent and 2 percent, respectively.

Last, but not the least, the decline in Russian gas production, which has been accelerating dramatically this year (-28 percent YoY in May), is likely to reverse in 2H09, with higher oil prices eliminating the spread between European contract and spot prices, coupled with the approaching winter all supporting the European demand for Russian gas. Therefore, the third quarter is likely to provide a basis for a recovery in Russian gas operations, which would then last for longer, should the global macro context improve towards the year-end.

The major near-term risk for the Russian gas sector, and Gazprom in particular, is Ukrainian transit. The January agreement set forth the terms (first and foremost pricing issues) for supplying Russian gas to Ukraine, reducing long-term uncertainty. Meanwhile, the short-term risks of Ukraine potentially defaulting on its obligations to Gazprom have increased recently.

Gazprom is due to receive the next payment for May gas supplies to Ukraine (around $600 million) by 7 June. Considering Ukraine's debt of approximately $4.5 billion to Naftogaz, and the tension in the country's domestic economy, the risk of a technical default is significant. Should this risk materialize, potentially resulting in yet another disruption of supplies to Europe, Gazprom's share price could suffer.

At the same time, should a supply disruption happen during the third quarter, when European gas prices hit the lows, it could potentially benefit Gazprom's 2009 financials, as the European customers would have to compensate with higher gas imports in the fourth quarter, when gas prices start to recover.