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. Last Updated: 07/27/2016

Gazprom Domestic Proves Too Good to Resist

Foreigners are technically barred from buying Gazprom shares in Russia. But more and more creative investors are finding ways around the rules. Mark Whitehouse reports.

At the Moscow Stock Exchange, traders have found a new way to quit smoking. Call it the Gazprom cure.

Shares in the natural gas giant, once the pariah of Russia's stock market, have been attracting a lot of interest from foreign investors lately. As a result, turnover on the fledgling Moscow exchange, which deals almost exclusively in Gazprom, jumped last week to more than $9.8 million a day. The company's stock price rose 12.81 percent to $1.063 from March 10 to 20, before dropping Monday on news of President Boris Yeltsin's dismissal of his Cabinet.

The Gazprom surge has recently left the smoking lounge outside the exchange's trading floor unusually empty. "The higher the volume, the less time we have for cigarette breaks," said Alexander Zhirnov, a trader for SVA Bank who found time for a few puffs one day last week. "Lately, there's been practically no time to smoke."

Zhirnov owes his improving health to three key factors: Yeltsin, who last year signed a decree making the Moscow exchange one of the few places in the world where investors can buy Gazprom shares hassle-free; sinking oil prices, which have made foreign funds start actively seeking alternatives to blue-chip oil stocks such as LUKoil; and securities lawyers, who have provided foreign investors with schemes to avoid restrictions on buying Gazprom shares in Russia.

"A significant part of the market [for Gazprom] is being driven by foreign capital," said Vladimir Milovidov, board member of Hermitage Investments Group. "Everything shows that Gazprom is one of the best buys in Russia at this moment."

Nobody with a desire to make money can ignore Gazprom. Despite its many deadbeat clients in Russia and the former Soviet Union and odd non-profile investments such as farms and tractor factories, the state-controlled company has about a quarter of the world's natural gas reserves, lots of hard-currency income and a dominant position on European markets.

Not all Gazprom shares, however, are created equal. The company's American Depositary Receipts, or ADRs, which are stock substitutes that trade on foreign exchanges, presently cost about twice as much as the underlying domestic shares. Most investors don't buy the argument that the ease of trading ADRs justifies a 100-percent premium, and would prefer to get their hands on the domestic shares.

"It doesn't take a rocket scientist to figure out you're buying the same thing," said James Fenkner, head of research at CentreInvest Securities. "I believe that in the future these two prices are going to converge. Why stay in the one that's going to decay?"

Buying Gazprom shares in Russia has never been easy: The government and Gazprom managers see the company as a unique strategic asset that should be guarded from outsiders. Gazprom not only counts former Prime Minister Viktor Chernomyrdin among its ex-directors, but it makes up about a quarter of the country's tax revenues and has immense political influence throughout Eastern Europe and the former Soviet Union thanks to its stranglehold on gas supplies.

The company's managers have set up a gauntlet of limitations to discourage outside shareholdings. They have barred foreigners from buying domestic Gazprom stock, and implemented something traders call "the right to the first night," under which the company's registrar refuses to accept trades unless the shares have first been offered to Gazprom.

As usually happens in the Russian market, creative foreign investors have found ways around the rules. Last year, for example, Regent Fund Management Limited set up a Cayman Islands-based entity called Regent GAZ, which announced plans to buy $200 million worth of domestic Gazprom shares and sell derivatives to foreign investors. But after Gazprom director Rem Vyakhirev publicly denounced the scheme, Regent GAZ closed shop.

Yeltsin appeared to support Vyakhirev in May, when he signed a decree limiting foreign ownership in Gazprom to 9 percent and legalizing the company's ban on direct purchases of domestic shares by foreigners and foreign-owned companies. Interest in Gazprom shares fell, and in July the company delisted itself from the Russian Trading System, where its share price had been languishing at 58 cents, less than a third of the ADR price, on meager daily trading volumes of about $1.5 million.

The decree, however, had an upside for the market that few noticed at the time. It removed Gazprom's "right to the first night" on shares traded at four small exchanges -- Moscow, St. Petersburg, Yekaterinburg and Novosibirsk.

Trade in Gazprom on the Moscow exchange soon took off. From a mere $115,000 on the first day of trade July 1, daily volumes reached a peak of $19.5 million in November. The Asian crisis stopped that rally in its tracks, but recently the market has regained its momentum: With daily volumes of $8 million to $10 million, Gazprom has become a relatively liquid share, comparable to such blue chips as LUKoil, Rostelekom and Unified Energy Systems. And during the past few weeks, its share price has outperformed all of them.

"At the moment Gazprom shares have become the growth leader," said Nikolai Rives, senior analyst at the Moscow exchange. "Such events can't fail to attract the attention of investors."

Encouraged by the changes, foreign investors have quietly started buying Gazprom shares again through various Russian fronts, avoiding not only the decree but local taxes. "There are a lot of new schemes out there to buy Gazprom without paying the reported 35-percent capital gains," said Fenkner. "This is one of those times when the legal profession has added significant value to the markets."

The key for foreigners buying Gazprom, said Hermitage's Milovidov, is not to make too much noise.

"Regent's mistake was that they announced it very loudly," he said. "If they created not one but three Russian entities and placed the derivatives of these entities, it would be absolutely the same, but no one would care about it."

Irina Latysheva, a trader for MB Invest, estimated that about 40 percent of all orders at the Moscow exchange come from abroad, although she speculated that most were probably Russian money that had been parked offshore.

"In principle they come from the West," she said. "But they were sent there from Russia."

For the time being, Gazprom appears to have made peace with the foreigners. Vladimir Soskov, deputy head of Gazprom's securities department, drew a fine line between Regent's scheme and other "gray" trade, saying that the company objected only to foreign derivatives that could compete directly with its ADR program. Otherwise, he said, any company with more than 50 percent Russian capital could trade in domestic shares.

"If they have a Russian company here ... they can buy the shares on the internal market and they have the right to sell them here," he said. "As long as you buy and sell the shares here, you don't have any relation to that 9 percent limit, or to our ADR program."

Traders say that Gazprom keeps the Moscow exchange under tight scrutiny, and that chances are slim that any one outsider could build up a big stake. Latysheva estimated that only about 10 percent of Gazprom's shares trade freely, half of them through the exchange. At present turnover, less than 1 percent of the company's shares changes hands every month.

Gazprom also maintains close ties to both share depositaries that work with the exchange. The more prominent of the two is depositary No. 883, run by Gazprombank.

Beyond the exchange, innovators haven't stopped coming up with new ways to offer domestic Gazprom stock to foreigners. Milovidov, who manages an offshore fund, said he recently received a call from a company in one of Russia's regions, offering to sell him a regional bank that had most of its money invested in Gazprom shares.

"This is an example of how people are designing different products to increase the market for Gazprom," he said. "It's a significant risk for investors, but they are offering these things."