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. Last Updated: 07/27/2016

Gazprom and Miller Stand at a Crossroad

Russia's largest corporation stands at a crossroad where it will be forced to choose between market-oriented reforms that may expose the company's weak spots and the status quo that could undermine the nation's role as a strategic natural gas supplier.

Gazprom CEO Alexei Miller will be mulling over this kaleidoscope of pressures as he addresses Gazprom shareholders at their annual meeting Friday.

With the explicit support of President Vladimir Putin, Miller and his new management team embarked on a campaign one year ago to return valuable gas fields to Gazprom's balance sheet.

The success of the campaign -- illustrated by the return of petrochemical holding Sibur, Purgaz and Zapsibgazprom -- weighed on an alliance formed by foreign investors, new Gazprom management and the government, which owns a 38 percent stake in the gas monopoly.

But the issue of domestic gas prices threatens to blow this alliance apart as shareholders lobby for higher tariffs that the government is reluctant to provide. Management, which was handpicked by the government but must answer to all shareholders, is caught in the middle.

"Monopoly behavior can only be changed by force," said Adam Landes, an oil and gas analyst at Renaissance Capital. "Management is unwilling to embrace the process. Federal regulators aren't strong enough. We hope to see management that embraces the liberalization process, or, frankly, a new management."

Miller fulfilled his mission of cleaning up the business and wrestling out the Communist-era holdovers headed by former CEO Rem Vyakhirev, Landes said. Now, Miller must either step up to new challenges or step down.

Gas prices still don't cover the costs of production despite a recent 15 percent hike in wholesale tariffs. This market distortion, in effect, subsidizes industrial production, which includes the state electricity monopoly and railways sector and accounts for 90 percent of Russia's gas consumption.

Gazprom has had to leverage export contracts to Western Europe to make up the difference. Long-term debt stood at 182 billion rubles ($5.9 billion) at the end of 2001, a 3 percent increase from the beginning of the year. If short-term obligations are included, Gazprom's debt figure shoots up to about $10 billion.

And most of these funds are earmarked for operating costs. The development of new fields, such as the Zapolyarnoye giant brought onstream in October 2001, is becoming less of a possibility. The gas monopoly is focusing its energy on reaching its production goal of 530 billion cubic meters by 2010 and subsequently maintaining that level.

Inflation fears are fueling the government's unwillingness to hike tariffs to the $40 to $50 per 1,000 cubic meters considered break even by Gazprom and other independent producers. Experts have concluded that any real increase in tariffs will happen after the State Duma elections next year and the presidential race in 2004.

Utility fee hikes have already proved to be unpopular with thousands of Russians, who in the past months have staged street protests across the nation. Households will see another 16 percent increase from Aug. 1.

Independent producers say they are the logical choice to fill the gap between Gazprom's flat production and Europe's needs, which are expected to double by 2020. But they say they can only do so in a better price environment.

These producers eager to get on the market, however, overlook a major side effect of price increases, said Gazprom Deputy CEO Yury Komarov.

"It's difficult to predict demand for gas if tariffs are on the upswing," Komarov said. "A high level might price some consumers out of the market. It will stimulate savings and encourage use of other fuels."

David Morgan, board chairman of independent producer Northgas, disagreed.

"There is no question that people can pay for gas at liberalized prices," Morgan said.

Independent natural gas producers are a rare species in the Yamal-Nenets autonomous region. According to the regional administration, 34 are registered, although only a handful actually operate. During the past two years, though, their ranks have swelled with the likes of LUKoil, Yukos and other oil majors who are nudging their way into Russia's regulated gas market.

They lay no claim to Gazprom's extensive network of gas fields inherited from the Soviet Union. They are ready to develop difficult gas deposits that Gazprom won't touch. They just want one thing: access to its nationwide pipeline network.

"The investment appeal in Russia's gas market remains low because the question of access prevents dynamic growth for independent producers, who are forced to pay twice as much as Gazprom," Morgan said.

Gazprom expects to lose $475 million on domestic gas sales in 2002. As compensation, the company is lobbying for a 15 percent increase in the tariffs it can charge independent producers. The Federal Energy Commission is scheduled to consider Gazprom's request in two weeks.

In response to critics who say such treatment is unfair, Komarov said other producers must contribute to the construction of new pipeline capacity, not just maintenance of the old.

Russia's most famous independent producer, Itera, has been forced to diversify into gold mining in Mongolia and metallurgy to stay afloat, said Itera president Igor Makarov.

"Low gas tariffs, high taxes and uncertain access to the pipeline have pushed down profits of independent producers to almost zero," Makarov said.

His open plea for investment at this year's Moscow International Oil and Gas Conference was in sharp contrast to the Itera that prospered under Gazprom's patronage in the 1990s. Registered in Jacksonville, Florida, Itera is believed to be partly owned by former Gazprom management, and this explains why Itera was able to buy Gazprom assets for a nominal sum.

New Gazprom managers have kept Itera at arm's length.

"Our plans completely depend on Gazprom," Makarov said. "We began with gas from Turkmenistan, and this gives our company its international character. We would like to keep these markets but that depends on what Gazprom plans on doing."

The gas monopoly announced earlier this month that it wanted to regain market share lost to Itera in former Soviet states.

Closer to the hearts of foreign investors is liberalization of Gazprom's two-tiered share structure. Foreigners are officially prohibited from buying local shares, which also cannot be converted into its American Depositary Receipts. More than a year after Putin demanded liberalization, investors are still waiting.

They are also anticipating the results of the race between incumbent board member Boris Fyodorov and William Browder, CEO of Hermitage Capital Management, for a seat on

Gazprom's board. The winner, if any, will be made known at Friday's shareholders meeting.

Both advocate for the kind of gas market reform that will increase Gazprom's ability to produce gas and, thus, its valuation.

If the government puts off reform, "there will be no gas for Russia, no gas for Europe and everything will be done in panic mode," said Landes of Renaissance Capital.