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. Last Updated: 07/27/2016

Rosneft and Gazprom Put Their Feud Aside

Recent partnership deals between Rosneft and Gazprom have paved the way for major shifts in the energy industry that will further squeeze out foreign oil majors while enabling a much-needed boost in production, analysts say.

The two state-owned companies have emerged from the dust of a failed merger that collapsed in May 2005 amid an acrimonious struggle over who would snatch up the main production unit of bankrupt Yukos, and now appear ready to put their feuding behind them.

With the remainder of Yukos' assets up for auction this year -- and the fate yet unknown of several projects in which the state does not have a controlling stake -- Rosneft and Gazprom are expected to expand their respective empires as the Kremlin's national champions of choice.

President Vladimir Putin has designated the two companies as guardians of the country's vast oil and gas resources, laying the groundwork for the firms to take on majority stakes in all major energy projects.

A law on subsoil use that would codify those rules has been stalled in the Duma for the last two years, but is widely expected to pass this year.

Gazprom has already sealed a deal to buy a controlling stake in Sakhalin-2, after months of pressure by state environmental regulators prompted Shell and its Japanese partners to sell half their stakes to the state gas giant in December.

Government officials have recently accused both French oil major Total and British-Russian venture TNK-BP of failing to fulfill the terms of their licenses to develop large oil and gas fields.

Gazprom has repeatedly said it is interested in buying out the 50 percent stake in TNK-BP held by Russian shareholders, Mikhail Fridman's Alfa Group and Viktor Vekselberg's Access-Renova. Analysts agreed that they would likely sell this year when a contract clause obliging them to hold on to their 50 percent stake in the joint venture expires.

A potential sale would also boost Gazprom's stake in Slavneft. TNK-BP and Gazprom Neft, the Gazprom oil unit formerly called Sibneft, currently hold 50 percent each in the company. Gazprom took up the Slavneft shares through its purchase of Sibneft last year.

Analysts believe a sale would ease TNK-BP's problems at its flagship project, the giant Kovykta field in east Siberia. TNK-BP chief Robert Dudley said at the World Economic Forum in Davos, Switzerland, last week that he expected a deal to be reached by the middle of this year.

The Kovykta project, run by TNK-BP subsidiary Rusia Petroleum, has come under fire for failing to fulfill production contracts that stipulate it produce 9 billion cubic meters of gas per year. But Gazprom has blocked the construction of a pipeline to China, and TNK-BP currently can only supply gas to a local market that uses just 1.5-2.5 bcm per year.

"The rules aren't defined yet. They will be once TNK-BP is settled," Joseph Stanislaw, a senior energy adviser to Deloitte & Touche and the co-founder of Cambridge Energy Research Associates, said in a recent interview.

The TNK-BP joint venture in 2003 marked the last large-scale entry into Russia by a foreign oil major. Most foreign projects date from the mid-1990s, when the state awarded three production sharing agreements, or PSAs, to develop oil and gas fields jointly.

One of those projects, Sakhalin-2, has already made way for a majority Russian partner. Analysts say Total's PSA at Kharyaga -- facing steady criticism for allegedly failing to develop the field quickly enough -- could be next. The third PSA, at the Exxon-led Sakhalin-1 project, will also likely face review, analysts said. Rosneft holds a 20 percent stake in the project.

Government control of the energy sector has risen dramatically in the past two years, after the state's legal onslaught against Yukos dismantled what was once the country's largest oil producer. After Rosneft bought Yuganskneftegaz, Yukos' main oil production unit, in December 2004 and Gazprom snatched up Sibneft nine months later, the state's control over total crude oil output doubled to one-third.

Putin initially sought to harness the country's energy resources within one large company, but negotiations on a Rosneft-Gazprom merger fell apart over the proposed terms, which would have seen Rosneft playing second fiddle to the gas giant.

While a formal merger is no longer in the cards, the two companies have signed a series of agreements in recent months that should allow them to move forward with ever more acquisitions.

At a meeting with senior officials on Jan. 16, Putin approved a decision to split all new offshore oil and gas fields equally between the two companies, Vedomosti reported, adding that the new subsoil law would formalize the move. In December, the two firms signed a strategic partnership agreement to make joint bids for licenses and join forces in the production and delivery of oil, gas and electricity.

"These two companies are in natural competition with each other, but from a political point of view, it became too serious," said Valery Nesterov, an analyst at Troika Dialog. "This is a government attempt to reconcile them."

Reconciliation is necessary, analysts say, if the country is to boost oil and gas production as older fields in western Siberia begin to dry up at the same time that demand in Europe and Asia is expected to rise exponentially.

"The state hasn't awarded any major projects, aside from the PSAs of the mid-90s, since the end of the Soviet Union, meaning major fields, both onshore and offshore, have been sitting idle and unallocated," said Chris Weafer, chief strategist at Alfa Bank.

The two companies are setting aside competition because, Weafer said, "there are enough spoils to go around."

Yukos' remaining assets, including refineries and two large oil-production units, are due to be sold off in auctions over the next few months.

Rosneft has its eyes on the refineries and the 9.4 percent stake that Yukos still holds in the company.

Gazprom, meanwhile, is eager to buy the 20 percent stake Yukos holds in Gazprom Neft.

The Yukos assets most likely to cause friction between Rosneft and Gazprom are the bankrupt firm's two largest production units, Samaraneftegaz and Tomskneft, which both firms have expressed interest in acquiring, analysts said.

The state is also due to re-auction the Sakhalin-3 project this year, after dissolving a preliminary license awarded to a consortium comprising ExxonMobil and Chevron in 1993.

And although analysts are skeptical the decision is final, Gazprom currently holds 100 percent ownership of the massive Shtokman field in the Arctic, after canceling plans to award an equity stake to a foreign oil major.

"The next generation of projects in Russia is going to be a lot riskier and represent a whole new area for both of these companies," said Julia Nanay of PFC Energy, a Washington-based consultancy. "If Russia is going to keep sustaining its gas production and potentially grow it, it will need a greater level of cooperation between these companies," she said.

Growing European concerns have less to do with worries over the delivery of oil and gas, following supply disruptions through Ukraine and Belarus, and more to do with fear that lagging production in Russia will be unable to fulfill future European demand, Weafer said.

"Now that the government has both national champions in place and its direct ownership in the energy sector has been established, it is moving on to the next phase: development," he said.

Russian crude output rose by 2.2 percent to 480 million tons last year, the smallest annual increase since 1999. Gas output rose by 2.4 percent to 656 billion cubic meters, holding relatively steady as annual global demand continues to rise.