BMI View: Gazprom's Q311 results (July - September 2011) conform with BMI's long-held caution over the company's numerous capital-intensive projects. Indeed, these colossal commitments, which have always placed the firm in a difficult cashflow position, are now starting to take a toll on net profit. While the 3% y-o-y fall in earnings is likely to be an exception caused by a weakened rouble, the underlying concerns over capital expenditure will remain. Although the rouble only started to regain some of the losses made in H211 in early 2012, suggesting Q411 y-o-y growth could disappoint, we believe booming winter gas and fuels demand will boost q-o-q expansion.

Gazprom's Q311 earnings fell to RUB156bn (US$5.14bn), a 3% fall from Q310. This is the first 2011 quarter that saw a year-on-year contraction in net profit. Despite a 22% growth in gas sales, the company's returns were hit by RUB148bn (US$4.89bn) worth of financial expense, a 228% increase on Q310, mostly caused by foreign exchange (FX) losses on debt issued for the company's capital-intensive investments. The company had increased its net debt by 20% to RUB1.04trn (US$34.37bn). Despite these underwhelming results, the company beat expectations with a net profit attributable to shareholders of RUB152bn (US$5.02bn) against a RUB150bn (US$4.94bn) consensus estimate from Analysts polled by Reuters.

The company's revenues were however boosted by its refining business, which thanks to secure feedstock at a time when European refiners were struggling to compensate for the interruption in Libyan light crude supplies, grew by 43% y-o-y. Gazprom also benefited from successful diversification into the power sector, which bolstered its bottom line.

Cashflow performance for the period was dire, in line with previous quarters. Operating expenses for Q311 rose 6% y-o-y. On a positive note, this was the first 2011 quarter to experience slower growth for operating expenses than for operating cashflow, which expanded by 40%. The overall picture remains nonetheless negative as capital expenditure grew 63% y-o-y. Although, these low figures did not come as a surprise and were in line with the company's colossal investment, they suggest the company could possibly be over-extending itself after embarking on a gigantic spending spree.

In Q111, we said that net profit of RUB479bn (US$16bn) was a peak that would prove difficult to sustain for the rest of the year and Q211 proved that this was indeed the case. Q311 did even more than that and conforms with our view that, stripped from seasonal spikes in demand due to cold weather, the most salient aspect of Gazprom's activities is its worrying spending spree. The firm's capital-intensive investments are only sustainable while energy prices remain high. This fragile position is being threatened by Gazprom's client which, due to rising global gas production and the decoupling of oil and gas prices, are exerting increasing pressure on the company to move away from oil-indexed supply contracts to agreements with a stronger focus on gas sport prices.

However, on the short term, the status quo will remain mostly unchanged, which is why BMI believes that 2011 will be a particularly good year for Gazprom. We said, when the Q111 results came out, that the company would beat its RUB776bn (US$26bn) all-time record profit posted in 2010 and this is now already been officially the case.

Lifted By A Gas Cloud

The company's results and strategy reflect its competitive advantage in gas, usage of which as a 'bridge fuel' is likely to rise, as it facilitates the long and slow transition from oil to renewables. Gazprom expects global gas consumption to reach 5.1tn cubic metres (tcm) by 2030, up from its current level of 3tcm. Gas was the second-fastest-growing business segment for the company, with sales increasing 17% y-o-y in Q311.

The fact that this is the first 2011 quarter where gas sales growth was lower than total sales growth, which was at 22% y-o-y, should not cause alarm for investors as milder summer weather explains the relative fall in gas sales vis-a-vis other segments. This is notably the case with refining which, thanks to the driving season, enjoyed 43% y-o-y growth. However, the fact that y-o-y gas sales growth has been slowing down from 42% in Q111 to 36% in Q2111 and now to 17% in Q311 is much bigger source of concern. It could be the start of a worrying trend for overall growth. However, sales are still expanding at a very healthy pace and Q411 could still disprove these worries.

The company's domestic sales delivered the slowest growth at 10% y-o-y, while Former Soviet Union (FSU) countries posted more-than-double that rate with 20% y-o-y growth. However, with an increase in gas sales of about 23% and contracted volumes of 131bcm in 2010 - 66% of Gazprom's total sales - Europe remains fundamental to the company.

The European market is at the heart of Gazprom's revenues and there is considerable room for growth. According to the company, European gas imports could rise to as much as 500bn cubic metres (bcm) by 2030, with Gazprom accounting for 32% of this figure. Gas usage in Europe is expected to rise, as the EU targets a 20% reduction in greenhouse gas emissions by 2020, necessitating a reduction in coal and oil usage in favour of cleaner-burning natural gas, among other energy sources. Nevertheless, we see many downside risks to these bullish assumptions; the main one being that of lower-than-expected European growth or even a double-dip recession that could depress demand.

European Price Wars

Gazprom's image as a reliable gas provider took a hit in hit in March 2005, when Russia complained that Ukraine was not paying for its gas imports and that it had diverted transit gas to its domestic market. After Ukraine admitted some of the volumes had been diverted, Russia suspended exports in January 2006. Although flows were restored later the same month, similar disputes have re-emerged regularly and have often resulted in supply disruptions to the rest of Europe. Tensions have risen once again in 2011-2012, particularly in the wake of the winter cold snap, which saw Gazprom officials accuse Ukraine of importing more than its contracted share of gas, reducing flows elsewhere in Europe.

Gazprom's supply contracts are increasingly being challenged by its European partners as oil-linked prices have soared along with global benchmark crude prices. Companies such as Italy's Eni, Germany's E.ON, Greece's DEPA, Poland's PGNiG, as well as a handful of other smaller or mid-sized utilities, have all filed arbitration procedures or obtained a renegotiation of their long-term price formula in 2011-2012.

Considering Gazprom's dependence on the European market, we believe that the firm will be forced to adopt a more flexible form of contract. Renegotiations will focus mainly on expanding spot-priced volumes and softening the take-or-pay clause. However, there is not one-size-fits-all model; meaning that it will remain a painstaking bilateral process where countries with access to alternative suppliers, such as Italy, will get better discounts than other customers with limited other options, such as Ukraine. Indeed, given its dominant position in these markets and the fact that Russia subsidised energy consumption for many eastern European countries during the Soviet era, the state-owned company has little incentive to adopt a weak stance.

Worried about possible disruptions and swelling prices, European countries have tried to diversify their gas import sources, but this has proved difficult given Gazprom's huge market share. Although we see these tensions as a threat, we believe they remain manageable and are unlikely to considerably impact short-term results.

Pipeline Offensive Could Face A Shale Wall

With the official inauguration of the 27.5bcm Nord Stream pipeline on November 8 2011, Gazprom has further strengthened its position in the European market. The EUR7.4bn (US$10.2bn) project offers an alternative to the Ukrainian route. Most of Nord Stream's volumes will be consumed in Germany, with some gas to be transported on to the Netherlands and France. This pipeline has tightened Russia's grip on Western Europe while undermining Eastern Europe's strategic midstream role.

Furthermore, this geopolitical imbalance is likely to be exacerbated by the proposed 63bcm South Stream project which Gazprom is hoping to bring on-stream by 2015. South Stream, which we estimate could cost as much as EUR15.5bn (US$21.0bn), has managed to attract several European investors including Eni (20%), Electricité de France (EDF) (15%) and Germany's BASF (15%). Although this entreprise could be undermined by greenfield projects to transport gas from Azerbaijan through the southern corridor we believe it remains likely to go ahead.

In the longer run, we see shale gas exploration in Europe as a real threat to Gazprom. The US Energy Information Agency (EIA) estimates that Europe's technically recoverable shale gas resources could amount to 18tcm. Hydraulic fracturing (fraccing), a drilling technique used to recover shale gas, remains highly controversial, and regulation varies widely throughout the continent. Some countries, such as Poland, which could have shale resources of up to 5.3tcm, are pushing ahead aggressively to develop their resources, while France, which has resources estimated at around 5.1tcm, has banned fraccing. Uneven policies across Europe offer relief for Gazprom in the near future, but if these were to be resolved the firm's 2030 growth prospects would undoubtedly be affected.

Russia's Eastern Frontier

Over-reliance on European imports has pushed the company to consider new export markets. In November 2010 the board of directors set new strategic goals for the company that included expanding exports outside Europe - particularly to the Asia-Pacific region where growth is strongest - by building new pipelines and boosting the share of liquefied natural gas (LNG) in the company's portfolio. The company currently has 85bcm worth of new LNG projects and 186bcm worth of new pipeline projects.

Nevertheless, Gazprom has had difficulty accessing Asian markets and opening them up for export. Although growth prospects are enticing, particularly in neighbouring China, benchmark prices are substantially lower. In China, the official price has been capped at US$169 per thousand cubic metres (mcm) since June 2010, much lower than Europe's US$396/mcm. This has been a major obstacle to the signing of a US$1trn 30-year supply deal that would see Gazprom export up to 68bcm to China every year. Following months of bargaining, in late-2010 a Chinese energy official revealed that the difference between the prices offered by Russia and China had been reduced to only US$100/mcm. However, during Vladimir Putin's visit to Beijing in October 2011, Alexander Medvedev, director-general of Gazprom's export arm, told Reuters that 'it is quite clear that it is not easy to find a solution'. Additionally, Russian government deputy chief of staff, Yuri Ushakov, said that the 'signing of the gas pricing deal is not planned at this point'. This means the Chinese market will be closed to Russian exports for the time being.

Nevertheless, Japan offers growth potential with LNG import levels soaring in the wake of the Fukushima nuclear accident, and Tokyo making clear its desire to step back from further nuclear electricity development. Japan is, by far, the world's largest LNG importer, taking 93.5bcm in 2010, and we expect gas imports to rise at least 6% in 2011 to 102bcm and 108bcm by 2015, though recent import data suggest upside risk to these forecasts.

Gazprom is planning to take advantage of this new opportunity by starting up the Kirinskoye gas field, part of the Sakhalin-III project, in Q212 - more than a year ahead of schedule. The Kirinskoye block is one of four that are due to supply the Sakhalin-III project, alongside East-Odoptu, Ayashshy and the Rosneft-operated Veninskoye field. The four blocks, which have reserves estimated at 5.1bbl of oil and 1.3tcm of gas, will be commercialised using the Sakhalin-Khabarovsk-Vladivostok pipeline, which will help increase gas exports to the Asia-Pacific region.

Gazprom's deputy CEO, Alexander Ananenkov, also said that the Chayandinskoye field would be launched on schedule in 2016. The field, which is located to the north of Lake Baikal in the heart of Russia's Asian hinterland, will be crucial to the start of production at the LNG terminal planned for Russia's Pacific coast, according to Ananenkov. The terminal, which is expected to come onstream in 2017, will reportedly have a capacity of at least 6.9bcm, according to Japanese media reports in December 2010. Russia is considering doubling capacity to around 13.8bcm, in the light of increased Japanese demand.

Gazprom has also started looking beyond the Far East. Speaking at the Australia Gas Conference in Sydney in November 2011, Nigel Kuzemko, global director of LNG development at Gazprom's trading arm, said that India was an 'incredible' market where a significant shortfall in supply offers a huge opportunity for LNG exports. He said that his company saw India as one of its key markets for LNG supplies in the east, along with Japan, South Korea and other north-Asian countries. Although Russia did not have any contracts with India in 2010, volumes are set to grow following the signing of preliminary deals between Gazprom and four Indian companies - state-owned gas distributor GAIL, Gujarat State Petroleum Corporation, Petronet LNG and Indian Oil Corporation- to supply up to 10mn tonnes per annum (tpa) (13bcm) of LNG.

A  Worrying Spending Spree

Substantial investment in infrastructure and exploration and production (E&P) projects - to take advantage of growth - has forced a 63% rise in capital expenditure (capex), from RUB249bn (US$8.22bn) in Q310 to RUB404bn (US$13.36bm) in Q311. Most of this investment is aimed at boosting exports. In addition to investment geared towards the Asia-Pacific region, Gazprom has also been eyeing high-capex LNG projects, such as Yamal LNG and the offshore Shtokman LNG projects.

Investors have long complained about the company's cashflow. Gazprom's capex has in the past tended to match its operating cashflow, but 2011 has seen a clear decoupling between the two. The 2008 financial crisis, which led to an oil and gas price collapse, forced the company to slash its investments, but they are now rising much faster than operating cashflow. We view this spending spree as a sign that the company, worried by the maturity of its currently operating fields, is being forced to make considerable investments in order to cement its high export growth potential.

Cracking Ahead

The company's refining business experienced the highest increase in sales in Q311 thanks to the summer driving season. The segment recorded growth of 43% y-o-y. This is a trend that has been observed across the board in the Russian downstream. Significant expansion in downstream sales can be explained by growing demand in both the domestic and export markets. Growth was highest in the domestic market with 47% compared to 39% in Europe and 31% in the FSU.

Higher growth in the domestic market can be explained by both strong demand and by a de facto ban on gasoline exports. Indeed, the government's attempt to contain inflation by keeping refined product prices artificially low, combined with soaring European gasoil prices during 4M11 (prices reached a peak of around US$1,050/tonne in mid-April, the highest since mid-2008), created huge incentives to maximise diesel production at the expense of gasoline. However, this trend reversed in May 2011, when the government, in a bid to force output to be rechanneled towards the domestic market, increased the gasoline export tariff to 44%, a level high enough to act as a de facto export ban. Refinery runs across Russia increased 6% month-on-month (m-o-m) and 9% y-o-y to 5.4mn barrels per day (b/d) of crude in June. This set a modern high, the likes of which had not been seen since the fall of the Soviet Union. Gasoline output rose 10% m-o-m and 12% y-o-y, significantly more than gasoil, which increased 8.6% m-o-m and 8.6% y-o-y. Since gasoline accounts for the majority of Russia's refined fuels consumption, unlike Europe which uses diesel, this indicates that production was being geared towards the domestic market.

The outlook for Q411 is also rather positive as higher gasoline output has pushed the authorities to adopt a more relaxed stance towards fuels exports. Additionally, the end of the summer driving season and the winter heating season should continue to bolster domestic demand. Therefore, we believe that refining will likely be the company's best performing segment in 2011.

A Bumpy Road Forward

Gazprom's mixed results, with the company registering high sales and profits but a sharp fall in free cash flow, have been reflected in the company's share performance. Since the announcement, the upward trend the stock had followed since the financial crisis has been broken, with multi-year support becoming a resistance in August 2011. It appears that Gazprom's share performance, rather than being unequivocally positive, which is what one would expect from a company with such strong sales growth, remains muted. This in our view is a clear indication that despite the numerous opportunities for growth, the ongoing spending spree and the risks that surround Gazprom's ambitious projects are being perceived as a clear threat to the company's operational and financial performance. Therefore, until some of the major projects start coming online, we do not see much scope for a break through resistance.

Nevertheless, given its strong fundamentals, we believe the firm will register record earnings in 2011 while potential for growth in Asia will bolster the long-term outlook.

Copyright 2012 Business Monitor International Ltd. All Rights Reserved.

(Originally published in the May 1, 2012, edition of BMI Emerging Europe Oil and Gas Insights.)