VZCZCXRO4339
PP RUEHDBU RUEHFL RUEHKW RUEHLA RUEHNP RUEHROV RUEHSL RUEHSR
DE RUEHMO #2541/01 2801342
ZNY CCCCC ZZH
P 071342Z OCT 09
FM AMEMBASSY MOSCOW
TO RUEHC/SECSTATE WASHDC PRIORITY 5023
INFO RUCNCIS/CIS COLLECTIVE PRIORITY
RUEHZL/EUROPEAN POLITICAL COLLECTIVE PRIORITY
RUEHXD/MOSCOW POLITICAL COLLECTIVE PRIORITY
RHEHNSC/NSC WASHDC PRIORITY
RHMFISS/DEPT OF ENERGY WASHINGTON DC PRIORITY
RUCPDOC/DEPT OF COMMERCE WASHDC PRIORITY

C O N F I D E N T I A L SECTION 01 OF 04 MOSCOW 002541

SIPDIS

DEPT FOR EUR/RUS, EEB/ESC/IEC GALLOGLY AND GREENSTEIN,
S/EEE MORNINGSTAR
DOE FOR HEGBURG, EKIMOFF
DOC FOR JBROUGHER
NSC FOR MMCFAUL

E.O. 12958: DECL: 10/06/2019
TAGS: EPET ENRG ECON PREL RS
SUBJECT: GAZPROM'S REVERSAL OF FORTUNE PART TWO; COMEBACK UNLIKELY

REF: A. MOSCOW 2528
¶B. VLADIVOSTOK 110
¶C. MOSCOW 854

Classified By: Ambassador John R. Beyrle for Reasons 1.4 (b/d)

¶1. (U) This is part two of a two-part cable on the new
economic realities facing Gazprom, Russia's state-owned gas
sector giant.

-------
Summary
-------

¶2. (C) Gazprom faces many external and internal constraints
to renewed growth, following a dismal year in which all main
indicators of its performance deteriorated dramatically. The
globalizing gas market, a gas glut that shows no signs of
reversal, and politicized management likely mean that Gazprom
will not reach the heights of revenues and power achieved at
its peak in 2008. Unfortunately, the types of reforms (e.g.
privatization) that would result in a more valuable and
productive gas industry are stymied by the GOR's seemingly
firm belief in a state-controlled sector. While Gazprom will
remain a major economic force, its influence on GOR policy
and its relative role in the Russian economy likely will
diminish in the short- and medium-term. End summary.

---------------------------------
external constraints to a rebound
---------------------------------

¶3. (SBU) Gazprom's current problems (ref A) are not solely
the result of one-off contractions in demand due to the
economic crisis. Gazprom faces a fundamental shift in the
gas demand picture at a time of increasing competition.

Demand stabilization and decline --

¶4. (SBU) xxxxxxxxxxxx told us recently that Gazprom was simply unprepared
for the inevitable leveling off and current decline in
European gas demand. He explained that Gazprom's management
has only known rapidly rising European demand for Russian gas
as most European countries "gassified" their economies over
the past two decades. He noted that anyone looking at the
trend could have been excused for thinking it would continue
perpetually; but now the period of gassification is over.
According to xxxxxxxxxxxx demand for gas in Germany is
actually in decline, as industrial production in Germany (and
across Europe) has become more efficient and as much of it
has been outsourced.

Competition --

¶5. (SBU) Gazprom not only faces a demand problem, but also
competition from an increasingly globalized gas market --
"for the next 5 to 10 years, gas will clearly be a buyers
market," said xxxxxxxxxxxx has calculated (using data
from the BP Statistical Review of World Energy) that
Gazprom's share of EU 27 gas imports has dropped steadily
from about 50% in the mid-90s (when gassification increased
demand) to just 34% in 2009. xxxxxxxxxxxx expects Gazprom's share to
decline to about 30% and stabilize at that level. xxxxxxxxxxxx also
calculated that LNG's contribution to EU imports over the
last decade has increased from about 10% to about 20%, a
figure he projected to continue to grow. In addition,
Gazprom will have to cope with massive new volumes of LNG on
the global market from projects already underway in Qatar and
elsewhere (ref C).

No help from other markets --

¶6. (C) Gazprom is unlikely to get any relief from its former
Soviet Union(FSU) customers either. Despite the likely rise
to "market prices" for gas sales to the FSU, lower demand
will continue to hurt Gazprom. Ukraine, Gazprom's major
export market outside of non-FSU Europe, earlier signed a
take-or-pay contract which outlines a minimum amount of gas
which Ukraine is obliged to purchase from Russia. Ukraine

Moscow 00002541 002 of 004


has recently indicated it might take as little as 50% of the
52 bcm of gas it had earlier agreed to buy in 2010. Russian
government officials remain concerned over Ukraine's ability
to pay for gas this winter and are already signaling they are
prepared to shut off exports to Ukraine in the event of
non-payment.

¶7. (SBU) Global markets will also offer little hope for
Gazprom, at least in the medium-term. Gazprom executives
have often expressed the expectation that the company would
become a global gas supplier, perhaps through newly expanded
LNG capacity. However, their preferred future export
destination, the U.S., is looking more and more saturated
every day with ever larger estimates for domestic production.
In a recent meeting with Embassy officials in Sakhalin,
Shell oil representatives stated that no LNG had been shipped
from the Sakhalin II facility to the U.S. due to soft prices
in that market. Much of this LNG has been shipped to Japan
instead.

Domestic market --

¶8. (SBU) Gazprom often touts future revenue gains from
domestic market price liberalization. However, it neglects
to account for demand elasticity in the wake of sharp
proposed increases in prices. With one of the most energy
intensive economies in the world, future hikes in domestic
gas prices would likely cut domestic demand substantially, as
evidenced in other countries that have implemented rational
pricing. Thus Gazprom's revenue gains from higher domestic
prices would be at least partly offset by lower sales volumes.

External politics --

¶9. (SBU) In addition to the headwinds from market forces,
Gazprom faces the political and PR difficulties in external
markets that it has largely brought on itself through the gas
cutoffs of 2009 and 2006. Despite some pain in certain
Central and Eastern European countries, Ovchinnikov
explained, the 2009 gas cutoff showed that Europe could get
by without Russian gas. This should bolster EU determination
to minimize its dependence on Russian gas, and to explore new
options to diversify energy supplies.

------------------------------
internal constraints to growth
------------------------------

The Ministry of Gas --

¶10. (SBU) A Gazprom that behaved more like a competitive
global company would probably find a new path to growth more
quickly. But Gazprom is not a competitive global company,
despite sitting on the world's largest gas reserves. Gazprom
is a legacy of the old Soviet Ministry of Gas and it still
operates much the same way. As a Gazprom executive himself
admitted to us, the company's first two priorities are to
provide reliable and affordable gas to the domestic
population, to "fulfill its social obligations." One contact
with direct information told us it took a senior partner from
a major accounting firm two years of full-time investigation
just to unravel Gazprom's holdings, which include one of
Russia's largest banks, one of Russia's major media
companies, and a major construction company.

Technologically backward --

¶11. (SBU) Gazprom's legacy and the government's ownership of
the company also mean that it must act in the interests of
its political masters, even at the expense of sound economic
decision-making. From building unneeded pipelines (ref B) to
maintaining employment at some unneeded facilities, Gazprom
declines to solely act on financial and economic grounds. As
a state-controlled monopoly during the flush times of the
past decade, Gazprom had little incentive to develop new
technologies and capabilities long enjoyed by other global
oil and gas companies. Despite management's interest in
expanding Gazprom's LNG capacity, the company has only one
LNG export terminal, which it took over by forcibly becoming
the majority owner in a Shell-led consortium. Rapid

Moscow 00002541 003 of 004


expansion of LNG export capacity is unlikely without the help
of international oil companies (IOCs), who are still trying
to find an acceptable future working model in Russia.

Inability to adapt --

¶12. (SBU) Gazprom's inability to meet competitive pressures
is apparent in the current European gas market. According to
xxxxxxxxxxxx Gazprom is the only major European supplier that
has had to cut production. xxxxxxxxxxxx blames Gazprom's "self
inflicting wound" of tying gas prices to oil prices. He said
this convention dates back to when gas was a substitute for
fuel oil for heating. xxxxxxxxxxxx explained that this oil
price link has made Gazprom the high-price supplier in
Europe, a situation that is likely to continue into the near
future. xxxxxxxxxxxx said that with European gas demand unlikely to
recover to pre-crisis levels until 2013 and Europe facing
"excess supply" for at least the next decade, Gazprom will
have a very tough time just maintaining market share. A
major oil company senior executive echoed this analysis in a
recent meeting with us, noting "if you are a European
consumer, the last molecule of gas you want to buy is from
Gazprom."

---------------------------------------
possible tensions, but reforms unlikely
---------------------------------------

¶13. (SBU) The tough times may be creating (or exacerbating)
tensions within Gazprom and the GOR over the company's
future. Several contacts have told us they have heard of
such tensions. One Russian company executive said he has
heard that xxxxxxxxxxxx has been pushing for dismantling
Gazprom, to at least take away its control over the domestic
gas pipeline system. An executive at a Western company told
us recently that there are two camps within the upper levels
of the GOR on the issue of Gazprom's direction. One camp
favors the current "one national company" approach, while the
other favors competition to spur a more efficient and modern
gas sector. Unfortunately, this executive explained, "the
number one factor" in managing Gazprom from the GOR
perspective is "how to increase government revenues from the
company."

¶14. (C) xxxxxxxxxxxx, brushed off rumors of infighting
at Gazprom as nothing new. xxxxxxxxxxxx said there has always been
infighting at the company because it is such a bureaucratic
behemoth. "Everyone is always looking to make others look
bad in order to move ahead themselves," xxxxxxxxxxxx said. While
xxxxxxxxxxxx acknowledged Gazprom's substantial problems, xxxxxxxxxxxx did
not think any major reforms would be forthcoming.

¶15. (SBU) Rumors aside, nobody with whom we have talked
believes Gazprom is in any danger of losing its monopoly on
exports or its preferred status within the Russian economy.
Nor is the government likely to give up control of the
company anytime soon. Without such fundamental reforms, it
is difficult to see how Gazprom can transform itself into a
modern corporation in the current environment.

-------
comment
-------

¶16. (C) Gazprom is what one would expect of a state-owned
monopoly sitting atop huge wealth -- inefficient, politically
driven, and corrupt. For years, with its exports and export
prices rising rapidly, it could easily pretend that all was
well and that the future was bright. That pretense may now
be giving way to the new reality of declining sales, lost
market share, and an inability to maneuver adeptly in the
face of global competition. Although Gazprom will likely
muddle along as a major corporation and major contributor of
jobs and budget funds, its economic contribution will likely
be diminished. While Gazprom can still shut off gas to
Ukraine or to other parts of Europe, each such threat further
undermines the company's credibility as a reliable energy
supplier, and underscores the fact that Gazprom is

Moscow 00002541 004 of 004


politically subordinate to the Kremlin. Gazprom's influence,
both domestic and international, has been directly tied to
its cash flow -- money that funds employment, suppliers,
budgets, charities, foreign ventures, and, surely, many
private bank accounts and dirty deals. Unfortunately for
Gazprom and for the GOR, the massive revenues and profits
that the company produced in 2008 are unlikely to return
anytime soon. End comment.
Beyrle