The liberalization of Russia’s gas market would almost certainly entail the downsizing of Gazprom and the rise of new “independent” producers competing on a level playing field.

The head of Russia's largest oil company Rosneft, Igor Sechin (left), and the head of Russia's state-controlled gas company Gazprom, Alexei Miller (right), during a ceremony of the Nord Stream gas pipeline in Portovaya Bay in 2011. Photo: AP / TASS

As the cold temperatures of January 2017 resulted in an unprecedented surge in demand for Russian gas, Gazprom’s daily exports reached an all-time high. This comes at a time when the company’s share in supplying aggregate European demand is now up to 34 percent. Yet, despite the company’s recent successes, there could be a significant change in the pipeline.

Over the last few years, various energy analysts have examined virtually all aspects of Gazprom’s relations with Europe, ranging from its standoff with the Ukrainian authorities and its drive to wean itself off Ukrainian transit dependence to the prospects of its Baltic liquefied natural gas (LNG) project. Yet there still remains one more problem to consider: What do other gas-producing companies of Russia think of Gazprom’s market sway?

It has been more than 25 years since the dissolution of the Soviet Union, yet the mechanisms within Russia’s gas sector have barely changed. Has the time come to enact radical reforms? On the surface, the case for liberalizing Russia’s gas market is quite convincing.

The rise of the independents

The underlying cause behind recent initiatives to liberalize Russia’s gas market is a notable uptick in the production of other producers (often referred to as the “independents”). In 2000, Gazprom constituted 90 percent of aggregate Russian gas production. However, as of 2016, its share had fallen to 65 percent. Although Gazprom’s production did indeed fell between 2000 and 2016 by almost 100 billion cubic meters (to 419 billion cubic meters), there is more to it - contenders in the form of Rosneft, NOVATEK and Lukoil have been cranking up production capacity.

Also read: "What you need to know about Rosneft"

With a total gas output of 220 billion cubic meters (equivalent of Canada’s and Algeria’s production), the independents are now calling into question Gazprom’s pipeline export monopoly. In 2014, in fact, Rosneft and NOVATEK were granted rights to export LNG.

Gazprom reacted in an irritated manner, linking any change in Russia’s current gas export legislation with an expanded ability to supply gas to domestic customers at market prices. Here’s why it would be ideal to implement both radical measures, simultaneously and without any distinction.

Unimpeded access for all

As the gas output of the “independents” grew over the last decade, their concerns about the unfairness of Russia’s gas export regime were voiced on numerous occasions. Foremost among them is Rosneft, which, technically, hardly qualifies for the “independent” status, given the state’s majority stake in the company. The company’s CEO, Igor Sechin, reiterated in mid-January the company’s desire to see the export ban modified.

Rosneft’s latest argument in favor of lifting the export ban is a 16-year supply contract to be concluded with British Petroleum, stipulating the export of 10 billion cubic meters of natural gas per year via the Nord Stream pipeline. As the gas would be sold from Greifswald, Germany (the city next to which Nord Stream reaches the European mainland), such a deal would most likely bypass the European Union’s stringent Third Energy Package policies. Much like Rosneft’s arguments prior to the Bashneft privatization, it pledges to augment the state’s budget revenues if this initiative were to materialize.

Rosneft became the leading “independent” gas producer in Russia by increasing its gas production to 67 billion cubic meters in 2016, outpacing NOVATEK. Rosneft’s target production volume of 100 billion cubic meters by 2020 might prove too difficult to achieve. Nevertheless, the company’s gas output will almost surely continue to grow, thus rendering the issue of export liberalization increasingly vital and pressing.

Moreover, Rosneft concluded another supply deal with the Chinese company Beijing Gas Group in November 2016, meaning that the Chinese factor in the export schemes of the company could lead to a multi-vector development course. It should be noted that for now Rosneft, despite its massive lobbying clout, does not want to supplant Gazprom from the gas export mechanisms – it envisions an agent contract, under which Gazprom Export would be the factual supplier. Thus, at this point, Rosneft is shying away from a direct encroachment on Gazprom’s monopolist status.

Yet, in the long run, Rosneft is hoping for a gradual dismantling of Gazprom’s gas export monopoly. It has even suggested that Gazprom be split up into two separate entities – one dealing with gas production, the other dedicated solely to transportation issues.

Many might deem this measure long overdue, as Russia’s oil sector has already undergone the same process, dating back to the first years of the newly-formed democratic Russia. In 1993, Transneft was formed, a state-owned transportation company with no interest whatsoever in oil production, dedicated solely to pipeline oil transportation.

Yet Gazprom, which even in its name retains the traces of its Gas Ministry past, is profoundly linked to the Russian state authorities and will do its utmost to retain its preferential status. Although the Russian state, controlling 50.2 percent of Gazprom, is technically entitled to initiate the unbundling procedure, it will not propose any radical reforms under the current distribution of power.

Gazprom’s travails

Rosneft is not alone in its quest to earn a place in the sun, as NOVATEK is also stepping up its efforts to liberalize Russia’s gas exports. Leonid Mikhelson, NOVATEK’s owner, has sent a letter to Russian President Vladimir Putin in which he advocated granting access to gas export routes with respect to “independent” companies, much like Sechin proposed.

Also read: "What US energy exports to Europe mean for Russia"

Other gas producers, such as LUKOIL, which currently sells its natural gas to Gazprom directly on the premises of the field, would also derive benefit from such a move. Gazprom’s argument tended to be straightforward – there is no need for additional exporters as everything has been working fine, especially now, when each week has seen a new all-time daily supply record. Moreover, Gazprom argues, the influx of new producers would depress prices on European markets and thus lead to a reduction in state budget revenues. Yet, there might be some potential for an all-encompassing deal.

Gazprom has exclusive rights to export Russian gas, but on the domestic market it is confined by its state-mandated responsibilities. The domestic gas market is its largest outlet, with annual volumes reaching 221 billion cubic meters in 2016. The bottom line, however, is that Gazprom supplies this gas by means of state-regulated contracts, by which the domestic price for gas is significantly lower than that of export-bound gas.

On average, domestic market-supplied gas is three times as cheap as the Europe-bound one, whilst the regional allocation of prices does not differ greatly. Almost all federal regions of Russia pay 3,000-4,000 rubles per 1000 cubic meters, with the highest prices being in Altai and Arkhangelsk regions (4,354 rubles and 4,185 rubles per 1000 cubic meters). [This corresponds to a low of $50 per 1000 cubic meters and a high of $72.5 per 1000 cubic meters – Editor’s note].

Wholesale prices are just a shade more expensive than for the public. In this respect, it is telling that the Federal Anti-Monopoly Service (FAS) is concurrently pursuing the liberalization of both domestic and export regimes. To implement one without the other would only cause harm.

“Independents” oppose the liberalization of the domestic Russian gas market in its current form. Currently, Russian authorities set the upper and lower limits of the pricing range for Gazprom, and the company is obliged to stick to this range. Were FAS to implement three pilot initiatives in the Tyumen, Yamalo-Nenets and Khanty-Mansiysk regions with the aim of liberalizing domestic pricing (as it planned to do in 2017), Gazprom would be given a covert boost, since without control over gas transportation, which remains firmly in the hands of Gazprom, “independents” would surely be discriminated against.

And, perhaps even more troubling, they would face the prospect of Gazprom offering massive price discounts to sideline the “independents.” So far, the decision has been to delay any action on both fronts, and it is becoming increasingly unlikely that in the lead-up to the Presidential election in 2018 the current course will be altered. It remains to be seen whether this course can be sustained henceforth.

Double utility

Unbundling Gazprom’s production and transportation activities would be the soundest decision from an economic point of view. Under the current distribution of rights, Gazprom concentrates too much power in its hands, thus squelching competitiveness. Rosneft and NOVATEK should have the opportunity to trade freely, even without the involvement of a state-owned intermediary, yet they should also assume new responsibilities.

Also read: Gazprom: Three key challenges facing Russia's energy giant

For instance, the fact that Gazprom would see its lobbying clout diminished does not mean that Rosneft should be given even more space to influence government decisions. The dual liberalization of Russia’s gas market should level the playing field for all actors, no matter if they are big, medium-sized or small. It should also transform the state’s role into that of a facilitator, instead of the final controlling owner. All the more so as the government budget already receives hefty sums from share auctions or when the government levies an export duty.

If a separate gas transportation company would be established, it would still reap its profits. Moreover, it would substantially aid Russian negotiators vis-à-vis the European Commission, which, despite its manifest intent to wean itself off Russian dependence, could not implement discriminatory regulations and would have to deal with Russian companies using solely market instruments.

Gazprom finds itself in a difficult position vis-à-vis the increasingly emphatic demands to liberalize Russia’s gas exports. Additional export volumes would translate into additional transportation service fees. Moreover, it could raise its revenues by means of price hikes on the domestic market. However, what if the contenders use the liberalization of gas exports to seek further concessions?

Were the dual liberalization to be seen through the end (i.e. the unbundling of production and transportation), Gazprom would be resoundingly downsized. Yet it is a worthy objective. It should be remembered and reiterated that Gazprom is only an instrument of state policy.

Putting the company’s interests ahead of those of Russia’s population is tantamount to acquiescing that Russia is effectively an oligarchy. After all, it is not Gazprom that is Russia’s “national heritage” (as the company’s advertisements claimed until the Federal Anti-Monopoly Service banned it from doing so), but its people and its vast hydrocarbon resources.