Commentary: The Bigger Gazprom Grows, The Further Russia Backslides

If its Yugansk deal goes through, serious market reform is endangered

It has been the talk of Moscow, an event that is already seen as a defining moment in the history of Russian business. The scheduled sale on Dec. 19 of Yuganskneftegaz, the main production subsidiary of Russian oil company Yukos, will mark more than just the final destruction of Yukos, which is being torn apart by the government to pay massive tax arrears of an implausible $26 billion. It will also mark the biggest nationalization of private property in Russia since the end of communism. That's because Yugansk looks almost certain to be acquired by Gazprom, Russia's giant state-dominated gas concern. "Gazprom has been told by the Kremlin to bid," says Christopher Weafer, head of research at Russia's Alfa Bank.

This is a bid Gazprom officials vowed they would never make -- until they changed their tune on Nov. 30. The price will be $8.6 billion, and overnight Gazprom will acquire oil reserves of 11.63 billion barrels, equal to 17% of Russia's total. Gazprom's annual revenues of $34 billion will be boosted by an additional $7.5 billion by the deal, which comes hot on the heels of Gazprom's merger with Rosneft, Russia's state-owned oil company. Gazprom will end up with almost one-quarter of Russia's oil reserves and a fifth of its oil output after merging with Rosneft and acquiring Yugansk. And there may be more deals down the road. Gazpromneft, Gazprom's oil arm, confirmed that it has received a recommendation from Deutsche Bank (DB ) "to buy large companies such as Sibneft, Surgutneftegaz, and Yuganskneftegaz." If it ends up buying all three, then Gazprom will end up not only owning most of Russia's gas but also 40% of its oil reserves. Gazprom declined requests for comment.

What would this agglomeration do to the Russian economy? It would probably mark the end of serious reform under President Vladimir V. Putin -- reform the country needs more than ever. Despite record high oil prices, Russia's growth is slowing. The economy grew an annualized 4.5% in November compared to the same month last year. That's well below the 7.6% clocked in November, 2003. Domestic investment has plummeted, particularly in the oil sector, largely because of the attack on Yukos. Since the sale of Yugansk was announced on Nov. 19, the stock market has lost 15% of its value.

The reformers in Putin's administration are now issuing dark warnings about the impact a Yugansk-Gazprom deal would have on the drive to open the economy further. Presidential economic adviser, Andrey N. Illarionov, has repeatedly slammed the destruction of Yukos. Now German Gref, Russia's Economic Development & Trade Minister and the chief architect of Putin's economic reform program, has entered the fray. On Dec. 1 he condemned the likely sale of Yugansk to Gazprom. "Where we have competition, state participation is inappropriate," he told Parliament.

Putin's economic advisers are especially concerned by the growing appetite of Gazprom for new businesses, including electric utilities. In November, Gazprom acquired 25% of Mosenergo, the main power company supplying Moscow. "Such actions completely contradict the economic policy of the government: liberalization and de-monopolization of the economy, and a reduction in the nonmarket sector," says Deputy Economy Minister Andrei Sharonov, who is responsible for reform of the gas industry.

A Stumbling Giant

The reformers' comments are not likely to change the mind of Putin or his ex-KGB advisers. That's too bad, because Russia needs the most efficient energy companies it can build if it is to realize the full potential of its gas and oil reserves. That's not what the country is getting with Gazprom, whose performance to date is hardly a great advertisement for expanding its economic role. While Russian oil companies -- most of them private -- have managed to boost output by 50% since 1998, Gazprom's production has fallen by 1.6% over the same period. Helped by high global energy prices, Gazprom's revenues have risen by some 70% since 2001, the year Putin appointed Alexei B. Miller, a close associate, as Gazprom's chairman. But most of the increase has been offset by an even faster rise in costs. According to the Organization for Economic Cooperation & Development, employment in Russia's gas industry -- which mostly consists of Gazprom -- increased by over 80% between 1997 and 2003, while labor productivity dropped by 40%. Unit labor costs in the gas industry jumped 107% in the same period, while they rose only 25% in the mostly privatized oil industry. "State companies [in Russia] time and time again underperform in terms of profit," says Anders Aslund, who is the director of the Russian and Eurasian Program at the Carnegie Endowment for International Peace in Washington.

Gazprom's inability to cut costs is taking a financial toll. In a research note, United Financial Group describes the quarter ending June 30, the most recent one for which results have been published, as "one of the worst in Gazprom's history." Pretax earnings fell by 15% compared with a year earlier. The bank forecasts that this year Gazprom's costs will have risen by some 99% since 2001, while earnings will be up by just 32%.

It doesn't help that Gazprom, in sharp contrast to state-owned utilities in Western economies, is not subject to effective regulation that might encourage it to behave like a commercially driven company. As Gazprom's economic power grows, surely its political clout will too, making attempts to regulate it even more difficult. As it is, the Economy Ministry's attempts to reform Gazprom have gone nowhere: "The company is big and strong and enjoys political influence, so of course for the regulator it's quite complicated to work with," says Sharonov.

There are still some optimists who think the impact of Gazprom's expansion will be limited. In their view, Putin's main objective all along was to curtail the excessive power of oligarchs such as Mikhail B. Khodorkovsky, Yukos's major shareholder, who acquired their vast wealth through dubious means in the 1990s. Gazprom's acquisition of Yugansk is merely an unfortunate side effect: "It's not the first step in a well-thought-out strategy to buy out Russian oil. It's just convenient: The Russian government needed someone, and no one else could bid," says Steven Dashevsky, head of research at Moscow's Aton Brokerage.

But convenience is producing a mega-company that could end up crimping competition, rolling back market reforms, and damaging Russia's investment climate. "Considerations of efficiency didn't play any role. It was a political and financial decision because the authorities believe that big money should be controlled by the state," says Yevgeny Yasin, director of research at Moscow's Higher School of Economics and a former Economy Minister under Boris N. Yeltsin. Gazprom will end up big, powerful, and scary -- not what Russia needs.

By Jason Bush

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