Jason Corcoran in Moscow -
Russia's plan to raise gas prices by 15% next year and fully liberalise the domestic market by 2011 was hardly the shock therapy the industry had hoped for, but the outcome is still a shot-in-the arm for the players in this market.
Last month's cabinet-approved blueprint, which came after two months of debate, calls for a 15% rise in the domestic gas price in 2007 from $44 to $51 per 1,000 cubic metre (cm) and a 25% rise in 2008 to $63 per 1,000 cm. Ultimately, the plan calls for the domestic gas price to converge with European gas prices by 2011.
The government will introduce a deregulated market from January 2007, whose share will initially be 5% of total deliveries to the domestic Russian market. From July 1, the share of the deregulated market will increase to 10% with further increases being made twice per year going forward.
Analyst assumptions estimate that 30bn-36bn square metres of gas will be traded at the deregulated price in 2007.
State monopoly Gazprom is primed to be the main beneficiary and its representatives have already said that domestic deregulation will raise the company's operating cash flow three-fold by 2011. The measures should also have a positive effect on independent gas producers Novatek, Lukoil and Rosneft, who will have the opportunity to sell their gas on a liberalised market at higher prices.
The government has adopted a piecemeal approach to energy market reform, adhering to its original modest proposals for raising gas prices and deregulating the electricity sector.
Gazprom had lobbied hard for the right to sell more of their output at free market prices, but the finance and economic ministers argued such a move would add half a percentage point to inflation over the next two years.
Dmitri Fedotkin, economist at VTB Europe, says: "It was a tough decision for the cabinet to make with the upcoming elections and it is relatively positive for gas producers, but it's not the doubling of prices they had fought for in the near term."
Fair price confusion
The polarised debate over the prospects for gas liberalisation is reflected in investment banks' contrasting estimates of Gazpom's "fair value" share price.
Prior to the announcement, Renaissance Capital had Gazprom as a 'Sell' with a fair price at about $8.25 a share, while UralSib marks the company up as a 'Buy,' expecting the stock's price to top $17 in the near future. Renaissance had factored in the slow pace of deregulation more highly into its valuation, whereas UralSib's emphasis was on Gazprom's growing export business.
Renaissance, which declined to say whether it is reviewing Gazprom's target price, remains sceptical of the liberalisation pay-off. "The key regulatory and legislative steps needed to make a liberalised market actually come about and work are missing," says director of oil research Adam Landes. "Second, it remains unclear who will capture these higher end-customer prices. Will independents get it, or will Gazprom take a disproportionate cut via transportation fees?"
Uralsib views the gas tariff hikes as a boon for both Gazprom and leading independent Novatek, and has boosted their target prices by 18% and 52%, respectively.
Aton Capital has kept its 'Hold' ratings on Gazprom and Novatek, while Deutsche Bank/UFG is reviewing its models for both companies.
Tariff hikes hit bottom lines
The newly approved plan is expected to augment Gazprom's earnings by $2.7bn (or more than 10%) in 2008 and a further $6bn in 2009. Ultimately, the plan will add $17bn to Gazprom's 2011 earnings, a 70% rise above projected earnings without the tariff hikes. Fitch Ratings has already raised Gazprom's outlook from stable to positive following the announcement.
Fitch forecasts the revised gas price will increase Gazprom's top-line revenue roughly by $43bn, and EBITDA by $15bn over the next five years, if oil prices remain $50-60 per barrel by 2010-2011. If oil prices slip back to $40 per barrel, Gazprom's revenues and EBITDA in the same period are expected to rise by some $29bn and $10bn, respectively.
Hermitage Capital, whose biggest bet is Gazprom, sees plenty of upside for the state monopoly and Russia's oil producers.
"The increase in the domestic price of gas is also good news for Russian oil producers," says a Hermitage report. "This is something that the market has not yet fully appreciated."
Novatek, a pure-play gas producer that sells all of its production domestically, has fully incorporated the impact of liberalisation and now trades at 29.8 times 2007 earnings.
Gazprom, which sells some two-thirds of its production domestically, trades at only 11 times 2007 earnings. Lukoil, which could get over 10% of its revenue from gas sales in three years, trades in line with the other pure-play Russian oil majors at 10 times earnings. In total, gas makes up some 13% of the reserves of Russian oil majors, but only a tiny percentage of their current revenues.
Hermitage said its discussions with management at major Russian oil companies indicate that a significant part of their growth strategy and future business will come from the domestic gas business.
"As the domestic price of gas rises, it will become much more economical for these companies to develop and monetise their gas reserves. Taking advantage of the domestic gas opportunity will help enable these companies to continue to post impressive earnings in the future," it reckons.
Mattias Westman, chief executive of Prosperity Capital Management, believes the drift towards full liberalisation will slowly open up the market to more independents.
"Gazprom is unable to supply all the needed volumes and does not really respond to price signals. It should be good news for both large and small independents even if it might take some time," he says.
For Gazprom, the upshot of full liberalisation is less certain as it focuses on meeting its export demands.
"The pain of eventually separating production and transportation is still vaguely in the future but they will however get higher prices," says Westman.
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