Putting a price on Gazprom

By bne IntelliNews November 7, 2006

Jason Corcoran in Moscow -

The wide spread in valuations of Gazprom is a reflection of the many imponderables that plague the firm, among them uncertainty over its capex programme and the speed of gas liberalisation.

Analysts at Russia’s investment banks could almost be forgiven for their wildly conflicting valuations of Gazprom with the state-controlled giant still adopting a parsimonious approach to corporate transparency.

Gazprom's stock is currently trading at between $10.50 and $11.00 and the price has been fluctuating pretty wildly in recent weeks since the Kremlin opened a debate on whether to sharply hike gas prices next year and the gas monopolist announced it would massively increase its capital expenditure. Gazprom shareholders have been left trying to make sense of the news.

The confusion has dogged the company all year and is most evident in the wild discrepancies between investment banks' estimates of the "fair value" of the share price.

At one end of the spectrum, Renaissance Capital has 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. This is a huge spread by any standards, so what can explain the gaping chasm between these two prices?

Different drivers

Renaissance had at one point the most aggressive target price, which goes to show it is not intrinsically negative on the stock. Its current view is founded on the speed of domestic gas price liberalisation, Gazprom’s ability to cut costs and the effectiveness of its investment programme, according to head of research Roland Nash.

“We have no problem in admitting that the company could be valued at well above current levels, and even above UralSib estimates,” says Nash. “However, it can only do so by becoming more efficient and cutting costs. The burden of proof remains with the company. When we see progress, we will obviously amend our target price. So far we have seen little.”

Renaissance’s stress on gas liberalisation is not shared by UralSib, which has factored in a 15% gas price increase for next year and potentially 20% for 2008.

"Our drivers for Gazprom are not domestic production nor liberalisation,” says Alex Kormschikov, an oil and gas analyst at the UralSib. “Our drivers are based on the growing export business, with Gazprom gaining foreign assets in an effort to build an entire energy chain to serve consumers in Europe.”

Fund managers who hold Gazprom stock have been less than impressed with some valuations. “Analysts are not taking all the factors into consideration if you look at that spread," complains Vadim Kleiner, director of research at Hermitage Capital Management.

Mattias Westman, chief executive of Prosperity Capital Management, errs towards the lower the end of the spread. “We are more inclined to agree with lower valuations since the shareholders see so little in terms of returns,” he says. “Gazprom has the best assets in the world, reports good profits but has no cash-flow. All operational cash-flow goes to capex and there is very little in terms of growth to show for it.”

To be fair to analysts, Gazprom’s level of disclosure hardly befits a company whose market capitalisation recently overtook that Microsoft.

The recent announcement it was doubling its capex from $12bn this year to some $22bn in 2007-2009 left many scrabbling to find out details on how the money will be spent.

“We need more detail from them on the investment programme. So far we only have the negatives, which reduces the value tremendously,” says Kormschikov.

There appears to be at least as much chance that Gazprom will use the extra capital to buy into other non-core activities, which may not be the best use of the funds. Analysts at Alfa Bank continue to have Gazprom under review as they revise their model to take into account the increase in 2007-2009 capex.

Divided government

The question of state regulation of gas prices and the liberalisation of the gas market is preoccupying the government, with ministers appearing split over the issue. Economic Development and Trade Minister German Gref has criticised plans to raise gas prices by more than 15%, while energy officials are reported to favour higher energy prices and less state interference in Gazprom.

President Vladimir Putin is clearly reluctant to let inflation rip by allowing prices to rise too fast, but he knows there is a risk that there might not be enough supply under the current system. One solution is to raise prices to decrease demand and maybe encourage supply from independent producers

“I think there is an unfinished discussion about this," says Westman. "In my view, it would be better to liberalise and let others produce more: Gazprom, naturally, does not like this scenario."

Domestically, a political consensus is building that price rises need to take place to stimulate efficient use of gas and mitigate the impact of an anticipated gas shortage. Analysts at Troika have even suggested that 2007 could become the first year when Russians' demand for gas exceeds Gazprom ability to supply it.

"Recently there has been talk about sharp increases, which is needed," says Hermitage Capital's Vadim Kleiner. "The demand for gas is big, but Gazprom does not have the resources to meet domestic supply when they are sending so much abroad."

Prime Minister Fradkov last month signed a decree allowing up to 10bn cubic meters (cm) to be sold domestically at unregulated prices. Although small in scale, this move reflects, some feel, what will become a broader tolerance for at least limited gas price hikes for domestic industrial customers from the current low level of $42 per 1,000 cm.

Another positive move was Gazprom’s deal to take Lukoil’s gas from the Nakhodkinskoye field at $40 per 1,000 cm beginning July 1, 2007 – twice what it paid in 2006.

To prevent any potential gas deficit on the Russian market, Gref and other officials have called for independent producers such as Novatek and Lukoil to be given more incentives to sell gas at home.

While Gazprom appears to be producing enough gas to meet its commitments for export, its domestic supply is another matter, with consumers already having a hard time getting enough.

The company recently conceded that supplies were running low and called on the government to act to avert cutbacks similar to last winter's, which also led to shortfalls in supplies to Europe

For its part, Gazprom appears ready and willing to leave a larger share of the domestic market to independent producers so it can pursue higher margins from pipelines and distribution networks in other countries.

“The prospects for independents and more established companies are very bright,” says Westman. “They will probably be allowed to produce and sell more at the same time as Gazprom raises the prices on the wholesale market. There is a lot of potential for production growth in several companies.

Lukoil is already ramping up with plans to raise gas production from its considerable reserves to 70bn-76bn cm per year by 2016 from the present 9.2bn cm per year.

Analysts at MDM Bank estimate Lukoil’s gas business adds another 23% to its current market value based on higher gas production growth rate and an assumption that domestic gas prices will move up while the oil price declines.

Based on official figures, Lukoil had 1.12 times more proven gas reserves and 1.29 times more 2P reserves than Novatek, Russia’s second-largest independent gas producer.

Novatek this week said its gas output increased 13.7% during the first nine months of the year, to 21.5bn cm.

Send comments to Jason Corcoran

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