Ben Aris in Moscow -

Gazprom is massively reorganising its business both in Russia and abroad, though some doubt it can completely change its ways.

Sweeping reforms have finally begun at what has been called the “state within the state” that will cut Gazprom's titanic waste and dramatically boost the company's market capitalisation.

Following the long-awaited removal of the so-called “ring fence” - special rules that prevented foreigners from buying the locally traded shares - in April, Gazprom applied to increase the share of its capital issued as American Depositary Receipts, or ADRs, to 35% from 4.4% and made its international and domestic shares fully fungible. The stock soared from about $9.60 to over $11.50 in a matter of weeks.

The company is also on the cusp of choosing a partner to develop the Shtokman gas field in the Barents Sea. The biggest in the world, the Shtokman field will form the basis of Gazprom's plans to develop a liquidified natural gas (LNG) business that will transform the company from being an important European energy provider to one with global clout. Among the prospective clients are the US and UK, both of which recently took delivery of their first Russian LNG. Gazprom and Kremlin officials have been touring places such as Algeria, Portugal, China, Italy and Albania to cut supply deals and plan new pipelines. Work on the two biggest pipeline projects - from Siberia to China and from Russia's northwest to Germany - should both be well underway by the end of this year.

In short, the company's plan is to boost Gazprom's share of the European market from the current 25% to 30%, according to an export strategy document leaked in March. And Gazprom is already trying to move into the gas distribution business: it has broken German-controlled RWE Transgas' hold over the Czech gas distribution market and put the willies up the British government by threatening to buy into Centrica, the UK's dominant gas distributor. The UK prides itself on a lack of political interference in such dealings, but could take exception to a bid from Gazprom. So what has changed to prompt this flurry of activity?

Taking Control

The key event came last year when the state lifted its stake in the company to 51%.

Taking majority control cleared the way for the Kremlin to push through deep reforms not only to Gazprom, but also to the country's entire gas sector.

Gazprom began life as a Soviet ministry, before being transformed into a cash cow for its top management during the Yeltsin-era.

President Vladimir Putin retook control of the company that accounts for 8% of Russia's GDP and about a fifth of the state's tax revenues by ousting the former chief executive Rem Vyakhirev in 2002. Since then Gazprom has begun to look a little more like a business, but the Kremlin is not above wielding it like a foreign policy club when it fancies - as Ukraine and other CIS states have discovered to their cost.

The company haemorrhages billions of dollars a year from the worst kind of Sovietera bloated cost structure and remains a feeding trough for insiders. The Russian investment fund Hermitage Capital details some of the most egregious abuses in an annual report on Gazprom. Perhaps not coincidentally, Hermitage's chairman, Bill Browder, had his Russian visa revoked in November.

However, the first green shoots of change are already visible. The company reported its non-consolidated Russian accounting standards profits were up by over a quarter yearon- year in April, and the company is flush with cash.

In 2001 when Russia's economics guru German Gref first drew up his blueprint for economic reform, the plan included a modest internal restructuring of the gas giant that basically separated the production and transport parts of the business.

Prime Minister Mikhail Kasyanov was supposed to come up with concrete proposals by December 2002, but the plan never materialised and the few attempts Gref made to put reform back on the agenda were met by vociferous (and effective) opposition by the company's piggish management.

Then, out of the blue, Gazprom announced a complete two-stage internal restructuring in April that will separate the different business units, gathering like with like.

The changes will radically improve the company's transparency and, most importantly, focus managers on profitability by making them more accountable. Over the next two years, Gazprom units will spin off their non-core assets and the company's various units will be collected into six new subsidiaries, whose activities will include gas processing and underground gas storage - although Gazprom will maintain control over transport and production for the meantime.

The restructuring comes as the government is preparing to launch trading on an independent domestic gas exchange, which will throw the gas business open to independent producers - albeit in a small way to begin with.

All Russia's oil companies produce some gas and production has been rising slowly, keeping pace with reforms to the gas market.

But the first sign that the pace of reform is picking up was Lukoil's announcement in April that it had boosted gas production by 141% in the first quarter compared with the same period a year ago.

Industry and Energy Ministry Viktor Khristenko - who is emerging as Russia's industrial policy tsar - has drawn up a draft government order authorising pilot gas sales at the Mezhregiongaz gas exchange and submitted it to the federal agencies concerned for approval. This wholesale market would allow independent producers to sell 5 billion cubic metres of gas this year at a market price, freed from the strictures of the state regulated tariffs. This would match the quota that Gazprom is allowed to trade on the open market.

A Leopard and its spots

On the face of it, Russia's gas sector is starting to look very promising. However, pessimists argue much of this is talk and won't be matched by action: Gazprom would like to buy into European gas distributors, but will be blocked by national governments; internal restructuring is a nice idea, but the murky nature of intermediates like RosUkrEnergo in gas deliveries to Ukraine show Gazprom is as corrupt as ever; and the wholesale gas market is tiny and will remain tiny.

Still, portfolio investors have been buoyed by all the news. Gazprom's share price has soared in the last few months, rising from $6.67 on December 31, 2005 to $9.83 by the middle of April as investors anticipated the fall of the ring fence and a big increase in Gazprom's share of the MSCI index - a leading emerging markets index - due in May.

But the banks are less sanguine and confusion reigns over the importance of all the recent action.

Renaissance Capital, for example, remains unconvinced and has the stock marked down as a 'sell' with a target price of $6.96 at the end of April, while Alfa Bank thinks there is more good news to come and recommends it as a 'buy' with a target price of $10.37 - a price Gazprom shares left in the dust in May.

Gazprom's management is even more optimistic and have started talking about the company's share price for the first time.

Deputy CEO Alexander Medvedev said in November that the company's value could more than double over the next three to five years. And Gazprom's chief, Alexei Miller, began crowing about the company's market capitalisation reaching $1 trillion by 2010, shortly after it passed the $200 billion mark in April, overtaking Microsoft in value. This is from a company that was worth about $15 billion five years ago.

“Gazprom became the third largest company in the oil and gas sector in terms of market capitalization after ExxonMobil and BP and the world's sixth largest company,” says Miller in an interview. “We won the bronze, although we are a few steps away from the silver.

We can say that the company has largescale ambitions. We are sure the investment community will appreciate them at their true value.”

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