Gazprom's Cash-Flow Machine: Easy to Hate. Irrational to Ignore.

Gazprom: hated but still a monopoly with high cash flow generation that stands up to stress test

“The state of entropy of the entire universe, as a closed isolated system, will always increase over time.” The Second Law of Thermodynamics

“Cheap natural gas from Russia is the only factor that glues much of Europe today” Marin Katusa, The Colder War

In the era of high technology, internet, and people running on Dunkin – it is easy to forget what the world is really running on. Gazprom has the largest hydrocarbon base in the world, 20% share of both global gas reserves and production. The company has booked 5X more reserves than the next closest rival Exxon, and has more gas than the next five rivals combined.

Russian government owns 50% of Gazprom, and the way Putin and his long-time ally Alexei Miller, the current CEO of Gazprom, transformed it is simply remarkable – the company went from infamously accepting in-kind payments for gas and selling assets to relatives - to becoming the world’s leading gas player. The transparency of Gazprom reporting and disclosures is at least as good, if not better, than that of its best U.S. peers. In 2010 Gazprom won IR magazine best annual disclosures award.

Russia sits on roughly a quarter of world’s known gas reserves, and this is just counting the conventional sources. Gazprom essentially inherited the entire Soviet gas infrastructure and has first hand in the new discoveries, as well as export monopoly.

While gas is an ultimate commodity and there is no shortage of it –the delivery infrastructure is a make-or-break factor in the natural gas market. Unlike oil – gas only travels through pipelines or as LNG. Both routes are incredibly expensive. Over the last 10 years Gazprom has built an infrastructure based on its strategic vision of becoming an incumbent supplier to both Europe and Asia.

The two factors that contributed to the Russian market decline in 2014 – the drop in oil prices and 100% devaluation of Russian ruble, as a matter of fact, will have little effect on Gazprom free cash flow. The company’s 66% of sales is USD-denominated while 60% of Opex and 80% of Capex is RUB-denominated. At the same time, the lately actively discussed potential for the EU to decrease its dependency on Russian gas has more political than economic substance.

In case of Gazprom, one has a perfect combination of hate factors: stagnating end markets in both Russia and Europe, a fallen from grace country, a hated sector, currency risks, two major pipeline projects with unclear prospects, record Capex over the next five years, and a lot of political bluffing. You also get a lot of free cash flow for the price, even making quite drastic oil prices assumptions.

1.Russian domestic market: no growth but a lot of pricing upside
Given vast gas resources, Russian economy is very much gas-based: gas accounts for 60% of total energy use (vs. 20% globally). Gazprom sells about 250 bcm/year (50% of its gas volumes) on the domestic market, and has about 50% domestic market share.

Russian gas consumption will likely just stay flat or decline slightly. It has never recovered after the 2008 crisis. While electricity consumption is growing with GDP and population at about 0.5%/year - it is, however, hugely inefficient. By some estimates, if Russia used gas as efficiently as OECD countries – it could save about 35% of its consumption. This is increasing becoming a goal, even though hard to reach.

Gazprom has a lot of pricing upside domestically. Prior to 2006 Russian gas market was regulated – government set residential electricity and industrial gas prices. Back then Gazprom domestic realized price was about 1/3 of European export netbacks (export price minus export duty and transportation costs).

While the residential market remains government controlled - the industrials market was deregulated in 2006 with the stated goal to reach “the netback parity” via tariffs increases. By 2014 Gazprom domestic price doubled but still reached only 50% of the netback price. The net effect of RUB losing 100% of its value since 2014 and the similar drop in oil price will keep the ratio at a similar level for 2015.

2.Ukraine - likely still needed for few years
Gazprom supplies about 30bcm/year of gas to Ukraine (about 6% of its total production). Prior to the Ukrainian conflict Ukraine was getting a discount off the European price for providing transit for Gazprom gas to the rest of Europe. Super-cheap gas didn’t help Ukraine - in 20 years since separating from the Soviet Union they never developed their own economy, and demanded higher and higher transit tariffs from Gazprom. On few occasions Gazprom had to turn off the gas as cash-strapped Ukraine could not pay and siphoned gas meant for Europe.

In 2012 Gazprom switched almost 50% of its European transit volumes (about 80bcm) to the pipeline that runs through Belarus and to the then completed Nord Stream (it takes gas to Germany directly under the Baltic Sea). It also started negotiations to build so called South Stream to bypass Ukraine altogether. The pipeline with capacity of 63bcm/year would run under the Black Sea through Bulgaria. In 2015 Bulgaria got cold feet. The pipeline will now go through Turkey.

For the next three to four years Gazprom will still need Ukraine, and will likely still provide discounts. The question now is how much volume Ukraine needs? In 2014 the civil war destroyed Ukrainian manufacturing base (coal and steel) that was concentrated in Eastern Ukraine – it is hard to come up with an estimate of how much gas Ukraine will need going forward. I am assuming Ukraine will consume roughly 70% of its pre-war needs.

3.European market - who needs who
Gazprom directly supplies Europe with 160 bcm of gas - 30% of European gas consumption. Europe is 50% gas self-sufficient (through production in Norway, Netherlands, and the UK) but the mature domestic production base is depleting.

Gazprom European contracts are take-or-pay with 75% of gas oil-indexed. It’s a popular topic but there is no reason to switch to hub pricing even if oil remains at low levels – historically the correlation is about 0.85.

European dependency on Russian gas is unlikely to change significantly, if at all. LNG from N. Africa and Central Asia is certainly an option. Theoretical European LNG receiving capacity is about 200bcm vs. its 250bcm imports. But the price from Qatar is almost double the Russian contract price. Some EU members are 100% dependant on Russian supply (Poland, Baltic and Balkan countries) and simply don’t have LNG access. It would be very expensive to build it, especially in Europe, especially for those countries, especially considering that Gazprom has been a reliable and reasonably priced supplier for decades, and other than politics – there is simply no reason to cut it off.

So far European LNG capacity has been increasingly idle as post-Fukushima Asian markets soaked in all available LNG supplies and pay a lot more than what EU pays to Gazprom. From 2016 – if the US and Australian LNG supplies hit the market all perfectly as planned - global LNG export capacity will increase by 20%. Some of it will still go to Asia. However, considering low cost of Gazprom production – it will be competitive with potential U.S. deliveries into Europe. Besides, once adjusted for the drop in oil price- lower gas prices will encourage switching from coal to gas, particularly in the UK. This factor helped Gazprom quite a bit when oil last dropped to $30+ levels in 2008.

Even in the unlikely case that Gazprom will lose some market share in Europe – the Chinese contract signed in 2014 is for about 25% of Gazprom European volumes. Those would be volumes from deposits in Siberia, higher cost than gas from Urals that is shipped to Europe.

Gazprom might be much harder to get rid of than implied in newspapers. Some would wonder why, with as much gas as Gazprom has in Russia, it would be interested in gas projects in Africa. It is simple – Africa is the third-largest supplier of gas to the EU and over carefully accumulated assets Gazprom controls a large portion of Africa’s production - Moscow has its hand on close to 40% of EU gas supply.

4.2014 Contract with China
Russia and China negotiated this gas deal for long 11 years. The 30-year deal for 38 bcm (about 20% of current Chinese consumption) was finally signed in May 2014 – its formula is also linked to oil, the contract currency was never revealed.

The gas will start flowing in 2019. To make it happen Gazprom is building a pipeline with a meaningful name “Power of Siberia” and with a no less meaningful cost of $75B (with $20B coming from China). The pipeline will have a total capacity of 61 bcm/year and a hub to also potentially supply Japan and S.Korea.

5.Cost of production and finding reserves
Gazprom reserve life at current production rates is 70 years for gas and 50 years for oil. Over the last 5 years Gazprom was able to replace around 120% of its annual production. Being government-backed brings some benefits: recent license purchases indicate that Gazprom average reserves acquisitions price is $0.10/boe (barrel of oil equivalent) – the global average was close to $9/boe in 2013.

On the gas production side Gazprom opex is around 1,400 RUB/mcm* ($23/mcm at current exchange rate) of which about 50% is the mineral extraction tax. The transportation cost is around RUB 60/100 km ($1/100 km). The distance between Urals and Paris is 4,700 km or about $50 in gas transport costs. That is $73 vs $250/mcm currently paid by France, net of export tax. My worst case scenario assumes $120/mcm average European price at $40/barrel oil.

*mcm stands for thousand cubic meters

6.Russian Ruble
While 100% devaluation of RUB in 2014 has taken many by surprise – it demonstrates nothing more than Fisher parity in action. Over the last 10 years RUB/USD has in fact been strangely stable at around RUB/USD 30. US average inflation over the same period was hovering around 3% vs. 10% in Russia. Adjusting for the inflation differential RUB should have devaluated by 100%, which is exactly what it did.

Contrary to popular belief, the RUB devaluation has nothing to do with oil, and it won’t reverse. Considering the opposite revenues and cost FX structures - further devaluation of RUB is a net positive for Gazprom margins. To account for the currency risk for a US investor I calculate Gazprom cash flows in USD.

7.Valuation
I assume oil will stay at $55/barrel in 2016 base case, $70/barrel in bull case and $40/barrel in bear case. 2016 can be also used as a normalized year as without the Chinese contract – Gazprom volumes are pretty much stable – but with much higher than normal Capex. I also assume that European gas contracts will fully adjust for the change in oil price – and drop from $220 now to $170/mcm. In fact, last time oil hit the $30+ levels – the average contract price remained quite above $200/mcm. The floor for gas pricing in Europe should be determined by the price of marginal source of energy – coal.

As it embarks on both South Stream and Power of Siberia projects, Gazprom expects Capex to run on average at $25B/year for 2015-2020, roughly twice its maintenance levels. In my base case scenario Gazprom is able of generating close to $5B in FCF which implies 10% FCF yield, and $4B in the bear case (7% FCF yield). Not adding the Chinese volumes to the base case calculations effectively means $55B Capex will be wasted.

Gazprom debt stands at $50B (85% of it is USD and EUR-denominated), at a very healthy 20% debt/capital ratio. Gazprom will need to pay around $7B in debt principal over 2015-16. Currently Gazprom is not included into the EU sanctions that cut Russian companies off the European capital markets. However the company prepared for it: its last reported cash position in Q3 2014 was $15 bn. Thanks to the fact that RUB already depreciated in 2014 while gas contracts have 6-9 month lag to oil – Gazprom will get a record $10B FCF in 2014.

Both current MSCI emerging markets and SP 500 forward FCF yield is 4.5%. MSCI Energy FCF yield is 0.5%, vs. Gazprom at 10%. Gazprom is trading at 14X EV/FCF vs. Exxon at 33X. It is hard to answer how much fear is justified. Gazprom is a monopoly with stable cash flow generation and low production costs. Russian government has a controlling stake but it has no reason to expropriate it.

Even if FCF yield decreases to just 7% and oil stays at $55/barrel levels - Gazprom shares offer 45% upside.

8.Risks
1.Currency risk
Russian inflation has recently shot to 15% and forward USD/RUB curve is 95 RUB/USD in 2019. While the opposite revenues and cost FX structures makes further devaluation of RUB is a net positive for Gazprom margins, for a US investor there is a translation risk. To account for the currency risk I calculate Gazprom cash flows in USD.

2.South Stream cost
The project cost through Bulgaria was $40B, and it was included into Gazprom planned Capex. There are no details released yet over the cost of the pipeline running through Turkey. Just looking at a map of Europe – it will be slightly longer.

3.Siberian pipeline (Chinese contract).
Gazprom will obviously need to borrow $55B to build the Power of Siberia. Depending on where the money will come from – Russia or China – the cost of debt will be very different.

Due to higher cost of production in Siberia vs. Urals, and all brand-new pipes - the project will have worse returns than supplies to Europe. The fact that Russian government promised a mineral tax exemption for the Chinese contract is not a good sign. I calculate that over 30 years the project will likely have just 6% IRR at $100/mcm cost and $55/barrel oil, but the input information is quite limited at this point, and the deliveries will start in remote 2019. I simply wrote it off in my valuation.