The Expansion of Gazprom into the European Downstream Market

Table of Content

1 Introduction
1.1 Preface and Motivation
1.2 Research Objectives and Research Questions
1.3 Structure and Methodology

2 OAO Gazprom - Company Background
2.1 The Formation Period
2.2 Gazprom Today
2.3 Resources and Production
2.4 Exports, Infrastructure and Gas Prices
2.5 Strategic Objectives

3 Gazprom’s Activities in Europe
3.1 Characteristics of the European Gas Market
3.2 Regulatory Framework and Liberalization
3.3 European Demand for Natural Gas
3.4 Competition from Other Gas Supplying Countries
3.5 Gazprom’s Share Holdings in Europe

4 Conjoint Analysis of Consumer Preferences
4.1 Objectives
4.2 Theory and Methodology
4.3 Hypotheses
4.4 Operationalization
4.4.1 Technical Aspects
4.4.2 Identifying Attributes and Levels: Preliminary Qualitative Study
4.4.3 Questionnaire Design
4.4.4 Structure of the Sample
4.4.5 Data Analysis
4.5 Results
4.5.1 Part-Worth Utilities of All Attributes
4.5.2 Relative Importance of Attributes
4.5.3 Evaluation of Socio-Economic Criteria
4.5.4 Further Findings
4.5.5 Part-Worth Utilities and Euro-Equivalents
4.6 Testing of Hypotheses
4.7 Summary of Selected CA-Results

5 Strategic Suggestions for Gazprom
5.1 Reconsideration of Brand Strategy
5.2 Improvement of Transparency and Communication
5.3 Differentiation vs. Cost Efficiency

6 Conclusion
6.1 Summary
6.2 Methodological Critique
6.3 Further Considerations

Bibliography

Internet Sources

Appendix I: Online Questionnaire

Appendix II: CA-Results

Appendix III: Biogas Analysis

Appendix IV: Market Simulation

Appendix V: Definitions of Frequently Used Expressions

Abstract

This paper analyzes the expansion of Gazprom into the European downstream market from an interdisciplinary perspective. First, an analysis of the “macro perspective” gives insights into the strategic objectives of Gazprom in Europe and the peculiarities of the European gas market. Second, the focus is drawn to the “micro perspective”, i.e. the European consumer of natural gas. Hereby an empirical conjoint analysis (ACA) has been conducted, giving insights into the preferences of European consumers towards the product gas. The respondents had to consecutively state their preferences towards hypothetical product combinations containing the predefined attributes price, contract duration, biogas share, supplier and origin. Finally, the findings of each “perspective” were consolidated into concrete strategic suggestions for Gazprom’s expansion into the European downstream market.

The conjoint analysis revealed, inter alia, that the most important attribute towards a gas product among private gas customers in Europe is the price. Furthermore, the consumers prefer gas originating from stable, mature democracies - like Norway - over gas from Iran, Russia or Algeria. Furthermore, European consumers are willing to pay a premium of more than 25% (300 € per year) for gas that is not supplied by Gazprom. Although European consumers are positive about the possibility to receive a share of biogas among the supplied natural gas, a majority is not willing to pay a premium of 30% for a 45% biogas share.

These results lead to the suggestion that Gazprom should reconsider its brand strategy in Europe, that the company should significantly improve transparency and public relations and that it should seriously consider embarking on a strategy more sensitive towards Corporate Social Responsibility (CSR). If the liberalization of the gas market in Europe continues as planned, European consumers will soon have the choice among several different gas suppliers. By choosing the right supplier, they might be able to contribute to modernizing companies like Gazprom, ultimately leading to improved Russian-European relations and energy security.

List of Figures

Figure 1: Share of Energy Sources in Energy Consumption

Figure 2: Proven Gas Reserves of Selected Countries at the End of 2006

Figure 3: Projected Net Import Requirements of Natural Gas to the EU

Figure 4: Origin of Consumed Gas in Europe and Reserves

Figure 5: Gazprom's Links with German Companies

Figure 6: Attribute-Levels Ranked by Part-Worth Utility

Figure 7: Relative Importance of Attributes

Figure 8: Part-Worth Utility Differences - Origin and Supplier

Figure 9: Part-Worth Utility Differences - Contract Duration, Supplier and Origin

Figure 10: Age Distribution of Respondents

Figure 11: Histograms of Estimated Gas-Costs per kWh

Figure 12: Password Page

Figure 13: Welcome Page

Figure 14: Gas Customer Request

Figure 15: Information

Figure 16: ACA Rating Questions

Figure 17: ACA Importance Questions

Figure 18: ACA Pairs Questions-Comparison Trade-Off: Two Attributes

Figure 19: ACA Pairs Questions-Comparison Trade-Off: Three Attributes

Figure 20: Additional Questions - Gas Consumption

Figure 21: Additional Questions - Biogas

Figure 22: Additional Questions - Socio-Economic

Figure 23: Lottery Drawing and Feedback

Figure 24: Final Page

Figure 25: Biogas Knowledge

Figure 26: Biogas Potential

List of Tables

Table 1: Overview - Structure, Research Questions, Methods and Perspectives

Table 2: Gazprom - Financial Figures

Table 3: Evaluating the Different Methods of Conjoint Analysis

Table 4: Selected Attributes and Levels

Table 5: Characteristics of Respondents

Table 6: Part-Worth Utilities of Attribute-Levels and t-Test

Table 7: Euro-Equivalents of Attribute Levels

Table 8: Results of Hypotheses-Testing

Table 9: ACA File .Acd

Table 10: Excerpt of ACA Utilities File .utl

Table 11: Analysis of Variance - Nationality of Respondents (Relative Importance)

Table 12: Mean Comparison Part-Worth Utilities - Nationality of Respondents

Table 13: Analysis of Variance - Gender of Respondents (Relative Importance)

Table 14: Mean Comparison Part-Worth Utilities - Gender of Respondents

Table 15: Correlations between Selected Variables

Table 16: Biogas Knowledge

Table 17: Biogas Potential

Table 18: Market Simulation - Local/Regional Supplier vs. Gazprom

Table 19: Market Simulation - Biogas vs. Natural Gas

List of Interviews

M. X. (Director, Association of XY Industry): Interview on May 30, 2007

Prof. Y (Director, Centre for Business Metrics, University of St.Gallen): Interview on March 3, 2007

Mr. W. (Research expert on conjoint analysis): Various meetings in spring 2007

M. L. (Director Marketing Strategy, XY AG): Interview on April 4, 2007

Dr. XY (Vice-Director, Institute for Economy and the Environment, University of St. Gallen): Various meetings in spring/summer 2007.

List of Abbreviations

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“ Every time you spend money, you ’ re casting a vote for the kind of world you want. ” Anna Lapp é

1 Introduction

1.1 Preface and Motivation

When it comes to energy issues, the world today is in a fundamental process of reorganization. Securing the national energy supply has truly become Realpolitik for many countries and the international balance-of-power is being shaped along the question of who will be in control of the remaining energy resources. Traditional energy resources like oil, coal and gas are close to reaching their production-peaks, while the demand for energy is still increasing, due to worldwide economic growth. Thus, global competition is becoming more intense, and at the same time, environmental considerations regarding climate change suggest a reorientation of energy politics towards renewable energy sources. Similar to the period after the first oil price shock, when people reflected about the “Limits of Growth” (Meadows, 1972), energy topics are becoming highly politicized again. Today the reasons are the growing dependence of industrial nations on energy imports and the increasing perception of the danger of climate change.

During the process of industrialization, Europe¹ depleted almost its entire fossil energy resources. Since consumption is, however, further increasing, the continent is increasingly dependent on energy imports. According to estimations of the European Commission (2007, p. 13) Europe’s import dependency, measured as the share of imports in total energy consumption, will increase from around 40% in 2000 to about 65% in the year 2030.² At the same time, Europe will probably remain a relatively solvent export region. Therefore, as long as market forces are in place, international trade will equal European demand. But if unexpected political instabilities occur, Europe could easily find itself in another energy crisis with potentially disastrous effects on the economy. The obvious long term solution to meet the future energy demand in Europe, besides improving energy efficiency, is to heavily invest in renewable energy sources produced within European territory. This would have at least three positive effects: Firstly, it would reduce import dependency, secondly it would reduce CO2-emission and thirdly it would keep the value creation within the European borders, with respective effects on the labor market. Unfortunately the growth potential for renewable energies is limited for several reasons; e.g. technological hurdles with fuel cells, resource shortage for the production of solar cells, limited space for wind-power facilities etc. Figure 1 shows estimations from the European Commission which expects a share of around 12% of renewable energy sources in total European energy consumption in the year 2030, implying a steep growth from 4% in 1990.

Figure 1: Share of Energy Sources in Energy Consumption (in % for EU-25)

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Source: Own illustration, data from European Commission (2006, p. 7).

The whole issue of future energy security³ in Europe is very complex and contains several subtopics. Among those subtopics there are three of utmost importance: Which will be the most important future energy source? Where are these resources located? And finally, who will be in control of these resources?

The first question cannot be answered in an all-embracing manner and requires a restriction regarding the observed time period. When considering the different energy sources for the medium future (10 to 30 years), it becomes obvious that some sources will become more important than they are today. Beside the long term importance of renewable energy, especially the significance of natural gas⁴ will be increasing worldwide, due to its relative abundance, technological improvements in processing and distribution and its relatively low C02-emissions: “Natural gas is indeed the fastest growing energy commodity today: first, because of the virtues of gas in its own right; second, because of the increasing use of gas in power generation worldwide - due to low emissions; and, third, while the exact amount of oil reserves of major oil companies such as Shell Royal Dutch has been recently readjusted to lower numbers, the state of gas reserves remains remarkably promising” (Geman, 2006, p. 227). Figure 1 confirms this statement; the share of natural gas among total European consumption is assumed to increase from 17% in 1990 to around 27% in year 2030.⁵

This trend towards natural gas as a major energy source will be accelerated by an increasing energy demand and the specific problems of competing energy sources, e.g. multiple risks of nuclear energy, crude oil scarcity, high C02-emissions of coal and the early market-stage of renewable energies. The Green Paper of the European Commission, published on March 8, 2006, stated that natural gas imports to the EU would increase by up to 80% over the next 25 years (European Commission, 2006b, p. 3). Therefore several facts support the hypothesis that natural gas will, at least for a transition period of 10 to 30 years, become the most important energy source in Europe.

The second question of where gas resources will be located can be answered more easily: the required natural gas can be provided by Russia. While the European natural gas reserves are almost depleted, Russia today supplies 25% of the natural gas consumed in Europe and is endowed with 26% of the world’s gas reserves.⁶ Other regions could also significantly increase the exports to Europe, but they either lack in production capabilities (e.g. Northern Africa), or they are located too far away and would therefore bear high transportation costs (Middle and Far East).

The third question concerning gas resource control contains many political issues and there is no precise answer to this question of; who controls the gas resources. Because of the above mentioned significance of Russian gas, the further considerations about resource control are restricted to Russia. In order to increase the political influence on energy exports, the Putin Government conducted a fierce re-nationalization policy of the previously privatized domestic energy sector. One result of this policy is the vertically integrated energy giant OAO Gazprom, which is controlled by the Kremlin and accountable for 100% of Russia’s natural gas exports.⁷ Since the Russian state obviously pursues a strategy of re-nationalization of energy resources, production capacities and distribution infrastructure, it remains unclear which role Gazprom will play as a supplier of natural gas and whether its strategy will mainly follow economic or political considerations. It is therefore unclear to predict whether the Russian gas sector will be controlled by private investors or whether Russian politics will keep control of the gas sector.

In this study the activities of Gazprom towards the European market have been chosen to constitute the main subject, because the author considers Gazprom’s role and the various political and economic interests as a focal point of the before mentioned developments. Recent developments in the European energy sector point at the significance of this subject; e.g. only a few days before the end of this research, on September 3, 2007, the French energy giant Gaz de France decided to merge with Suez. The aim of this merger is to form a French energy giant, balancing the perceived threads from competing energy giants E.on Ruhrgas, ENEL, Gazprom and others (NZZ Online, September, 3 2007). Within this environment, it is particularly interesting to analyze the corporate strategy of Gazprom and the companies’ objectives within the European downstream market.⁸ However, it will not be sufficient just to analyze the strategic decisions on top-management-level but in the case of the European market, it could be dangerous to underestimate the power of European consumers. The example of Shell’s image being shaken in the wake of the Brent Spar issue is a vivid example of the power of consumers and constituted a cornerstone for emerging Corporate Social Responsibility (CSR) among multinational energy companies and sustainability issues in general.⁹ If European consumers will have the choice among different energy sources, different suppliers and different supplying regions it will be particularly interesting to analyze their attitudes regarding the image of energy giants like Gazprom and their social and environmental record. Therefore a thorough analysis of Gazprom’s expansion into the European market also has to take the perspective of consumers into account, especially when considering the liberalization plans in the EU context.

By analyzing Gazprom’s strategy and consumer preferences in Europe, this research aims at identifying appropriate actions that are necessary to contribute to a sustainable success of Gazprom in the European market. Beside all the threats of Gazproms’s expansion into the European downstream market (e.g. monopoly of supply, power to blackmail, energy dependency etc.), this will open up various opportunities to bind both entities more closely together, to promote energy cooperation and to finally spread democratic values. After all, if Gazprom chooses to engage with European consumers, it has to deal with a spoiled and demanding customer in a competitive market environment, regulated by the national regulatory authorities and the European Commission. In any case, an analysis of this complex topic requires a broad and interdisciplinary approach, embracing political aspects as well as managerial and economic developments, but also environmental, geological and legal issues.

1.2 Research Objectives and Research Questions

The expansion of Gazprom into the European downstream market might have effects on, and is being affected by, several different areas outside the immediate corporate sphere; the regulatory environment in Europe, competition in the energy market, Russian-European political relations, corporate governance, issues regarding sustainability and last but not least on the security of gas supply to Europe. This random enumeration shows the complexity of this issue and the difficulty of focusing on one issue without neglecting important repercussions on other areas. In order to identify the crucial facts and to be able to create profound hypotheses about future developments, this research therefore takes a broad and interdisciplinary approach. Starting with an overview of the Gazprom company history, general business activities and inter relations with Europe, the macro perspective, the focus will then be narrowed down to the micro perspective, the individual gas customer. The aim is to focus on the most important issues, in order to create realistic and valuable strategic suggestions that could contribute to a sustainable success of Gazprom in the business with European consumers. Furthermore, the scientific objective of this research is to advance interdisciplinary approaches at the interface between political science, management and economics. The following research questions were formulated in order to lead the research process towards the mentioned objectives:

Research Questions:

I. What are the explicit strategic objectives of Gazprom, and why is the expansion into the European downstream market a particularly attractive target?
II. What are the preferences of European consumers towards the product gas in general and towards Gazprom as a potential supplier in particular?
III. According to the previous findings, which strategic initiatives would contribute to a sustainable success in a competitive liberalized European downstream market?

These research questions have in common that they are describing, and in the case of question III prescribing, the subject of this thesis: the expansion of Gazprom into the European downstream market. Moreover, this approach will enable further normative discussions of the subject. Ultimately, adding further information and transparency to Gazproms’s activities in Europe, might even contribute to a renaissance of a seminal process called “Annäherung durch Verflechtung” (Rapprochement by integration) (Schöllgen, 2007, p. 6) between Europe and Russia, leading to increasing trust among the actors, enhanced cooperation and ultimately further democratization and the proliferation of CSR-issues.

1.3 Structure and Methodology

Due to the eclectic nature of the research subject, this paper deliberately includes applies a mix of qualitative and quantitative methodologies from different academic disciplines. This research design should reflect the diverse and interdisciplinary character of the research subject. As table

1 indicates, this research is divided into six parts: After the Introduction, Part II will provide an overview over the company’s history and its current activities. Part III contains an analysis of the European gas market, the European demand for natural gas and the company’s objectives in Europe. These two chapters comprise a qualitative analysis, based on secondary analysis of media coverage, literature about the corporation, official company information and personal interviews. The empirical conjoint analysis in Part IV portraits the centre of this thesis. The intensive analysis of consumer preferences is being regarded as crucial for a holistic approach to the topic. By analyzing the preferences of private costumers in German speaking Europe (Germany, Switzerland and Austria), the analysis aims at finding evidence about general consumer preferences. Part V will then give strategic suggestions for Gazprom and continuative considerations on the entire subject. Thus, the quantitative part will be integrated into a wide line of qualitative arguments, and at the same time will be the basis for further qualitative interpretations and hypotheses (strategic suggestions).

Table 1: Overview - Structure, Research Questions, Methods and Perspectives

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The epistemological considerations behind this research can rather be characterized by a “Popperian” perspective, or what is called methodological individualism and the rational choice perspective, originating from economics. The rational choice perspective becomes explicitly obvious in the empirical part four, where rational choices of individual consumers are analyzed, in order to be able to explain further incentives and possible choices among the decision makers on the political level and the decision makers within the Gazprom management. More precisely, the objective of the empirical investigation in part four is to determine which combination of a limited number of attributes is most influential on the respondents’ choices and requires further methodological explanations. This approach furthermore reflects the interdisciplinary perspective of this research between political science on the one hand and business/economic studies on the other. The methodology of Conjoint Analysis (CA) originated from psychology and spread out to become one of the most important methods in marketing for determining consumer preferences.¹⁰ Marketing academics Paul Green and Vithala Rao (1971) applied the findings of mathematical psychologists Duncan R. Luce and John Tukey (1964) to purchasing situations of consumers. The general idea was that humans evaluate the overall desirability of a complex product alternative based on a function of the value of its separate (yet conjoint) parts (attributes or features) (Orme, 2006, p. 2). In other words, buyers view the respective product as composed of various attributes and levels. Thus, buyers place a certain part-worth utility on each of those characteristics, and we can determine the overall utility of any product by summing up the values of its parts or levels (Orme, 2006, p. 43).

At the beginning of the 1990ies, CA pioneers Paul Green and V Srinivasan (1990) reviewed the theoretical developments of the methodology during the recent decades and proposed potentially useful avenues for further research. According to this paper, one way to progress the methodology is by broadening the scope of applications into other scientific disciplines: “In addition to the use of CA for marketing and strategic analysis, its applications are becoming increasingly diverse. The extension of the conjoint methodology to new application areas comprises: litigation, employee benefit packages, conflict resolution, corporate strategy, and social/environmental tradeoffs” (Green & Srinivasan, 1990, p. 15). Beside the above mentioned practical objectives, this research therefore also aims at contributing to the advancement of CAtheory, by applying the CA within an interdisciplinary context.

This methodological approach leads from a political science perspective to a management perspective and then returns to political interpretations about the empirical results. The broader framework therefore rather originated in political science, but at the same time it included methods of other disciplines. “In many respects, politics is the junction subject of the social sciences, born out of history and philosophy, but drawing on the insights of economics and sociology and, to a lesser extent, the study of law, psychology and geography” (Burnham, Gilland, Grand & Layton Henry, 2004, p. 8). The aim of this paper was to reflect this characterization of politics as a “junction subject” and it therefore comprises the benefits as well as the shortcomings of political science: “This openness to other perspectives can enrich the discipline, but also leaves it open to the accusation that it lacks a distinctive theoretical and methodological core” (Burnham et al., 2004, p. 8).

2 OAO Gazprom - Company Background

2.1 The Formation Period

“Gazprom is a ministry that has become a corporation”. These words by Russia expert Anders Åslund (2006) reflect very well the peculiar transformation process that Gazprom has been undergoing since the end of the Soviet Union. The last Soviet Minister of Gas Industry, and Prime Minister from 1992 to 1998, Viktor Chernomyrdin, formed Gazprom out of his ministry, incorporating all the elements of it - production, transportation, distribution, sales, research, and even regulation (Åslund, 2006). In November 1992, Gazprom became a joint-stock company (OAO) and it was partly privatized in 1994, with the state holding 40% of all shares. About 15% of the stocks were sold to workers and management at preferential prices. Furthermore, the leadership of Gazprom restricted the sale, by ensuring that sales of shares took place at closed auctions (Stern, 2005, p. 176). This meant that the company could determine who attended the auctions and who had to stay aside, leaving considerable leeway for nepotism and corruption. Similar developments within other key industries triggered the ascent of a new social class of oligarchs, the so called “Bisnesmeni”, during the 1990ies. In this period, various decrees were passed limiting the foreign share-ownership of the company to about 14%. This legislation led to a formal separation between the shares that could be owned and traded on the Russian stock market, and those owned and traded by foreigners (Stern, 2005, p. 171). As a consequence, the market capitalization was kept at an artificially low level until the share-trading liberalization in 2005.

After Vladimir Putin came to power in 2000, he was influential in selecting the new Gazprom management. His former colleague at the St.Petersburg Mayor’s Office, Alexei Miller, became Chairman of the Management Committee of Gazprom in 2001, with the assignment to render the company more efficient and to end the self-service mentality among the Gazprom cadre. Miller enjoyed a reputation of being incorrupt and since his nomination as Gazprom CEO the value of the company increased more than twenty fold (Follath & Schepp, 2007, p. 126). The main reasons for this increase in value are obviously soaring energy prices, the rising control of Gazprom over the abundant Russian resources, and the liberalization in share trading, but it also reflects an increasing confidence of foreign and institutional investors in the new management of the company. As Chairman of the Board of Directors, Putin selected Dmitri Medvedev, who became First Deputy Prime Minister in 2005 and who is among the favorite candidates for succeeding Putin as President of the Russian Federation in 2008. The career of Medvedev is a good example for the close ties between the Kremlin and the Gazprom leaders. Similar to the US, there is today a “revolving door” between high positions in federal politics and the management within the Russian energy sector. This revolving door triggers speculations about an alleged future role of Vladimir Putin’s within Gazprom, after he has to step down as President in 2008.

2.2 Gazprom Today

Today, Gazprom is an integrated globally active energy giant - Voswinkel (2006) even calls it an “Energy Leviathan” - ranking among the largest corporations in the world. In terms of market capitalization it overtook Microsoft Corp. in 2006, to become the third largest company in the world (Reynolds, 2006). Its market capitalization in 2006 was on average 239 Billion US$, up from 91 Billion US$ in 2005, and the company employed about 432000 people (Gazprom, 2007a, pp. 63).

Table 2: Gazprom - Financial Figures

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Source: www.gazprom.ru.

The Gazprom Group holds significant ownership stakes in 175 other companies, ranging from the core business of natural gas, to other energy sources like oil companies, nuclear power facilities and coal producing companies (Gazprom, 2007b).¹¹ Furthermore it also includes TV stations (e.g. NTW) and newspapers (e.g. Izvestia), several banks (e.g Gazprombank) and investment companies, construction companies, several Hotels, tire producers, a soccer club (Zenit St. Petersburg), chicken farms, a skiing resort in Sochi (host town of the winter Olympics in 2014), an air line and many other non-energy subsidiaries (Follath & Schepp, 2007, p. 126). These non-energy activities are the reason why the company is often referred to as a “state within a state”, or more lately also “the states own state”.

Recently Gazprom was able to significantly improve its position in the Russian oil and coal sector. In September 2005 the company acquired 75.7% of OAO Sibneft¹² by oligarch Roman Abramovitch for the price of 13.1 Billion US$, strengthening the company’s oil activities and emphasizing the objective to become an integrated, all-embracing energy company (Kneissl, 2006, p. 195). With the Sibneft takeover, Gazprom could increase its oil production by 257% compared to the year before (Gazprom, 2007a, p. 5). In the coal sector, Gazprom seeks the majority in a joint venture with the Russian coal company OAO Suek, which accounts for about 30% of power station coal supply in the domestic market: “The joint venture’s activities will be aimed at increasing economic efficiency of using coal and gas in electric power generation” (Gazprom, 2007, p. 59). Others, however state that these activities are aimed at expanding the monopoly in natural gas towards a monopoly position in the entire energy sector (Müller- Kraenner, 2007, p. 64). The year 2005 was not only important due to the takeover of Sibneft and the associated expansion within the oil sector, but also in terms of ownership. For the first time since the liberalization period of the early 1990s, Gazprom became a company with a majority stake held by the Russian Government (Stern, 2005, p. 197). Today, the state officially owns today a 50.002% controlling stake in Gazprom (Gazprom, 2007b). Thus, similar to other countries like the US, France and Japan, by 2005 the energy sector in Russia is again an integral part of foreign and security policy (Kneissl, 2006, p. 94).

2.3 Resources and Production

If measured in gas reserves, Russia is endowed with about a quarter of the global known natural gas reserves, i.e. around 48 tcm. In terms of resources¹³, it is estimated, that Russia is endowed with about 170 tcm of natural gas (BP, 2007, p. 22). The bulk of this treasure is controlled by Gazprom:

Figure 2: Proven Gas Reserves of Selected Countries at the End of 2006 (In tcm)

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Source: Own illustration, data from BP (2007, p. 22)

Currently, the Gazprom group owns approximately 30 tcm of proven gas reserves by licensing as of December 31, 2006 (Gazprom Germania, 2007, p. 31). Consequently Gazprom is one of the world’s largest energy companies, if measured by the volume of its proven reserves. When it comes to resources, Gazprom is supposed to control about 16% of the world’s natural gas resources (Voswinkel, 2006). If these resources are measured in oil equivalent, Gazprom controls more crude oil than there are resources in the entire country of Iraq (Kramer, 2005).

The Urals federal administrative district in Western Siberia is the main gas producing area today and it will maintain its significance for the next decades. When it comes to future production capabilities the gas fields at the Yamal peninsula and in the Barents Sea are of utmost importance. On January 14, 2002 the Gazprom board declared the Yamal peninsula as its strategic area of interest with deposits primarily to be exploited by 2010. The industrial development of Yamal peninsula’s reserves allows natural gas production of up to 250 gcm per year. Within the Barents Sea, the largest area of development is the Shtokman gas field. Its planned output rate totals 70 to 100 gcm of natural gas per year (Gazprom Germania, 2007, p. 32). The gas deposits from Shtokman will form the basis for future European supply through the planned North Stream Pipeline.

In 2006, Gazprom produced 556 bcm of natural gas, which accounted for 84.7% of the total gas production in the Russian Federation (Gazprom, 2007, p. 31). This amount of gas produced was only slightly more than the 555 bcm in 2005 and 552.5 bcm in 2004, indicating a sluggish increase in production volume (Gazprom, 2007, p. 6). Compared to the production level at the end of the Soviet Union, in 1991 production peaked at 643 bcm, there has been a subsequent drop during the 1990s - giving rise to speculations about an imminent and irreversible production decline (IEA, 2002, p. 111). In fact, a great deal of new capacity has to come on stream over the next two decades in order to maintain current production levels and this requires a huge amount of capital. Within the EU there have been severe concerns about Gazprom’s ability to fulfill its export commitments. EU Commissionaire for Energy, Andris Piebalgs, recently stated: “the current gas fields under exploitation are not sufficient to fulfill the existing obligations over the next years. I have information that Gazprom already has to confine domestic supply in order to achieve the current export volume. (. . .) Within the next 20 years, Russian infrastructure requires investments of several hundred billion Euros” (Seith, 2006, own translation).

More than 90% of Gazprom’s production has been sustained by six fields - three giant fields in Western Siberia (Urengoy, Yamburg and Medvezhe) and three smaller fields. The declining output from existing fields during the recent years could only be accommodated by increasing exploitation of the new super giant Siberian field Zapolyarnoye (Stern, 2005, p. 58). But this accommodation can only be a temporary solution. Gazprom’s production capabilities in the near future heavily depend on its ability to exploit the gas reserves at Shtokman, Yamal and Sachalin. In October 2006, Gazprom informed the public that, despite earlier statements, it would not cooperate with foreign companies for the exploitation of the Shtokman gas field (Götz, 2006). At the same time, the projected start for getting Shtokman on stream had been delayed from 2010 to 2013. The decision to exploit gas fields without foreign assistance is particularly interesting because in times of relatively high oil and gas price there should be higher incentives to invest in the upstream sector than in times of low prices. If Gazprom really plans to develop Shtokman on its own, it will be a very challenging task both in terms of financial capacity and in terms of technological know-how.

2.4 Exports, Infrastructure and Gas Prices

All of Gazprom’s sales to Europe are handled by its wholly-owned subsidiary OOO Gazexport (also called OOO Gazprom export), which either directly or through its affiliates sells gas throughout Europe (Stern, 2005, p. 111). Alexander Medvedev,¹⁴ Director General of OOO Gazexport, is responsible for negotiating delivery contracts abroad. The exports to Middle and Western Europe are subject to long term contracts, often longer than 25 years, including the so called ”take-or-pay” clauses.¹⁵

The structure of Gazprom’s sales in the major export markets has been characterized, until recently, by a distinct disparity of prices. This was most noticeable in the beginning of the current decade when Gazprom’s sales of natural gas to Europe at free market prices provided for over 60 % of its total revenues, although they only accounted for one third of the total volume of gas sold (Gazprom, 2007, p. 10). The other two third of Gazprom’s gas were either consumed inside Russia, or sold at a significant rebate to neighboring countries. Thus, the losses from selling natural gas in the domestic market (including the CIS countries), which were due to the governmental regulation of gas prices, were covered by the export revenues to Western Europe. During the recent years Gazprom is trying to abolish the price rebate to the neighboring countries, causing severe tensions with countries like Ukraine, Georgia and Belarus. These countries were not only complaining about the steep gas price increases itself, severely harming their economies, but also about the way Gazprom conducted the price negotiations. In fact, Gazprom was only willing to compromise on the price increases, if the other side was willing to open up their domestic infrastructure for Gazprom investments (Heinrich, 2006). By doing so, Gazprom tried to regain the ownership of the crucial pipelines to Western Europe, which had been lost after the end of the Soviet Union.

This course of action (i.e. the sequence, timing and manner) indicated that Gazprom did not seize the opportunity of using the declared elimination of political prices for achieving political objectives in the Russian interest. In Western Europe especially the procedure against Ukraine was conceived rather critical and the Western media mainly reported negatively about it. Many commentators used the notion of “Russia is using energy as a weapon”, thereby disseminating fear among consumers.

Similar to the procedure in the countries formerly influenced by the Soviet Union, Gazprom also seeks a steep increase in domestic market sales: “It is also planned to bring the sales profitability up to the European market level by 2011 (adjusted to the transportation costs and customs duties)” (Gazprom, 2007, p. 45). This ambitious objective will cause severe political obstacles, since the entire industrial sector heavily depends on inexpensive gas. Furthermore, Russian voters will not tolerate the increase in gas-prices, necessary to meet this plan. Nevertheless, increasing the domestic gas price is crucial for improving energy efficiency, avoiding further resource waste¹⁶ and securing gas supply for future generations within Russia and abroad.

2.5 Strategic Objectives

“Gazprom’s strategic goal is to establish itself as a leader among global energy companies by entering new markets, diversifying its activities, and ensuring reliable supplies” (Gazprom, 2007, p. 1). In order to reach this goal stated in the Annual Report 2006, Gazprom follows a strategy that can be characterized by a vertical as well as horizontal expansion. The vertical expansion includes the activities in the upstream sector on the one hand, and the increasing downstream activities in Europe and other potentially lucrative markets on the other. The horizontal expansion includes the already mentioned activities in the oil sector, the coal sector, the nuclear power sector and other non-energy related activities. In the light of the research questions, this research will focus on Gazprom’s strategic objectives within the export and downstream sector. However one crucial general question for understanding the actions of this company has to be discussed. To what extent does Gazprom follow a political and not an economic paradigm? The following statement within the Annual Report of 2006 shows that it is not only the shareholders or the consumers that drive the business, but it is also Russia’s position in the world: “Our goal is to raise its shareholder value and strengthen the consumers’ trust. (. . .) The results achieved in 2006 as presented in the Annual Report allow us to make a well-grounded statement that Gazprom consistently increases its influence as a leader among the world’s largest energy companies. All this strengthens not only Gazprom’s but also Russia’s position globally and makes it possible for our shareholders to be confident in the future” (Gazprom, 2007, p. 9). This paper will not be able to solve this question, but it is important to emphasize the fact that it remains unclear, whether the company has to follow interests of the political elite or whether the political influence of individuals are used to maximize company profits. In any case, there is a very close connection between both entities, which becomes evident simply by analyzing the personal relations between Gazprom management and the political elite within the Kremlin.

In terms of financial figures, Gazprom’s objectives are very ambitious: “We will reach a 1 US$ trillion market capitalization in a period of seven to 10 years. (. . .) We'd like to be the most valued and most capitalized company in the world” Alexander Medvedev, Deputy Chairman of the Management Committee, remarked in an interview with Bloomberg (Bloomberg.com, 2007). However, it is still unclear and highly depending on the legal environment in Europe how exactly Gazprom will conduct its expansion in Europe. Due to its favorable geographic position within the given and planned infrastructure, it has been anticipated that Gazprom would use Germany as a distribution hub (Götz, 2006). The investment plan of Gazprom leaves about 20 billion US$ for acquisitions and around 6 billion US$ for financial investments (Flauger & Wiede, 2006).

But after the German Government stated its opposition against foreign takeovers in the energy sector and the European Commission revealed its plans about the “unbundling” of energy companies, Gazprom decided to temporarily stop its expansion until there is clarity about the legal environment (Spiegel Online, April, 24 2007). The expansion strategy into the downstream market will therefore not be realized as fast as anticipated. However the following section from the Annual Report leaves no doubt about the long term strategy: “Gazprom is working towards a competitive presence in a new sector, i.e. the energy power industry. Its strategic goal is to increase return on investment in the course of reforms in the Russian power industry, diversify tariff regulation risks, optimize the share of national gas in the Russian fuel balance, and achieve synergy with other types of activities. The following measures are planned to implement these goals: purchase of generation and distribution companies that will develop in a competitive environment; construction of coal generation facilities in the regions with high share of natural gas in the fuel balance” (Gazprom, 2007, p. 58) This discussion of Gazprom’s company background was a necessary prerequisite to approach an answer to Research Question I (What are the explicit strategic objectives of Gazprom, and why is the expansion into the European downstream market a particularly attractive target?). The analysis in this part identified at least three explicit strategic objectives:

1. Becoming the biggest company in the world regarding market capitalization.
2. Striving to become an integrated globally active energy company.
3. Attaining access to European consumer in the long-term.

Answering the remainder of Research Question I (Why is the expansion into the European downstream market a particularly attractive target?), will be the objective of chapter III.

3 Gazprom’s Activities in Europe

The Russian-European energy relations have a long and impressive historic record. Since 1973 and during critical phases of the Cold War, Russia has been a reliable supplier of gas and oil to Europe (Schöllgen, 2007). As mentioned in the previous section, the European market is and remains crucial for Gazprom’s financial success. Still two thirds of the revenues are made by exporting gas to Europe and the analysis of the general company strategy revealed that Gazprom has even more ambitious plans regarding its sales in Europe. This chapter will give further insights on Gazprom’s expansion plans in Europe and it will lead to completely answering Research Question I (What are the explicit strategic objectives of Gazprom, and why is the expansion into the European downstream market a particularly attractive target?).

3.1 Characteristics of the European Gas Market

The analysis of gas export to Europe has to consider various features of the gas business in general and specific characteristics of the European market in particular.

Due to its elusive characteristics, the transport of natural gas mainly requires an expensive pipeline infrastructure. In fact, 70% of natural gas is being transported through pipelines, because the other common way of transporting gas by liquefying it (LNG)¹⁷ is still very costly even though these costs are decreasing.¹⁸ Transporting gas via pipeline is financially attractive for a distance of up to 4000 km, beyond this distance it becomes too expensive (Müller- Kraenner, 2007, p. 23). Because of this reason the markets for natural gas have been regionally segmented (Götz, 2007, pp. 14). Until recently, the world has been divided into three regional gas markets, with limited trade in between America (Canada supplying the United States), Europe (Norway, Russia and Algeria supplying Western Europe) and Asia (Indonesia, Australia, Middle East supplying Japan) (Geman, 2006, p. 229). The increasing importance of LNG will contribute to break up the current world segmentation and will slowly enable a world market for natural gas. But this development will take several decades.

The international gas trade is either conducted via bilateral (long-term or short-term) contracts or via spot and futures transactions at natural gas trading platforms. The majority of gas deliveries in Europe are, as mentioned before, done via long-term bilateral contracts with “take- or-pay” clauses. In this context the established tagging of the gas prices to the oil price (replacement value) and other energy substitutes can be explained as well. Due to the substitutive relation between natural gas and oil, natural gas could lose its competitiveness in times of low oil prices, making it harder to collect the required high initial capital investments. In this sense, the tagging to the oil price was initially established in order to promote the use of natural gas.

In other words these long-term contracts can be characterized by transferring the quantity risk within the contract away from the producer to the demand side (in this case the regional gas provider) and at the same time partially transferring the price risk from the demand side to the supply side (BFE, 2007, p. 31). If the oil price is very low, the margins of the supplier is squeezed, but if oil prices are high, the supplier can realize a substantive rent between his upstream costs and the sale at oil price level. In general, these long term contracts have been heavily contested, especially under competition aspects. However, today it has been acknowledged that in the absence of a true world market for natural gas, this practice is appropriate for ensuring sufficient capital investments in the upstream business and thereby contributing to supply security.

Due to the pipeline-bound nature of natural gas and the dominance of long-term contracts, the respective price for natural gas is not the result of market forces, but it often reflects political interests.¹⁹ The price movements might be indexed to the oil price and other substitutes, but the price level does often not only reflect economic considerations.

3.2 Regulatory Framework and Liberalization

On June 26, 2003 the EU Parliament and the EU Council of Ministers decided upon a new directive concerning the rules about the common gas market (2003/55/EC). This second directive on gas replaced the earlier directive from 1998 and stipulated that by July 1, 2007 the European gas customers should be able to freely choose their gas supplier. This aim of completely opening of the EU gas market by July 1, 2007 was only realized in legal terms. The reality within the particular gas markets looks quite different. Like every directive, this specific one must also be translated into national law and therefore the legal reality within the member states still differs substantially from the intended liberalization steps.

Furthermore it is still unclear how the EU will proceed with the topic of “unbundling”, i.e. the legal separation of ownership of the infrastructure and the actual operation of supplying gas to consumers. A strategy paper of the European Commission President Barroso launched in January 2007, stated that the integrated gas and power providers would have to sell their assets in the infrastructure networks (Hauschild, 2006). It is still unclear how the energy sector in Europe will be regulated, since these suggestions by the Commission are heavily contested by certain member states fearing disadvantages for their domestic energy providers. Therefore, even though liberalization has been on the agenda for decades, the regulatory environment of the gas market has not yet been fully liberalized. This means, that today the EU is far from having a common energy policy. On the contrary, energy policy is still an area where national egoism and mistrust are shaping the policies of the member states. This means, that we are not only facing an unclear and transforming regulatory situation in Russia, but also within the EU itself, where market conditions are still in flux. Nevertheless, it will be highly relevant for future energy supply to Europe that the EU-Commission and the member states will enable a competitive domestic gas market.

Since the legal requirements for an open and liberalized gas market are, at least formally, in place, it will be decisive how the EU Commission will deal with the integrated energy giants operating in Europe. If consumers are able to choose among a broad range of suppliers within a competitive European gas market, the regulatory authorities will have rendered a huge success. Ultimately it will also be important if the consumers are taking advantage of this new choice and which gas product they desire. In any case, the development of the legal framework in Europe will severely influence Gazprom’s future activities in Europe. While at the end of 2006 it already seemed as if Gazprom would use Germany as a hub for its downstream business, the unclear legal environment forced Gazprom to decelerate its expansion plans in Germany (Spiegel Online, April, 24 2007).

3.3 European Demand for Natural Gas

In general, it is very difficult to forecast future demand for natural gas, since so many factors influence the actual demand. Not only do population growth, economic growth and reserve changes play an decisive role, but it is also important to determine the developments of competing energy sources like oil, coal, nuclear energy and renewable energies. However, as seen in the previous part, there is reasonable evidence to expect an increasing role of natural gas for the European Union, at least for the medium term i.e. the next 20 to 30 years. These assumptions coincide with other projections, or even exceed them when it comes to the role for natural gas in total global energy consumption. For example the Swiss bank UBS expects a smooth transition from oil to natural gas: “global production of natural gas will clearly outpace the production of oil by 2030 or even earlier” (UBS, 2006, p. 42, own translation). The most important factor for the increase in natural gas production is its relatively clean combustion. Additionally the widely unexploited global resource base adds momentum to this trend.

Since the reserves of natural gas within Europe are dramatically declining, the need to import the required natural gas will significantly increase. This rather negative fact on the one hand, is partly equalized by a more positive fact on the other hand, namely that Europe is in the reach of about 80% of the world’s energy resources via pipelines (Müller, 2006, p. 17).

Figure 3: Projected Net Import Requirements of Natural Gas to the EU (In Oil Equivalents)

illustration not visible in this excerpt

Source: Own illustration, data from European Commission (2006, p. 74).

Figure 3 shows estimations about the future net import requirements of natural gas to the EU (European Commission, 2006). These figures predict a more than 100% increase of imports between 2000 and 2020. These numbers lead to an increase in import dependency from around 50% in 2000 to around 83% in the year 2030 (European Commission, 2007, p. 13). The obvious conclusion from these figures is: Europe will continue to be a very attractive sales market for Gazprom with a stable demand for natural gas.

3.4 Competition from Other Gas Supplying Countries

When thinking about the future security of gas supply, one has to take the given infrastructure into account. It is very costly and takes a lot of time to build up the necessary pipeline system. As seen before it is furthermore not cost-efficient to transport gas more than 4.000 kilometers. Evidently, the amount of gas transported as LNG will increase in future, but it will still be an economically reasonable decision to transport gas via already existing pipelines.

Figure 4 compares the most important supply countries of natural gas to Europe in 2005 (Western Europe, Russia and Algeria) with their respective available reserves. Considering these figures, the already existing infrastructure and the history of energy cooperation, it becomes obvious that Russia will play a decisive role in meeting Europe’s future energy demand.

Figure 4: Origin of Consumed Gas in Europe and Reserves (Selected Countries)

illustration not visible in this excerpt

Source: Own illustration, data from European Commission (2007, p. 11) and BP (2007, p. 22).

The significance of middle-eastern countries like Iran and Qatar for the European energy supply will heavily depend on the development of LNG technology and the demand for natural gas in other regions like Asia and North America and the willingness to pay respective prices.

According to a study by the consultancy McKinsey & Company, the additional costs for gas deliveries from the Middle East instead of Russia would cost the European consumers between 40 and 60 Billion US$ (Bozon, Campbell & Vahlenkamp, 2006). At the same time Russia would lose around 50 to 70 Billion US$ if it would sell its Western Siberian gas to countries outside Western Europe (Bozon et al., 2006). These estimations show that there is a mutual dependency between Russia/Gazprom and Europe and that it is very likely that Europe will continue to receive the majority of its gas imports from Russia.

3.5 Gazprom’s Share Holdings in Europe

Among the various strategic objectives of Gazprom analyzed in part II, the most relevant for this research are Gazprom’s plans to expand into the European downstream market. Today, this expansion is accompanied by a complicated network of shareholdings and subsidiaries all over the continent. Even though there has been progress in recent years, it is still very difficult to get an overview of all of Gazprom’s activities in Europe. According to Wadim Kleiner, Hermitage Capital Management, the company still lacks a sufficient level of transparency: “The company structure is complicated, making it impossible for shareholders to identify which operations and investments are profitable” (Voswinkel, 2006).²⁰

In order to give an example of Gazprom’s links in Europe, Figure 5 shows Gazprom’s links within Germany. The German company E.on Ruhrgas AG can be regarded as one of the most important partners of Gazprom, not only in Germany, but in Europe as a whole. Together with BASF (through Wintershall Holding), E.on Ruhrgas is the most important partner in the planned pipeline project through the Baltic Sea (Nord Stream). With 6.5% E.on Ruhrgas itself even holds a significant share in OAO Gazprom.

Figure 5: Gazprom's Links with German Companies (As of Mai 12, 2007)

illustration not visible in this excerpt

Source: Own illustration, data from www.gazprom.ru.

The recent activities of Gazprom in Europe indicated that beside the strategy of expanding the business through cooperation with other large suppliers like Gaz de France, ENI or E.on Ruhrgas and subsidiaries (Wingas, Nord Stream etc.), Gazprom’s marketing strategy aims at implementing the name “Gazprom” as a brand within the minds of consumers.

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¹ If not further specified, the term Europe comprises all countries on the continent west of the CIS states.

² In 2030 the dependency on oil imports will increase to 90%, for natural gas to more than 80% and for coal to more than 60%.

³ According to the European Commission, energy security is the supply of affordable, reliable and environmentally friendly energy (European Commission, 2006b).

⁴ Natural gas is defined as colorless, highly flammable gaseous hydrocarbon consisting of methane and ethane. It is a type of petroleum that commonly occurs in association with crude oil (Encyclopedia Britannica Online, 2007c).

⁵ In general it is very difficult to estimate the ultimate future gas demand for Europe, because so many factors have to be taken into account. During the end of the 20th century an even higher natural gas demand has been projected, but due to the high oil and gas prices, coal has experienced an astonishing revival especially in power generation, slowing down the natural gas demand (Götz, 2007a, p. 14). Nevertheless, the long term trend away from fossil fuels will continue, because in the light of the dangers of climate change, the decisive question will not be how long the resources last, but what amount of emissions the earth is able to accommodate.

⁶ See figure 4.

⁷ Since 2006 Gazprom enjoys the exclusive right to export natural gas (Götz, 2007b, p. 2).

⁸ The downstream sector is a term commonly used to refer to the refining of crude oil, and the selling and distribution of natural gas. The upstream sector on the other hand, includes the search for potential underground or underwater oil and gas fields, drilling and operating the wells that recover and deliver the crude oil or raw natural gas to the surface.

⁹ “Corporate Social Responsibility is a concept whereby companies integrate social and environmental concerns in their business operations and in their interaction with their stakeholders on a voluntary basis” (European Commission, 2006c).

¹⁰ For further insights into the theory of Conjoint Analysis see part 4.2.

¹¹ According to Voswinkel (2006) more then 1000 subsidiaries belong to the Gazprom Empire. On the Gazprom website it is stated that Gazprom holds a majority stake in 175 subsidiaries (Gazprom, 2007b).

¹² The company name “OAO Sibneft” was changed to “Gazprom Neft” in June 2006.

¹³ Energy experts make the distinction between already usable “reserves” and “resources”, which can only be exploitable in the future.

¹⁴ Alexander Medvedev (Director General of OOO Gazexport and Deputy Chairman of the Management Committee of OAO Gazprom) is not to be confused with Dmitri Medvedev (Chairman of the Board of Directors of OAO Gazprom and First Deputy Head of the Government of the Russian Federation).

¹⁵ With a “take-or-pay” clause, the demand side commits itself to pay for a minimum amount, irrespective of the actual amount demanded. In other words, there is a monetary penalty for demanding less than the negotiated volumes. At the same time the supply side obliges to deliver the respective volume.

¹⁶ The extent of energy waste in Russia is enormous. Russian households often require ten times the amount of energy than households in Western Europe (due to housing and construction quality), but on average they only pay 130 € per year for heating (Voswinkel, 2007). This is only about 10% of the heating costs of Western Europeans.

¹⁷ Liquefied Natural Gas (LNG) is defined as natural gas (primarily methane) that has been liquefied for ease of storing and transporting. LNG takes up about 1/600 the space that natural gas does in its gaseous form, and it can be easily shipped overseas. It is produced by cooling natural gas below its boiling point, - 162° C (Encyclopedia Britannica Online, 2007b).

¹⁸ The energy of one ton of oil equals the amount of about 1000 m³ of natural gas. This implies that while oil needs about one m³ of space, natural gas needs under atmospheric pressure roughly 1000 times more space than oil. Under high pressure and very low temperature natural gas can be liquefied, which decreases its volume and makes it less costly to transport it (UBS, 2006, p. 40).

¹⁹ For example, the countries of the former Soviet Union used to obtain highly subsidized gas deliveries from Russia. Even though Russia is leveling its export prices, the timing and the selective manner of doing so, indicates political interests. This can be observed regarding the negotiation with the Ukraine, Belarus and Georgia.

²⁰ The following episode during the inquiry about Gazprom, supports this fact: When analyzing the shareholdings of Gazprom with Nord Stream in July 2007, the web link on the official Gazprom page “list of subsidiary companies” showed a outdated list form July 1, 2006 (This information was found under http://www.gazprom.com/eng/articles/article8526.shtml.). The version in Russian language also showed information from July 1, 2006; http://www.gazprom.ru/articles/child_company.shtml. This informational policy cannot be regarded as up-to-date and in this case we obviously do not encounter a level of transparency sufficient to give comprehensive information to the interested public (Gazprom’s Annual Report 2006 did not give more evidence on the question about the company’s links in Europe).