Market Development Prospects

OJSC Gazprom Reforming Strategy

The reform of OJSC Gazprom is going on

The second stage of the internal reform of OJSC Gazprom is currently underway. Its aim is concentration of vertical integration and optimization of the management structure at the level of subsidiaries.

According to the plans, structural transformations will complete works for dividing financial flows in production, transportation, processing, underground storage, and sales of gas and liquid hydrocarbons.

The main approach to improvement of the intra-corporate structure is division of multi-profile enterprises of OJSC Gazprom, consolidation of core activities in dedicated legal entities, and separation services and social infrastructure into individual legal entities.

On March 29, 2006, the Board of Directors of OJSC Gazprom approved proposals for reorganization of the subsidiaries in which the only participant is OJSC Gazprom in order to separate core activities and concentrate them in dedicated subsidiaries with 100% participation of OJSC Gazprom, namely, in Gazprom Underground Storage LLC, Gazprom Processing LLC, Gazprom Severpodzemremont LLC, and Gazprom Yugpodzemremont LLC, and increase the stake of OJSC Gazprom in Gazpromtrans LLC up to 100%.

Practical implementation of this approach implies reorganization of subsidiaries in two stages:

· separation of activities and assets: the subsidiaries of OJSC Gazprom (donor companies) separate their core assets into independent legal entities (buffer companies);

· consolidation of activities and assets: the buffer companies established by separation from subsidiaries are subsequently consolidated according to their activities through their reorganization and incorporation (a main company is chosen from the buffer companies and all other buffer companies are incorporated in it).

The reform will ineluctably lead to commercialization and transparency

The reform of OJSC Gazprom management should result in higher transparency of financial flows, business structures, and expenditures of the holding. Some businesses will probably separated from the holding at the nearest stage. The businesses left in the holding will be separated on an organizational basis. In spite of the budgetary principle of planning and financing used in OJSC Gazprom, it will be very hard to prevent and eliminate possibilities of getting additional profits by certain individual companies.

Internal conflicts stimulate market development

The presence of different special interest groups in OJSC Gazprom and commercialization of certain businesses of the holding will encourage development of intra-corporate market relations, division of the spheres of external relations, and clustering by types of services. Appearance of organizationally separated suppliers and consumers of specific services of the same type in the company will create the conditions necessary for development of market relations.

Changes will take 5-7 years

According to the structure of internal reforms in OJSC Gazprom, the last stage of reforms will be completed after 2010. Key transformations will be implemented during the next presidential term.

Market formation requires structural reconstruction of the existing legal framework. Development, approval and adoption of one industry-related resolution of the Russian Federation Government takes time from six months to one year. This means that essential changes in the situation will be ready and possible in some 5-7 years.

Dynamics of Changes in the Legal Framework of the Gas Industry

Procedure of setting wholesale prices

The oldest draft regulatory document discussed in the Russian Federation Government is the procedure of setting wholesale prices of gas produced by OJSC Gazprom. The issue of adopting rules for regulation of wholesale prices came to the fore during the development of the procedure of determining trunk pipeline gas transportation tariffs for independent producers. The public discussion of this procedure revealed the conflict between the cost-plus theoretical principle enshrined in the laws of the Russian Federation and the actual practice of macroeconomic regulation of prices and tariffs of the gas monopoly.

The draft procedure worked out by the Russian Federation Government so far is seriously vulnerable to expert criticism. The Government has not set any strict deadlines for discussing and adopting this document. The persons responsible for development of the procedure are open to discussion.

The method of concrete implementation of the procedure will set up new rules for competition between gas of OJSC Gazprom and gas of independent producers on regional markets. Approval and adoption of the procedure is the prerogative of the Federal Tariff Service of the Russian Federation.

Rules of trading on an organized market

One of the most popular subject of the gas market in 2006 is organization of open trade. In fall 2006, an experiment was started on the basis of the trading site of Mezhregiongaz LLC, whose results will be used by the Russian Federation Government for working out the legal framework of the new gas trading market. The Russian Federation Government will apparently approve a whole set of resolutions regulating the following:

· rules for access to the market

· rules for access of participants to the transportation infrastructure

· rules for organization of trading sessions

· rules for supply of gas purchased on the trading market

· changes in the existing laws and regulatory documents.

These documents will be discussed and approved in spring-summer 2007.

Law of Gas Supply

Most of the current innovations do not require mandatory changes in the Law of Gas Supply. However, this law is rather outdated and requires modernization. There are numerous claims to this law from experts of OJSC Gazprom and other participants of the market. Earlier this law was viewed as a sacred cow, but now OJSC Gazprom itself is initiating works for correction of certain provisions of this law.

The law sets the key principles of relations in the industry and any changes in its provisions will affect the entire industry. In the current political conditions, changes in this law will probably be initiated and supported by OJSC Gazprom.

Rules of supply

The rules of gas supply in the Russian Federation are seriously outdated, but still remain one of the key regulatory documents in the gas industry although they do not reflect the current problems on the gas market. Initiatives for changing the rules of gas supply were not systematic and were mainly oriented to solving certain individual problems. The Russian Federation Government and OJSC Gazprom realize that this document requires serious revision and are ready to start expert discussions in this direction.

A new version of this document will apparently be developed and coordinated in spring-summer 2007 together with the development of rules of trade on an organized market.

Versions of access: unified buyer, investment-based access, antimonopoly persecution, proportional access…

One of the urgent problems of the gas industry is the problem of access to the transportation capacities of OJSC Gazprom. Most of the standard solutions to this problem proposed today are political and aimed at maintaining expert relations with the Russian Federation Government or OJSC Gazprom. The main lines of activities for solving this problem are explained in the study «Proposals for Organization of Access to the Transportation System of OJSC Gazprom» carried out by a group of experts of ERTA in 2006.

Trading Site Formation Prospects

There are rules of trading, but no rules of market

The current experimental trading sessions on the trading site of Mezhregiongaz LLC are based on the regulations developed and approved by OJSC Gazprom. These regulations prescribe the sequence of actions of participants in transactions on the trading site affiliated to OJSC Gazprom. The regulations contain no provisions regulating the strategy of market development. Analysis of these regulations does not provide sufficient information for predicting price formation mechanisms and guarantees of transactions on the gas market in future.

OJSC Gazprom does not need open trade and, therefore, has no future

From the strategic point of view, OJSC Gazprom, as the owner of the gas transportation and storage infrastructure, is interested in maximum periods of gas supply planning. In this case, the processes of balancing and system development are more controllable and predictable.

Integration of active open trading will increase obligations to revise the schemes of gas transportation system loading, obligations to redirect gas flows, and obligations related to operation and development of the gas transportation infrastructure. Open trade will necessitate extremely intensive additional flows of documents in OJSC Gazprom and between the trading site and its participants. Objective trading sessions may lead to formation of free-market prices differing from the prices of guaranteed coverage of OJSC Gazprom’s expenditures (regulated by the cost-plus principle).

Open trade — subject of political bargaining

The subject of open trade was brought to the fore by Mezhregiongaz LLC as a reason for raising the regulated prices of the internal market. This move was an attempt to enhance the influence of Mezhregiongaz LLC in the structure of OJSC Gazprom. In conditions of gas shortage on the internal market, this initiative was supported by the Russian Federation Government and other players of the gas industry. Nonetheless, in the current conditions, open trade may only be considered as a political argument in discussions.

Way forward — formalization of informal obligations, rights and demands

Real changes may be brought about by gradually introducing the rules and regulations actually formed on the current gas market into the legal framework of the gas industry. Legalization of relations and information disclosure will bring stability and predictability to the market. The market is functioning, but a considerable part of it is regulated by informal procedures.

The already formed relations may be used for organization of the existing market and introduced into the legal framework of the industry. This approach will guarantee maintenance of the already formed balance of interests and make it possible to pass the trade organization stage with less pain and losses.

Contours of the prospective gas market

According to the most popular model, the prospective structure of the internal gas market implies availability of two sectors: regulated and unregulated.

In the regulated sector, gas is supplied to consumers subsidized from the budget, that is, consumers supplied with gas at the prices regulated by the state. The concrete list of such consumers (and their groups) or principles and criteria for there identification are formed by the state and should be documented in the legal framework regulating relations on the gas market.

One of the main provisions is that gas is supplied to such subsidized consumers by guaranteeing suppliers, which also guarantee gas export supplies in peak periods and in force majeure circumstances. There are two possible versions (two different levels of guaranteeing suppliers):

1. The guaranteeing supplier is OJSC Gazprom as the owner of the Unified Gas Supply System owning trunk gas pipelines for transportation and underground gas storages and dispatching the system. In this case, the range of obligations of this guaranteeing supplier includes supply/sales of gas to any customer resorting to the guaranteeing supplier in peak periods or in force majeure circumstances.

For performing these functions, this guaranteeing supplier is granted certain privileges and benefits, such as, for example, lower tariffs of gas transportation through trunk gas pipelines or the high-priority right to store gas in underground gas storage facilities.

2. The guaranteeing supplier is an economic entity supplying gas to consumers subsidized from the budget. Gas is purchased on the wholesale gas market at the current market price and sold to subsidized consumers at the price regulated by the state. Obviously, the unregulated price will be higher than the price regulated by the state.

Accordingly, there are several versions of compensating the price difference between the regulated and unregulated market sectors to the guaranteeing supplier.

Apart from that, the state (represented by a regulating authority) sets a regulated markup for the guaranteeing supplier for providing supply and distribution services.

The guaranteeing supplier must sign a long-term contract with OJSC Gazprom for supplying gas in emergency cases. This contract must specify the volume of gas (or principles for determining the required volume of gas). The gas price is calculated using a special price formula with due regard to the principle of equal profits and may be differentiated according to the season (winter/summer), underground gas storage costs, flexible schedule of supplies (or consumption), etc.

A guaranteeing supplier of this type may be any economic entity chosen by the state according to the principles, rules and procedures prescribed by Federal Law of the Russian Federation No.94-FZ of July 21, 2005 «On Placing Orders for Supply of Goods, Performance of Works, and Provision of Services for Governmental and Municipal Needs.» In other words, signing a state contract in accordance with the established tender procedures is necessary for getting the status of a guaranteeing supplier.

The guaranteeing supplier may be granted the right to take part in operations on the unregulated sector of the gas market (in addition to purchasing gas for performance of its core activities).

In the unregulated sector of the gas market, gas may be supplied under direct two-sided contracts or through the mechanism of organized gas trade.

The mechanism of organized gas trade may also be used for the trade of derivative financial instruments. Participants of the market are granted opportunities of signing contracts for future supplies of gas and selling or buying fixed volumes of gas for supplying it at the stipulated time and price (stipulated in forward contracts and future contracts) with insurance (hedging) against risks of sharp changes in market prices. There may also be conditions for establishment of a balance market, where market participant would sell and buy their imbalances for regulating the flexibility of their supplies.

Summary

1. The structure of the gas industry will change for the better, but not as fast as market players may wish. The period of changes is approximately 5-7 years. Changes may be triggered by internal conflicts between the Russian Federation Government and OJSC Gazprom.

2. In the nearest future, markets players will raise the issue of making radical changes in the legal framework of the gas industry. OJSC Gazprom will support this initiative. However, the subsequent development depends on the initiatives of participants and their determination to attain their own goals.

3. The best strategy is legalization of the relations already formed in the gas industry and covert formation of new relations through establishment of industry standards. The key role will be played by terms: there is a possibility to introduce the principles of the future market on the wave of reforms without calling things by their proper names.

Other Links:

Report Outline
General Outline of the Gas Market
Prices and Tariffs
Infrastructure of the Gas Industry
State Regulation of Natural Gas Transportation and Sales
Market Participants and Their Strategies
Consumers. Economic and Regional Segmentation
Key Problems of the Market
Risks and Limitations
Market Development Prospects
Conclusions

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Оглавление и сокращения
Краткое содержание отчета
Цены и тарифы
Центральная отраслевая инфраструктура
Государственное регулирование
Участники рынка
Сегментация потребителей
Проблемы рынка
Риски и ограничения
Перспективы рынка
Выводы

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