by Tsvetalin Radev and Koen van Delft

“The behavior displayed by the state was surprising; they unannounced a big U-turn and regained control over the industry, with re-nationalizing assets, and increasing its role in regulation, planning, and investments. This almost immediately led to diminishing hopes for higher share of FDI in the energy sector. The government has reinstated itself as the National Champion.” Such was the opening given by current Russian opposition leader and former deputy energy minister of the Russian Federation Vladimir Milov. Milov, who heads the Russian political party, Democratic Choice, continued his presentation at European University’s Golden Hall on November 6 with sharp and knowledgeable criticism of decision-making in Russia’s energy industry. Speaking without the aid of notes or a powerpoint presentation behind him, Milov said that discussing Russian energy issues was easy for him. Milov’s background is that of a Russian energy specialist – he was a vocal advocate of privatization and liberal economics when he served as deputy energy minister in the early 2000s. He has been left disillusioned with the state-dominated path Russia’s energy policy has taken following his departure from the Russian government.

“The first sign of the new course that Putin was taking was his statement in February 2003 that he is against the idea of market restructuring and unbundling of Gazprom. This was also the year that marked the first takeover of private companies with the acquisition of Severnayaneft by Rosneft. It has been a decade since this U-turn in energy policy was announced and it is time to evaluate the ultimate results. We should bear in mind that Russian energy industry is in totally different shape than it was 10 years ago. Today there are two main challenges that were not present a decade ago; the shift from a brown field era to green field era, and the higher level of competition on international markets. Most of the new green fields are located in very remote, difficult areas, particularly in the Pacific and Arctic offshore area where Russian companies have virtually no experience and the investments are significantly higher. Thus, these green fields present a two-folded challenge: technology and investment.”

Milov underlines that previous decision makers were wrong in interpreting the outcome of global markets and energy prices, “the prospects and gas dependence on Russian exports, which was particularly exciting for some policy makers in this country, vanished. What we see is more competition, more opportunities for traditionally energy dependent countries to actually escape their energy dependence. We need to evaluate the implications for the Russian sector.”

“The privatization of the coal industry is considered a huge success, but nevertheless, is not promoted as one since it undermines the logic of re-nationalization and increased of state control.”

Milov highlighted the catastrophic loss of the European market. Further, he reiterated that Gazprom has lost a third of its supply to Europe compared to the peak year 2008. Milov expects that Gazprom will never reach those numbers again. It is often claimed by Gazprom that the problem lies with the economic crisis, however, Milov points out that competitors – Qatar and Norway – have gained market share. Russia has completely lost markets such as Belgium and Croatia since they have been heavily investing in LNG terminals. At the same time, the EU is increasing internal interconnectedness to lower Gazprom’s grip on the market. Milov further elaborates on the financial contribution to the state budget and points to higher proceeds from private companies than from those owned by the state. This argument is based on the amount paid to their share-holders is $2/$3 per barrel annually (oil equivalent), while Rosneft and Gazprom pay only $1 or less per barrel. Furthermore 75% of Rosneft and 11% of Gazprom are owned not by the Russian Government but by a ‘shady’ intermediary, Rosneftegaz, which until this year was exempt from paying dividends to the state budget. According to Milov, the acquisition of energy companies by the state did not bring the expected additional revenues and most stateowned companies are not able to develop offshore green fields on their own.

As Russia’s market share in Europe is eroding, Russia faces increased competition in Central Asia, Milov points out. “A decade ago Russia was the only country that was buying gas from Turkmenistan. Currently, Russia is outpaced not only by China but also by Iran. Furthermore, Turkmenistan signed an agreement to supply 30 bcm of gas to China in 2006. This was just three weeks after Putin had signed the same agreement for 30 bcm to China. The major difference between Russia and Turkmenistan is that Turkmen gas is already flowing for four years to China while negotiations between Russia and China are ongoing.”

The two main sectors that experienced privatization are the coal and oil sectors. The gas sector did not go through the same process and was not privatized to the same extent, and as a result, Milov argues, has been less successful. “The privatization of the coal industry is considered a huge success, but nevertheless, is not promoted as one since it undermines the logic of re-nationalization and increased of state control. In the privatization process the coal industry was restructured and labor productivity doubled in just ten years. In 1997 Russia became a net exporter of coal for the first time.

Russia emerged as a major player in the international coal markets. This clearly shows the benefits of bringing private investments and increased competition.”

Milov sees the privatization period of the oil industry as its most effective: “The privatization of the oil sector led to average growth rate of 8,4% in the Russian oil industry for the period 2000-2004. The private companies were also able to increase well productivity of their fields has increased by about one third. After the re-nationalization in 2005, the average oil output was only slightly above 1%. This is actually the price we paid for re-nationalization.” Gazprom, from Milov’s point of view, continuously denies the market trend towards more competitive environment driven by the shale gas revolution in the US.

Milov’s analysis is that the current role of the state in the energy sector is significantly hindering Russia’s prospects of retaining and developing its position in the energy business.

Following Milov’s roughly hour-long monologue, he opened the floor to questions. The following is a transcription of the Q&A session and has been edited for length and clarity.

Question and Answer Session:

Question: Recently, the Russian government passed a law to liberalize LNG export. This would seem to encourage competition, but the bill’s wording explicitly states the goal is to minimize competition. To what extent is this kind of liberalization good for the Russian gas industry?

I wish there were more liberalization, but it is a good step in the right direction. The presence of Russian companies in the global LNG market is important. It is very clear that private companies have achieved the best breakthroughs. So far, only private companies have been able to successfully develop new fields and produce gas through LNG. An example is the Novatek Yamal LNG project that has no formal connection with the government. This is one more proof of the theory that if private investors are allowed to do this, then more LNG facilities will be brought about in Russia, which is the ultimate goal. We have had problems with competition between Russians at the international markets before. When oil export was liberalized all at once in the 1990s, there were some instances of price dampening. The same thing happened in the coal industry. With LNG projects, however, the production costs are so high that the companies will not be able to compete on prices, except for maybe a few dollars per thousand cubic meters. So, we would not see a huge price differential that would result from competition. These projects would be so costly that investors would be unwilllng to bring the price down and the government would get its fair share in tax revenue. In order to make the Russian LNG market more competitive on a global scale, all export restrictions should be lifted. Liberalization is needed regardless of the upstream license or contract a certain company has. Additionally, there should be no government interference in the market, which would only serve to hinder the development.

Market forces rather than regulators drive Europe’s need for more [gas] suppliers and the accompanying diversification.

Question: With regard to the ongoing anti-competition investigation against Gazprom, do you think it will provide an incentive for Gazprom to change its strategy in eastern Europe? What kind of impact will it have? And do you think that it will speed up the deal of the century with China?

I do take this investigation very seriously and I believe Mr. Putin and Gazprom do as well. Just to give an illustration: after the EU opened the investigation, Putin issued a decree that prohibited Gazprom from giving certain information to the EU. This was very helpful for Gazprom, as they could now turn the EU Commission and say “we would love to give you the papers but the presidential decree forbids us.” The investigation is not the biggest threat to Gazprom in the European gas market. The main challenges for Gazprom in the European market are connected to market (liberalization) developments, such as the spread of gas storage capacity and LNG terminals from western to eastern Europe, including LNG projects in former Gazprom strongholds. These projects, even more than all the regulation put in place by Brussels, give Europe a stronger negotiation power vis a vis Gazprom. The competition regulatory committee, investigating Gazprom anti competition case, is strong and adequate, however the changes in European gas markets are the result of market forces rather than regulators. These regulators have only played a supplementary or marginal role in this regard. Market forces rather than regulators drive Europe’s need for more suppliers and the accompanying diversification. This has changed the fundamental situation and brings choice to European consumers.

Question: It is my understanding that the role of Gazprom is to bring socio-economic benefits for Russia. However, if the gas market is liberalized, who is going to fulfill the role to gasify remote areas in, for instance, the eastern Russian regions?

The gas in the far eastern Russian regions is sometimes more expensive for consumers based on net-back prices than in regions of certain European countries. To illustrate this, ten years ago the people in the far eastern regions wanted to replace coal with gas from Sakhalin due to lower prices. Now, the price of gas has increased and these people want coal back, it is simply cheaper for them. A colleague and I calculated that if Gazprom had been unbundled into 5 or 6 companies, these companies would have required $80 or $90 per thousand cubic meters to make a decent market based profit and invest in the future development of their networks and companies. Most consumers now pay $110, therefore Gazprom is not at all helping these remote locations. They are not subsidizing these regions. I think Russia has already bypassed the competitive price threshold and no single company is selling gas without profit margin. Some people argue that this export monopoly is justified since Gazprom is a big donor of the Russian budget. However it is not at all a big donor. Roughly 45% of income of the government comes from oil and gas, but only 5% comes from Gazprom and the other 40% comes from oil. If this is compared to the different out-puts of these industries, Gazprom alone is bigger than the total Russian oil industry.

Gazprom heavily underpays to the government’s budget but at the same time asks domestic consumers to pay more and more.

This clearly shows that Gazprom pays far less tax and therefore contributes far less even though it is by itself bigger than the complete oil industry. In 2004 when there was a big increase in taxation, on the mostly private oil industry, the gas industry was untouchable and is still mostly untouchable. The mineral extraction tax on gas is about $30 per thousand cubic meters, whereas for oil it’s $130 per metric ton. This is a huge gap. Gazprom heavily underpays to the government’s budget but at the same time asks domestic consumers to pay more and more. A third important issue is that all streams – Bluestream and Nordstream – receive tax exemptions from the state. Bluestream gas that is transported to Turkey is completely free of tax. This gas is completely exempt from export duties even though export duties are the main streams of revenue for the government.

Question: Some people believe that Russia should stay in control of these resources. What do you think is more important, high control or high profits?

The issue is that the general Russian population tends to favor control because they assume that it eventually leads to benefits for the state. However, this is not at all the case. So far, the control over companies has not led to increased profits. If we look at the taxes paid by private companies and state controlled companies, we can see that private companies contribute far more to the budget. For example, Lukoil is paying far more taxes than Gazprom even though they are 5 or 6 times smaller. The problem with state-owned companies is that the bureaucracy in Russia is not capable of dealing with new and complex projects. The division of labor should be that companies explore their fields, make their profits, pay their taxes, and then they are free to spend their profits. This is the best way to increase state revenue. Since the public is unaware of the real situation, we fight to tell people that the country gains more from private industry than from the state controlled companies. This public perception comes from a lack of knowledge of facts.

Question: What is your opinion on Turkey? In terms of its oil and gas dependence on Russia and possible diversification to northern Iraq, Turkmenistan etc. Do you think Russia views Turkey as a threat or is Turkey not enough of a transit state to threaten Russia?

Turkey is significantly improving Gazprom’s balance sheet. The rest of Europe is lowering its gas purchases and Turkey is the only country that is rapidly increasing its purchases. However, the Russian state does not profit from these sales since the gas is not taxed with export duties. If it were taxed, Gazprom would probably not be able to sell profitably to Turkey. Some people argue that Gazprom should start operating on the now open Turkish market and establish a presence before someone else will. But what is the benefit for the state if no taxes are paid? Taxation is the ultimate interest of the Russian federation. This national treasure should work for the benefit of the Russian state and people. It is not Gazprom who owns the gas; it is Russia’s gas and should therefore bring something to the state. Another aspect is the relation between Russia and Turkey. Turkey wants to promote itself as a transit hub for multiple sources. Geographically, Turkey is one of the few options for countries that want to bypass Russia to Europe. Russia has been jealous of the fact that Turkey buys Azeri gas and resells it to Europe. Russia is taking two steps to limit Turkey’s power as a transit state without openly contesting their actions. First, Russia is trying to please Turkey to outplay the other countries that want to sell gas to Turkey, thereby making it harder for these sellers. Second, Russia is trying to pressure European consumers to make them go away from the temptation to buy non-Russian gas. Russia tries to keep countries reliant on Russian gas. Additionally, Russia believes that the Trans-Caspian pipeline will not be operational soon. The relations between Azerbaijan and Turkey are still too difficult to make this pipeline work. It is more of a dream and therefore Gazprom and Russia are not too worried. From Russia’s viewpoint, Turkey remains a major transit competitor to Gazprom. Turkey maintains a very solid and independent approach to things and I don’t think Gazprom has much leverage to change that.

When the first concepts of the reform were drafted in the year 2000, we had no clue that Gazprom would not only remain a state monopoly, but would start buying electricity companies. This was a nightmare.

Question: You have discussed the success of liberalization of the coal market. What are your ideas on the electricity market?

The liberalization of the electricity market is not as successful as that of the coal market. In April 2003, right in the middle of the developments in electricity reform in Russia, a colleague and I wrote a memo to two government officials working on the reform, warning about one major issue: the need for a sufficient amount of independent market players interested in competing. If we would have been able to achieve a market structure that could have ensured a sufficient number of independent players – privately owned and interested in competing with each other – then the whole electricity reform could have had a positive effect. If the ownership of generation was going to be more cartel-type with a very limited number of players, somehow connected – particularly to the state – then it could turn out to be a disaster. The liberalization and lack of competition could result in growing electricity prices and lack of private investment in upgrading capital scope of generation companies. Unfortunately, we see that this scenario has happened and I think there are two major things that contributed to that; one, the general pattern of development in the Russian energy sector and economy that was not envisioned at that time. When the first concepts of the reform were drafted, in the year 2000, we had no clue that Gazprom would not only remain a state monopoly, but would start buying electricity companies. This was a nightmare. If we had been told, then we would have spent all our time trying to prevent this from happening. It is a very unfortunate development for a competitive power market when fuel companies start to interfere and become integrated with power companies because fuel supplies can then be used as leverage to influence competitors – something Gazprom is currently doing. We also had no idea that the government would stay involved at this level. The government retains more than 50% control over hydro generation. What is also important is that there was hope for more (international) investors such as Yukos, but many are, in fact, leaving. We hope for more Russian and international players. So we don’t have clean foreign investors, there is no competition; most is in the hands of state. Large business groups are effectively acting as a cartel and are in control of price. The second factor negatively influencing the outcome was a state official in charge of selling the state-owned parts to private investors, only interested in the price and not in who got to own the assets. Thereby, he created a situation in which a few rich people and companies could buy everything. He thought that Russians would remember him for the money he brought in, rather than for the contribution to market development. This greatly and negatively contributed to the non-competitive situation in the electricity market.

Before the pricing war was launched with Ukraine in 2007, they had sold 54 bcm to Ukraine, in the past couple of years it was around 30 bcm. In the first half of this year (2013), they sold just 9 bcm to Ukraine, which may lead to just 20 bcm for the year.

Question: It seems that the liberalization of LNG exports is put in place as a punishment for Gazprom. How much of the market share does Gazprom have to lose before the Russian government will give the export license to someone else or create a situation where limited competition is allowed?

The fact that Gazprom is losing market share in the European market is, of course, not good. There are a number of reasons for these losses; Russian decision makers still have the opinion that they can dictate the market. Therefore they do not consider the needs of their consumers. Gazprom is basically an Soviet enterprise – it was never reformed. It was just a bunch of guys from St. Petersburg with nice suits and ties. There is an old Soviet joke about a deputy director of a Soviet enterprise in marketing and sales, who once called his department and said, “Guys, you have to congratulate me, I got rid of all our clients so you do not have to do anything in the office and still receive the same salary.” The reason I use that joke is that I switched on Russia 24 channel and literally almost dropped my cup of coffee because I heard the woman host say the following text: “Yesterday, the board of directors of Gazprom was deciding on the strategy in Europe. Whether to sell more gas volumes at a discount or less gas at higher price. They chose to sell less gas at higher price.” This was considered to be a good practice since it did not matter anyway, Russian gas had to be bought by Europe. This can be clearly illustrated in the case of Ukraine. Before the pricing war was launched with Ukraine in 2007, they had sold 54 bcm to Ukraine, in the past couple of years it was around 30 bcm. In the first half of this year (2013), they sold just 9 bcm to Ukraine, which may lead to just 20 bcm for the year. This is what happens when you push this strategy. However, there is no concern among top decision makers, unfortunately. With regard to the LNG market, you are right when you say that Putin understands that Russia is outdated. He has been brainwashed with the idea that we need more pipes and more streams. When he takes a look at the international gas market, he can’t deny the growth of LNG. Putin’s worries come more from the fact that Russia is not present in that part of the market rather than from a lack of overall strategy. The LNG market shows Putin’s position. There is no real competition. Rather, it is systemic bargaining among influential people within Putin’s inner circle – people he cannot refuse their share. At the same time, he lacks an obvious plan/strategy for the development of LNG projects. If he does not interfere, he is trying to maneuver between clans and parties. These clans have grown in the last year and it has gotten harder and harder for him to maneuver. When he does interfere, it means he has a strategy.

Question: What is the biggest misperception of the Russian people with regard to their government?

The real problem is information blockade, lack of awareness of the real situation. Our party wants to increase competition and clarity for voters everywhere. The Russian people are very interested in learning the real information; our party educates and explains how everything really works in society and business. It is difficult for Russian people to receive unbiased information due to state control over most information channels. For example, due to the distorted information flow to normal people, they think they would die without Gazprom. They are completely unaware of the real situation – that Gazprom is not paying much in taxes. Most people believe that the increases in government spending, which went up significantly, are due to increases in social spending. However, it is not. It is due to subsidization of companies close to and aligned with the government. Spending on so-called national economy was 1.7 trillion rubles. It is the biggest growing expenditure of the Russian government in past years.

At the same time it is very difficult for our political party to go to people directly, as this is very costly and time consuming. In general, the opposition parties in Russia struggle to raise funds. Our party is built on grassroots movements and we don’t rush. We have started from the bottom of society. Thereby we can educate the normal people and help them in their daily life. We do not (yet) aim for presidency.

Question: You have been arguing against state controlled and vertically integrated companies. However, there are success stories of vertically integrated companies that bring benefits to their country. What makes other countries, such as Norway, different? Is Russia suffering from a resource curse?

I have a different vision on resource curse. In my opinion, it is possible to develop a country only with resources, look at Australia and Brazil; it is not necessarily a curse. There can only be one conclusion with regard to the efficiency of state controlled companies; there are efficient state controlled companies. However, these companies are a small minority compared to more profitable non-state controlled companies in the oil and gas sector. As a general rule, an effective state company might exist, but in most cases it is still an exception. It can be debated what efficient state controlled companies are; these debates mostly go on within the home country. If a state is in control, there is sometimes the perception that it is inefficient and paying too little in taxes.

Question: How is the quality of Gazprom Public Relations?

The public relations of Gazprom are something special, and not always adequate for the situation. We now see the aftertaste of the vision of ten years ago. The idea, as explained by top management, was that importing countries would become more dependent. This is still present and results in snubbing behavior. The signal sent from the top is that Gazprom is cool and the rest in EU is not. Europe is not as dependent as it was it previous decades, therefore the Russian attitude has to change. The result should be a more equal participation and thinking towards the European market. The people that work in the public relations branch in Brussels know what top management thinks and they carry out what is given to them. Bad PR is a consequence of this behavior.

Tsvetalin Radev and Koen van Delft are MA students in the ENERPO program at European University at St. Petersburg.