Gazprom's Debts, Costs Are Becoming a Liability

Surging costs and record new debt levels at Gazprom are setting off alarm bells, even as the fate of its bid to become one of the world's top energy majors hangs in the balance in a Houston courtroom.

At a time when gas prices have been soaring at home and abroad, Gazprom racked up record levels of debt to send its net debt up $2.69 billion to an all-time high of $15.2 billion by the end of last September, according to an analysis by Renaissance Capital of its latest financial report to international accounting standards for the third quarter of last year. Gross debt also stood at a record $19.7 billion.

Operating costs soared too, rising 14 percent year on year in the third quarter in dollar terms to $5.1 billion, and leaving the company cash flow negative overall, Renaissance Capital said.

Even though net income more than doubled to $1.6 billion, analysts said Wednesday that the surge was due to a one-off debt settlement deal with Ukraine that closed in August.

"This is shocking," said Adam Landes, oil and gas analyst at Renaissance Capital. "From a financial performance perspective, Gazprom is doing very badly at the moment."

"Without a market structure in Russia, Gazprom's costs and capital spending will continue to grow and its financial position will continue to deteriorate. This is a massive long-term problem."

No one at Gazprom was available to comment on its rising costs Wednesday, a public holiday.

Investors shook off fears over Gazprom's inefficiency after President Vladimir Putin last September announced that the company would merge with state-owned oil firm Rosneft, and would lift barriers to foreigners' owning Gazprom shares. The merger is aimed at boosting the state's stake in the gas giant to a controlling one, opening the way to greater foreign ownership.

The deal to liberalize the market in Gazprom shares, if it comes off, could make it an emerging market investment heavyweight to rival Korea's Samsung.

But the fate of the merger, and the liberalization, is now in the hands of a Houston judge who could decide later this week whether to allow troubled oil major Yukos bankruptcy protection in the United States. If jurisdiction is granted, Gazprom's merger with Rosneft could be in jeopardy, as Rosneft would face legal action over its acquisition of Yukos' main production unit, Yuganskneftegaz, in breach of a Houston court ruling banning the sale.

If the judge refuses jurisdiction and Gazprom merges with Rosneft, it could become the owner of almost 20 percent of the nation's oil production, and join the ranks of the world's top oil and gas producers, such as Saudi Arabia's Aramco.

As the market waited for a ruling, the release of Gazprom's latest financials late Monday further exposed it as a nontransparent runaway spender with few returns to offer investors, analysts said. That does not bode well for the economy as Gazprom bids to increase its clout by moving into the oil and electricity sectors.

"If Gazprom is going to return to being the oil and gas ministry, then it is going to be very difficult to get any accountability about what drives the company, apart from expanding its assets," said Mattias Westman, CEO of Prosperity Capital Management, which holds $550 million in Russian stocks. "It's already a cash cow for the government. But it's not a cash cow for shareholders."

Most investors last year bailed out of Yukos and other oligarch-owned stocks and moved into Gazprom and other companies seen as Kremlin-friendly, as the government stepped up its attack against Yukos. Westman's fund, however, has always steered clear of Gazprom.

As a result, while the rest of the investment community reaped the gains from the surge in Gazprom's value in anticipation of liberalization, Prosperity lost out. But Westman said he was sticking to his guns.

"Gazprom has the biggest gas reserves in the world and is operating in a good environment, and yet it still does not have any free cash flow," he said. "This is absolutely shocking. It has always been inefficient and has never had a positive cash flow. But now I think it's getting worse."

Ian Hague, a fund manager at New York-based Firebird Management, which holds $1 billion in Russian stocks, said Gazprom's rapid growth in debt levels could start constraining its ability to attract more financing. "Gazprom's never going to go bankrupt," he said. "Because of its massive reserves, it can always collateralize what it borrows. But now they are approaching a period where they will find it increasingly difficult to raise financing," he said.

That could be a stimulus for the government to make sure plans to liberalize the share market go ahead, as it would raise the gas giant's market capitalization and lower the cost of borrowing, Hague said. "Russia is not going to allow itself to become a hostage to global financiers, and it will not allow Gazprom to have its assets potentially impaired," he said.