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Responsible Investment, Gazprom


How a Corrupt Gas Company Became One of the World’s Most Valuable Businesses

Orient Global was founded in 2006 following the demerger of Sovereign Global, a substantial portfolio investor in global emerging markets from 1986 to 2006. 3



As Goes Gazprom, So Goes Russia


Capital Misallocation without Accountability


Encouraging Dialogue


Breaking the Ice


The Government Finally Acts... ... The Transformation Begins


Towards Prosperity



“What is good for Gazprom is good for Russia” Banner hung at Gazprom Headquarters

As Goes Gazprom, So Goes Russia Throughout more than two decades of investing around the world, we have observed first hand the relationship between corporate governance, effective capital allocation and national prosperity. These issues took on particular importance in Russia as the country transitioned from communism to capitalism in the early 1990s. The Price of Poor Corporate Governance As Russia worked to undo the legacy left by 74 years of central planning, there was one issue that didn’t get much attention: corporate governance. Given the poor legal and financial infrastructure that existed as approximately 15,000 companies switched from state control to the private sector, the oversight was perhaps inevitable. There would, however, be a high price to pay. In 2001, when an analyst at Troika Dialog, Russia’s largest brokerage firm, analysed the cost – in the form of reduced equity prices – of Russia’s poor corporate governance, he put it at a whopping $54 billion.1 However, even this would prove to be a vast understatement. Gazprom, Russia’s National Champion Gazprom is Russia’s largest corporation with 340,000 employees, and the world’s largest hydrocarbon company controlling one-third of the world’s known natural gas reserves. The importance of Gazprom to Russia’s economy cannot be overstated. In 2000, the company accounted for over 5% of GDP, 15% of export reserves and 20% of tax revenues. Sovereign Invests in Gazprom Our investment philosophy focuses on world-scale companies in the world’s largest developing economies. Gazprom was not only a natural investment choice for Sovereign, but for any large institutional investor in Russia. After making an initial investment in May 1994, Sovereign gradually increased its stake and by February 1998 it owned nearly 5% of the company’s shares.2 A Complete Lack of Transparency Gazprom had extraordinary potential; it enjoyed a monopoly in Russia and supplied 20% of Western Europe’s gas needs. The company also reported healthy pre-tax profits - $7.8 billion in 1996, having risen from $931 million in 19943 – although it was impossible to

know if these numbers were accurate given that they were not subject to internationally-recognised audits. Furthermore, these encouraging returns were offset by Gazprom’s fiscal woes: the Russian government froze Gazprom’s accounts in October 1996, saying it owed $2.8 billion in back taxes4; the company posted losses of $7 billion in 1998 and $2.8 billion in 1999; and in a sign of how bleak conditions had become at the company, and in the region, in 1998 Gazprom accepted $1 billion worth of food from Belarus and Ukraine in lieu of payments and then used this food to pay its tax bills to the Russian government.5 Meanwhile, as a result of insufficient investment, production declined sharply. Gazprom’s Value Reflects Corporate Governance Discount Complicating reform at Gazprom was not just its size, but its entanglement with the state. Even after being privatised, 37% of Gazprom’s shares were owned by the Russian government, which initially left the management to run the company as if it were a family business. The ties between the company and the government were uncomfortably intimate, with Prime Minister Viktor Chernomyrdin a former Gazprom CEO and important Gazprom affiliates having close ties to the private family members of Gazprom’s leadership. State involvement contributed to serious corporate governance shortcomings, which in turn led the company to be severely undervalued among investors. Despite energy reserves six times greater than Exxon Mobil, Gazprom’s market capitalisation was just a fraction of its respective international peer. In August 1994, Baring Securities calculated that Gazprom was being valued at just 0.3 cents per barrel of oil equivalent, while the comparable analysis valued British Gas at more than $10 per barrel.6



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Russian Eurobond Price, 1998 - 2002 ($)






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Gazprom Share Price, 1996 - 2000 ($)











Capital Misallocation without Accountability As Russia’s formerly state-controlled economy shifted into private hands, Gazprom was faced with a multitude of fiscal, structural and cultural challenges. The Ring Fence – When Power and Principles Collide One fundamental problem for Gazprom was its two-tier share structure, which separated the domestic and foreign markets for Gazprom shares. This structure - known as a “Ring Fence” – empowered the company to approve (or deny) purchases of domestic shares by foreign investors. This, in turn, depressed Gazprom’s liquidity, and discouraged domestic investors. The Ring Fence created a great disparity between the fair value of the company and its market capitalisation, limiting its flexibility to finance its investment needs and therefore advance its long-term interests. By separating shareholders into two groups, the Ring Fence also undermined management’s accountability to shareholders. In May 1997, new rules were introduced limiting the ability of foreign investors to purchase Gazprom shares in the domestic market, as well as limiting the overall stake of foreign investors to 9% (later raised to 20% in March 1999).7 A few months later, Gazprom banned the sale of its shares through mediators, thus forcing its stockholders to meet in person with a depositary.8 Furthermore, owners of domestic registered shares looking to sell were required to offer their shares back to the company before offering them to a third party (a rule that expired in December 1998). Uneconomic Capital Investment Practices The Ring Fence was symptomatic of broader mismanagement at Gazprom. The company’s senior leadership engaged in little long-term planning and lacked the financial expertise necessary to manage such a large enterprise. Many business decisions were driven by a preoccupation with politics such as $1 billion in investments or loans to the influential Most media company. Gazprom also had large investments in non-core assets such as agricultural enterprises. As former Soviet farms collapsed in the 1990s, Gazprom provided them with

financing and eventually became the largest agricultural landowner in Russia.9 1998, the Russian Debt Default Leads to Stock Market Collapse In 1998, the Russian Government defaulted on its domestic debt obligations amounting to $40 billion. As a result, Russian Eurobonds fell from 100% to 20% of par value, the stock market fell 95% in dollar terms and in under one month, the Rouble fell 70% against the dollar. Gazprom’s share price fell from a high of $1.70 in late 1997 to as little as 4 cents less than a year later, which was representative of the market’s and Russia’s problems. Russia’s largest company was languishing, plagued by discredited management, collapsing profits, opaque business practices and a distracted major shareholder - the Russian State. The company was in such dire straits, many questioned its survival. The Oligarchs Undermine the Establishment of a Trust Based Market In the mid-1990s, a small group of businessmen came into control of many of Russia’s largest companies. Known as the ‘oligarchs’, these businessmen corrupted both the privatisation process and government officials in order to obtain significant shareholdings in key commodity and industrial companies. With Russia’s near financial collapse, the behaviour of the oligarchs grew ever more extreme – stripping assets, defaulting on loans and issuing dilutive shares to force out minority shareholders. The undeveloped legal system was wide open to such abuse and even where laws did exist, enforcement was virtually non-existent. The oligarch’s unscrupulous behaviour was often facilitated by international investment banks who were happy to adopt local rules enabling them to operate without any sense of moral conscience.



Encouraging Dialogue The 1998 debt default exposed the weak foundations of the Russian capital markets which were now in a state of crisis. Corporate management and regulators were failing in their responsibilities to investors. Trust had been broken, confidence shattered and investors had vanished. Stock market volumes had collapsed and without significant changes, capital and investment would continue to flee Russia. It was against this backdrop that Sovereign organised a conference in April 1999 for leading capital markets participants, to address the structural weaknesses which resulted in a lack of transparency and basic investor protections. Sovereign’s corporate governance efforts focused on bringing the questionable business practices of Gazprom executives to the attention of the Russian government and Gazprom’s board. If Gazprom was to survive, let alone prosper as a national champion, it would have to address corruption by increasing transparency, holding management accountable and instituting effective internal controls and capital discipline. Sovereign’s proposed reforms for Gazprom included: • An end to the sale of gas assets to opaque companies (such as Itera) at questionable prices; • Transparent tendering for construction and service contracts and a review of related party transactions; • Formal return on equity hurdles for capital investment decisions; • The reduction of investments in non-core assets such as media, banking, metals and manufacturing; • The reduction of excessive foreign currency borrowing. Approximately $5.5 billion of the $7 billion losses in 1998 was due to foreign exchange losses on foreign currency borrowings; • The adoption of rational gas tariff policies which reflect costs of production and capital expenditure requirements; and • An end to the Ring Fence.



Breaking the Ice In private meetings, correspondence and published policy papers, Sovereign demonstrated that its proposed initiatives would deliver many benefits to Gazprom and Russia. Greater profitability, an enhanced ability to raise capital and a re-rating of the company by investors would all enable the company to increase investment and arrest declining gas production. More importantly, if Gazprom were to develop into a role model for good corporate governance, this would set an important benchmark for Russian industry. Boris Federov, Championing Reform One person who understood Gazprom’s importance in Russian society as well as its role in influencing Russian business culture and ethical standards was Boris Fedorov, a highly respected former Finance Minister. He appreciated that reforming the gas giant was more than a matter of national pride; it was an economic imperative. Sovereign nominated Federov to the Board of Gazprom as an independent candidate. A First Victory for Corporate Governance Reform A significant breakthrough was achieved at Gazprom’s June 2000 annual general meeting. The company had initially threatened to hold the meeting in Novy Eurngoy, near the Arctic Circle, in order to prevent minority shareholders from participating. When the AGM was eventually held, minority shareholders secured two seats on the board. Receiving the most votes was Federov, who courageously called for greater transparency and accountability by Gapzom management. Meanwhile the newly-elected Russian President, Vladimir Putin, replaced Viktor Chernomyrdin with Dmitri Medvedev as Chairman of the Board. The day these changes were made, Gazprom’s share price rose nearly 12%.10 Gazprom Board Begins to Press for Management Accountability The company soon began to pursue some important reforms. In October 2000, the board voted to require the company’s management to seek board approval whenever significant assets were being sold or bought. The move reflected concerns that Gazprom was continuing to transfer valuable assets to subsidiary companies in a manner that was generating personal benefits for Gazprom leaders.11

The allegations centred on the transfer of company assets to a U.S.-based company, Itera, which conducted business throughout the former Soviet Union. The little-known company, founded in 1992, quickly became the thirdlargest gas producer in Russia,12 and the transactions were widely believed to benefit Gazprom directors. A major Gazprom shareholder, Hermitage Capital, estimated in 2002 that Gazprom’s transactions with Itera had cost the company’s shareholders $13 billion over the previous decade.13 Management Denies Shareholder Rights An important challenge to Gazprom’s governance came on February 1, 2001, when minority shareholders exercised their legal right under Article 103 of the Russian Civil Code to demand an independent audit of the company be carried out by Deloitte & Touche. However, Gazprom’s management refused to comply with their legal obligation and permit the audit, claiming it to be “illegal and damaging” and that it would “contradict existing laws and principles of business ethics.” To mollify its critics, the company agreed to have an auditor review its ties with Itera - but it selected its own auditor, thus putting it in the position of auditing its earlier work with the outcome a foregone conclusion.14 The auditor issue was critically important, as the quality of the audits would determine the reliability of the company’s financial statements and the accountability of senior management for these numbers. The widespread belief that the numbers weren’t reliable – the audits notwithstanding – contributed to Gazprom’s depressed share price.


20th November 2000

Gazprom on the Grill 8

Questions are mounting about officials’ self serving deals. Pictured: Gazprom CEO Rem Vyakhirev with Russian President Putin

The Government Finally Acts... ... The Transformation Begins Gazprom was so powerful that is was called “the country of Gazprom”, with thousands of employees operating across 11 time zones and more cash and influence than the Russian government itself. Indeed, it was Gazprom who provided the energy to keep Russia running, and paid the Kremlin’s bills.

A Precariously Balanced Power With pressure building for reform, President Putin announced at an April 2001 meeting of his cabinet that he wanted the government to “increase transparency and efficiency” at Gazprom.15 However, if there was to be a change in management at the company, Putin would have to act decisively.

The Beginning of a New Epoch Soon after Miller’s ascent, he made it clear that a new era was set to begin at Gazprom: “We have to take as much consideration as possible of our shareholders and partners. We must also see to it that our profits and capitalisation increase”.16 It was no coincidence that Gazprom’s share price doubled within a month of Miller taking the helm.17

The consequences of a failed attempt could have been damaging for the relatively new president. Holding only 37% of the shares, the government needed to be sure it would control the Gazprom board whose members were likely to rally around Rem Vyakhirev, the company’s well entrenched CEO.

In June 2001, the board did not renew the contracts of three of Gazprom’s most senior executives, all of whom had been accused by shareholders of mismanagement.18 President Putin told reporters that month “We know that enormous amounts of money were misspent” 19, whilst Marshall Goldman, Professor at Harvard, observed: “Until [Alexei] Miller was brought in, Gazprom was being run as a private gift bag… It was a black hole of graft for his predecessor and their families.”

Sovereign, being the largest shareholder in Gazprom after the Russian government, assured the Presidential administration that they could rely upon the support of minority shareholders whose votes could be essential in providing the crucial swing seat on the Gazprom board. The Old Guard are Removed On May 30, 2001, Putin put his stamp on Gazprom by engineering the replacement of Vyakhirev with Alexei Miller, Russia’s deputy energy minister and a long-time Putin ally. The old guard had been ousted and a new era of state control had begun with a new awareness of the roles and responsibilities of management and shareholders.

The new mood of optimisim about the company’s prospects was captured by Boris Federov who wrote in the Financial Times: “The enormous task of transforming a company that stood for all the worst of Russia’s economy, into an international corporation that western investors can increasingly understand, has begun.”20


Towards Prosperity In the months and years that followed his appointment, Alexei Miller initiated important corporate governance reforms at Gazprom. Throughout its time as a shareholder, Sovereign sought to assist the company by providing recommendations on business development including corporate governance reform.

Real Corporate Governance Reform In December 2001, Gazprom’s board voted to re-acquire a 32% stake in a gas company, Purgaz, which was managed by Itera. (A report by PwC earlier that year had recommended the reacquisition, given that Gazprom had sold the stake for just $1,200 even though it was valued at $400 million.21 An oil and gas analyst with Moscowbased United Financial Group said the move was “the first real evidence of changed management at Gazprom.” 22 Over time, Miller moved to sever ties with Itera and to more stringently review procurement practices. He also recovered misappropriated assets, such as chemicals producer Sibur, as well as nearly 5% of Gazprom shares, valued at approximately $1 billion. And he pushed for the introduction of rational tariff policies, while striving to improve budgeting and succeeding in selling a number of non-core assets such as its $900 million stake in a media company. These and other moves enabled Gazprom to launch an international bond issue valued at $500 million in April 2002. Progress, not Perfection Yet mitigating some of this progress were some continuing corporate governance failures. Shortly after Miller’s appointment the company revealed it had provided $2.6 billion in loan guarantees to a company, Stroitransgaz, in which family members of Gazprom executives had a controlling stake.23


Similarly, an independent audit committee of the Duma had concluded a year earlier that Gazprom had provided $850 million in interest-free loans to friends and supporters of the company’s management.24 Also troubling was the refusal to eliminate the Ring Fence. There was activity – a commission was established in 2001 to study the matter and the government and Gazprom officials declared the Ring Fence would be eliminated in 2002 – but no action followed. The stalling by Gazprom management and the government created uncertainty which undermined the company’s market value and liquidity. Corporate Governance, a National Issue Coincident with Gazprom’s reforms were positive changes at other companies, prompting the Financial Times to write in 2003 of a “revolution in [Russia’s] corporate governance.” 25 Sovereign divested its holding in Gazprom between 2002 and 2004, believing that while the company still had much to do to build shareholder value, it was making steady progress. Alexei Miller publicly praised Sovereign’s efforts in June 2003: “Sovereign’s unwavering support as a long-term shareholder has played a major role in the course of development and introduction in Gazprom of higher corporate governance standards. This in turn has helped Gazprom to reinforce its position among leading international energy companies.”

The Ring Fence Finally Falls The Ring Fence, which created Gazprom’s two-tier share structure was finally eliminated in January 2006. The move enabled foreign investors to buy the company’s stock without restrictions and in just the first three days of trading the stock price increased 24%.26 Through the first four months of 2006, the company’s valuation increased by $100 billion.27 New Leadership Creates over $200 billion of Value Under Miller’s leadership, Gazprom’s profitability increased, from $440 million in 2001 to over $10 billion in 2005. The company’s market value has followed, rising from $14 billion when Miller took control of the company in 2001, to $269 billion by the close of April 2006, becoming the world’s third most valuable company.28 The valuation received a boost from the company’s announcements that it had reached agreement with China to build two natural gas pipelines, valued at approximately $10 billion. The Financial Times wrote in April 2006, “What until recently was a corrupt, inefficient utility descended from a Soviet ministry, is emerging as one of the world’s most powerful companies.” 29

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Gazprom Share Price ($), 2000 - 2006

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capital to Russian companies. This is a clear dividend to the national economy from Gazprom’s improving corporate governance. Meeting Future Challenges There are still a number of issues facing Gazprom, such as its extensive involvement in non-core businesses and its entanglement with the state. As the Organisation for Economic Cooperation and Development has said, “It can at times be difficult even to identify where the state budget ends and Gazprom’s begins”.30 Indeed, Miller himself has publicly acknowledged that, “In Russia, the energy sector is developed on the basis of the State Energy Strategy adopted by the Government of my country.” 31 The corporate governance progress that Gazprom has made over the past decade has been significant. There could hardly be more compelling evidence than its stock market performance. While there is still more to do, Gazprom is already an example of the benefits for a company, and even a country, of the adoption of good corporate governance standards.

Furthermore, as a result of Gazprom’s increased valuation, the Russian stock market received a higher weighting in Morgan Stanley Capital International’s (MSCI) emerging market index. As a result, institutions will significantly increase their portfolio investments in Russia, lifting valuations and liquidity and thereby reducing the cost of


Endnotes 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. 13. 14. 15. 16. 17. 18. 19. 20. 21. 22. 23. 24. 25. 26. 27. 28. 29. 30. 31.


“Minority What?” The Economist, February 24, 2001. “Secrets of Sovereign”, Institutional Investor, March 2006. “Gazprom Announces Profits, Sale of Stake”, Moscow Times, June 1, 1996. “State Hits Gazprom for Back Taxes”, Moscow Times, October 2, 1996. “Gazprom Will Pay Taxes with Food ”, Moscow Times, October 24, 1998. “Foreign Capitalists Brush Aside Risks to Invest in Russia”, New York Times, October 11, 1994. “Decree Enforces Gazprom Share Ban”, Moscow Times, May 29, 1997. “Gazprom Blocks Sale of Shares by Proxy”, Moscow Times, September 4, 1997. “Workers’ Paradise is Rebranded as Kremlin Inc.”, New York Times, April 24, 2006. “Kremlin’s Men Join Gazprom Board”, Moscow Times, July 1, 2000. “Directors Act on Asset Sales at Gazprom”, New York Times, October 28, 2000. “It’s Time for Gazprom to Come Clean”, Moscow Times, November 14, 2000. “Investors Launch Actions Over PwC Audits of Gazprom”, Financial Times, April 16, 2002. “PwC Under Fire Over Double Role in Probe of Russian Gas Groups”, Financial Times, February 1, 2001. “Putin Seeks a Cleanup at Gazprom”, New York Times, April 10, 2001. “Kremlin Tightens Grip on Gazprom”, Moscow Times, July 2, 2001. “Kremlin Tightens Grip on Gazprom”, Moscow Times, July 2, 2001. “Gazprom Power Base Shifts”, Financial Times, June 20, 2001. “Russia’s Enron?” Business Week, February 18, 2002. “Boris Federov, “Putin’s Task”, Financial Times, June 18, 2002. “Russia’s Enron?” Business Week, February 18, 2002. “Gazprom to Buy Back Stake in Purgaz”, Financial Times, December 18, 2001. “Gazprom Reveals Link to Stroitransgaz”, Financial Times, June 14, 2001. “Secrets of Sovereign”, Institutional Investor, March 2006 “A Fresh Revolution Unlocks Many Secrets”, Financial Times, October 9, 2003. “Gazprom: Open for Global Investors”, Business Week Online, January 13, 2006. “Gazprom Makes an Energy Deal with BASF”, New York Times, April 28, 2006. “Russia’s Shy Man of Energy”, Financial Times, April 29, 2006. “Russia’s Shy Man of Energy”, Financial Times, April 29, 2006. “Energy of the State”, Financial Times, March 14, 2006.


All rights reserved. No part of this document may be reproduced or transmitted in any form or by any means, electronic or mechanical, without the prior written permission of the publisher. Whilst every care is taken in the preparation of this report, no responsibility can be accepted for any error or omission contained herein. Š 14 Designed and produced by Orient Global.



Gazprom Investment Profile  

Responsible Investment, Gazprom 2 Orient Global was founded in 2006 following the demerger of Sovereign Global, a substantial portfolio inve...

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