Why Russia's Gazprom is a Buy

Kenneth Rapoza
Why Russia's Gazprom is a Buy

Gazprom is the one Russian company investors cannot ignore, especially managers of energy and emerging market funds. The Russian government owned company sits on the biggest natural gas reserves in the world and is right next door to two energy intensive neighbors: Europe and China. It is a drama free supplier of gas to these markets, and has become a more reliable energy partner than the state run companies in the Middle East, many mired in political turmoil.

The stock sits on the top of the heap of emerging market stocks in the $15.38 billion DFA Emerging Markets Value (DFEVX) and the $12 billion GMO Emerging Markets (GEMMX) mutual funds, surpassing other energy companies like Brazil oil giant Petrobras (PBR).

What makes Gazprom a buy is its position in the natural gas market, its massive reserves, and regional demand for the only clean burning fossil fuel around.

In the volatile global energy markets, Gazprom increased its gas exports 30% this month compared to May 2010 as unrest in the Middle East and a nuclear crisis in Japan boosted demand for Russian natural gas abroad, the company's chief executive officer, Alexei Miller, said in a transcript posted on the Kremlin's website on May 28. Miller said that the company's natural gas exports were 12% more in the first quarter compared to 1Q10, and 20% more in April compared to April 2010.

"Any manager of a global fund would have an energy sector and I would make the case for such a fund to own Gazprom," says John Connor, manager of the Third Millennium Russia (TMRFX) mutual fund. "It's got great market share, no monopoly purchasers, great cash flows and strong projected pricing dynamics. I run a Russia fund so it would be absurd for me not to own Gazprom. But, I have underweighted it for years. Not anymore. I've increased the fund's holding from 4% to 6% this year and plan to continue slowly on up 8%," Connor says.

Gazprom has been between 40% and 50% of the Russian MICEX exchange's market cap for  years.  It did not performed as well as other commodities last year because the government has put high taxes on Gazprom at home, and capped natural gas prices. That's changing. The new and ongoing domestic tax adjustments are part of the Russian government's decision to bring the domestic price up to world market levels.  Gazprom is going to see higher natural gas revenues going forward as a result.

"The bulk of Gazprom's sales are in the domestic market. When the government says it wants to close the pricing gap between national and international natural gas prices by allowing prices to converge, you are automatically looking at about a 15% price change for Gazprom. It's not going to happen all at once, but Gazprom is going to start see a revenue boost," says Mike Reynal, fund manager of the $1.79 billion Principal International Emerging Markets (PIEIX) fund.

There are some fundamental tail winds that are good for Gazprom, too. After Japan's near-nuclear meltdown in March at the Tokyo Electric Power Company Fukushima nuclear power facilitiy, both Japan and Europe are less gung-ho about nukkes. Natural gas is the most readily available alternative for countries that have strict environmental standards with limits on the amount of CO2 they can release into the atomosphere each year. Natural gas is as clean as hydrocarbons get, and Russia is a friend next door.

"Gazprom shares have gotten whip-sawed because investors are not sure how the price gap reduction is going to play out, but we like the stock," says Reynal. "Long term, if you want safe, fast access to natural gas, Russia is a lot more attractive than North Africa. Gazprom suddenly becomes a lot more valuable to a lot of people, not just to the shareholders," he says.

Gazprom's history dates back to the old Soviet Union in 1946 upon commissioning of the Saratov–Moscow gas pipeline. Gazprom State Gas Concern was established in 1989. In 1993 the Concern laid the foundation for setting up Gazprom Russian Joint Stock Company, which was renamed in 1998 as Gazprom Open Joint Stock Company, now listed on the London Stock Exchange.

Gazprom has over 33 trillion cubic meters of natural gas reserves, according to the company. It produced over 461 billion cubic meters of natural gas in 2009.

Russia is often considered the Wild East to Western investors. Plagued with corruption and a lack of transparency, Russia is rarely considered a top pick within the universe of big emerging market equity. But that is changing. The government of Dimitry Medvedev is forcing all government officials out of the boards of state-run, and mixed-capital corporations like Gazprom. The government wants to become a safer haven for foreign investors, and has addressed corruption issues over the past several years. A new Russia is trying to emerge again, says Connor.  Gazprom is a big part of the changes taking place in corporate governance.  Anyone who believes Russia might become more shareholder friendly in the mid- to long term, and thinks that natural gas prices are going to trend higher in the years ahead, might want to give Gazprom's London listed shares a look.

World's Proven Natural Gas Reserves as of Jan. 2010

1. Russia: 47,570,000,000,000 cubic meters, accounts for 25.02% of world's total.

2. Iran: 29,610,000,000,000, 15.57%

3. Qatar 25,470,000,000,000, 13.39%

4. Turkmenistan: 7,504,000,000,000, 3.95%

5. Saudi Arabia: 7,461,000,000,000, 3.92%

6. United States: 6,928,000,000,000, 3.64%

7. United Arab Emirates: 6,071,000,000,000, 3.19%

8. Nigeria: 5,246,000,000,000, 2.76%

9. Venezuela: 4,983,000,000,000, 2.62%

10. Algeria: 4,502,000,000,000, 2.37%

Source:CIA World Factbook