Fitch Affirms Gazprom at 'BBB-'; Outlook Negative
The ratings reflect our expectations that Gazprom will remain a vital gas supplier to Europe. We expect competition in the European gas market to intensify in the near future, as new LNG production projects come on-line globally. However, Gazprom's low cost position should help the company maintain its market share, provided it responds to changing market conditions. Gazprom's new projects, mainly the Power of Siberia to supply gas to China, should enhance the company's business profile in the long term but they could stretch leverage and free cash flow (FCF) in the next two to three years.
Gazprom has significantly reduced its presence in the international debt markets amid Russia's geopolitical tensions with the west; however, the company's one-year liquidity is strong. In 2015-16 Gazprom issued two medium-term Eurobonds, in October 2015 (EUR1bn, three years) and March 2016 (CHF500m; 2.5 years) but its ability to borrow larger amounts in the international Eurobond markets remains untested. We assume that Gazprom will be able to maintain its liquidity by borrowing from Russian banks, as well as occasionally international and Chinese debt markets.
Gazprom is Russia's largest state-owned energy company, engaged in natural gas production, transportation and distribution, as well as crude production and refining, heat and electricity generation. In 2015, Gazprom produced 445 billion cubic metres (bcm) of natural gas, including its share of associates, and generated RUB1,874bn (USD31bn) EBITDA. Its end-2015 funds from operations (FFO) adjusted net leverage was 1.3x, one of the lowest among global oil and gas companies.
Gazprom's ratings and Outlook are constrained by those of the sovereign, in view of the influence Russia (BBB-/Negative) exerts on the company as a key shareholder and through taxation.
KEY RATING DRIVERS
European Volumes Stable, Prices Falling
In 2015, Gazprom's exports to Europe (including Turkey) were 159bcm, up 8% yoy. Gazprom's total sales in Europe, including trading operations, amounted to 184bcm. The increase in exports is partly attributed to the volumes sold to Europe and re-directed to Ukraine (10bcm in 2015 vs. 5bcm in 2014). Gazprom's 1Q16 average gas prices in Europe fell to USD187.5 per thousand cubic meters (mcm), from USD284/mcm in 1Q15 and USD372/mcm in 1Q14. We expect Gazprom to maintain its market position in Europe by volume, but expect its realised prices to average around USD180/mcm in 2016, and to remain below USD190/mcm in 2017.
Weak FSU and Domestic Markets
Gazprom's 2015 gas sales volumes to former Soviet Union (FSU) countries and in Russia collapsed 16% and 5% yoy, respectively, reflecting a continuous gas conflict with Ukraine, which almost entirely stopped buying Russian gas in mid-2015, a weakening Russian economy and intensifying competition from domestic producers. FSU gas prices collapsed in line with Europe's, while domestic gas sales prices increased 4% yoy in rouble in 2015 and fell 35% in dollar terms to USD60/mcm, the lowest in years.
At the same time, sales in Russia should become a more important profit driver for Gazprom on the back of falling export prices. We estimate that in 2015 its domestic prices were 2.2x lower than the average export netback (export prices minus export duty and transportation) and that this ratio should reduce to 1.5x in 2016.
European Gas Prices Depressed
European gas prices have been negatively affected by weakening oil prices. We estimate around one-half of European gas imports remain oil-linked, though we believe this proportion will continue to decrease and there will be a gradual convergence of prices between various hubs. We also believe that Europe may attract more LNG volumes, including from North America, which may result in a slower price recovery.
Gazprom's strong competitive position in the European market is determined by the company's low cost position, available infrastructure and high natural gas reserves, as well as the company's long-term contracts with 'take-or-pay' provisions. We estimate Gazprom's current production cash costs, including transportation and export duty, at around USD3/mcf (USD106/mcm). However, we believe Gazprom may need to continue providing concessions to European customers to maintain its market share, including increasing the share of spot pricing, selectively relaxing take-or-pay obligations and reducing prices.
European gas prices started to fall in late in 2013, to USD4.6/mcf (USD162/mcm) in 2Q16 (for the UK National Balancing Point, or NBP) from USD11.2/mcf (USD395/mcm) in 4Q13. We assume prices to gradually recover to USD5.5/mcf (USD194/mcm) in 2017, USD6/mcf (USD212/mcm) in 2018 and USD6.5/mcf (USD229/mcm) in the long term.
Moderate Leverage, Negative FCF
We estimate Gazprom's FFO adjusted net leverage will increase to 1.9x at end-2016 and to 2.0x at end-2017, from 1.3x at end-2015, due to weak forecast oil and gas prices, an additional RUB100bn tax charge which we believe is likely to remain in place in the near future, and high, but falling, capex.
In addition, the metrics will be negatively affected by Gazprom's buyout of a 3.59% stake from Vnesheconombank for around RUB130bn. Nevertheless, we expect Gazprom's leverage to be below our negative rating action trigger of 2.5x. In net debt-to-EBITDA terms excluding Fitch's debt adjustments, we expect Gazprom's leverage to increase to 1.6x in 2016 and 1.7x in 2017, from 1.1x in 2015.
We expect Gazprom's FCF after dividends to be negative at least in 2016 and 2017, financed by the company's vast cash reserves and possibly additional borrowings. Gazprom should be able to broadly balance its after-dividend cash inflows and outflows by 2018.
Diversification into China
Gazprom's diversification into China is credit-positive in the long term. Deliveries through the Power of Siberia pipeline from the currently developed Chayanda and Kovykta greenfields should start in 2019-2021 and will gradually reach 38bcm/year. Gazprom has never explicitly announced the contract price, but our assessment is that it should be roughly around USD250/mcm (USD7/mcf), assuming a Brent price of USD65/bbl. We estimate this price should allow Gazprom to earn around USD5bn of incremental EBITDA annually.
Another project discussed by Russia and China is the Power of Siberia II; however, it is still not clear whether the project will go ahead as China's natural gas demand may not grow as fast as assumed before.
Gazprom said in 2014 its total investments in the Power of Siberia I would amount to USD55bn over the project's lifetime; however, we believe the amount will be materially lower due to the rouble's depreciation. We believe that Gazprom should be able to finance the project according to schedule; however, it will negatively affect its leverage and FCF in the next several years. In 2016, total capex associated with the project amounted to RUB168bn, 11% of Gazprom's capex budget.
New Pipelines to Europe
Gazprom is contemplating two prospective pipeline projects that, if completed, would allow it to significantly reduce gas transit via Ukraine, which still accounts for nearly half of Russian gas transit to Europe. The first is Nord Stream II, the 55bcm capacity Lines 3 and 4 of Nord Stream, doubling its total capacity to 110bcm. The second is the 32bcm (previously planned - 63bcm) capacity Turkish Stream (via the Black Sea and Turkey to Southern Europe), which may now be revived as geopolitical tensions between Russia and Turkey ease.
There is no certainty that the projects will be realised due to political hurdles as Europe is exploring ways to reduce its dependence on Russian gas. Our base case scenario is that the projects are unlikely to be realised at the same time, due to political and funding constraints.
European Antitrust Investigation
The European commission opened anti-trust proceeding against Gazprom in August 2012, and the investigation is still ongoing. The commission believes that Gazprom may have abused its dominant market position in central and eastern Europe by charging excessive prices and reducing the customers' ability to resell the gas cross-border. Gazprom denies the claims. There are no firm dates when the investigation will be completed.
According to EU rules, antitrust fines cannot exceed 10% of a company's revenue, which for Gazprom amounts to USD6.5bn (based on its revenue as projected by Fitch). Our base case is that the parties will manage to find an amicable solution with Gazprom, by possibly providing further concessions to its customers in central and eastern Europe. A large fine (which is not our base case) can potentially affect Gazprom's liquidity and financial position, but not to the extent that would threaten current ratings, in the absence of other negative developments.
Ongoing Disputes with Naftogaz
Gazprom's ongoing disputes with NJSC Naftogaz of Ukraine (CCC) are exacerbated by Russia's political tensions with Ukraine. The companies signed a 10-year gas supply contract in 2009. Ukraine is disputing it in the Arbitration Institute of the Stockholm Chamber of Commerce though Gazprom considers it to be legally binding. In addition, Naftogaz claims the 10-year gas transit contract signed in 2009 is unfair and seeks to increase transit fees. In turn, Gazprom believes that Ukraine does not honour its 'take-or-pay' obligations under the gas delivery contract and has also filed litigation. Naftogaz's claims against Gazprom amount to USD26.6bn, compared with Gazprom's counter-claim of USD38.7bn.
The final decision on both cases should be delivered in early 2017. While there is no certainty on the outcome of the litigation, we view a scenario under which Gazprom will be required to pay large compensation to Naftogaz as unlikely. We believe that although Gazprom's sales to Ukraine may remain minimal, this will be partially offset by higher sales to Europe, as Europe and Gazprom are Ukraine's only imported gas sources.
Fitch's key assumptions within our rating case for the issuer include:
- Fitch's Brent price deck: USD42/bbl in 2016, USD45/bbl in 2017, USD55/bbl in 2018 and USD65/bbl in the long term
- NBP: USD5.0/mcf in 2016, USD5.5/mcf in 2017, USD6/mcf in 2018 and USD6.5/mcf in the long term;
- USD/RUB exchange rate: RUB69 per 1 USD in 2016, RUB68 in 2017, RUB62 in 2018 and RUB57 in the long term;
- Slightly higher gas exports to Europe; slightly lower Russian and FSU gas volumes in 2016-2019 compared with 2015;
- Gazprom's average European gas price influenced by Brent with a six-month lag and spot natural gas prices;
- Capex falling 15% yoy in 2016 and 5% yoy in 2017 in rouble terms;
- The minimum required cash balance is assumed at RUB150bn. This amount is deemed not readily available for debt service.
Negative: Future developments that may, individually or collectively, lead to negative rating action include:
- Negative rating action on Russia, stemming from a sharp decline in international reserves, failure to recover from recession, coupled with significant deviation from stated macroeconomic and fiscal policy aims, or a rise in geopolitical tensions or sanctions risks (for more details see 'Fitch Affirms Russia at 'BBB-'; Outlook Negative', dated 15 April 2016 at www. fitchratings. com).
- Material deterioration of credit metrics, e. g. FFO adjusted net leverage above 2.5x (2016E: 1.9x) and FFO interest cover of below 8x (2016E:8.6x) on a sustained basis due to a prolonged decline in oil and gas prices, aggressive capex or sizable acquisitions.
- Significantly falling gas sales to Europe.
- Prolonged interruptions in gas transit via Ukraine to Europe.
- Deteriorated liquidity.
Positive: - An upgrade is unlikely at present, given the sovereign's ratings and Outlook which constrain Gazprom's ratings. Positive triggers for the Russian sovereign rating potentially leading to the Outlook being revised to Stable are: continued commitment to contain expenditure and implementation of a credible medium-term fiscal framework, and avoiding further significant depletion in international reserves.
At 31 March 2016, Gazprom had RUB1,565bn in cash, sufficient to cover RUB660bn of short-term debt and projected annual negative FCF of RUB381bn, including dividends and the buyout of its shares from Vnesheconombank. However, without new borrowings Gazprom's strong liquidity position could worsen in 2017. Our base case scenario is for Gazprom to restore its strong liquidity in 2017-18 by attracting new loans from domestic and, possibly, Chinese banks, as well as occasionally issuing international bonds.
While Gazprom is currently exempt from US/EU financial sanctions, its oil subsidiary JSC Gazprom neft (BBB-/Negative) is subject to US and EU financial and sectoral sanctions. We view stringent US and EU sanctions against Gazprom unlikely, as Gazprom is Europe's key gas supplier.
FULL LIST OF RATING ACTIONS
Long-Term Foreign Currency IDR: affirmed at 'BBB-', Negative Outlook
Long-Term Local Currency IDR: affirmed at 'BBB-', Negative Outlook
Foreign currency senior unsecured rating: affirmed at 'BBB-'
Short-Term Foreign Currency IDR: affirmed at 'F3'
National Long-Term Rating: affirmed at 'AAA(rus)', Outlook Stable
Gaz Capital S. A.
USD40bn debt issuance programme and the notes issued thereunder
Foreign currency senior unsecured rating: affirmed at 'BBB-'
OOO Gazprom Capital
Debt issuance programme and the notes issued thereunder
Local currency senior unsecured rating: affirmed at 'BBB-'
National senior unsecured rating: affirmed at 'AAA(rus)'
Gazprom ECP SA
Commercial paper programme: affirmed at 'F3'