OREANDA-NEWS. The EU Competition Commission's formal objections to Gazprom's business practices in eastern Europe may accelerate the trend towards market-based pricing, Fitch Ratings says. The most likely outcome is further reduction of oil-linked pricing in eastern Europe, which represents less than 30% of Gazprom's European gas sales. This will bring pricing more into line with north-west Europe, where hub-based pricing dominates. The final outcome is unpredictable, but our scenario analysis suggests any changes are by themselves unlikely to threaten Gazprom's 'BBB-'/Negative rating.

The process is likely to take years to complete, and over this time we believe that economics will force both sides to reach a workable solution. Gazprom's low production costs and abundant supplies, a solid, wealthy European market, and existing pipeline infrastructure still present a compelling case for trade on both sides.

In the meantime, Gazprom and its European buyers are seeking to diversify. Gazprom is constructing a pipeline to China and has plans for a second. Combined capacity would be about two-thirds of the natural gas it supplies to Europe.

Diversification of supply in eastern Europe includes Lithuania's recently launched Klaipeda LNG terminal, which could import up to 20% of the country's gas in 2015, including LNG from the US. Poland's Swinoujscie LNG terminal should be ready in mid-2015, potentially channelling nearly a third of the country's gas demand. But even with these new projects, eastern Europe will have to rely on Russia for most of its gas for the foreseeable future.

Whether gas market-based pricing would be negative for Gazprom is not clear. When oil prices were over USD100/bbl, spot gas prices were usually below oil-linked prices. But lower oil prices make the spot gas price advantage to customers less clear. Gas is complex to transport, which allows different pricing regimes around the world. Even within the EU the infrastructure is subject to bottlenecks, with limited interconnections. This makes it difficult to predict how any market-based solution will evolve and who will benefit.

Determining the outcome of the EU process with any degree of precision is also impossible at this stage. But to understand better the potential magnitude of a change in business practice, we stressed our current forecasts for Gazprom's EBITDA and funds from operations (FFO) in 2015-2017. Our stress case assumptions include a 20% drop in sales volumes to eight eastern European countries due to higher competition from LNG and a 20% reduction in prices to align them closer with western and central Europe. This translates into a 4% drop in both Gazprom's overall gas sales volumes and average gas prices in Europe. We also stressed Gazprom's EBITDA margin to account for moderate penalties or retroactive payments that Gazprom may be forced to make as a result of the European Commission's findings.

Gazprom's EBITDA and FFO dropped by 10% under the stress scenario compared to our original rating case. Its net FFO-adjusted leverage increased by up to 25% in 2015-2017. This is material, but would be unlikely to lead to negative rating pressure by itself due to Gazprom's headroom under our current rating triggers. Any actual impact is also likely to take longer to be felt as the process will be drawn out.

The European Commission's statement of objections to Gazprom alleged market abuses in some business practices in Bulgaria, Czech Republic, Estonia, Hungary, Latvia, Lithuania, Poland and Slovakia. Potential implications for Gazprom include large, but probably still manageable fines and changes to its contracts to allow off-takers more discretion in re-selling gas to other countries.