OREANDA-NEWS. Fitch Ratings has assigned Gaz Capital S.A.'s (Gaz Capital) loan participation notes (LPNs) an expected senior unsecured 'BBB-(EXP)' rating. The planned notes are the 37th series to be issued under Gaz Capital's USD40bn debt issuance programme rated 'BBB-' by Fitch. The final rating is contingent upon the receipt of final documentation conforming materially to information already received and details regarding the amount and tenor.

The LPNs will be issued on a limited recourse basis for the sole purpose of funding a loan by Gaz Capital to PJSC Gazprom (BBB-/Negative). The proceeds from the loan are expected to be used by Gazprom for general corporate purposes. The noteholders will rely solely on Gazprom's credit and financial standing for the payment of obligations under the notes.

Gazprom's ratings reflect our expectations that it will remain a vital gas supplier to Europe over the medium term. European off-takers are still limited in their ability to diversify pipeline gas imports at the time when Europe is coping with declining indigenous gas production. Gazprom's new projects, mainly the Eastern Gas Program to supply gas to China and, to a lesser extent, planned LNG expansion, should enhance its business profile in the long term but they could stretch leverage and free cash flow (FCF). Gazprom's access to international banks and debt capital markets improved in 2015 despite geopolitical tensions over Ukraine, and its liquidity is strong. We also believe the latest US sanctions against the Yuzhno-Kirinskoye oil and gas field should not materially affect Gazprom's operations.

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. It is also the largest publicly listed oil and gas company in the world by hydrocarbon reserves and production. In 2014, Gazprom produced 445 billion cubic metres (bcm) of natural gas and generated RUB2,096bn (USD55bn) in EBITDA. Its end-2014 funds from operations (FFO) adjusted net leverage was 1.1x, one of the lowest among global oil and gas companies.

KEY RATING DRIVERS
European Gas Revenues Down
In 2014-1H15 Gazprom faced lower gas sales and prices in Europe (including Turkey), its principal market by value. Its 1H15 gas sales volumes to Europe were down 7% yoy to 80bcm, principally on lower sales in 1Q15. This was due to (i) the reduced off-take by European customers in anticipation of lower gas prices, as Gazprom still sells sizable gas volumes at oil-linked prices that track that of oil products with a six- to nine-month lag, and (ii) a relatively mild winter. Gazprom's average 1H15 gas prices in Europe were down 26% yoy to USD270 per thousand cubic metres (mcm), the multi-year low. We anticipate that European gas prices will fall another 15% in 2H15 on weak Brent, but sales volumes should increase on 1H15. In 2015-17, we expect European gas sales volumes to remain broadly stable despite the EU's efforts to diversify away from Russian gas and increase gas market competitiveness, as well as higher European gas prices in line with our rising Brent price deck with a time lag.

Falling Domestic and FSU Sales
In 1H15, Gazprom's domestic gas sales volumes were down 4% yoy as it continued to lose market share to OAO Novatek (BBB-/Negative) and OJSC OC Rosneft. Over the same period, its gas sales volumes to the Former Soviet Union (FSU) countries were sharply down by 32%, mainly due to a significant drop in shipments to Ukraine. Furthermore, as domestic sales represent over half of gas sales volumes, in 1H15 Gazprom's average gas price dropped to USD151/mcm or 31% yoy on the weak rouble. We forecast that Gazprom's overall gas sales volumes are likely to decrease further on continuing weak sales to Ukraine and domestic sales.

Chinese Deals Diversify Exports
In May 2014 Gazprom and China National Petroleum Corporation (CNPC, A+/Stable) signed a contract for gas deliveries via the 'eastern route'. It calls for gas deliveries of 38 bcm per year over 30 years, with first shipments expected in 2019, a take-or-pay clause and gas prices linked to oil products prices. The gas will be sourced from Gazprom's Chayanda and Kovykta fields in Eastern Siberia, currently under development, and delivered through the 4,000km Power of Siberia pipeline, currently under construction. The company estimated the project's total capex at USD55bn in May 2014, ie, before the significant rouble depreciation in 2H14. The current project cost in dollar terms is likely to be lower as its major part is rouble-denominated.

Gazprom and CNPC are also discussing a second gas deal with deliveries via the 'western route' (Power of Siberia 2). This would allow Gazprom to supply gas to China from its operating gasfields in Western Siberia and would consequently require less capex. In November 2014 the parties signed a framework agreement stipulating a potential delivery of 30bcm a year. These two projects, when completed, would allow Gazprom to diversify its exports way from the European gas market, a positive development for its credit quality in the long term. On the other hand, high capex associated with the 'eastern route' may result in a moderate deterioration of credit metrics and liquidity, exacerbated by the limited access to international capital markets.

LNG Ambitions Threatened
Gazprom's plans to expand its LNG business beyond the 2-train, 9.6m tons per annum (mtpa) capacity Sakhalin 2 project are threatened by the negative sentiment in the Asian LNG market and international sanctions. In August 2015, the US extended their sanctions to Gazprom's large Yuzhno-Kirinskoye oil and gas field (115.2 bcm in gas reserves and 21bcm per year plateau production expected in 2031) in the Sea of Okhotsk in the Far East of Russia, the prospective resource base for the third Sakhalin 2 LNG train, by prohibiting the availability of US-made equipment for its development. Prior to that, in July 2015, Gazprom signed a memorandum with Royal Dutch Shell plc (Shell, AA/Rating Watch Negative) that included, among others, the Sakhalin 2 expansion. Earlier this year, Gazprom said that it effectively shelved its plans to construct the 10mpta Vladivostok LNG announced in 2014.

Pipeline Projects Increase Capex
Gazprom announced two prospective pipeline projects that, if completed, would allow it to reduce gas transit via Ukraine, which still accounts for nearly half of Russian gas transit to Europe. The first is the 63bcm capacity Turkish Stream (via the Black Sea and Turkey to Southern Europe) announced in December 2014, in place of the defunct South Stream. The discussions with Turkey on Turkish Stream are currently ongoing. The second is Nord Stream II, the 55bcm capacity Lines 3 and 4 of Nord Stream, doubling its total capacity to 110bcm. In September 2015, Gazprom signed the shareholder agreement with E.ON SE (A-/Rating Watch Negative), Shell, OMV AG (A-/Stable), BASF SE (A+/Stable) and ENGIE Group to establish a joint venture for implementation of Nord Stream II.

We believe that Gazprom faces commercial and funding challenges on both projects that could hamper their implementation and significantly increase Gazprom's leverage if it had to raise funding for them directly. Raising multi-billion dollar project financing for pipeline projects could provide much harder at present, as Western sanctions have significantly hindered international funding to Russian corporates, even those not directly sanctioned.

Simultaneous construction of these two pipelines could therefore stretch Gazprom's credit metrics, albeit not enough to trigger a negative rating action. Gazprom would not be able to fund its share of capex from internally generated funds, as even before considering Nord Stream II and Turkish Stream capex we expected Gazprom to generate negative free cash flows of about USD3bn per year in 2015-2018 (after capex and dividends). If project financing were not available it could borrow directly to fund its share of pipeline projects' costs, but this too would be difficult and potentially expensive in the current environment.

Ongoing Disputes with Naftogaz
Gazprom's ongoing disputes with NJSC Naftogaz of Ukraine (CC) are exacerbated by Russia's political tensions with Ukraine. The 10-year gas supply contract signed in 2009 has effectively been abandoned (although Gazprom considers it to be legally binding) as Ukraine is disputing it in the Arbitration Institute of the Stockholm Chamber of Commerce. In addition, Naftogaz claims that the 10-year gas transit contract signed in 2009 is unfair. In turn, Gazprom believes that Naftogaz does not honour its 'take-or-pay' obligations under the gas delivery contract and has also filed litigation. While there is no certainty as to 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 continue to fall, they will be partially offset by higher sales to Europe as it remains Ukraine's only alternative gas source.

Solid Leverage, Negative FCF
Using our Brent prices deck of USD55-USD75 per barrel (bbl) in 2015-17, we forecast that Gazprom's leverage should stay within our guidance over the medium term. We expect the company's FFO adjusted net leverage to increase on lower US dollar-denominated revenues and ambitious capex programme and to fluctuate within the 1.0x-1.5x range. Gazprom has some flexibility to reduce capex without a significant impact on gas production should additional funding not be available.

EU Market Abuse Case
In April 2015, the European Commission sent Gazprom a statement of objections, alleging market abuses across central and eastern Europe. While the case's ultimate outcome for Gazprom may take years to become known, we expect Gazprom and the EU to reach a pragmatic agreement as Gazprom remains very important to Europe's energy supply. In September 2015, Gazprom submitted to the European Commission its proposals to the amicable resolution of the matter. Therefore, in our rating case for Gazprom, we have not included any monetary penalties. Should these be material, we will treat them as event risk.

'A' Unconstrained Rating
Gazprom's unconstrained rating corresponds to the mid-'A' rating category. This takes into account (i) the company's strong business profile as it remains the major natural gas supplier to Europe; (ii) its relatively low leverage; (iii) high profitability of operations even under lower oil prices; and (iv) unhindered access to domestic funding and presently sound liquidity. At the same time, Gazprom's unconstrained rating includes the two-notch discount for higher corporate governance and systemic risks that we apply to Russian companies' ratings. Gazprom's IDR is also constrained by Russia's current 'BBB-/Negative' rating to reflect the high level of influence that the state exerts over the company.

The moderate deterioration of Gazprom's financial metrics expected in 2015-17 stemming from lower oil prices and lower sales to Europe do not put much pressure on Gazprom's unconstrained credit profile in line with the 'through-the-cycle' rating approach by Fitch.

KEY ASSUMPTIONS
Fitch's key assumptions within our rating case for the issuer include:
- Fitch's Brent price deck: USD55/bbl in 2015, USD65 in 2016, USD75 in 2017 and USD80 in the long term.
- Flat European gas volumes and lower Russian and FSU gas volumes.
- European gas prices follow Brent with a six to nine month lag.
- USD/RUB exchange rate: RUB60 per 1 USD in 2015, RUB55 in 2016, RUB50 in the long term.
- Total group capex at around USD30bn p.a.

RATING SENSITIVITIES
Negative: Future developments that may, individually or collectively, lead to negative rating action include:
- Negative rating action on Russia, stemming from a financial sector instability, depressed oil prices, faster than forecast international reserves, intensification of sanctions and/or geopolitical tensions (for more details see 'Fitch Affirms Russia at 'BBB-'; Outlook Negative', dated 3 July 2015 at www.fitchratings.com).
- Material deterioration of credit metrics, eg, FFO net adjusted leverage above 2.5x and FFO interest cover of below 8x on a sustained basis due to a prolonged decline in oil and gas prices, aggressive capex or sizable acquisitions. Our base case forecast indicates that FFO net adjusted leverage will not exceed 1.5x and FFO interest cover will be above 10x in 2015-2018.
- Significantly falling gas sales to Europe (not offset by gas sales to China and/or LNG production).
- Prolonged interruptions in gas transit via Ukraine to Europe.
- Deteriorated liquidity.

Positive: Future developments that may, individually or collectively, lead to positive rating action include:
- An upgrade is unlikely at present, given the sovereign's rating and Outlook. The Outlook on Russia and hence on Gazprom could be revised to Stable should tensions with the international community reduce, resulting in a lower risk of wide-ranging sanctions being imposed and improved access to international funding.

LIQUIDITY
Strong Liquidity, Related-Party Balances
At 30 June 2015 Gazprom had RUB1,115bn in cash and short-term investments, more than sufficient to cover RUB508bn of short-term debt on that date. We note that RUB670bn or 60% of Gazprom's cash was held with OJSC Gazprombank (BB+/Negative), a related party under US and EU financial sanctions. Gazprom and its subsidiaries continue to have unhindered access to Russia's domestic banks. In August 2015 Gazprom raised a USD1.5bn loan due 2020 from a consortium of banks with China Construction Bank Corporation (A/Stable) acting as a bank agent, while its Eurobond issuance has largely stalled since 2014.

Sanctions Limit Funding Options
While Gazprom is currently exempt from financial sanctions, its oil subsidiary JSC Gazprom neft (BBB-/Negative) is subject to US and EU financial and sectoral sanctions. We view broader sanctions against Gazprom (e.g. those targeting with the supply of oil and gas from Russia) as unlikely given Europe's high dependence on Russian gas.