How Gazprom turned up the heat on the West

The soaring concrete and glass office block thrusts towards the sky, like a rocket with its boosters strapped to its side, in downtown Moscow's Ulitsa Nametkina. After passing through security and handing over your passport to a stern-looking official, you cross a bleak windswept plaza to the tower of power. You don't need to be paranoid to feel hundreds of eyes bearing down on you. Once inside, your papers are scrutinised again and your bags put through X-ray machines. It is hard not to think of Fritz Lang's science fiction film Metropolis, with its giant tower filled with toiling workers yearning to be free.

The Moscow headquarters of Gazprom, considered by many in the West to be the heart of an "evil empire", projects power. It positively oozes it. The world's largest gas company, which has made Europe tremble by cutting off gas supplies to transit states in the height of winter, boasts security worthy of the Kremlin and it doesn't care who knows it. Because Gazprom is the Kremlin.

It is often called a state within a state. But Gazprom is the mother of all nanny states. It is the father, mother and (literally) babysitter of its 430,000 employees. In a company town like Novy Urengoi, on the fringes of the Arctic Circle, Gazprom not only houses its employees in Soviet-style blocks of flats, but it also runs the schools, shops, libraries and even the children's nurseries.

You need something of the pioneer spirit to work in the field for Gazprom, which occasionally opens up its closed cities in Siberia to Western journalists. In winter, the frozen wasteland is so cold, at minus 50-60C, that the droplets inside your nose freeze. Daylight begins to fade shortly after lunch. In summer, when the days are hot and humid, hordes of mosquitoes descend in search of human flesh.

In return for submitting to such extreme conditions, the Gazprom employees receive the Russian equivalent of a king's ransom, earning far higher wages than the national average and enjoying perks to match.

But Gazprom is not just a company providing a quarter of Europe's gas supplies. In 2005, it staged the biggest takeover in Russian history by buying the Sibneft oil firm for $13bn from Roman Abramovich, the owner of Chelsea Football Club.

It has gobbled up Russian television stations, major newspapers, a football team and Russia's third-largest bank. It owns an insurance company. It has an airline, and it builds roads. It

has Black Sea holiday resorts. It has controversial plans to build another soaring tower bang in the historic centre of St Petersburg. And, just for good measure, it runs a private army.

Its tentacles spread way beyond Russia's borders, thanks to the purchase of strategic energy assets in countries ranging from Belarus to Germany, where the Gazprom-sponsored FC Schalke football team wear blue Gazprom shirts, and is currently trying to muscle its way into the US market via Trinidad.

Last week, it emerged that a Gazprom associate, the billionaire Uzbek-born oligarch Alisher Usmanov, had bought a 14.5 per cent stake in Arsenal – fuelling speculation of a Russian-led buyout at another of Britain's top football clubs.

"Gazprom is a mutant," says the Oslo-based Russian analyst Pavel Baev. "People need to be aware of what kind of animal it is. It doesn't follow business logic or political logic. It's a mixture of a business empire and a presidential administration."

The company, which owns 17 per cent of the world's known gas reserves, is locked in an embrace with President Vladimir Putin's government. The state holds a stake of just over 50 per cent, and the Gazprom chairman is a deputy prime minister, Dmitry Medvedev, tipped as a possible successor to Putin when the President steps down next year. The board, and its chief executive Alexei Miller, one of Putin's former associates from St Petersburg, is totally loyal to Putin. Not for them the fate of the businessman Mikhail Khodorkovsky, the oligarch who paid for his independence by losing his company – Yukos, once the largest oil firm in the country – and ending up in a Siberian jail serving a nine-year sentence on charges of tax evasion and fraud.

When Alisher Usmanov bought the business newspaper Kommersant in 2006, he called in the editorial staff for a pep talk. "He said, 'We will not censor anything – but we will support the Kremlin,'" says a former Kommersant journalist. "They have no idea about the notion of freedom of speech." NTV, the formerly combative national television station bought by Gazprom in 2001, is now an infinitely more obedient beast, having lost the campaigning journalists who made its name. Izvestiya, the respected daily newspaper bought by Gazprom in June 2005, has become a Kremlin mouthpiece, just as it was in Soviet times. In the wake of the poisoning of Alexander Litvinenko by radioactive polonium-210, the newspaper reported that the former KGB agent, who died an agonising death in a London hospital, had poisoned himself. It also gave credence to the Kremlin claim that Litvinenko had himself poisoned the former agent Andrei Lugovoy, who is wanted by Britain for the murder of Litvinenko, and his colleague Dmitri Kovtun, who were both found to have been contaminated by polonium-210 and briefly hospitalised in Moscow.

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Gazprom was born in 1992, when the Soviet gas ministry was dismantled, and was partly privatised in 1994. But the leadership of Gazprom, closely linked to the government of Boris Yeltsin, was able to keep control by ensuring that sales of shares took place at closed auctions. For almost a decade, it was characterised by the corrupt practices and cronyism that were the hallmark of the Soviet era. But all that changed in 2001, after the American businessman Bill Browder, the chief executive officer of the investment fund Hermitage Capital Management and a minority Gazprom shareholder, exposed the extent of the fraud, asset stripping and insider dealing at the heart of the energy giant. The Gazprom chief executive, Rem Vyakhirev, was shown the door, and Putin brought in a new team.

Baev explains: "It's not a gas monopoly in the usual sense, because it can't fix prices and can't think strategically. Political expediency dictates its policy – its investment programme is revised more than once every year. This makes it very difficult for foreign partners."

Now, the order of the day is making Russia count in world affairs. And the Kremlin's instrument for doing so is Gazprom. In January 2006, just a month after Ukraine's "orange revolution", which ousted the pro-Russian leadership in favour of pro-Western reformers under President Viktor Yushchenko, the former Soviet republic suddenly found its gas supply had been switched off by Moscow, which raised prices fourfold overnight.

The cruel midwinter move sent European governments into a tailspin as they realised the inherent vulnerability stemming from their own dependence on Russian gas. The Kremlin promised that Gazprom would honour its contracts elsewhere, and that the shutdown to Ukraine would not have a knock-on effect in Western Europe. France, Italy, Poland, Austria, Hungary, Slovakia and Romania all suffered a dip in gas supplies as a result of Ukraine's disconnection, yet curiously Germany, which depends on Russia for 40 per cent of its natural gas supplies, was not affected. The former German Chancellor, Gerhard Schröder, is chairman of a Gazprom German-Russian pipeline that will carry gas to Europe via the Baltic.

Later that same month, another pro-Western former Soviet republic, Georgia, was the victim of unexplained sabotage to the gas pipeline, which left supplies cut off. The prime suspect was Russia, but Moscow simply accused Georgia of "hysteria" for suggesting that the Kremlin might be using gas as a political weapon.

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Western governments have become increasingly wary of Russia's reputation as a reliable energy source as Putin has moved to curb democratic freedoms ahead of next year's elections. Last year, the alarm spread to London. Gazprom was suspected of an interest in buying Centrica, the owner of British Gas. While an approach never came, it prompted speculation that the British government would move to bar Gazprom from buying a strategic energy asset, much in the same way that the Kremlin has now decided to stop foreign ownership of its own strategic interests.

"They were never interested in Centrica. Gazprom would have been mad at a time of such high costs," says the British energy specialist Jonathan Stern. He adds that Britain has allowed nationalised French companies to own utilities in the UK. "They find nothing wrong with it until it gets to people they don't like. And when you scratch beneath the surface, they don't like Vladimir Putin." Indeed, for Britain, the last straw was the poisoning of Litvinenko, a British citizen, in the heart of London.

The Moscow-based analyst Roland Nash criticises the "hypocrisy" which, it seems, would prevent Gazprom from taking over a major utility in Britain (although last year it bought Natural Gas Shipping Services, the sister company of Pennine Natural Gas). And Gazprom is clearly still sniffing for bargains in Britain, which gets 4 per cent of its gas supplies from Russia, although Gazprom officials expect that to rise to 10 per cent in the next five years.

Despite political relations having hit rock bottom between Britain and Russia over the Litvinenko poisoning, economic ties have never been so strong. Both sides were careful to ensure that when tit-for-tat diplomatic expulsions were ordered by London, followed by Moscow, as Britain protested against Russia's refusal to extradite Lugovoy for trial in the UK, there was no effect on the booming business that has led to Britain becoming the leading foreign investor in Russia.

At the same time, Gazprom has had such bad publicity from

the Ukraine and Belarus incidents that there would be a danger of it losing customers should it make major investments in Britain, according to Jonathan Stern, who is director of gas research at the Oxford Institute for Energy Studies. "The Tories would say that Gazprom shouldn't supply the NHS because they'll turn off the gas and all the patients will freeze," he said.

Britain remains especially wary following the experience of BP, whose TNK-BP joint venture agreed in June to sell its stake in the eastern Siberian gas field of Kovykta to Gazprom for up to £450m, after being accused by Russian officials of breaching the terms of its licence by failing to produce enough gas. This came after Shell and its Japanese partners were forced to hand over a controlling stake to Gazprom in the Sakhalin-II project in the Russian far east, after being accused of violating environmental clauses in the licence.

Then, last month, the French oil company Total was invited by Gazprom into its Shtokman field in the Arctic, despite having turned down a partnership offer from the same company last year, saying that it wanted to develop the field on its own. So what's going on? "Political favouritism," declares Roland Nash, who is the chief strategist of the Renaissance Capital investment bank. "It is very straightforward. Russia recognises that relations with France are better than with the UK."

So should we be afraid, very afraid, of the ever-expanding Gazprom behemoth? Not necessarily, say the experts, because Gazprom is sinking into its own feet of clay. In a sense, its management exemplifies a problem of the Russian economy as a whole, with companies falling more and more under political influence since Putin came to power in 2000. In the long run, according to the Prague-based analyst Petr Kratochvil, "it will lead to an ineffective economy because of the intertwining of business with politics. The company bosses will always agree with the politicians."

Far from its monster image, because of a combination of inefficiency and a chronic lack of investment, gas production is stagnating while domestic demand is growing, and Gazprom is obliged to meet its profitable export commitments to the West. The company is already having to branch out to the central Asian republic of Turkmenistan to help it meet demand, but that country too is suffering from under-investment problems. At the same time, Gazprom is subsidising prices to Russian consumers, meaning that it can barely cover its costs domestically. It has been ordered to hit its home users with a 15 per cent price rise.

If – or when – push comes to shove, who will Gazprom punish in order to maintain energy security for its lucrative Western customers? In the run-up to parliamentary and presidential elections, there is no question of Gazprom cutting off supplies in Russia.

For Pavel Baev, a specialist with the International Peace Research Institute, this means that another stand-off with a transit state from one of the former Soviet republics, such as Ukraine or Belarus, is inevitable. "They are the victims of choice," he says. "A new gas war is predetermined."

Belarus – whose Communist President Alexander Luka-shenko has been kept in power in part because of support from the Kremlin – was last month given an ultimatum to pay $460m in overdue charges or face the halving of it gas supplies. Lukashenko, who rules over what has become known as the last dictatorship in Europe, promptly caved in – reportedly thanks to a little help from his new ally, the Venezuelan President Hugo Chavez.

According to the American analyst Cliff Kupchan, a Russia specialist with the New York-based Eurasia Group risk analysis firm, there is no risk of a major disruption to Western gas supplies. He says: "Given the Ukraine episode and Belarus, Russia will be a quirky seller but not unreliable. There's an important difference. Where countries want reassurance is that Russia evolves further in its post-Soviet trajectory and that there will not be unusual political strings attached. What is unknowable is whether the hiccups are caused by relations with transit states – which I think – or whether there is a willingness to use energy as a political tool, which I don't think." In other words, if you happen to live in a former Soviet satellite state, you'd better start stocking up on firewood.

"The more Gazprom focuses on the economy and keeps out of foreign policy, the better for the world," says Roland Nash. He argues, after 13 years working in Russia, through good times and bad, that "it's better to engage. The best thing they could do is to tie it in economically."

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The European Union, meanwhile, seems to be heading in a different direction by starting to plan escape routes in order to be less dependent on the Russian gas pipelines. "The British government, the Merkel government – they're all going to be looking at alternative sources of energy," Kupchan says. But developing serious alternatives – including greater reliance on nuclear power – will take years.

Russia feels aggrieved at the lack of sympathy in the West for its argument that it is simply freeing up prices that have been kept artificially low for far too long. They are damned if they do, and damned if they don't.

The Russians also point out that there is nothing wrong with Gazprom wanting to control the chain of supply from extraction to delivery to the consumer. And as for political interference, it argues, take a look around the other gas exporters, where gas utilities are dominated by the state.

"There is this myth that we are making all this investment in Europe so that we can squeeze the customers there," Gazprom's deputy chief executive, Alexander Medvedev (no relation to Dmitry) said in a recent interview. "That's ridiculous. We are heavily dependent on Europe for our revenues."

But, at the same time, Gazprom recognises that it has a problem with its image as the neighbourhood bully. It has suffered from its association with the Kremlin, accused of an over-aggressive foreign policy that has seen Russia plant a flag on the seabed of the Arctic in pursuit of its claim to presumed vast amounts of mineral deposits, prompting talk of a "new Cold War" with the West. So, last month, it announced that it had taken on a trio of Western public relations firms.

Gazprom's chief spokesman, Sergei Kupriyanov, an austere and humourless figure who talks to visitors in a grim conference room inside Gazprom's equally grim tower, says that his company doesn't get "enough objective press". All that may change now, thanks to the new PR contracts. There's just one thing, though –two of the PR firms Gazprom has engaged also advise the Kremlin. Coincidence?

Gazprom: how it all adds up

By Ed Caesar

In 2006, Gazprom employed 432,000

Its annual earnings last year were 1,633bn roubles (£31.55bn)

With a current market value of more than $300bn (£150bn), Gazprom is the world's third-largest corporation, after Exxon Mobil and General Electric Gazprom's chairman estimates that the company's market value will quadruple in the next 10 years, making it the world's most valuable company

Gazprom began in 1989, when the USSR's Ministry of the Gas Industry was reorganised into a gas concern called Gazprom

Gazprom is the world's biggest extractor of natural gas

Gazprom accounts for 92% of Russian gas production, and controls 17% of the world's gas reserves

The European Union receives 25% of its natural gas from Gazprom

The Russian Federation owns

50.002% of the shares in Gazprom

Gazprom is the sole gas supplier to Estonia, Finland, Bosnia-Herzegovina, Macedonia, Moldova, Latvia, Lithuania and Slovakia

Gazprom has a private army

Gazprom is in the process of engineering a

558-milegas pipeline to carry 30 billion cubic metres of gas a year to southern Europe

Gazprom sponsors the Russian Premier Division football club FC Zenit St Petersburg and the German Bundesliga club FC Schalke 04. The deal with Schalke is said to be worth 25m euros (£17bn) a year

The chairman of Gazprom, Dmitry Medvedev, is also the Deputy President of the Russian Federation