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The Sunday Times: Special Report: Make or break for Shell in Russia

Success in Siberia is vital to restore its reputation and secure reserves. By Tracey Boles in Sakhalin
SAMER SLIM grew up in the heat of Lebanon, but he has made a quick adjustment to the bone-chilling temperatures of Siberia. If it gets above -10C, he works in a T-shirt.
It sounds mad, but -10C feels warm in Siberia, where the temperature can drop to -40C.
Slim is in the frontline of Shell’s ambitious drive to cement its place in the lucrative Russian oil and gas scene. He works on Sakhalin, an island north of Japan off the frozen coast of Siberia. Sakhalin is a narrow island, as long as Britain, and home to oil and gas reserves equal in size to those left in the North Sea.
Slim is in charge of laying a stretch of two 800km pipelines that will carry oil and gas landed from Shell’s offshore fields north of the island to a new, liquefied natural gas (LNG) terminal in the south, where ships are not hindered by sea ice.
It is a mammoth undertaking, and one being closely monitored not only by Shell executives — the company admitted last year that its costs had doubled to $20 billion (£12 billion) — but also by environmentalists, who are highly critical of the project.
Because of this, teams of contractors have to be extremely careful when they lay the pipelines across the island’s 1,000 rivers, streams and brooks.
Each crossing takes an international team of 30 contractors and observers, plus numerous excavators, laying machines and pumps. They aim to complete a river crossing in six to ten hours. Topsoil is restored on the banks and gravel relaid on the river beds so that salmon will be able to spawn.
In oil industry jargon, Sakhalin is an “elephant” — a giant oil and gas field. When complete, Shell’s Sakhalin II development will deliver 150,000 barrels of oil a day and 9.6m tonnes of LNG a year, or 7.5% of current global demand for LNG. The project is central to Shell’s plan to recover from the reserves scandal in 2004 when it had to admit that it had exaggerated its “proved” reserves.
Shell and its minority partners in Sakhalin Energy — Japan’s Mitsui and Mitsubishi — have rights to four billion barrels of the island’s 45 billion oil and gas reserves in the block known as Sakhalin II. It is Shell’s biggest single project, and the largest direct foreign investment in Russia.
Shell will obtain revenues of several billion dollars from the island. Jeroen van der Veer, chief executive, believes the company’s future lies in such huge exploration programmes. The oil giant hopes that Sakhalin will be a stepping stone to an even greater prize, Russia’s vast, untapped Arctic reserves, believed to contain hundreds of billions of barrels of oil and gas.
Chris Finlayson, chairman of Shell in Russia, said: “All natural-resources companies have to go where the natural resources are. Russia has 40% of the world’s natural gas and is the largest oil producer after Saudi Arabia. Russia is by definition very important. It is where the opportunities lie.”
He said Sakhalin would give Shell an “edge” when it competes for contracts in other areas in Russia such as the Arctic and the rest of the Sakhalin shelf, which has nine exploration blocks in total.
However, Sakhalin is an elephant that is proving difficult to control. The scale of the cost increase was a big blow to the oil giant and grist to the mill of those who have criticised the Sakhalin II development.
The timing was delicate for Shell because it is negotiating an asset swap with Gazprom in which the Russian company will take 25% of Sakhalin II. In return, Shell will get cash and a 50% interest in the Zapolyarnoye gas field in West Siberia. The asset swap is expected to be finalised this year.
On Sakhalin itself, local Shell executives are enthusiastic about the project’s prospects. The $1 billion pipelines are due for completion next year and the export facility should be operational by the middle of 2008.
Ian Craig, chief executive of Sakhalin Energy, the Shell consortium installing the new infrastructure, said: “Sakhalin is a world-class oil and gas province. It is close to the consumer markets of Japan, Korea and China that will be driving a lot of future energy demand.”
Besides building the export terminal and the two pipelines down the length of the island, Sakhalin Energy is installing two giant platforms offshore.
The bases of the platforms were put in place last year after being towed from South Korea. Amec, the British company that designed them, said the oil platforms are the biggest of their type in the world.
This year, Sakhalin Energy hopes to arrange $6 billion of new financing with banks that include Japan’s JBIC and the European Bank for Reconstruction and Development, to install the topside of the Lunskoye gas platform, and continue to lay the onshore pipelines.
Sakhalin II has attracted criticism on the island itself, where some feel that the production agreement is slanted too far in Shell’s favour. Craig said Shell will make “substantially less” than the $50 billion Sakhalin II will generate for Russia in royalties and taxes over the next 40 years.
Others feel the project is disrupting the local community as many now work on Sakhalin II instead of its other big industry, fishing. The development employs 17,000 people, including 35% of the island’s population.
The project has caught the attention of environmental groups all over the world because, as well as being located near salmon spawning grounds, it infringes on the feeding grounds of the Western gray whale. There are only 100 of these whales left, including just 23 breeding females.
Local opposition and endangered whales are only two of the obstacles facing Shell as it develops Sakhalin II, however.
Ice floes from the Amur river mean Sakhalin endures Arctic-type conditions for nearly six months of the year. The average winter temperature is -24C. Earthquakes frequently shake the island, which is littered with unexploded ordnance from the second world war.
Shell said the conditions on the frontier project are the most extreme it has had to operate in. The sheer complexity of Sakhalin II has also led the company into difficulty. Its four main elements — the platforms, an onshore processing facility, the pipelines and the LNG terminal — are each expensive undertakings in their own right.
Shell underestimated some of the challenges. Scouring on the seabed from giant ice floes penetrated much deeper than it anticipated, meaning subsea pipelines to the platforms had to be laid more deeply. There were delays in getting approvals. Russian contractors were not experienced in the island’s unique conditions. Drilling did not go as smoothly as planned. The price of materials such as steel rose. The value of the rouble went up. Costs seemed to rise on all fronts until the company was forced to announce the $10 billion overrun last year.
Shell is determined to get Sakhalin II right. It knows it must if it is to stand a chance of winning other frontier exploration contracts in Russia. In December, it failed to make the shortlist for the contract to explore Shtokman on the Barents Sea. It is time for Shell to prove that it has tamed the Sakhalin “elephant”.

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