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International Herald Tribune: Shell’s success in Russia hinges on Sakhalin site

By Stephen Voss Bloomberg News

Published: July 21, 2006
 
YUZHNO-SAKHALINSK, Russia The photos on the wall of Samer Slim’s office catalogue the hurdles that Royal Dutch Shell must overcome on Sakhalin Island: ice-choked drilling rigs, snowmelt-swollen rivers and wilderness so remote supplies are dropped by helicopter. His T-shirt warns of another: “Beware of Bears.”

 
“You’ve got rivers, railways, mountains, swamps, seismic faults, everything, on this section,” said Slim, 35, supervising engineer for the southern reach of an 800-kilometer, or 497-mile, pipeline across the island. “The hardest time is the end and beginning of winter because of the rain and mud.”
 
Shell has turned to the frigid seas north of Japan as dwindling energy supplies force producers to venture into more hostile locations. Costs for the Shell-led Sakhalin II project, the company’s biggest single investment, have doubled to $20 billion, undermining Shell’s effort to convince investors that it can bounce back after being forced repeatedly to restate its reserves.
 
“Shell, like its peers, requires access to resources,” said Craig Pennington, energy researcher at Schroders. “They claim to have learned a huge amount from Sakhalin and that it will give them the ability to take on equally large projects in the future. That remains to be seen.”
 
On Sakhalin, Shell, Europe’s second- biggest oil company after BP, is struggling with rising costs for steel, equipment and labor. Environmental groups seeking to protect whales and salmon have forced Shell to reroute pipelines, while the European Bank for Reconstruction and Development is reviewing the project before approving loans.
 
Shell, based in The Hague, is still recovering from the 2004 accounting review that forced it to reduce proven reserves by 5.63 billion barrels, or 29 percent. The cut cost the company’s chairman, Philip Watts, his job and persuaded Shell to ditch its century-old dual ownership structure.
 
Shell in May said it might miss its goal of replacing all the oil and gas it produces as rising prices for contractors and materials delay some projects. Under U.S. accounting rules, the company last year replaced 67 percent of the proven reserves that it pumped following exploration lagged behind its competitors. BP, in comparison, replaced 95 percent of reserves
 
The Shell chief executive, Jeroen van der Veer, thinks “unconventional” projects, which do not show up in U.S. reserve calculations, to become more important. Sakhalin II, oil sands in Canada and two deep-water fields in Nigeria and the Gulf of Mexico will produce the equivalent of one million barrels of oil a day in the next decade, a quarter of current output, Shell has said.
 
Sakhalin is a rich petroleum province, with as much oil and gas as the North Sea, attracting companies like Exxon Mobil, BP and India’s Oil & Natural Gas Corp. Shell’s venture is the most advanced. The island, once dotted with Soviet-era prison camps and top- secret military bases, also is one of the harshest environments in which to drill for oil.
 
Shifting pack-ice covers Sakhalin’s offshore fields for half the year, forcing Shell and its Japanese partners Mitsui and Mitsubishi to build twin oil and gas pipelines to an ice-free port under construction at the island’s southern tip.
 
The port will include the first Russian liquefied natural gas plant, which will cool gas to a liquid so it can be exported by ship. Deliveries are to start in 2008, with shipments rising to 9.6 million tons a year, equal to about a third of China’s gas needs. Most of the LNG has been sold to buyers from Japan to California.
 
Surging demand for oil in China and India has helped triple oil prices this decade, making it possible to finance projects that were not considered economically viable a few years ago. Shell’s first-quarter net income rose 3 percent to $6.89 billion.
 
The company reports second-quarter earnings on Thursday.
 
Still, investors’ appetite for risk on such projects is limited. Shell’s stock fell 6 percent in July 2005 when Van der Veer said costs for the second phase of Sakhalin II had doubled and LNG exports would start eight months late.
 
The cost overruns and delays were criticized as well by Gazprom, which two weeks earlier had agreed to swap half of a Siberian gas field for some of Shell’s 55 percent stake in Sakhalin II. The government and Gazprom are discussing whether to alter terms of the deal amid a probe into the setbacks by the Natural Resources Ministry.
 
Rising labor and steel costs, and a strengthening ruble have also played their part as oil prices increase energy exploration around the world. Efforts to preserve feeding grounds for western gray whales and spawning grounds for salmon have also increased costs.
 
The EBRD, established to promote development in the former Soviet Union and Eastern Europe, is examining the environmental and social record to determine whether to lend Sakhalin Energy about $200 million. The bank plans to decide by September.
 
Sakhalin Energy employs about 17,000 people on the island, 70 percent of them Russian. The venture projects that taxes and royalties for Russia will total $50 billion during the project’s 40- year life, with most going to the government. The government may yet pose the biggest threat to Shell’s Sakhalin profits – and the reserves the company can put on its books – should it demand a larger stake in the project.
 
 YUZHNO-SAKHALINSK, Russia The photos on the wall of Samer Slim’s office catalogue the hurdles that Royal Dutch Shell must overcome on Sakhalin Island: ice-choked drilling rigs, snowmelt-swollen rivers and wilderness so remote supplies are dropped by helicopter. His T-shirt warns of another: “Beware of Bears.”
 
“You’ve got rivers, railways, mountains, swamps, seismic faults, everything, on this section,” said Slim, 35, supervising engineer for the southern reach of an 800-kilometer, or 497-mile, pipeline across the island. “The hardest time is the end and beginning of winter because of the rain and mud.”
 
Shell has turned to the frigid seas north of Japan as dwindling energy supplies force producers to venture into more hostile locations. Costs for the Shell-led Sakhalin II project, the company’s biggest single investment, have doubled to $20 billion, undermining Shell’s effort to convince investors that it can bounce back after being forced repeatedly to restate its reserves.
 
“Shell, like its peers, requires access to resources,” said Craig Pennington, energy researcher at Schroders. “They claim to have learned a huge amount from Sakhalin and that it will give them the ability to take on equally large projects in the future. That remains to be seen.”
 
On Sakhalin, Shell, Europe’s second- biggest oil company after BP, is struggling with rising costs for steel, equipment and labor. Environmental groups seeking to protect whales and salmon have forced Shell to reroute pipelines, while the European Bank for Reconstruction and Development is reviewing the project before approving loans.
 
Shell, based in The Hague, is still recovering from the 2004 accounting review that forced it to reduce proven reserves by 5.63 billion barrels, or 29 percent. The cut cost the company’s chairman, Philip Watts, his job and persuaded Shell to ditch its century-old dual ownership structure.
 
Shell in May said it might miss its goal of replacing all the oil and gas it produces as rising prices for contractors and materials delay some projects. Under U.S. accounting rules, the company last year replaced 67 percent of the proven reserves that it pumped following exploration lagged behind its competitors. BP, in comparison, replaced 95 percent of reserves
 
The Shell chief executive, Jeroen van der Veer, thinks “unconventional” projects, which do not show up in U.S. reserve calculations, to become more important. Sakhalin II, oil sands in Canada and two deep-water fields in Nigeria and the Gulf of Mexico will produce the equivalent of one million barrels of oil a day in the next decade, a quarter of current output, Shell has said.
 
Sakhalin is a rich petroleum province, with as much oil and gas as the North Sea, attracting companies like Exxon Mobil, BP and India’s Oil & Natural Gas Corp. Shell’s venture is the most advanced. The island, once dotted with Soviet-era prison camps and top- secret military bases, also is one of the harshest environments in which to drill for oil.
 
Shifting pack-ice covers Sakhalin’s offshore fields for half the year, forcing Shell and its Japanese partners Mitsui and Mitsubishi to build twin oil and gas pipelines to an ice-free port under construction at the island’s southern tip.
 
The port will include the first Russian liquefied natural gas plant, which will cool gas to a liquid so it can be exported by ship. Deliveries are to start in 2008, with shipments rising to 9.6 million tons a year, equal to about a third of China’s gas needs. Most of the LNG has been sold to buyers from Japan to California.
 
Surging demand for oil in China and India has helped triple oil prices this decade, making it possible to finance projects that were not considered economically viable a few years ago. Shell’s first-quarter net income rose 3 percent to $6.89 billion.
 
The company reports second-quarter earnings on Thursday.
 
Still, investors’ appetite for risk on such projects is limited. Shell’s stock fell 6 percent in July 2005 when Van der Veer said costs for the second phase of Sakhalin II had doubled and LNG exports would start eight months late.
 
The cost overruns and delays were criticized as well by Gazprom, which two weeks earlier had agreed to swap half of a Siberian gas field for some of Shell’s 55 percent stake in Sakhalin II. The government and Gazprom are discussing whether to alter terms of the deal amid a probe into the setbacks by the Natural Resources Ministry.
 
Rising labor and steel costs, and a strengthening ruble have also played their part as oil prices increase energy exploration around the world. Efforts to preserve feeding grounds for western gray whales and spawning grounds for salmon have also increased costs.
 
The EBRD, established to promote development in the former Soviet Union and Eastern Europe, is examining the environmental and social record to determine whether to lend Sakhalin Energy about $200 million. The bank plans to decide by September.
 
Sakhalin Energy employs about 17,000 people on the island, 70 percent of them Russian. The venture projects that taxes and royalties for Russia will total $50 billion during the project’s 40- year life, with most going to the government. The government may yet pose the biggest threat to Shell’s Sakhalin profits – and the reserves the company can put on its books – should it demand a larger stake in the project.
 

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