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ISN Security Watch (Moscow): Kremlin eyes Sakhalin hydrocarbon riches (MAJOR ARTICLE)

Russia’s ambitious plans to expand to Asia-Pacific energy markets see the island of Sakhalin as their cornerstone – and a battle ground against Western oil majors for greater state control.

By Sergei Blagov in Moscow for ISN Security Watch (12/09/06)

Russia’s Sakhalin projects have been seen as a cornerstone of Moscow’s ambitious plans to expand to Asia-Pacific energy markets. Meanwhile, the island of Sakhalin has emerged as a battleground for increased government control over international production-sharing agreements.

Earlier this year, Russian government agencies have launched a regulatory assault on Western investors in Sakhalin, as the Kremlin appears to be trying to regain control over strategic energy resources. Notably, on 5 September, Russia’s Rosprirodnadzor announced plans to overturn its own earlier judgment, which dated back to 2003, to approve the Royal Dutch/Shell-led Sakhalin-2 project as ecologically safe.

Rosprirodnadzor, the Russian acronym for Federal Service for the Oversight of Natural Resources, said in a statement it had asked a Moscow court to rule that the Sakhalin-2 project was not in compliance with ecological regulations. The court’s agreement with Rosprirodnadzor’s arguments would entail a shutting down Sakhalin-2, the agency said.

Rosprirodnadzor started an inspection of Sakhalin-2 on 25 July and completed the first part of the audit on 31 August. The first part of the probe included a study of documentation concerning three offshore oil rigs: the Molikpaq, platforms in the Piltun-Astokh and Lunskaya license areas, as well as the pipelines connecting these platforms with the shoreline.

The Natural Resources Ministry and Rosprirodnadzor are expected to pursue the second phase of the audit in September-November, including on-site inspection of all Sakhalin-2 facilities. On 11 September, Rosprirodnadzor started the audit of the Sakhalin-1 and Sakhalin-4 projects.

On 5 September, Rosprirodnadzor also said it had asked prosecutors to investigate whether any forestland had been destroyed or damaged illegally in the laying of a shoreline pipeline.

In August, the Russian Academy of Sciences submitted a report to the Natural Resources Ministry highlighting geological processes endangering shoreline-pipelines as part of Sakhalin-2. The report said some 20 kilometers of the pipeline were under threat from floodwaters, and suggested suspending the construction of the pipelines.

Rosprirodnadzor has already ordered the suspension of construction of onshore pipelines and sought a criminal probe against a contractor working for the project. The Russian authorities have threatened to sue Shell, which holds a majority stake in Sakhalin Energy, if it fails to suspend work on the pipeline.

Earlier in the year, the European Bank of Reconstruction and Development (EBRD) decided to withhold a loan to Sakhalin-2 amid environmental concerns over a ground oil pipeline. Sakhalin Energy announced in March that pipelines would bypass the areas, but now environmentalists claim that the new pipeline routes could damage sturgeon-spawning areas.

Shell suspended pipe-laying operations for a liquefied natural gas plant after the environmental agency complained about the landslide threat, and on 5 September, announced it was halting work on a second stretch. Shell reportedly said it would restart only after solving its differences with the Russian authorities.

Furthermore, the Sakhalin authorities indicated plans to launch an ethnological audit on how the oil and gas projects affect local people. On 5 September, Deputy Governor Viktor Nagorny announced that the upcoming audit would aim at sustaining traditional way of life of ethnic minorities in Sakhalin.

Gazprom eyes Sakhalin
Back in 1994, the Russian government signed the Sakhalin-2 product-sharing agreement (PSA) with the Sakhalin Energy Investment Company, in which Shell Sakhalin Holding has a 55 percent stake, Mitsui Sakhalin Development has 25 percent and Diamond Gas Sakhalin 20 percent. It was Russia’s first PSA, and it became effective in 1996.

One of Russia’s major off-shore projects, Sakhalin-2 has reserves of some 150 million tons of oil and 500 billion cubic meters (bcm) of gas. The second stage includes gas production and liquefaction at a new liquefied natural gas (LNG) plant on Sakhalin with projected annual capacity of 9.6 million tons.

The increased pressure from Russia has been seen as an attempt by the authorities to get a better deal for gas monopoly Gazprom, although Shell had already agreed to sell a stake to Gazprom.

Gazprom has been discussing a deal to acquire a blocking 25 percent plus one share stake in the Sakhalin-2 project in exchange for a 50 percent stake in Gazprom’s Zapolyarnoye field in the arctic north of Western Siberia. Gazprom and Shell would become joint operators of Sakhalin-2.

Russian officials denied that Gazprom was seeking a bigger role in Sakhalin. Gazprom does not claim more than 25 percent plus one share in Sakhalin-2, Russia deputy Economic Development and Trade Minister Kirill Androsov said on 6 September. He also argued that Russia would honor all the existing PSAs. “Every signed PSA is a law,” Androsov said. “So far, we have not terminated a single PSA, and I see no reason for doing that.”

Sakhalin-2 is Sakhalin’s most successful project to date. It has been producing oil since 1999 and is planning to build the world’s largest liquefied natural gas plant. Not surprisingly, Gazprom has secured a strong government backing. The Russian Industry and Energy Ministry has said it would support Gazprom’s moves to join the Sakhalin projects.

Shell announced last July it had signed a memorandum of understanding with Gazprom on the swap, which it said at the time was “strategically important to both parties.” However, as costs of the Sakhalin-2 project have doubled to about US$20 billion, Gazprom has indicated its intention to reduce the stake it would like to offer in Zapolyarnoye-Neocomian, because the value of the Sakhalin asset has fallen.

In July last year, Shell raised cost estimates for Sakhalin-2 to US$20 billion from the previous US$10 billion. It also postponed the first liquefied natural gas shipment from the end of 2007 to summer 2008. At the time, Shell CEO Jeroen van der Veer conceded the “absolutely staggering” US$10 billion cost overrun on Sakhalin-2.

The Russian Industry and Energy Ministry postponed approval of the new budget to study the reasons for the higher costs. Russian officials are understood to be wary of significant delays in terms of Sakhalin-2’s planned LNG exports. Gazprom also indicated it considered Shell’s assets on Sakhalin to be worth less after Shell raised the project’s cost estimates.

Production sharing questioned
Russia has been recently moving towards abandoning the production-sharing system, which guarantees investors stable taxes over the lifespan of a project. Only three advanced PSA projects survived, including Sakhalin-1 and Sakhalin-2, as well as Total’s Kharyaga oil project in Siberia’s Nenets Autonomous region. The three PSAs were reported to bring the Russian state coffers a total of US$686 million in the past decade. Dozens of other less advanced PSA plans have been scrapped.

Last year, the Russian Academy of Natural Sciences submitted a report to the Natural Resources Ministry claiming that delays and inefficiency by foreign companies had cost Russia over US$10 billion. The academy called for PSAs to be revised to give Russian companies a 51 percent stake. Although the academy, also know as RAEN, is different from its well-established counterpart, the Russian Academy of Sciences, the government took notice of its advice.

The Natural Resources Ministry was also reportedly mulling restrictions on foreign investment in subsoil resources, drafting a bill that would limit foreign investment to 50 percent in the development of hydrocarbon fields with more than 50 million to 100 million tons of oil or 500 bcm of gas.

Kremlin treads carefully
The Kremlin was careful to deny it was deliberately targeting Western oil majors in Sakhalin. “Russia considers the Sakhalin-2 project as one of its most serious projects,” Russian President Vladimir Putin’s aide, Igor Shuvalov, said on 5 September. Shuvalov said he saw no grounds for Rosprirodnadzor’s moves to shut down the Sakhalin-2 project. “I see no reasons for such an intimidating move,” he said.

However, Shuvalov also reportedly suggested that the PSAs should operate within what he described as a “national tax regime.” According to Shuvalov, partners in the PSAs could voluntarily abandon their respective contracts and fully accept Russian domestic legislation and tax obligations.

Shuvalov’s scenario could have serious repercussions for Sakhalin projects. For instance, a recent bill on gas exports stipulates that only Gazprom has a right to export natural gas from Russia.

Yet regardless of Shuvalov’s suggestions, Gazprom has already moved to take over important infrastructure projects in the Far East. In April, Gazprom indicated plans to acquire both Sakhalin-Komsomolsk-on-Amur gas pipeline, controlled by Rosneft-Sakhalinmorneftegaz, as well as Komsomolsk-on-Amur-Khabarovsk 420-kilometer section.

On 2 August, Khabarovsk region’s governor Viktor Ishayev announced that regional authorities were mulling a new gas pipeline to China. The proposed Okha-Komsomolsk-on-Amur-Khabarovsk-China export pipeline, running from the island of Sakhalin off Russia’s pacific coast via the Russian mainland to China would have a projected capacity of 8 bcm per year. The pipeline would be built in parallel with the nearly completed Sakhalin-Komsomolsk-on-Amur-Khabarovsk domestic pipeline, which is due to reach Khabarovsk in late 2006.

Earlier this year, Gazprom was reported as planning to buy all gas from Sakhalin-1 for re-export to China. Although Gazprom has so far refrained from commenting on the reports, its intention to take over Okha-Komsomolsk-on-Amur-Khabarovsk gas pipeline arguably indicates that Gazprom would prefer to buy all gas from Sakhalin-1 and then re-export the gas to China to make sure it remains the sole Russian gas exporter.

Hydrocarbon bonanza slow to materialize
Moscow has prioritized hydrocarbon supplies to the energy-thirsty Asia-Pacific. Russia plans to boost its oil and gas exports to Asia, Putin announced earlier this month. Russia aims at exporting 30 percent of its oil and gas to Asia in 10-15 years compared with 3 percent now. Speaking on 9 September to foreign academics and journalists, Putin said prospects for the eastbound energy links were “very good” and that Russia, with its border on the Pacific Ocean, had “a certain natural advantage” in developing ties in Asia.

Neighboring China, Japan and South Korea are understood to count on Sakhalin to cut its dependence on oil supplies from the Middle East.

Yet apart from the PSA-related disputes, Sakhalin oil and gas projects have been facing a reality check. State-controlled oil company Rosneft, which acts as the government’s agent in foreign oil projects in Russia, is involved in five out of the six Sakhalin projects.

In December 2003, Rosneft announced it would halt work due to poor exploration results on Sakhalin-4, known as the Astrakhan block. The US$2.5 billion project was previously believed to hold up to 100 bcm of gas.

In January 2004, Rosneft also announced withdrawal from Sakhalin-6. Rosneft was disappointed by the results of exploration on this block, which was initially believed to contain reserves of up to 2.2 billion barrels of oil.

Sakhalin-5 is potentially one of the largest, with oil and gas condensate output forecast at a maximum of over 700,000 barrels per day, close to all the output of OPEC member Qatar. The hypothetical recoverable reserves of oil amount to 433 million tons. The estimated total cost of the project is US$30 billion, while gross income estimates exceed US$100 billion.

In 1998, Rosneft formed an alliance with British Petroleum (BP) to complete the Sakhalin-5 project. The deal gave BP 49 percent in an exploration venture for Sakhalin-5, while operator Rosneft had 51 percent. Rosneft says it expects the first oil in 2010.

In January 2004, the Russian government annulled the results of the Sakhalin-3 tender, which had been won by a consortium led by ExxonMobil back in 1993. Sakhalin-3 consists of three blocks – Ayashsky, Kirinsky and Odoptinsky – on the shelf of Sakhalin with combined estimated reserves 4.6 billion barrels of oil.

Meanwhile, ExxonMobil is still operating a US$12-billion Sakhalin-1 project with a 30 percent stake. Sakhalin-1 includes three offshore fields – Chayvo, Odoptu and Arkutun Dagi – with potential recoverable resources are 2.3 billion barrels oil and 17.3 trillion cubic feet of gas.

On 8 September, ExxonMobil warned Russia to honor the PSA to develop the Sakhalin-1. “As the Sakhalin-1 project is one of the largest single foreign direct investments in Russia, it is globally visible and therefore serves as an indicator to others of the success or failure for other potential large foreign investment in the Russian oil and gas industry,” Exxon spokesman Bob Davis said in a statement. “Any failure to honor the [agreement] could inevitably undermine the confidence of foreign investors and have a significant negative impact on the Russian investment climate.”

The Sakhalin-1 consortium was hoping to sell natural gas to Japan by constructing a pipeline stretching 2,400 kilometers from Sakhalin to the greater Tokyo area. The pipeline would pump 6 million tons of LNG a year, or about 10 percent of Japan’s annual consumption. The plan has been in limbo due to lack of progress in negotiations with Japanese gas and power companies.

China welcome in Sakhalin
Against the backdrop of a regulatory assault on Western investors, Russia is now trying to lure China’s leading petroleum companies to Sakhalin, hoping that China will join in the exploration of oil and gas reserves there, members of the Sakhalin regional government announced at Changchun Northeast Asia trade expo on 2 September.

In July 2005, Rosneft and Sinopec, a subsidiary of the China National Petroleum Corporation, clinched a deal to launch a joint company for geological exploration of the Veninsky deposit, part of the Sakhalin-3 project. Now state-owned Rosneft holds a 75 percent stake in Sakhalin-3.

In May this year, China’s State Bank of Development (CSBD) announced it had begun financing Chinese companies in Sakhalin. Later this year, Cinopec is due to take part in exploration drilling at one of the off-shore oil fields of the Sakhalin shelf.

Meanwhile, as major Sakhalin projects appear to face regulatory hurdles, cost overruns and delays, it remains to be seen whether their performance could eventually justify Moscow’s confidence in Sakhalin’s future as a predominant hydrocarbon producer in North-East Asia.

Sergei Blagov is a senior correspondent for ISN Security Watch in Moscow.

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