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Sunday Express: To the ends of the earth: did Shell underestimate Russia?

Sunday 25 September 2006

Oil, finance and a far flung deal. Did Shell underestimate Russia? asks Tracey Boles

SHELL staked a great deal on the Russian island of Sakhalin, off the frozen coast of Siberia. This former Soviet arms dump and penal colony that lies north of Japan endures Arctic weather for much of the year. Earthquakes frequently shake the island. The Russian author Anton Chekhov called it “hell”.

The conditions may be tough but Sakhalin attracted Shell and other international energy giants, including Exxon and BP, because it is home to oil and gas reserves equal in size to those left in the North Sea.

As global demand for energy increases and supplies of oil and gas diminish, the world’s fuel giants have had to seek new resources in far-flung corners of the earth.

Anglo-Dutch company Shell is the lead partner in the Sakhalin Energy consortium that is developing a $20 billion (£10.5 billion) oil and gas project on the island.

The oil firm hopes the project, Sakhalin II, will top up its dwindling reserves and put it in pole position to take on other programmes in resource-rich Russia. But Sakhalin II has been dogged by both enormous cost overruns and criticism from environmental groups across the world.

Last week the project hit one of its biggest hurdles yet when the Kremlin revoked its environmental licence. The decision, if rubber-stamped, would stall the project as it nears completion and could send costs up further, according to Shell.

It not only jeopardises billions of dollars-worth of bank loans being lined up for the next phase of the project but also puts a question mark over the credibility of Russia as a country with which to do business.

At first Russia, eager for foreign expertise, welcomed the consortium with open arms and in 1994 Shell and its Japanese minority partners Mitsui and Mitsubishi signed the deal to develop Sakhalin.

The agreement gave them the right to 4 billion barrels of the island’s 45 billion oil and gas reserves. Other companies that have rights include America’s Exxon and Russia’s Rosneft.

When complete, Shell’s Sakhalin II development will deliver 150,000 barrels of oil a day and 9.6 million tonnes of liquefied natural gas (LNG) a year, or 7.5 per cent of current global demand for the gas. For Shell, it will generate several billion dollars in revenue.

The development has been a vast undertaking. Two 800 km pipelines are being laid down the island, which involves crossing 1,000 rivers, streams and brooks. The pipelines will carry oil and gas landed from Shell’s offshore fields north of the island to a new liquefied natural gas terminal in the south where ships are not hindered by sea ice.

The $1 billion oil and gas pipelines are scheduled for completion next year and the export facility is due to become operational by the middle of 2008. Japan will be a big customer.

Shell’s chief executive Jeroen van der Veer believes the company’s future lies in such huge exploration programmes, which he calls “elephants”. They are central to Shell’s plan to recover from events in 2004 when it had to admit it exaggerated its “proven” reserves.

But Shell underestimated some of the challenges of working in Sakhalin where temperatures can drop to -40C in winter and reach 30C in summer.

For example, drilling did not go as smoothly as planned. The price of materials such as steel rose. Last year, Shell admitted costs for the project had doubled to an estimated $20billion.

Sakhalin II also became a cause celebre among environmental groups all over the world, largely because it is claimed it infringes on the feeding ground of a number of Western gray whales. There are just 100 of these mammals left, which include 23 breeding females. The project is also located near to salmon spawning grounds.

The environmental disruption caused by laying the pipelines, such as erosion and landslides, has also attracted criticism.

The final straw came last week when the Russian authorities said they would revoke Shell’s environmental licence after allegedly finding its workers had gone into protected forests.

“If Shell had addressed the environmental issues earlier, it would not have given the Russians the ammunition to use against it,” said James Leaton of the environmental charity WWF.

Some believe the Kremlin’s motives are suspect — that it wants to rewrite its agreement with Shell in its own favour.

Other Western firms on the island, such as Exxon, are also coming under scrutiny.

The full impact on Shell may take time to emerge.

Jason Kenney, energy analyst at banking group ING, said he did not expect Sakhalin to feed into cash flows until 2115 but he currently valued the company’s share in the asset at about $7 billion. “This is serious in terms of implications,” Kenney explained. “The environmental challenge of Sakhalin is huge, the technical challenge is phenomenal, and the commercial challenge is very significant. “The contract negotiations are as large a challenge as any.”

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