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ECONOMIST INTELLIGENCE UNIT: Russia business: Shell’s Sakhalin surrender

12/11/2006 05:24:14 PM EST
EIU ViewsWire Russia

Shell has reportedly offered to cede control of the Sakhalin-2 project to Gazprom, the state-controlled gas giant. Although Gazprom’s entry to Sakhalin-2 has been expected for some time, the news that it has been offered a majority stake—in return for unspecified assets—is surprising and underlines the weakness of foreign investors in the face of Russia’s energy nationalism. For foreign investors in other oil and gas projects, the Sakhalin-2 episode sets a worrying precedent.

According to reports from Reuters on November 11th, Shell offered a week earlier to cede control of the Sakhalin-2 oil and gas project—one of three production sharing agreements (PSAs) in Russia—to Gazprom, and an agreement in principle was reached between the two CEOs, Jeroen van der Veer and Alexei Miller. In response to the report, Gazprom and Shell officials have confirmed that talks took place but have refused to confirm that a deal has been reached or a definite offer made by Shell.

The details of the offer, as reported by Reuters, are only partial. They provide for Gazprom to gain a majority stake in Sakhalin-2, which is currently a purely foreign-owned venture: Shell has 55% and Japanese firms Mitsui and Mitsubishi 25% and 20% respectively. Reportedly, Shell will retain 25% plus one share—a blocking minority stake—in return for assets in mainland Russia and perhaps a cash injection to Sakhalin-2. This implies that Gazprom will acquire a 30% share from Shell and around 20% from the Japanese partners.

Expected, but with a surprise

A deal between the two firms is wholly consistent with developments surrounding Sakhalin-2 over the past year or two. Gazprom has for most of this time been negotiating with Shell to join the project. In 2005 the two sides reached an outline agreement that would give Gazprom 25% of Sakhalin-2 in return for 50% of Gazprom’s Zapolyarnoye gas field in Russia’s far north. In the past few months, Shell and its Sakhalin partners have been under intense pressure from the Russian authorities over alleged environmental violations at Sakhalin-2 and a doubling of the official project costs to over US$20bn. (Under the terms of the PSA, Russia will not receive any royalties from Sakhalin-2 until the costs are recovered.) The official pressure on the Sakhalin-2 investors seems to have been directed towards two objectives: increasing the financial returns for the Russian state; and ensuring Gazprom’s entry to the prestige project. Two months ago, the Economist Intelligence Unit suggested that Shell would have little choice but to concede on one or both points, in order to avoid the cancellation of its operating licence.

The one surprising aspect of Shell’s reported offer is that Gazprom’s stake has jumped from a presumed 25% to majority control—despite the fact it has little or no experience of operating offshore and no experience of producing liquefied natural gas (LNG). If Gazprom does gain a majority stake in Sakhalin-2, it will mark a more extreme assertion of energy nationalism that many observers had contemplated.

The widely held assumption today is that no major projects in Russia’s oil and gas complex can proceed without the involvement of Russian companies—and specifically, one of the state-run champions, Gazprom and Rosneft. Legislation is in preparation that will ensure that foreigners in any sizeable oil, gas or precious metals project are limited to a minority stake. With regard to the handful of already established foreign-controlled projects—Sakhalin-2, Total’s Kharyaga project, and TNK-BP’s Kovykta field—the assumption was that Gazprom’s participation was a prerequisite for the start of production. The implication arising from Shell’s offer is that participation alone is not sufficient: Gazprom must be given a majority stake.

For Gazprom, the rationale for entering Sakhalin-2 is clear enough. By law, Gazprom is Russia’s single gas export channel but that legislation (passed in 2006) made an exception for Sakhalin-2. By acquiring a majority stake, Gazprom will largely neutralise the challenge to its export monopoly that Sakhalin-2 would have raised. More importantly, following the decision to develop the Shtokman field alone and to direct most of its output to Europe via pipelines rather than to North America in the form of LNG, Gazprom needed to gain entry to Sakhalin-2 in order to build its LNG portfolio. As Mr Miller made clear in his speech to the mid-2006 Gazprom AGM, participation in LNG is essential for Gazprom to become a global gas giant rather than simply a European one. With a scheduled capacity of 9.6m tonnes of LNG per year, Sakhalin-2 will be one of the biggest LNG projects in the world. Entry to Sakhalin-2 would repair the damage done to Gazprom’s strategy by the company’s decision on Shtokman.

Who’s next?

Where does this leave the other two PSA projects—ExxonMobil-led Sakhalin-1 and Kharyaga—as well as TNK-BP at Kovykta? Seemingly, the spotlight is likely to turn on them once the Sakhalin-2 deal is finally done.

For Exxon-Mobil, the position is perhaps not as grim as it may first appear. In three crucial respects, the US giant is better off than Shell at Sakhalin-2. First, the Sakhalin-1 PSA is less controversial for Russia’s government than the Sakhalin-2 PSA. Although ExxonMobil is at odds with the government over project costs, it is not seeking anything like a doubling in approved expenditures. Second, there is already a state-approved partner in Sakhalin-1: state oil champion Rosneft, which has a 20% stake. Third, and perhaps crucially, Gazprom has less interest in Sakhalin-1 than Sakhalin-2—partly because it has more oil than gas, and partly because the gas (initially at least) is to be marketed in Russia rather than exported.

The situations facing Total and TNK-BP via Rusia Petroleum (the operator of Kovykta) are arguably more difficult, as both are gas projects and as a result fall squarely within Gazprom’s primary remit. Rosneft might aspire to dominate Russia’s oil sector, but having operated as a medium-sized player in a privately-dominated industry for the past 10-15 years, it does not have a monopoly mentality. In the gas sector, that’s precisely what Gazprom has. In the case of Kovykta, Rusia Petroleum is beset by problems: it stands accused of failing to comply with licence terms; is unable to export its output; and has violated Russian norms with regard to pipeline construction. Viewed from this perspective, its bargaining position is as weak if not weaker than that of Shell at Sakhalin-2. Already several months ago, Gazprom is reported to have refused an offer to take a 50% stake in Kovykta. If this is true, it is worrying to wonder just how far Gazprom’s ambitions for that project extend. At Kharyaga, Total’s position seems little better than Rusia Petroleum’s at Kovykta.

At the outset of the attacks on Shell over Sakhalin-2, there were three facets to the Russian authorities disapproval of that project and by extension the other PSAs: that such agreements were a stain on Russian prestige (being more appropriate for countries such as Nigeria and Indonesia); that they unduly favoured foreign investors with regard to revenue distribution; and that Russian firms were largely excluded from landmark projects. The worst possible outcome was that Russia would seek to scrap the PSAs. Although the authorities have not taken this route, putting Gazprom in charge of Sakhalin-2 goes most of the way to remedying these perceived flaws.

SOURCE: ViewsWire

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