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Financial Time: ‘Elephant project’ turned into bit of a beast

By Ed Crooks: Published: December 11 2006 18:48
Last updated: December 11 2006 18:48

Jeroen Van der Veer, Royal Dutch Shell’s chief executive, likes to talk about “elephant projects”.

Most people might call them mammoth, he says, but he prefers to call them elephants, because they are not extinct. By 2015, he says, he wants the company to have 10 of these huge oil and gas projects, driving forward the company’s growth over the coming decade. Now one of his elephants has been frozen in the Russian ice.

The financial implications of a deal with Gazprom over Sakhalin-2 are still unclear. It seems that the details are still being haggled over. Shell’s shares lost just 0.6 per cent of their value yesterday, closing at 1,822p.

But beyond the specifics of this project, the pressure on Sakhalin-2 raises questions about Shell’s long-term future.

The possible deal with Gazprom has not dashed hopes that Sakhalin-2 will turn out to be a great success. Those crumbled some time ago, as Shell owned up to delays and soaring costs for phase two – the main part of the project – which is now expected to cost $20bn, double the first estimate of $10bn.

In part that was a consequence of cost inflation affecting the entire industry, such as soaring steel prices, and a reflection of the technical difficulty of the project.

The cost overrun was a disaster in terms of Shell’s relationship with the Russian authorities. Under the terms of the production sharing agreement for Sakhalin-2, costs are recovered before the main revenue streams start to flow to the government. So higher costs put back by years the time when Russia could expect to get the maximum returns from the project.

But, contrary to what is sometimes assumed, and sometimes argued in Russia, that does not mean that the overrun was costless to Shell. Having to put up billions more up-front, and to wait longer for payback, significantly worsens the lifetime return of the project.

Analysts at Citigroup have estimated that the internal rate of return on Sakhalin-2 will be just 7 per cent: desperately low for a project fraught with so many technological and political risks. For comparison, they estimated in October that BP’s Thunder Horse project in the deep water Gulf of Mexico, similarly plagued by engineering challenges, would have a lifetime internal rate of return of 26 per cent.

Having invested so much – Sakhalin-2 is now 80 per cent complete, and on schedule to come on stream in the third quarter of 2008 – Shell could never have walked away. A deal with Gazprom, by ensuring that the project will be completed and begin to deliver revenues, at least removes some of the uncertainty from it, however galling the outcome may be to Shell’s executives. But with the benefit of perfect hindsight, the project should arguably never have been given the green light.

The problem for Shell and the other “super-major” oil companies is that if they do not take on huge challenges such as Sakhalin-2, what do they do?

Mr Van der Veer has spoken about the end of “easy oil”: reserves that can be cheaply and safely extracted with little risk are not available any more, and where they do exist, they are generally locked up by the countries that own them.

Companies such as Shell are increasingly pushed towards the extremes: oil in places that are more remote, deeper, colder, more difficult and more dangerous than where they have operated before.

Look at two of Shell’s other elephant projects, for example. One is the Canadian oil sands, where Shell has been stepping up its investment, buying out the minority shareholders in Shell Canada. Costs have been soaring such that some in the industry argue that oil will have to stay at at least $50 a barrel for it to be profitable, although Shell argues that it can make a profit at lower prices. Another is its Gas-to-Liquids project in Qatar: a project to create large volumes of new clean road fuel from natural gas, for which it is unclear how big the market will be.

Jonathan Wright at Citigroup points out that Shell’s recent results have been good. When the Sakhalin-2 issue gets resolved, he says, the company will have moved past another of its problems. But the questions over the long-term outlook for Shell and the other large international oil companies will not go away.

Copyright The Financial Times Limited 2006

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