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Financial Times: Kremlin plays hardball in Sakhalin

By Arkady Ostrovsky and Neil Buckley: Published: December 11 2006 18:48 | Last updated: December 11 2006 18:48

However crude or unacceptable Russia’s methods may seem to foreign investors, the Kremlin is still prepared to use them.

The months of pressure on Royal Dutch Shell over alleged environmental violations by its Sakhalin-2 development were widely suspected to be a cover for an attempt to secure Gazprom a substantial stake in the project.

And now Shell has offered to cede control over the $22bn venture to the state-controlled gas giant.

The lesson for foreign energy companies operating in Russia is two-fold: the state will have control over any significant project and will use any means, including political, regulatory and legal pressure, to get it.

Addressing specific complaints – on taxes, the environment or fire regulations -– will never be enough solve the underlying issues.

The case has potentially worrying implications for companies such as Exxon-Mobil and BP, and groups in other strategic sectors such as metals and mining – even if, for now, investors in non-strategic sectors are not experiencing the same degrees of difficulties.

Just as the fraud charges and tax claims against Mikhail Khodorkovsky and his Yukos oil company were an example to the country’s other “oligarchs” – in that case to stay out of politics – the Russian authorities seemed happy for Sakhalin-2, the biggest foreign investment in the country, to become a cautionary tale for foreign energy investors.

While Shell tried to confine, at least initially, any disagreement with regulators to an exchange of letters, the Russian government conducted its crackdown on the oil giant in public and answered Shell’s enquiries through the television screen.

The campaign started a few weeks after July’s summit of the G8 industrialised nations in St Petersburg, where Russia assured the world it was a reliable energy partner.

Oleg Mitvol, a low-ranking but high-profile environmental official, told reporters that Shell’s environmental license for Sakhalin would shortly be revoked for violating Russian laws. Prosecutors and the natural resources ministry promptly launched a fresh probe into Sakhalin-2’s environmental impact. First Mr Mitvol and later Yuri Trutnev, the natural resources minister, led journalists to Sakhalin to demonstrate the damage.

Direct contact with the company itself was kept to a minimum.

Shell, which admitted to some environmental violations, submitted a detailed clean-up plan running to several hundred pages.

The document seemed to enrage Mr Mitvol, who called it “not a remedy plan, but a collection of jokes”.

Last week the natural resources minister and Yuri Chaika, prosecutor-general, discussed Sakhalin-2 in a joint session. Mr Trutnev said the Sakhalin-2 violations were “outrageous” and Mr Chaika said his office might launch criminal cases.

The same day, Jeroen van der Veer, Shell’s chief executive, met Alexei Miller, his counterpart at Gazprom, to offer a deal.

Shell says it has always wanted Gazprom as a partner in Sakhalin – to shield it from official pressures. But giving Gazprom control of the project goes well beyond a deal Shell almost reached with the Russian giant last year. Under that agreement,Shell was to swap 25 per cent of Sakhalin-2 for 50 per cent of Gazprom’s Zapolyarnoye field in Siberia.

But the agreement soured after Shell doubled Sakhalin’s estimated costs to more than $20bn. Russian officials openly linked Shell’s environmental problems, and the desire to get Gazprom in on more advantageous terms, with the cost increase.   Sakhalin-2 is governed by a production-sharing agreement, supposed to protect foreign investors from political and economic uncertainty. It allows foreign companies to recoup all their investment before starting to share oil and gas with the host country.

Higher costs meant a lower share of the proceeds for Russia from Sakhalin-2. The new structure lets Russia get the lion’s share of profits without seemingly breaking its legal obligations.

But retaking state control over Russia’s energy resources has been a leit-motif of Vladimir Putin’s presidency. The state’s share of oil production could have doubled in three years, according to the Organisation for Economic Co-operation and Development.

The state has also increased its share of gas production. Until now, however, the state’s share had increased at the expense of private Russian companies.

If Gazprom gets a majority of Sakhalin-2, it will mark the takeover of foreign assets as well. 

But there remains a sharp distinction between strategic sectors, notably energy, and non-strategic manufacturing and consumer sectors, where foreign investors are currently operating without any significant hindrance.

The only state incursion into the booming auto sector, for example, has been the seizure of control of Avtovaz, the maker of Lada cars, by Rosoboronexport, an arms export agency headed by a close associate of Mr Putin. But analysts suggest that may be largely motivated by the social sensitivity of Avtovaz, which employs 100,000 people.

The Kremlin is still encouraging foreign car makers to open plants in Russia, provided they use a certain proportion of locally-produced components.

In a recent TV broadcast Mr Putin declared proudly that 15 foreign automakers would soon have assembly lines in Russia.

Consumer goods manufacturers and retailers have also experienced little state pressure. But some have had problems with regional authorities.

Ikea, the Swedish furniture retailer, saw a new flagship store and linked shopping centre in Moscow closed down for alleged “safety reasons” for two weeks at the start of the 2004 Christmas shopping season.

A similar newly-opened Ikea store and mall in Nizhny Novgorod, Russia’s fourth-largest city, was shut down last week for 30 days by fire safety officials, at a potential revenue cost of tens of millions of dollars.

However, that safety inspection followed an incident last month when a child was killed by an out-of-control shopping cart laden with building materials.

Copyright The Financial Times Limited 2006

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