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The Scotsman: Shell may struggle to recoup Sakhalin-2 costs

By Tom Bergin

LONDON (Reuters) – Gazprom may pay Royal Dutch Shell for money already spent developing the Sakhalin-2 oil and gas fields if it buys a stake, but analysts do not expect the Russian giant to pay a premium for expected profits or control.

Shell has offered to cede control of the project, Russia’s biggest single foreign investment, to the world’s largest gas company after months of government pressure, industry sources told Reuters on Monday.

On Tuesday Gazprom Chairman Dmitry Medvedev said his company planned to buy around 50 percent of the Shell-led project, which is based off Russia’s east coast.

This would represent a blow for Shell, which is struggling to find big new fields, but the exact impact depends on price.

Sakhalin-2 is expected to cost $22 billion (11.2 billion pounds). On top of recouping this investment, analysts said the project would yield its shareholders future profits with a net present value (NPV) of $12.7 billion to $23.6 billion.

However, the final sale price may be based on other factors.

“It’s all down to politics. It’s beyond the fundamentals of the project … It looks like Gazprom wants to try and get in at cost, and it looks like Shell wants to make some money,” said Peter Hitchens at Teather & Greenwood.

A spokesman said on Tuesday that Shell expected to be treated equitably in negotiations, but analysts said this was unlikely.

“I wouldn’t be massively optimistic Gazprom would pay above cost,” said Dominic Ellis, an oil analyst at Man Securities said.

One analyst who asked not to be named said Gazprom may not even be willing to pay the full price for the costs already incurred.

“They’re going to squeeze and squeeze until they get the deal they want … Would they pay past development costs? It’s debatable,” the analyst said, adding that Shell and Gazprom were unlikely to disclose the terms of any deal.


News of the offer to cede control and Medvedev’s statements weighed on Shell’s shares on Monday and Tuesday.

Its London-listed A shares traded down 1.27 percent at 1783 pence at 2:41 p.m., compared to a 0.3 percent fall in the DJ Stoxx European oil and gas sector index < .SXEP>.

Analysts’ estimates of the NPV of Sakhalin-2 vary wildly partly because of the decades-long nature of the investment and their differing forecasts for oil and gas prices.

Citigroup estimates the project’s NPV at $12.7 billion, while Morgan Stanley said that if oil prices were $60 per barrel, it could be worth $23.6 billion to its shareholders, Shell and Japanese companies Mitsui & Co <8031.T> and Mitsubishi <8058.T>.

Wood Mackenzie has put the project’s value at $15 billion and Merrill Lynch at $17.5 billion.

Even for the world’s second-largest fully quoted oil company by market capitalisation, the loss of most of its Sakhalin-2 stake without fair compensation would hurt.

Shell’s 55 percent stake in Sakhalin-2 represents up to 6 percent of the Anglo-Dutch company’s market capitalisation, Morgan Stanley said in a research note last month.

This explains its share price weakness, but investors have also expected some destruction of value for months.

Most analysts’ valuations are based on the partners being able to recoup all costs — something the production-sharing contract covering the project is supposed to allow.

However, Russia has objected to a doubling of the original $10 billion budget due to soaring costs in the oil industry and overly optimistic budgeting by Shell in the 1990s, while a state regulator has threatened big fines for environmental damage.

Analysts now expect a compromise on the budget overrun and increased costs to deal with the regulator’s environmental complaints, both of which would hit the value of the project.

If not balanced with the right to buy other assets in Russia — something proposed as part of a deal by which Gazprom would take a 25 percent stake in Sakhalin-2 — the loss of a large chunk of Sakhalin-2 would also be damaging to Shell’s reserves base and production growth plans.

“This would put a serious dent in the company’s target of achieving 3.8 to 4.0 million barrels of oil equivalent per day of production in 2009,” Merrill Lynch said in a research note.

(Additional reporting Dmitry Zhdannikov and Douglas Busvine in Moscow)

(c) Reuters 2006. All rights reserved.

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