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Asia Times: Sakhalin gas: Shell loses, whales win

December 15, 2006

By John Helmer

MOSCOW- There are three opponents of Russia’s strategy to become a global liquefied natural gas (LNG) exporter – the western gray whale, the US government and Gazprom.

Until this week, and for quite different reasons, all three, including the LNG producer itself, Gazprom, have succeeded in delaying and redirecting plans to start shipments from the first of Russia’s LNG plants at Aniva Bay on Sakhalin Island, in the Far East; and to postpone indefinitely drawing-board plans and joint-venture agreements to build the second and third LNG plants on the Baltic, and to the north, on the Barents Sea.

During the Soviet period, energy planners in Moscow concentrated on piping natural gas to domestic users, and for export westward by pipeline across land to Europe. At the consumer end of this pipeline system, reliance on Russian gas is currently 100% in Finland; 99% in Bulgaria; 97% in Slovakia; and 76% in Greece. In volume of Russian gas consumption, Germany takes most, followed by Italy, Turkey and France. In the Soviet period, the technology for liquefaction was costly, and although in development by Soviet ally Algeria, Moscow believed there was no pressing economic reason for installing it.

The energy-price boom of the past three years has created enormous cash reserves for Gazprom, which the Kremlin-directed management wants invested as quickly as possible, avoiding devaluation by the unstable dollar, and threatened market manipulation by the Americans and Western Europeans. That has meant increasing interest on Gazprom’s part in diversifying upstream, as well as downstream, in the gas market.

Shell had started the ball rolling a decade ago with its plan to build the Aniva Bay plant to liquefy gas, and tanker it to Japan and South Korea. With 9.6 million tonnes in annual export capacity, this plant has already contracted to sell more than 7 million tonnes for 20 years to Japanese and Korean buyers. However, a combination of huge cost overruns, postponements of tax payments to the Russian Treasury, and environmental damage led the Kremlin to attempt a move this year to transfer operating control, and shareholding equity in the project, to Gazprom. For the time being, Asian buyers cannot count on a whiff, or a drop, of gas from Sakhalin.

The campaign to protect the whales by Russian environmental organizations – endorsed by regional court rulings – has been under way for several years. Royal Dutch Shell, controlling shareholder and operator of the Sakhalin-2 project, has repeatedly denied that its dredging, construction of offshore production platforms and a tanker-berthing jetty, and the laying of undersea pipelines, had upset the marine ecology in the Sea of Okhotsk. Starting in 2005, the Russian courts began to disagree.

This year, the federal authorities extended their criticism to onshore pipeline construction, the cutting of forest, the heightened threat of mudslides, and other problems. After suspending the project’s environmental clearances, the deputy head of the Russian environmental protection agency Rospriradnadzor, Oleg Mitvol, said Shell’s proposed new cleanup plan was worthless. “It is not serious. It is a joke collection. We had expected to see technical solutions and they are dealing with small local problems,” Mitvol said during a site inspection on November 11.

The changing economics of gas exports persuaded Gazprom strategists in Moscow that they too should build their own LNG facilities. Accordingly, during 2006, Gazprom negotiated agreements with Algeria’s Sonatrach to cooperate in developing these plants in Russia for export of the product to the North American market.

Natalia Bortsova, a gas-industry analyst in Moscow, told Asia Times Online: “Gazprom has a serious intention to produce LNG, but currently has no production facilities of its own.” She said the technology required is readily available, and Sonatrach has unique experience building LNG plants, operating them, and marketing the product. “Sakhalin LNG is controlled by Shell, and Gazprom has been trying to get a share there without success yet. [An LNG project for St Petersburg involves] Petro-Canada and Gazprom, but the negotiations are still at the stage of memorandum of intentions.”

She acknowledged that Gazprom’s desire to export LNG to the US market will run into potential competition with Sonatrach, already a major US supplier, unless the two companies agree to cooperate. “It is very important to create the partnership, not to compete,” Bortsova said.

The US government has objected, saying that a Gazprom-Sonatrach combination threatens gas markets with the potential for cartel pricing. European Union officials mimicked the Washington line in public. But neither they nor the Americans were able to dissuade Sonatrach from signing its memorandum of understanding (MoU) with Gazprom.

In case the Algerians started marching to the Western tune, in October Gazprom negotiated a fresh option with Repsol of Spain. A communique, issued in October by Gazprom, after a meeting of chief executive officers Alexey Miller for Gazprom and Antonio Brufau for Repsol, referred to their plan of cooperation as extending to “the territory of Europe, Latin America and Africa, and also in projects for production of LNG with use of the resource base of the Russian Federation, including the project Baltic LNG”.
At the same time, the Kremlin was persuaded to rethink the usefulness of allowing US partners to take equity and possibly operational control of the northwestern LNG plants in planning – one on the shore of the Gulf of Finland, near St Petersburg, in planning with Petro-Canada; and another on the Barents Sea coast, above the Arctic Circle, with US oil companies ChevronTexaco and ConocoPhillips.

According to the statement by Petro-Canada on October 12, 2004, CEO Ron Brenneman and Gazprom’s chairman, Alexey Miller, had signed an MoU “to investigate a joint liquefied-natural-gas project which would see LNG from Russia shipped to North American markets by 2009. Specifically, the MoU covers options for Petro-Canada and Gazprom to jointly develop a liquefaction plant in the St Petersburg region, and investigate options for gas supplies to that LNG plant and re-gasification in North America.”

Without a supply of gas on tap, however, that deal is a dead letter.

Thus the decision Gazprom made on October 9 this year – two years after the Petro-Canada MoU – to limit initial production from the Shtokman field to pipeline deliveries of natural gas could defer the Baltic plant indefinitely. According to the Gazprom announcement, “pipeline gas deliveries from the Shtokman field to the European market would take priority over LNG shipments. Shtokman will be the resource base for Russian gas export to Europe via the Nord Stream gas pipeline. Gazprom will develop the field on its own, without attracting foreign partners.”

The latest Gazprom evaluation of Shtokman boosted field reserves by 10% to more than 4 trillion cubic meters. It also concluded that lifting the gas and condensate, and piping it 550 kilometers to shore, will be less risky, and less costly, than Gazprom has previously thought. The political value, however, of liquefying the gas, either on the Barents shore or on the Gulf of Finland, has vanished, at least for the time being – and Russia will leave the American LNG market to Sonatrach for the foreseeable future.

The China market remains difficult for Gazprom to supply, unless it can divert Sakhalin gas away from its intended and contracted Japanese and Korean customers. A fresh estimate, released last month, suggests that the cost of building overland the 2,700km Altai gas pipeline from West Siberia to China would require an investment of about US$14 billion. Even if that is affordable, Gazprom’s ambition to place large volumes of gas in the Chinese market as early as 2010 may be defeated by lack of gas.

“We do not think that Gazprom has the gas for this, at least from West Siberia,” said Adam Landes, a Renaissance Capital analyst. “We therefore continue to believe that Russian gas exports to Asia will be sourced from East Siberia and Sakhalin only, and dismiss the notion that the Altai pipeline will ever be built.”

When Russian President Vladimir Putin was last in Beijing a few weeks ago, the emphasis in the energy-sector talks was on overland pipeline transportation, not on increased shipping from Sakhalin, industry sources say. All CEO Miller would say in China was that his company might start shipping gas to China through pipelines, from Sakhalin, East Siberia, and West Siberia, within five years. New gas deliveries from Western Siberia are estimated to total 30 billion to 40 billion cubic meters. An alternative to the Altai pipeline route to China is being considered from the Eastern Siberian field of Kovykta to China.

Gazprom’s size is deceptive. Its capacity for grand strategy is quite limited, and its drive into both the Asian and European markets much more commercially driven, and opportunistic, than the Western press understands. Had Shell’s public relations advisers, along with Mitsui and Mitsubishi, not tried to defend against Moscow’s charges against the Sakhalin-2 investors of cost overruns, tax evasion, and environmental non-compliance by attacking the Kremlin for political interference, a resolution of Shell’s problems in completing the Aniva Bay project might have come more swiftly, and less painfully for Shell.

Russian finance officials accuse Shell, principal shareholder of the Sakhalin Energy Investment Co (SEIC), and operator of the Sakhalin-2 project, of fabricating costs, which have jumped since last year by almost 125% to $22 billion.

According to the terms of their production sharing agreement (PSA), signed by corrupt officials of former president Boris Yeltsin’s administration when Russia’s Treasury was close to bankruptcy, oil production declining, and Russian corporates desperately short of investment capital, Shell (and ExxonMobil at Sakhalin-1, an oil-export project) would not have to pay profit taxes until they had cleared their project costs. The cost overruns have significantly postponed these tax payments.

“If costs continue to rise without control, Russia will be left with only 6% of royalties, while all profit will go to repaying costs,” Sergei Fyodorov, head of geological and subsoil use policies at the Natural Resources Ministry, said in September.

“The production sharing agreement presumes two kinds of taxes, the royalty and the profit tax,” Fyodorov explained. “From Sakhalin-2 we receive about $20 million in royalties. There is no profit. They are now extracting 1.5 million to 2 million tonnes [of crude oil] a year. If we take $60 a barrel and convert the barrels to tonnes, we get about $400 a ton. Accordingly, if the usual tax regime were operative here, that is, 50-55% of earnings, we would have about $200 of taxes from every ton of oil. In a year we would receive $300 million to $400 million. And we get just $20 million.”

To convince Shell that the terms of the PSA should be voluntarily renegotiated, the government in Moscow has identified other, equally pressing, violations and reopened the environmental file which Russia’s environmentalists and regional courts have been urging for years. The first regular oil shipments by ExxonMobil from the field, through DeKastri port, were delayed, while environmental inspectors checked regulatory compliance at the port terminal.

Leaders of Russian environmental-protection organizations on the island of Sakhalin have told Asia Times Online that they back their government’s decision to cancel the three-year-old license for completion of the Sakhalin-2 project. Dmitri Kisitsin of Ecological Watch of Sakhalin said: “It is obvious that the first ecological clearance [for Sakhalin-2] was granted with violations already. They started to construct from simple stages, but now they can’t make the rest go normally. The Sakhalin-1 story is more simple. Exxon didn’t make the same level of violations, but they have some problems too.”

Oleg Mitvol, deputy director of Rospriradnadzor, said at a press conference in Moscow that SEIC’s pipelines risk landslide damage, oil spills, and threats to marine life. “We are just doing what any country in the world would do,” Mitvol said. If someone had done this in the United States, “he’d be in jail. Here, he’s sitting in a Mercedes.”

For the longer term, the Russian government came to the conclusion that the optimum method of regulating the Sakhalin project would be a change in project shareholding. Gazprom then sought a 25% blocking stake in Sakhalin Energy, reducing both the Shell and Japanese stakes. The terms of this shareholding plan, reported by the Alfa Bank brokerage in Moscow in September, would have seen minority shareholders Mitsui and Mitsubishi selling parts of their respective 25% and 20% stakes to Shell, which currently holds the controlling 55% interest in the project company. Shell, it was reported, would then swap a 25% shareholding in Sakhalin-2 with Gazprom, in exchange for a 50% stake in Gazprom’s Zapolyarnoye field.

These terms did not stick, and as the public bickering between Russians and Westerners over the project intensified, shell’s bargaining position deteriorated. Gazprom told Asia Times Online in September that talks with Shell on this matter had been underway, but noted that the license cancellation ordered by the environmental regulators had halted them.

After a chief executives’ meeting last Friday, this week it has been reported in Moscow, but not confirmed officially, that Shell has agreed to sell Gazprom shareholding control of Sakhalin Energy. The terms are still under negotiation, according to Dmitri Medvedev, chief of the Kremlin staff and chairman of the Gazprom board.

Russian reports suggest that Gazprom will not pay cash up front. Instead, it will reportedly defer payment for its stake until the project starts operation, and cash is generated from LNG shipments and sales. This suggests that the takeover will oblige Shell to accept an audit of its actual project costs, instead of its estimated $22 billion in capital expenditure; and that the income that would otherwise have flowed to Shell under the PSA will be diverted to Gazprom, and then paid to Shell for shares. If Gazprom were to accept Shell’s capex estimate of $22 billion, its 50% buyout would notionally cost about $11 billion. But neither side is keen to acknowledge publicly what discount price has been tabled. This was clearly one of the sticking points when Russian Energy Minister Victor Khristenko said early this week that the talks were “difficult”.

A revision as clever as this to resolve the strategic control issue leaves undecided how Rospriradnadzor will settle the environmental non-compliance issues, and the agency’s claim, purportedly for $10 billion in damage to the Sakhalin land and marine environment charged against Shell’s project management. Mitvol of Rospriradnadzor has already announced that a Gazprom takeover would have no effect on his claims. It may, however, impact on the price Gazprom ends up having to pay Shell. In such a deal, even the whales may be compensated.

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