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The Sunday Times: Focus: Russia mauls Shell

December 17, 2006

The Kremlin’s determination to seize control of the Sakhalin venture is bad news for foreign investors in Russia. Dominic O’Connell reports 
 
Anton Chekhov, the Russian playwright, knew all about Sakhalin. In 1890 he took a three-month trip to the Siberian island, then a Russian penal colony, and summed it up in one word: “Hell”.

By the end of last week, Jeroen van der Veer, chief executive of the Royal Dutch Shell oil group, probably shared his view. 
 
On Friday, Van der Veer flew to Moscow in an attempt to salvage his company’s interests in a $20 billion (£10.2 billion) oil and gas field on Sakhalin, a project vital to Shell’s future.

It was his second trip to the Russian capital in a week. But despite his best efforts, the Shell boss knew he was fighting a rearguard action. The Russians wanted control of Sakhalin, and they were going to get it.

Pressure had mounted steadily on Shell for two years. The Kremlin bridled at cost-overruns on the project, and found fault with Shell’s environmental record, to the extent that it has started work on a $30 billion claim against the oil group.

Although no deal has been announced, oil-industry experts expect Gazprom, the gas group controlled by the Russian state, to take a large, and possibly majority, stake in the main Sakhalin II project. Van der Veer’s two Moscow meetings were with Alexei Miller, Gazprom’s chief executive.

Shell and its Japanese partners, Mitsubishi and Mitsui, will sell some of their shares in the project to the Russians, although it is not clear how much they will receive in return, or when. The deal is likely to be announced early next year, analysts said. Shell declined to comment beyond confirming that “constructive” talks had been held, and that they would continue over the next few weeks.

The Sakhalin coup is regarded as a watershed moment for foreign investment in Russia, throwing a spotlight on how the Kremlin is prepared to flex its muscles to regain control of key assets.

Whitehall sources say Number 10 is concerned at the tactics used, and that there could be a backlash if Gazprom attempts to pull off its long-rumoured takeover of Centrica, the parent company of British Gas. In parliament last week, Tony Blair hinted that he had raised concerns with Russian president Vladimir Putin at a recent meeting in Finland.

Europe is also on the case. “It is a matter of concern for us what is happening in Sakhalin,” said European Commission president José Manuel Barroso on Friday.

Putin’s critics said the affair harked back to other cases of strong-arm Russian tactics, and slammed Shell’s surrender.

“This decision on behalf of Royal Dutch Shell to give in to the extortion of the Russian government is a betrayal of not only their shareholders’ interests, but also an abandonment of those who fight for the rule of law,” said Robert Amsterdam of the law firm Amsterdam & Peroff, which represents Mikhail Khodorkovsky, the jailed oligarch and former chief executive of Yukos.

Away from the diplomacy, the immediate damage is to Shell and Van der Veer. Sakhalin has special significance for the company and the man; it embodied his faith in so-called “elephant” projects that could deliver big dollops of new hydrocarbons for the company and erase the lingering suspicion — created during a scandal over declaration of proven reserves three years ago — that Shell of all the oil giants was doing least to ensure its future in the big oil game.

By losing control of Sakhalin, Shell’s future production targets have been put in danger. According to forecasts by Citigroup, a reduced share of the Siberian field would mean that by 2009, rather than increasing production as planned, Shell would only pump as much oil and gas as it did last year.

SAKHALIN, a narrow island the length of Britain, sits off the Siberian coast a short distance north of Japan.

It is no longer the wretched penal colony it was during Chekhov’s visit, but home to a modern-day El Dorado of oil and gas. Beneath the chilly waters off its coast lie some 45 billion barrels of oil and gas, reserves equal in size to those estimated to remain beneath the entire North Sea.

Shell was until this week king of the Sakhalin castle. The company owned a majority stake in the main Sakhalin II field, a stake secured during the harum-scarum days of the early 1990s, when the low $10- a-barrel oil price meant Russia was desperate to earn cash by selling off the rights to its mineral wealth.

Right from the start, Sakhalin was a project of superlatives. It was Russia’s first offshore oil and gas development. It was Shell’s largest single project, the biggest foreign direct investment in Russia, and (until now) the only oil and gas scheme in the country without a Russian partner in the consortium.

The two offshore platforms that will bring oil and gas to the surface are among the largest concrete structures ever built. From them, two pipelines have been laid 800km across inhospitable and environmentally sensitive terrain to terminals in the south of the island, where ships can operate year round free of pack ice.

After a decade of hard work in extreme conditions — temperatures of -25C in the winter, hungry clouds of mosquitoes in the summer, not to mention earthquakes and a generous sprinkling of unexploded bombs left over from the second world war — Shell, Mitsubishi and Mitsui were close to cashing in. The first gas will leave the island in just over a year.

But two years ago it became apparent the partners would not be left to share the spoils unmolested. In a canny move, Shell began negotiations to give Gazprom a stake in Sakhalin II in return for cash and a 50% interest in another promising Siberian gas field called Zapolyarnoye.
 
Talks were going well until Shell dropped a bombshell on Sakhalin II’s costs. Rather than the $10 billion that had been estimated, developing the field and the associated infrastructure would cost $20 billion.  
 
The cost overruns infuriated the Kremlin. The structure of the production-sharing agreement between the partners and the Russian government meant cost overruns would delay and probably reduce the flow of revenues to the state.

The Zapolyarnoye talks were put on hold. Meanwhile, the project, which had always attracted criticism from international green groups — it could disturb the feeding grounds of grey whales and other sensitive habitats — began to fall foul of Russian environmental watchdogs.

The Ministry of Natural Resources and the Russian environmental watchdog, Rosprirodnadzor, have threatened to withdraw the permits that allow the consortium to work, and have recently started a claim for up to $30 billion in damages for alleged environmental breaches.

Mark Stephens, a partner at the London law firm Finers Stephens Innocent, has been retained to advise Rosprirodnadzor on its legal options. He and a group of international lawyers and green advocates met Oleg Mitvol, deputy head of Rosprirodnadzor, in Russia last week.

“This is a case of environmental vandalism by Shell,” said Stephens. “We have given our advice on the way forward and I would expect an announcement from the Russian government in the next few weeks.”

Stephens said talk of a $30 billion claim against the company was not fanciful. Relaying pipelines could cost $10 billion, and the Russian state could, if the claim was taken under American law, press for triple damages.

THE expected change of control at Sakhalin gives Van der Veer another headache — a large loss of future production.

This would be bad enough for any oil company, but is particularly painful for Shell. Investors still remember the nasty shock they received three years ago, when the company issued an out-of-the-blue warning over the state of its reserves — a measure of the amount of oil it has in the ground, and a key pointer to future growth, revenue and profitability. Shell’s shares plunged when the company said it had overstated reserves, at least according to the rules of the American financial watchdog, the Securities and Exchange Commission.

Since then the company’s reserves replacement ratio — in essence, Shell’s ability to discover and extract sufficient new oil and gas to replace its current assets — has become a crucial indicator for the company. Van der Veer had hoped “elephant” projects like Sakhalin would provide a way out of the reserves crisis, and has said that he hoped to have 10 such projects up and running by 2015.

Fortified by these new projects, Shell set itself ambitious targets for future oil production. It said it will produce the equivalent of 3.8m-4m barrels per day by 2009, and will have replaced 100% of its reserves between 2004 and 2008.

The loss of Sakhalin could dent these targets. Citigroup analysts say the sale of 30% of the company’s stake would reduce production to 3.5m barrels a day — meaning Shell would be producing the same amount of oil in 2009 as it did last year.

Even more worryingly, given the debacle of 2004, reserves might have to be “de-booked” — although the Citigroup research notes that it is not clear how much of Sakhalin is already included in Shell’s reserves figures.

As Van der Veer might reflect this weekend after the latest round of negotiations with the Russians, elephants can sometimes be difficult to control.

Miner holds on to licences

LIKE Shell’s Jeroen van der Veer, Peter Hambro made a trip to Russia last week.

Fortunately for Hambro, a goldmining entrepreneur with interests in eastern Russia, his visit appears to have had a more positive outcome.

Shares in the AIM-quoted Peter Hambro Mining had tumbled after reports that Oleg Mitvol, the deputy head of Russian environmental watchdog Rosprirodnadzor, was questioning five of the company’s mining licences. Investors feared yet another tale of Russian interference in a western company, with a consequent loss of valuable assets.

Hambro flew to Russia on Thursday to meet Mitvol. He appeared to win a result: in a statement from Rosprirodnadzor, translated and issued to the London Stock Exchange by Peter Hambro Mining, Mitvol said there was no issue of political interference with western companies.

“Rosprirodnadzor’s inspections are in no way related to politics. Inspectors do their work and exercise government control over use of mineral resources,” said Mitvol.

Hambro said he was satisfied with the outcome. “Three of the licences they were questioning we don’t even own anymore. There are minor infringements on which the regulator has a valid point, but we can fix those. I am fairly certain this will go away.”

The Litvinenko affair — a former Russian intelligence officer, Alexander Litvinenko, died in London from radiation poisoning — and the furore over Shell’s Sakhalin project have not helped investor sentiment towards companies with exposure to Russia, Hambro said.

Peter Hambro Mining shares fell as low as 822p, but recovered to end the week at 1,006p.

Hambro said that companies doing business in Russia needed a strong local partner. “A western company going in by itself wouldn’t understand what was going on,” he said.
 
http://www.timesonline.co.uk/article/0,,2095-2508214_1,00.html

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