stratfor.com: Russia: The Fallout from a Cash Deal on Sakhalin-2

December 20, 2006 17 40  GMT

Summary

The new rumor out of Russia is that Gazprom plans to pay cash to take over majority control of the Sakhalin-2 energy project in the Russian Far East. For the foreign firms involved, a bad deal just keeps getting worse.

Analysis

Press releases from Russian government spokesmen Dec. 20 cite Deputy Energy Minister Andrei Dementiev as saying that state energy firm Gazprom will pay cash for a majority stake in the Sakhalin-2 oil and natural gas project in the Russian Far East. Assuming for the moment that the Russians do intend to pay cash, it will be more than simply a bad financial deal for the foreign firms involved in Sakhalin-2.

For the past year, Gazprom has been using its connections throughout the Russian government to hound Sakhalin-2 with everything from environmental audits to criminal charges. Recently the operating consortium of Royal Dutch/Shell, Mitsui and Mitsubishi have given in to the inevitable and begun negotiating the terms of majority transfer to Gazprom.

It is no surprise that the negotiations have not been going well from the foreigners’ point of view. Gazprom has not simply been attempting to force its way into the Sakhalin-2 consortium; it intends to secure majority control and, barring that, simply kill the project outright. Gazprom currently enjoys a state-sponsored monopoly on all natural gas exports from the country — the source of nearly all its profits — and has no intention of allowing anyone to export energy without its leadership.

Nor does Gazprom intend to pay what might be considered market price. The total development costs of Sakhalin are expected to be about $22 billion (assuming there are no more unexpected price increases). If Gazprom is to attain a 51 percent to 55 percent stake, as it intends, that implies that it would need to compensate the existing consortium members for already-sunk investments and then pony up for half of future investment costs.

However, not only is Gazprom a cash-shy firm (most of its profits go directly into the Kremlin’s coffers) that expects everyone else to pay its way (its reinvestment rates in its assets are the lowest of major energy firms), but Sakhalin is among the most expensive and technically challenging energy projects anywhere.

At its peak, Sakhalin-2 is expected to produce 13.5 billion cubic meters of natural gas per year (to be liquefied and shipped by tanker) and 180,000 barrels of crude oil per day. Combined, that is about 400,000 barrels per day of oil equivalent (boe/day). So a realistic estimate of what a company would be paying for Sakhalin ownership comes out to approximately $55,000 per boe/day, which would in theory put Gazprom’s total costs (including future investment) for 55 percent ownership at $12.1 billion.

In comparison, in 2005 Gazprom paid — largely through borrowing — about $13 billion to buy 73 percent of rival oil producer Sibneft. At the time Sibneft had a daily output of about 910,000 boe/day, for a cost per boe/day of about $20,000. The indebted Gazprom is not about to commit to paying more than twice as much per boe/day for something it lacks the technical skills to run and that is not even fully operational yet. It will, however, be happy to pay less — far less.

Besides the obvious cash hit that the existing Sakhalin-2 partners are about to suffer, Royal Dutch/Shell will have another problem. Because of a bookkeeping scandal dating back to 2004, the supermajor has been scrambling to boost its reserves. While an asset swap granting Royal Dutch/Shell an additional project in Russia for its Sakhalin-2 shares would be problematic, and would likely in the end land the firm in even more trouble than it is now, a cash settlement (even a reasonable one) might actually be worse.

The plans that have leaked out of the Sakhalin-2 negotiations call for Royal Dutch/Shell’s ownership in Sakhalin-2 to drop from 55 percent to 25 percent, which would reduce Royal Dutch/Shell’s ability to count Sakhalin-2 reserves by a proportional amount. For a company already shy of reserves, such a change would hit everything from its share value to its credit rating and greatly complicate its global business.

The bottom line is that Gazprom’s influence in the government — Chairman Dmitry Medvedev is the deputy prime minister and likely next president — guarantees that it will get whatever deal it wants on Sakhalin-2. Which, for Royal Dutch/Shell, will ultimately be a paltry cash settlement, an asset that it will probably not want to develop or — by order of a Russian court — nothing at all.

Russia: The Fallout from a Cash Deal on Sakhalin-2   http://www.stratfor.com/products/premium/read_article.php?id=282153

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