Financial Times: Shell learns cold reality of Sakhalin deals: ‘…company’s prospects and reputation have taken a blow.’

By Ed Crooks and Arkady Ostrovsky
Published: December 21 2006 22:34 | Last updated: December 21 2006 22:34

As he heads home from chilly Moscow, Jeroen van der Veer, Royal Dutch Shell’s chief executive, can reflect ruefully that things might have been worse.

He is coming away with $4.1bn (£2.1bn) in cash, a 27.5 per cent stake in an important project that now seems likely to proceed without much further trouble, and the consoling prospect that once the wounds have healed, he may be able to develop profitable opportunities in Russia.

But he has been taught a hard lesson about the realities of doing business in today’s Russia, and his company’s prospects and reputation have taken a blow.

The best news for Shell in Thursday’s deal was that it ended the uncertainty hanging over the project. As the Kremlin closed in on Sakhalin-2, it seemed possible Shell might have to surrender control of the project without meaningful compensation.

From the Russian point of view, by taking control over Sakhalin-2 the Kremlin was “restoring justice” rather than expropriating assets, according to one senior Russian official. “The problem is that in Russian psyche justice and law are not the same thing,” the official said.

During the past few weeks, Gazprom has been aggressively pushing down the valuation of Sakhalin-2 project, arguing it should be set off against the cost increase and environmental damage it had caused.

At one point Gazprom argued that, taking everything into account, it owed almost nothing to Shell and its two Japanese partners for giving up majority control in the $20bn project.

However, Gazprom on Thursday said: “We are a civilised company and we are paying a market price for the stake.”

The price is certainly not generous: it works out at about $4 a barrel of oil equivalent in reserves. Shell on Thursday described it as “satisfactory”. Now Shell’s stake in Sakhalin-2 has fallen below 50 per cent, it will no longer be able to consolidate the project in its figures, so the hit to its reported reserves, which will be detailed by the company next year, could be large.

Jonathan Wright of Citigroup estimated that the possible reported loss could be up to between 5 per cent and 6 per cent of proven reserves, which on the US Securities and Exchange Commission’s definition were 11.5bn barrels of oil equivalent at the most recent estimate.

Shell prefers to look at the potential resources it could develop, which it estimates at about 60bn barrels of oil equivalent. On that basis, the lost resources would be about 1.1bn barrels, or less than 2 per cent.

More importantly, Shell’s production now looks likely to be roughly flat at about 3.5m to 3.6m barrels a day for the rest of the decade, Mr Wright believed.

Earlier in the year, Shell was indicating an objective of 3.8m to 4m barrels a day by 2009.

In the longer term, Shell could still do more in Russia. Mr van der Veer said the company would “consider all opportunities”.

Thursday’s deal included what was called an “area of mutual interest arrangement” between Gazprom and Shell and its Japanese partners in Sakhalin-2, which the companies said would “cover both future Sakhalin oil and gas exploration and production opportunities, and building of Sakhalin II into a regional oil and LNG [liquefied natural gas] hub.”

Jason Kenney of ING said that future developments in the area made possible by Gazprom’s involvement could turn out to be extremely significant.

“Later returns can be fantastic compared to the initial returns you get on a start-up investment,” he said. “Getting access to more gas reserves would seriously boost the value of the project.”

The problem for Shell is that it already has a long list of investments that will be reaching full production in 2009 or later.

Into the next decade, Shell’s prospects still look exciting. But it will demand a rare degree of patience from its investors.

Copyright The Financial Times Limited 2006

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