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The Wall Street Journal: Gazprom, Shell Reach Deal On Siberian Energy Project

By CHIP CUMMINS in London and GUY CHAZAN in Moscow
December 21, 2006 1:58 p.m.

Royal Dutch Shell PLC’s decision to relinquish control of a massive oil and natural-gas project on the far eastern Russian island of Sakhalin significantly crimps the Anglo-Dutch oil giant’s future production and reserve-replacement prospects.

But it also solidifies Kremlin support for the project, removing short-term questions over its timing and greatly improving Shell’s longer-term chances of remaining a big player in Russia.

Late Thursday in Moscow, Shell and its partners agreed to hand over 50%, plus one share, of the project to OAO Gazprom, the state-controlled Russian giant, for $7.45 billion in cash.

The stake is difficult to value because of steep cost overruns at the project. But by most estimates, the deal provides Gazprom with extremely attractive terms, essentially allowing it to buy into the project late in its development stages with little project risk and at a price that would be similar to one it could have paid as a ground-floor investor.

The deal values the project at about $15 billion, but Shell and its partners have already put $12 billion into the project, called Sakhalin II, which is about 80% complete. Gazprom will take a 50%-plus-one-share stake in operator Sakhalin Energy Investment Co. Shell, which had owned just over half of SEIC, will dilute its stake to 27.5%. Partners Mitsui & Co. and Mitsubishi Corp., both of Japan, agreed to lower their stakes to 12.5% and 10%, respectively.

A Shell spokesman said the company viewed the deal as “acceptable,” declining to elaborate.

The dilution is a big blow to Shell because it will force the company to slash future oil and gas production estimates and reserve-replacement goals. By slicing its stake roughly in half, Shell will likely see its share of production and reserves fall proportionately.

Rating agency Fitch estimates that the Sakhalin project accounted for about 50% of the company’s organic reserve replacement from 2003 to 2005. Reserves are the energy a company says it has stored in the ground, and so-called reserve-replacement rates are used by shareholders to gauge a company’s growth prospects. Fitch also estimated that eventual oil and gas production at Sakhalin would represent about 7% of Shell’s total, current production.

The dilution in reserves and output is especially troubling for Shell, which has lagged its peers in recent years in both reserves replacement and production growth. After assuming the helm at Shell in 2004 after a reserve-accounting scandal at Shell, chief executive Jeroen van der Veer trumpeted Sakhalin as one of a handful of super-big projects he hoped would help turn the company around.

Yet some think Shell could end up gaining from the Gazprom deal. “With Gazprom as a strategic partner, the prospects for bringing additional gas in the region to commercialization is much improved,” said Derek Butter, an analyst with oil consultant Wood MacKenzie, which has valued Sakhalin II at $17.5 billion. “That raises the value of the project for all the partners.”

The deal also ends months of acrimonious haggling between Shell officials and the Kremlin, which has moved aggressively in recent years to assert more control over its petroleum industry. By hammering out a deal – however painful – Shell wins the backing of the Kremlin and is likely to smooth its often rocky relationship with Russian regulators.

“Our first priority is to get Sakhalin II up and running,” said Mr. van der Veer in a statement. “This agreement is an important step forward, and positions Sakhalin II for further growth opportunities.”

Speaking Thursday evening, Russian President Vladimir Putin confirmed what had been widely expected – that Sakhalin II’s regulatory difficulties would evaporate as soon as Gazprom came onboard. At a signing ceremony for representatives of the new Sakhalin shareholders, he said the project’s “fundamental problems” — its cost overruns and environmental violations — “can be considered resolved.” Earlier, one regulator had threatened to sue the Sakhalin consortium for anything up to $30 billion in Russian and international courts over alleged environmental damage.

Sakhalin Energy had warned of possible project delays because of the regulatory pressure, but Shell said in a statement Thursday it now looked “forward to implementing the project in line with the current schedule.”

Write to Chip Cummins at [email protected] and Guy Chazan at [email protected]

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