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The Wall Street Journal: Shell Cedes Control Of Pivotal Russian Oil Project

The Wall Street Journal Sakhalin Map

Deal With Gazprom Dims
Output, Reserves Prospects
But Eases Kremlin Pressure
By CHIP CUMMINS in London and GUY CHAZAN in Moscow
December 22, 2006; Page A3

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 prospects for future production and replacing its reserves.

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

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

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 spokesman couldn’t comment on how Shell would account for the transaction.

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.

Ratings concern Fitch estimates that from 2003 to 2005, about half the reserves that Shell found to replace its production came from the Sakhalin project.

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 before the Gazprom deal that eventual oil and gas production at Sakhalin would represent about 7% of Shell’s total current production.
 
The hit to its reserves and output is especially troubling for Shell, which has lagged behind its peers in recent years in reserve replacement and production growth. After assuming the helm at Shell in 2004 after a reserve-accounting scandal at the company, Chief Executive Jeroen van der Veer trumpeted Sakhalin as one of a handful of super-big projects he hoped would help turnaround the company.

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 are 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.”

Russian President Vladimir Putin yesterday evening 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” — cost overruns and environmental violations — “can be considered resolved.” Earlier, one regulator had threatened to sue the Sakhalin consortium for as much as $30 billion in Russian and international courts over alleged environmental damage.

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

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