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World Politics Watch: Sakhalin Seizure Risks Discouraging Foreign Investment in Russia’s Energy Infrastructure

Richard Weitz | 26 Dec 2006
World Politics Watch Exclusive

On Dec. 22, the Russian government succeeded in its long-standing campaign to wrest control of the country’s largest single foreign investment project — the $22 billion natural gas development on the Russian Pacific island of Sakhalin. The project includes the first liquefied natural gas (LNG) plant and related export facilities built in Russia.

According to the deal, Royal Dutch Shell, Mitsui & Co., Ltd., and Mitsubishi Corp. will each surrender half of their shares in the Sakhalin Energy consortium. In their place, OAO Gazprom, Russia’s state-controlled natural gas monopoly, has taken a majority (50 percent plus one share) stake in the project, paying a discounted price of $7.45 billion, as much as 20 percent below market estimates of the surrendered assets’ true worth.

President Vladimir Putin’s presence at the Kremlin meeting announcing the deal was only fitting. For months, Russian government agencies had been escalating the pressure on Shell and its partners to renegotiate their original contract, made at a time when energy prices were low and the Russian government was poor and weak. Under the original production sharing arrangement negotiated a decade ago, Shell enjoyed a variety of special privileges, such as an exemption from profit taxes until it had recovered the costs of its original investment. In return, it accepted the substantial risks of locating and developing Russian energy assets when the market outlook for the country’s oil and gas was considerably bleaker than it is today.

The immediate catalyst for the buyout was the threat of Russian environmental regulators to revoke the consortium’s licenses on the grounds that its activities were damaging the island’s environment. Without these environmental permits, the Sakhalin-2 project, which had already experienced substantial cost overruns, would not have been able to start full operations in the summer of 2008 as scheduled. In praising the agreement, Putin indicated that these environmental concerns had essentially been resolved.

The deeper reason for the consortium’s surrender was that for several years the Putin administration has conducted a comprehensive campaign to place all the country’s strategic natural resources and industries under tight government control. Since coming to power, Putin and his entourage have been curbing the power of the independent energy producers (both foreign and domestic) operating in the country and have been establishing state-run holding companies in aviation and other important manufacturing sectors.

Although the Kremlin can rightly gloat over its triumph in the battle over Sakhalin-2 (ExxonMobil leads a smaller Sakhalin-1 project), its conquest may become a Pyrrhic victory. Moscow’s earlier moves against Yukos and other Russian energy companies generated much of the initial alarm among foreign observers about a decline in commercial and other freedoms under Putin. This year’s natural gas disputes between Russia and Ukraine, and subsequently between Russia and Georgia, have alarmed Western governments about the risks of becoming overly dependent on Russian energy supplies. At the recent NATO summit in Riga, U.S. Sen. Richard Lugar (R-Ind.) even proposed that the alliance treat Russian-induced energy stoppages as a security threat requiring a collective (non-military) response.

The rest of the world would benefit from additional Russian energy production. More Russian oil and gas would help curb rising global energy prices and further diversify international supply sources. Europeans still anticipate increasing their purchases of Russian oil and gas in the coming decades. China also wants to buy more Russian energy. Even the United States hopes at some point to import LNG from Sakhalin. Increased Russian energy production would generate extra revenue that the Russian government could use for social welfare, economic development, and other priorities.

Without major changes in government policies, however, Russia cannot substantially increase its oil and natural gas production. Russia has the world’s largest reserves of natural gas, and at least the fourth largest oil reserves. Many of these deposits, however, are located in remote areas like Sakhalin, with challenging geophysical characteristics. Russia needs foreign capital and technologies to exploit these fields as well as upgrade its aging energy transportation networks. Attracting the necessary foreign investment will require the Russian government to overcome outsiders’ perception that political factors determine its energy policies. At home, the Putin government’s efforts to retain near absolute control over Russian energy assets dampen foreign interest in developing the country’s energy resources. State-sponsored policies that discriminate among investors, undermine property rights, and sustain corrupt practices also discourage foreign direct investment.

Some Russians rejoice at their new status as an energy superpower. They see oil and gas as replacing the army and navy as the key pillars of Russian foreign policy. More far-sighted Russians recognize that energy wealth alone will not ensure that Russia becomes a liberal democracy underpinned by the free market principles supported by all other G-8 members. Nor will additional revenue from oil and gas exports guarantee Russia’s transformation into a strong, technologically advanced country capable of partnering with the United States and its allies in managing the many global issues that will shape international affairs in 2007.

Richard Weitz is a senior fellow at the Hudson Institute.

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