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MoneyCNN/Fortune Magazine: Shell shakedown

Fortune’s Abrahm Lustgarten reports how the world’s second-largest oil company lost control of its $22 billion project on Russia’s Sakhalin Island.

By Abrahm Lustgarten, Fortune
February 1 2007: 12:10 PM EST

(Fortune Magazine) — Word that control of the world’s largest integrated oil and gas project had been wrested from Royal Dutch Shell trickled down to the company’s staff on Russia’s Sakhalin Island in December the same way it reached everyone else: via the newswires.

Outside Shell’s six-story steel-and-glass compound in Yuzhno-Sakhalinsk, a town of 175,000, snow swirled in subzero wind past drab rows of communist-era cinderblock apartments. Inside, Jim Niven, the company’s gregarious head of external affairs, was halfway through an upbeat presentation on the vast potential held in this claw-shaped island dangling from the Siberian Arctic – an estimated 45 billion barrels of oil and gas – when he was interrupted by a nervous colleague, paper in hand.

The news was stunning, even if rumors had been flying: Shell (Charts) was halving its ownership in the $22 billion project, cutting its stake from 55% to 27.5%, and Gazprom, the Russian gas giant, was stepping in, buying Shell’s share plus half the stakes owned by Japanese partners Mitsui and Mitsubishi, for just $7.5 billion – the equivalent, says a Shell spokesman, of “paying to enter on the ground floor, as if they were a shareholder at the beginning.” The foreign companies also agreed to absorb $3.6 billion of the project’s mounting cost overruns.

Shell’s top executives, who were in Moscow at the time, weren’t negotiating from a position of strength. Not in Vladimir Putin’s Russia, where strong-arm tactics have been used to reassert government control of the country’s vast natural resources. Last summer the Russian Ministry of Natural Resources suddenly backed Sakhalin Island environmentalists, revoking permits and delaying work on twin 400-mile pipelines that connect to a monstrous LNG terminal and an oil-export facility. The threat of a $50 billion lawsuit meant Shell stood to lose everything.

“A guy says, ‘Give me half of what is in your pocket, or I shoot you and kill you,'” says Oppenheimer oil analyst Fadel Gheit. “You give him half and say, ‘Thank God I am alive to live another day.’ They could have lost all of it.”

That December night Yuzhno was abuzz with the news. In the Chameleon bar, where Russian bands hammer out Western rock riffs and twentysomethings pass the hose of a hookah pipe, phones started to vibrate and text messages were thumbed out. The talk was exultant, nationalistic. The feeling was that Shell had it coming.

“I’m not proud of how it was done,” said one Russian oil worker. “Russia has lost a lot of reputation on this. But I am happy. Shell – they just don’t understand how this place works.”

Risks on the frontier

That Shell and its partners were victims of an unscrupulous campaign by the Russians to win leverage at the negotiating table is certainly true. The company’s loss of its controlling interest in what chief executive Jeroen van der Veer called a “key part of Shell’s upstream strategy,” amounting to an estimated 5 percent of its global reserves, is largely a story about the high risks of frontier international energy projects. But it is also a tale of how Shell misplayed a strong hand and, after 12 years of work, lost untold billions of dollars in future earnings.

It starts with a production-sharing agreement that most observers agree was inherently unfair to Russia – a deal signed in 1996, when oil was $22 a barrel and Russia was on its knees, that gave the Shell-controlled Sakhalin Energy Investment Corp. the right to recoup all its costs plus a 17.5% rate of return before Russia would get a 10% share of the hydrocarbons coming out of the ground.

Then there was the cost of the second phase of the project, which ballooned from $10 billion in 1997 to $20 billion in 2005, fueling a perception that the company was profligate while Russians picked up the tab. The chapters in between include a calamitous safety record, a failure to meet local expectations for new roads and schools, a fuel spill in Sakhalin’s third-largest city, and environmental concerns that caused anger and resentment toward Shell’s leadership, earning it a reputation for stubbornness and for consistently misreading political realities.

“Shell is always resisting,” says Tom Madderom, a veteran Sakhalin contractor who has worked on the Shell project but is now employed at another site, run by Exxon Neftgas, on the northern tip of the island. “Instead of accommodating, they come out with lawyers and try to prove their case. You can run a project in Russia and have a win-win deal – even a project of this size. But it takes engaging with these people, and Sakhalin Energy hasn’t been real good at it.”

Take, for instance, the ire the company has drawn in Korsakov, a small weather-beaten port city on the island’s southern coast, near Sakhalin Energy’s Prigorodnoye LNG plant. Residents say the company led them to believe that housing for 6,000 construction workers would be located in the town, where it could later be reused by the community, which sorely needs it. Many people in Korsakov earn less than $300 a month – a sharp contrast to the wealth of Sakhalin Energy employees, many of whom, especially those who come from other countries, make more than $1,000 a day.

But when construction began, Sakhalin Energy built its housing for workers next to the plant itself, inside a one-kilometer safety zone, where it will be illegal for people to live once operations begin. “People here could use this place for their well-being, and it will be demolished,” says Elena Lopukhina, director of a Korsakov advocacy group and an assistant to a regional government official, who says that is just one of the emotional issues in the community that have swayed people against Sakhalin Energy. “The company did everything that was good for them and not good for us.”

Executives at Sakhalin Energy say the production-sharing agreement would have prohibited such a promise, and they maintain that these sorts of complaints are based on unrealistic hopes. “When big projects come along, expectations are always running higher than reality,” says Niven. “But clearly there are also opportunities.”

Local government revenue, he says, has increased fivefold, and unemployment is just over 1%. Sakhalin Energy has contributed more than $300 million so far to roads and infrastructure. And while it’s too early to offer a verdict, he believes Sakhalin is on the cusp of a four-decade period of economic development. There are at least nine major oil and gas projects planned on the island, involving many of the world’s largest oil companies. Shell’s problem is that its project, known as Sakhalin II, is the largest of them all – and therefore the biggest target.

Much of the ammunition for Russia’s political war against Sakhalin Energy comes from the cramped Yuzhno office of an independent environmental group called Sakhalin Environment Watch. At its helm is Dmitry Lisitsyn, a sharp-witted 39-year-old who has been hounding oil companies on the island for more than a decade. “We understand that our issues are being used as leverage,” Lisitsyn says, “but at the same time, real problems exist.”

If the government’s inspections were politically fueled, though, Lisitsyn’s motivations are not. He has the respect of his foes, and as Sakhalin Energy’s Hilary Mercer, who heads the LNG project, puts it, “wants what is best for this place.” Lisitsyn says Sakhalin II is a “lighthouse,” a template for how future projects will deal with environmental and social standards. Chief among his concerns is the impact of the LNG plant, Russia’s first, and the pipeline that leads to it.

The LNG plant and export terminal lie on a 1,210-acre patch of land about eight miles from Korsakov, abutting the steel-gray Aniva Bay. To the north a wide right-of-way cut in the forest marks the gas and oil pipelines’ path up over the hills to the offshore platforms. To the south a jetty sticks out into the bay like a needle, ready to inject the 156 LNG tankers expected to dock there annually with liquefied gas, before sending them off to markets in the U.S., Japan, and Korea. The plant, mostly completed, won’t come online until 2008, but already its output for the next 20 years is sold out.

Inside the perimeter fencing, where roughly 10,000 of Sakhalin Energy’s 18,000 employees work, is – for now – the world’s largest LNG facility. What happens inside the fence is by most accounts an orderly, world-class operation and a feat of engineering in Sakhalin’s near-arctic conditions. It’s what happens outside the fence that has drawn the scrutiny of Sakhalin Environment Watch and fomented ill will.

In order to bring LNG tankers into Aniva Bay, Sakhalin Energy had to dredge the bottom near shore, then dump the mud – two million cubic meters of it, Lisitsyn says – farther out in the bay. The island’s second-largest industry after oil is fishing, and Aniva Bay is home to a diverse ecosystem that could be threatened by the dredging.

Lisitsyn wanted the company to use a longer pier, requiring less dredging, and dump the material farther out at sea. Instead Sakhalin Energy pursued the cheaper near-shore option. Now Lisitsyn is taking Sakhalin Energy to court, seeking a full accounting of environmental damages in the bay. Among other things, he alleges some of the dredging was conducted during the summer, in violation of laws protecting salmon spawning.

In that case and in disputes over the pipeline route, Lisitsyn has been highly critical of Sakhalin Energy’s oil-spill preparedness and construction techniques. He says the company spends more time talking than taking action. “Sakhalin Energy loves the dialogue – it is one of their gods,” he says. “But we don’t want just talk, we want solutions.”

That approach has led to delays and cost increases. In 2005, Sakhalin Energy made routing adjustments to its pipeline design to minimize risk from a possible earthquake. The company says it followed proper channels, but Oleg Mitvol, deputy director for environmental inspections at the Natural Resources Ministry, told the press that the pipeline cut into a protected nature reserve, prompting him to describe Sakhalin Energy as “a pure banana republic – colonizers in cork helmets.”

The following year a controversy erupted over large piles of earth left along the pipeline, which Sakhalin Environment Watch says were never permitted and which led to the temporary revocation of construction licenses last September.

“Look, this is a huge, complex, frontier type of project,” says Sakhalin Energy’s Niven, explaining the slew of confrontations. “We were the first company ever to put an offshore production platform in here. These are new to Russia, so the Russians themselves have had to learn how to manage and approve them.”

To be sure, Shell isn’t the only culprit. Russia’s own oil and timber companies have been pillaging the island for resources for more than a century, and Lisitsyn says, “There is a common perception that Gazprom will be much worse.” Furthermore, it was the Kremlin, not Shell, that recently cut the island’s take of oil taxes from 60% to just 5%. And Sakhalin Energy deserves credit for keeping the project afloat and providing employment through a period of unprecedented economic and political change in Russia.

But to a large extent the mood on Sakhalin Island comes down to perception, not fact. Says Oleg Yugai, deputy for economic policy and budget for the regional government: “This is all about the psychology of the people.”

When Shell signed the Sakhalin production-sharing agreement in 1996, the oil company had the upper hand. The oil and gas reserves on the island had been identified, and there weren’t any exploration risks, but Moscow didn’t have the capital to get to them. Shell and its partners did. Details about the document are sketchy, and the company won’t comment. But in effect, the agreement meant that the higher the cost of the project, the longer the Kremlin would have to wait to see any royalties.

Production-sharing agreements are common in the oil industry, but the Sakhalin contract broke new ground. “This one is particularly disadvantageous to the Russian party,” Ian Rutledge, an economist with Sheffield Energy & Resources Information Services, wrote in a 2004 report. “SEIC has transferred most of the risks… to the Russian government.”

At the time the deal was struck, though, says Sakhalin Energy CEO Ian Craig, Russia was too volatile an investment without the framework and the fiscal regime the agreement provided. “You can debate whether [the terms] are fair or not now,” he says, pointing out that the $13 billion invested to date is all shareholder-funded. “But it’s a debate about dividing up a share that simply would not exist, had we not set them up then.”

Russia’s patience ran out in 2005, when Sakhalin Energy announced that project costs had doubled. Much of the jump can be attributed to a 20%-a-year leap in the price of labor, rising costs of materials like the steel used for pipelines, and higher oil prices. “It cost me twice as much to fly from Moscow to Yuzhno as it did two years ago,” Craig says. “We’re living in a $60-a-barrel world, and that applies to everything.”

But even if many of the extra costs can be rationalized, frustrated residents tend to focus on the ones that can’t. Sakhalin Energy is said by contractors to be spending up to $15,000 a month to house the families of some staff. When one contractor’s barge ignored storm warnings to leave port and broke apart, spilling 55,000 gallons of fuel, Madderom says the tab was about $60 million, just for the boat.

And when Sakhalin Energy rerouted the underwater portion of its pipeline in response to international criticism about the threat to endangered western gray whales – environmentalists say the original route was planned without thorough review – the shift cost nearly $300 million. The company says that was the pricetag for complying with environmental demands. It also denies spending extravagantly.

Still, there are the small things – the $4 pencils and $500 space heaters a customs officer says she saw listed on a Sakhalin import form, the flaunting of money by expatriate staff in downtown nightclubs, the waxed and polished Land Cruiser fleet lined up in an island parking lot – that give Sakhaliners a feeling of watching a party in their living room to which they haven’t been invited.

If Sakhaliners think spending is out of control, that could explain why prices in Yuzhno also seem divorced from reality. The town stretches just a few square miles, with a neat grid of unremarkable streets bookended by a 25-foot statue of Lenin and an imposing Victory Square. The city center is for the most part architectural remnants of the communist era, while the suburbs contain acres of new middle-class housing developments – a reflection of the oil industry’s impact on Sakhalin’s economy. One of these houses can cost nearly $1 million, while a one-bedroom apartment can rent for $3,000 a month, comparable to New York City prices. A five-minute taxi ride costs $12, and lunch at a casual Indian restaurant starts at about $40 per person.

“I’ve spent time in Moscow, Tokyo, and Hong Kong,” says an oil-well engineer for services company Schlumberger, who paid a $70 cover charge to walk into Yuzhno’s newest nightclub, Schastie Project, only to fork over another $19 for a whiskey. “Yuzhno-Sakhalinsk is the most expensive town I’ve worked in.”

Whether Gazprom or Shell owns Sakhalin Energy, the culture is probably not going to change. For one thing, as an analyst pointed out, Gazprom “might be omnipotent, but they still don’t make LNG.” That means Shell and many of its highly paid employees will stay on to manage the project, and staff may even increase as Gazprom brings in shadow workers to watch and learn.

One thing is certain, though: The deal stinks for Royal Dutch Shell, whose top executives declined to comment for this article. Its reserves will take a big hit, a tough swallow for a company already having trouble replacing its in-ground assets. Whether renegotiating a contract with a gun to its head was the smartest move for Shell is an open question. But now that the terms are settled in Russia’s favor, oil majors around the world can expect their playing fields to tilt too. 

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