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Economist Intelligence Unit: BP’s Russia worries

EXTRACT: “…six months ago most observers would have been shocked at the extent of the concessions wrung from the foreign consortium operating Sakhalin-2. Nor has there been much of a downside for Russia as a result of this behaviour: Shell’s bruising experience seems not to have deterred others from seeking greater exposure to the energy sector, as ConocoPhillips’ recent bid to participate in the Shtokman project with Gazprom demonstrates. In this climate, it should not be a surprise if sooner or later one foreign company with a coveted asset loses everything. BP must hope that day has not yet arrived.

It is tempting to conclude that Rusia Petroleum will… go the way of the Sakhalin Energy consortium, comprising Shell, Mitsui and Mitsubishi, which has developed the huge Sakhalin-2 oil and gas offshore complex. In late 2006, in the face of extreme pressure from the regulatory agencies over licence and environmental violations, the three foreign companies agreed to give Gazprom 50% plus one share in the US$20bn project for US$7.45bn, just at the point when large-scale production was set to begin; it is not even clear that the Russian company will pay the money up front. Gazprom was also protected from a liability that falls on the oil companies to cover US$3.6bn of the cost overruns at Sakhalin-2.

THE ARTICLE

Mar 12th 2007: ViewsWire
BP is struggling to tackle problems at the giant Kovykta field

TNK-BP, the Russian oil company 50% owned by BP, seems unable to meet the fast-approaching final deadline to correct alleged licence violations at the giant Kovykta gasfield, and so may lose its licence. The authorities have refused to compromise and seem minded to hand Kovykta to Gazprom, the state-owned gas monopoly. BP has little choice but to surrender majority control to Gazprom, as did the Shell-led foreign consortium at Sakhalin-2. Yet Gazprom’s persistently hard bargaining, coupled with recent statements by federal officials, suggest that an outright loss of the licence is distinctly possible.

Speaking at a March 6th press conference, Anatoly Ledovskikh, the director of Russia’s federal subsoil resources agency, Rosnedra, said that he was “100% certain” that Rusia-Petroleum would be unable to correct the licence violations at the Kovykta gas field by the May deadline. Rusia Petroleum is 62.4% owned by TNK-BP. For the last ten years it has held the licence to Kovykta, which has gas reserves estimated at 1.9trn cubic metres.

Since the Yukos affair, however, the Russian state has used its administrative resources to ensure a greater role for its proxies, Gazprom and Rosneft, in the oil and gas sectors. As the tide of energy nationalism has risen in Russia, Rusia Petroleum’s difficulties have multiplied. It hoped to establish a partnership with Gazprom that would permit the large-scale export of gas from Kovykta to China; Gazprom, however, has thus far refused all offers. Now Rusia Petroleum is in trouble for failing to produce the target volumes specified in the licence, and of having broken Russian norms with regard to pipeline construction.

This year, Kovykta is supposed to produce 9bn cu metres of gas for the Irkutsk region. In reality it will produce around 1bn cu metres. BP officials complain that demand in Irkutsk is well below the target level and will only reach 2.5bn cu metres by 2009. Without the ability to export gas, or even the right to market it directly in Russia, Rusia Petroleum has no customers for its gas—although it is ready to start supplies from Kovykta. Nevertheless, at the start of February it was given a three-month deadline to correct licence violations.

Arm-twisting

In his latest comments, Mr Ledovskikh did not limit himself to predicting that Rusia Petroleum would flunk its final test. He ruled out the possibility that the licence terms could be revised for the company, but added that Rosnedra was minded to be flexible on that question in negotiations with a new licence holder (almost universally understood to be Gazprom). Pointedly, Mr Ledovskikh did not explain why Rosnedra had failed to negotiate a similar compromise with Rusia Petroleum.

Mr Ledovskikh also alluded to the fact that Gazprom is in negotiations to secure a stake in Kovykta, and observed that he believed the issue would be settled.

Negotiations have been held periodically over at least the past two years, as TNK-BP sought to persuade Gazprom to build a pipeline to China so that the majority of Kovykta’s output could be sold profitably, rather than on the low-priced domestic market. BP and its partners in Rusia Petroleum have even offered Gazprom a majority stake in the field in return for the gas monopoly’s participation, which is presumed to come with a guarantee that the official attacks on Kovykta will end. The sticking point, seemingly, is that Rusia Petroleum wants Gazprom to enter on commercial terms—and the Russian giant isn’t minded to do so.

It is tempting to conclude that Rusia Petroleum will therefore go the way of the Sakhalin Energy consortium, comprising Shell, Mitsui and Mitsubishi, which has developed the huge Sakhalin-2 oil and gas offshore complex. In late 2006, in the face of extreme pressure from the regulatory agencies over licence and environmental violations, the three foreign companies agreed to give Gazprom 50% plus one share in the US$20bn project for US$7.45bn, just at the point when large-scale production was set to begin; it is not even clear that the Russian company will pay the money up front. Gazprom was also protected from a liability that falls on the oil companies to cover US$3.6bn of the cost overruns at Sakhalin-2.

TNK-BP has already spent around US$200m of the planned US$1bn to develop Kovykta. The field will potentially account for up to 20% of the company’s Russian operations in volume terms, when it is at peak output, although in value terms the share will be smaller as oil is generally more lucrative. It is thus clear that any cut-price deal for Gazprom to enter the project would be negative for Rusia Petroleum and its shareholders. This, however, is probably the best-case scenario. For BP, it is part of a broader battle in Russia. Gazprom has this year decided that TNK-BP subsidiary Rospan will only be able to ship 1.7bn cu metres from the Achimov field in western Siberia through Gazprom’s pipelines; in 2006 the allocation was 2.5bn cu metres. Looming over all these issues, Gazprom is reportedly seeking to buy out TNK-BP’s Russian owners, thereby gaining half of the company. Whether Gazprom will be content to stop at 50% is far from certain.

Losing the lot?

A negotiated solution for Kovykta—one that is hugely favourable for Gazprom—remains the most likely outcome. However, recent statements from Mr Ledovskikh and the deputy head of the environmental agency at the natural resources ministry, Oleg Mitvol, raise the possibility of a yet-bleaker outcome. Mr Ledovskikh, after all, spoke of the likelihood of a new licence holder emerging at Kovykta, one with which Rosnedra would be prepared to renegotiate key terms. Mr Mitvol, speaking on March 1st, was blunter: he said outright that the licence should be stripped from Rusia Petroleum.

There are a few arguments why outright loss of the licence is a possibility in the case of Kovykta. First, in contrast to Sakahlin-2, the project is not protected by a production-sharing agreement (PSA). Second, Rusia Petroleum has not invested huge sums—a couple of hundred million dollars, rather than billions—so arguably full forfeiture of the licence would be less controversial. Third, Kovykta is purely a gas field and thus is firmly within Gazprom’s primary sphere; Sakhalin-2, by contrast, has a large oil component and the oil sector in Russia is more competitive.

Finally, Gazprom has greater leverage over Kovykta because it controls domestic supplies and exports; at Sakhalin-2, Shell and its partners have the ability to export without recourse to Gazprom or another Russian state firm.

These factors could just as easily point to Gazprom entering the Kovykta project on highly preferential terms. The major constraint on the ambitions of Russia’s energy nationalists is presumed to be the fear of an international backlash.

However, six months ago most observers would have been shocked at the extent of the concessions wrung from the foreign consortium operating Sakhalin-2. Nor has there been much of a downside for Russia as a result of this behaviour: Shell’s bruising experience seems not to have deterred others from seeking greater exposure to the energy sector, as ConocoPhillips’ recent bid to participate in the Shtokman project with Gazprom demonstrates. In this climate, it should not be a surprise if sooner or later one foreign company with a coveted asset loses everything. BP must hope that day has not yet arrived.

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