The Wall Street Journal: Exxon Strives to Stay On Russia’s Good Side

Huge Sakhalin Project
Is Mostly on Track,
As Shell Feels Pinch
By GREGORY L. WHITE and JEFFREY BALL
May 7, 2007; Page A1

NOGLIKI, Russia — On the beach of Sakhalin Island, some of the roughest, remotest terrain in the world, Exxon Mobil Corp. scored a major technical victory last month: It finished drilling a seven-mile-long hole, the longest between an onshore oil rig and an undersea oil field. Done in record time, the well marked a triumph in Exxon’s bid to unlock one of the planet’s juiciest remaining oil troves.

But the technological difficulty of Exxon’s multibillion-dollar Russian odyssey pales beside a slew of political challenges. The world’s largest publicly traded oil company has clashed repeatedly with Russian authorities over various details of the project — details crucial, in Exxon’s mind, to maximizing the project’s profitability. The fights boil down to a basic difference in approach between the oil company and the oil-rich country. For Exxon, the motive is money. For Russia, it’s a complex stew of politics and profit.
 
The slog by Exxon and its chief executive, Rex Tillerson, to maintain its famous efficiency in infamously inefficient Russia shows how Big Oil is adapting to a power shift in the energy world. With most of the big fossil-fuel stores in the West already tapped, oil companies have been moving to the less politically predictable countries where the most alluring fields remain. Initially, those oil-rich governments, from Russia to South America to West Africa, largely deferred to Western companies they hired to harvest their hydrocarbons. Now, emboldened by rising energy demand, those governments are increasingly calling the shots.

Angola, Algeria and Libya all have recently ratcheted up their take, raising taxes on foreign oil companies or demanding bigger ownership stakes. Venezuela’s President Hugo Chávez has been particularly aggressive, demanding that Western companies give the state a 60% stake in heavy-oil projects in the country.

Last week, in response to Mr. Chávez’s directive, oil companies including Exxon transferred their heavy-oil operations to Venezuela’s state-owned oil company. Some Western oil executives have said that if Venezuela doesn’t offer their companies acceptable compensation for the transfer, their firms will leave the country.

Russia hasn’t gone that far. And Exxon is working to ensure that it doesn’t.

Known historically for its brash confidence, Exxon is now trying to keep a low profile and focus on the operational details it still can control. It’s betting that if it can produce the Sakhalin oil on schedule and within budget, it will be able to avoid the regulatory crackdown at Sakhalin that ensnared another oil giant, Royal Dutch Shell PLC. Exxon says a series of decisions have kept costs at the project within 10% of target on a per-barrel basis, despite surging prices for key supplies like pipe.

Exxon’s Russian project, called Sakhalin-1, is the 10th-largest project in Exxon’s portfolio, based on the value of the oil and gas it holds, according to Deutsche Bank. Exxon has spent more than a decade and about $2 billion so far on the project. Sakhalin is important beyond the numbers. Because of its technical difficulty, the project is used as Exhibit A by Exxon when the company is pitching its services to other oil-rich governments.

“I hope the Russian government…says, ‘Yeah, these guys did what they said they’d do,’ ” says Mr. Tillerson, who assumed Exxon’s top job in 2006 in large part because of the reputation he built through years of work putting together the Sakhalin project. So when other governments are looking to hire an oil company, “hopefully we’ll be looked on positively.”

Higher Energy Prices

Exxon almost certainly will make more money from Sakhalin than it envisioned when it entered the project, thanks to higher energy prices. But the increasing assertiveness of the Russian government means Exxon probably won’t capture the full benefit. Oil was trading at about $25 per barrel in 2000; it closed Friday at about $62.

Vladimir Milov, a former deputy energy minister and now a frequent critic of the Kremlin, warns that Exxon could find itself in authorities’ sights once other, bigger foreign projects have been brought under tighter state control. Russian officials are “busy with other things,” he said. “But they’ll come back to it.”

So far, Russian officials are playing their cards close to the vest. “There are problems that Exxon is running into and which must be solved in the near future,” Energy Minister Viktor Khristenko says in an interview, referring to a dispute over where to sell the gas from the project. Though Exxon so far has fared far better in Russia than Shell has, Mr. Khristenko says that’s no guarantee for the future: “I can’t say that Exxon is doing fine while Shell is doing badly.”
Exxon’s project there dates back to the 1970s, when a group of Japanese companies lent the Soviet Union money to explore for oil in the region. Cold War tensions put that deal in a deep freeze until the early 1990s, when Exxon got involved.

At that time, Exxon and other foreign oil giants insisted on special contracts, known as “production-sharing agreements.” Common in many developing countries, the deals exempt foreign oil companies from paying most local taxes. Instead, they require that the foreign companies, after selling enough oil to recover their capital investment, share the rest of the oil from the project with the government. Desperate for investment amid low world oil prices, Russia agreed to the terms.

Project Gets Going

The project really got going after President Vladimir Putin took office in 2000, looking to jump-start Russia’s battered economy. While tensions soon appeared, Exxon was initially successful in insisting on doing things its way. The regional governor on Sakhalin, one of Mr. Tillerson’s longtime contacts and friends, pushed Exxon to develop the massive project all at once to maximize the benefit to the local economy. He also insisted Exxon run its export pipeline from the sparsely populated north of the island to the island’s southern tip — a distance of 500 miles — to stimulate economic development. Exxon balked, arguing such moves were too risky and costly.

With Exxon digging in its heels, the Sakhalin governor delayed critical approvals for the project. Ultimately, as the Kremlin asserted its authority against regional governors across the country, Exxon won the day.

Exxon also was mindful of Russian politics. When Exxon signed on to the project, the Russian state-controlled company, OAO Rosneft, was widely regarded within the oil industry as a bureaucratic morass. But Exxon decided it wanted to have a state-owned company sharing its financial interest, in part anticipating disputes with Russia over the contract. So Exxon elected to keep Rosneft as a partner. Though Exxon manages the Sakhalin project, it doesn’t have a controlling stake.

“We felt it was important to keep the Russians involved,” Mr. Tillerson says, in part so that if economic disputes arose, the company and the Russian government would be “on the same side of the table.” The decision was prescient. Today, the Kremlin requires all major energy projects to have a Russian shareholder, preferably with a controlling stake.

Putin Tightens Control

In recent years, Mr. Putin has moved to tighten his control over large swaths of the Russian economy, none more than the energy sector, now the country’s largest single revenue source. Still, as recently as 2003, Exxon saw Russia as far more welcoming than other oil-rich countries to foreign investment. Exxon pursued a multibillion-dollar deal to acquire a large stake in OAO Yukos, then Russia’s largest private oil company. That deal fell apart after the Kremlin jailed Yukos’s chief executive and main shareholder in a case widely viewed as politically motivated. Most of Yukos’s assets have since been taken over by Russia’s state-controlled energy companies.

Meanwhile, with global oil and gas prices surging, Russian officials began to publicly criticize production-sharing agreements like those governing Sakhalin. They assailed the agreements as “colonial” — too generous to Western oil companies.

Then came the Shell debacle over an adjacent project, called Sakhalin-2. Years back, while Exxon and the Sakhalin governor were arguing over the pipeline route, Shell chose the route the governor wanted. Shell liked a north-south pipeline because it would bring gas to a new terminal the company was building on the southern tip of the island. And unlike Exxon, Shell launched Sakhalin-2 without a Russian partner. In the summer of 2005, Shell reached a deal to give Russia’s state gas giant Gazprom a 25% stake in that project in return for a share in one of Gazprom’s Arctic projects.

But days later, Shell made a surprise announcement, revealing that Sakhalin-2’s costs would be $20 billion, nearly double the planned level. Partly reflecting the high costs of building the north-south pipeline, Shell’s overruns meant it would take years before Moscow saw a dime of its share of profits from the project. Russian officials were livid.

Talks on Shell’s cost overrun and the deal with Gazprom dragged on for nearly a year. Then last summer, regulators announced they had found what they said were massive violations up and down the north-south pipeline route that Shell chose, especially at river crossings. On the verge of having to suspend work, Shell in December agreed to sell a controlling stake to Gazprom. Within weeks of ceding that stake, Shell saw its regulatory problems begin to clear up.

Shell officials now say they should have moved faster to address cost concerns and bring Gazprom into the project.

While Shell was under attack, Exxon was able to get key permits and other government approvals for its project relatively smoothly, according to company officials, allowing it to hit full production on schedule early this year. Exxon endured about 90 official inspections and reviews last year and cleared all of them, Exxon officials confirm.

But Exxon was also finding the new atmosphere chilly, with the Russian authorities increasingly unwilling to defer to Exxon’s business logic as they had been in the past. Last summer, Russia rejected an appeal by Exxon to extend the project’s production license to cover a recently discovered section on the north side of its field. Rosneft, Exxon’s partner, took the unusual step of warning publicly that the decision could leave the project unable to hit its production targets, which assumed the permit would be redrawn. Russian authorities, insisting the law doesn’t explicitly provide for expanding the license, still said no.

That decision frustrates Mr. Tillerson, who notes Exxon already has the equipment in the area. “I don’t know whether anybody ever will be able to sort it out entirely why the Russian government does what it does,” he says. “The rig’s sitting there,” he adds. “We don’t even have to move it.”

Dispute Over Gas

More recently, Exxon and Russia have clashed over who will decide what to do with the Sakhalin project’s massive potential output of natural gas. Exxon says the project’s contract gives it the right to choose the most profitable way to sell the gas. Last year, Exxon signed a preliminary agreement to ship gas to China, a move that would require building a relatively short pipeline to one of the most voracious energy markets in the world.

“We think the law is quite good and quite clear,” Mr. Tillerson says. “The real question is, can we navigate all the approvals to get what we need to export?”

Mr. Khristenko, the energy minister, says Russia wants to determine where the gas goes. Russia’s gas stores give it immense geopolitical clout. The country recently gave Gazprom a monopoly on exporting gas. While that decision contains an exemption for the Sakhalin project, Russian officials say the exemption doesn’t go so far as to let Exxon build a pipeline to China.

Exxon officials originally had hoped to begin exporting the gas to Asian markets next year. But thus far, as Exxon and Russian officials continue to talk, not much of the gas is being developed. Most is being pumped back into the ground.

Rosneft officials have argued for turning the gas into liquid form and shipping it on tankers to broaden the range of potential customers. Exxon says that option is too expensive.

But Ivan Malakhov, the current governor of Sakhalin, says Exxon should show the Russians all the potential options, not just its preferred one.

“If you’re telling us this girl is the prettiest one, then show us the photos of the others we haven’t seen,” he told a Russian newspaper earlier this year. “So far, we’ve seen only one lady.”

Write to Gregory L. White at [email protected] and Jeffrey Ball at [email protected]

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