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Business Week: COVER STORY: Sakhalin Island: Journey To Extreme Oil (article we missed from May 2006)

EXTRACT: “We were overoptimistic on budget and underestimated a number of things,” says Malcolm Brinded, Shell’s executive director for Exploration & Production.


Big Oil’s future lies in such forbidding places as Russia’s Far East
MAY 15, 2006
With their home reserves depleting fast, the big Western giants are increasingly compelled to go to any extreme to find new oil and gas. Sakhalin Island is about as extreme as they come.

Anton Chekhov, who visited in 1890, described the island, then a penal colony, as a hellish place. Even today Sakhalin is a remote, sparsely populated area whose few towns are dominated by shabby Soviet-era apartment blocks and patrolled by packs of semi-wild dogs.

The 600-mile-long strip of mountains and forests off Russia’s Far East is as good a vantage point as any to see the international oil industry’s future and the challenges it faces. Big Oil is having to place ever bigger bets to get the reserves it needs. As a result immense new landmarks — drilling platforms, pipelines, and liquefied natural gas facilities — are rising through the mists of this forbidding island. An estimated 45 billion barrels of oil equivalent lie beneath the icy seas off its shores, a figure rivaling what remains in the U.S. or Europe. But developing those resources is proving lengthy, difficult, and expensive. Cost overruns have been huge, and no one knows if the Russians will end up controlling the assets now being built. “This is a frontier project like the North Sea or Alaska [was],” says Ian Craig, CEO of Sakhalin Energy Investment Co. “The industry doesn’t know how to do everything” here yet.

Clearly, this is a game for the big boys only — Shell (RD ), ExxonMobil (XOM ), and BP (BP ) — and even they are struggling to get Sakhalin right. Operations of the island’s biggest player, Royal Dutch Shell PLC, stretch all the way from the island’s barren northeastern shore on the Sea of Okhotsk to the regional capital city, Yuzhno-Sakhalinsk, and further south. Shell is a 55% partner in Sakhalin Energy Investment Co., a controlling stake it picked up when Marathon Oil (MRO ) Corp. bailed out in 2000. Shell’s other partners are Mitsui & Co. and Mitsubishi Corp. Together they are building and operating Sakhalin II, a batch of five or six projects each costing a billion dollars or more and employing 17,000 people. Shell has hurt its reputation with investors and with its Russian hosts by letting the costs of the venture soar. In 2005, Shell announced that the price tag for the main phase of Sakhalin II would double, to $20 billion.

There’s a lot at stake. Oil and gas from beneath three platforms off the island’s northeast coast will be pumped onshore by pipeline and sent 500 miles south to the tip of the island. There the oil will be loaded into tankers and the gas supercooled in giant liquefied natural gas plants, to be shipped to energy-hungry Japan and South Korea, and probably to China. Some gas will also pass through a terminal in Baja California, Mexico, and on to the West Coast of the U.S.

If successful, the project will confirm Sakhalin’s stature as a major new energy province and transform Russia into a key supplier to Asia. Sakhalin II will also be Russia’s first ticket into the game of liquefied natural gas, a hot area of the energy industry these days. Altogether, Sakhalin II boasts 4.5 billion barrels of reserves. Shell expects to be producing 185,000 barrels a day of oil plus condensates from gas and 467 billion cubic feet per year of gas by 2008. Sakhalin II “is a vanguard project for all of Russia,” says Dinty Miller, BP PLC’s recently retired senior VP for Sakhalin. “It’s a huge barometer on what can be done.”

Just getting to Sakhalin, and to Shell’s operations, is challenging in itself. The island is located seven time zones, and a nine-hour flight, from Moscow. That’s the first part of the journey. Expatriate oil workers and visitors then board the train that runs north from Yuzhno-Sakhalinsk to Nogliki, the snowy gateway to the offshore oil fields. Sakhalin Energy maintains its own sleeping car with wood paneling, rugs, and burly, tattooed guards to fend off bandits. Passengers board in the evening and toss and turn on narrow bunks in steamy cabins while the train bumps and clatters for 15 hours through the snowy wastes. Sakhalin Energy’s operations in the north are so remote that it had to build a 43-mile road to get there. Bears roam the woods, and the weather is so bad that construction manager John Burn hires 70 people to keep the area clear of snow and ice six months a year.

Working conditions are ferocious. Even in March, heavy snow came down on workers struggling to build a 100-megawatt power plant near Nogliki that will be used to power Sakhalin Energy’s offshore drilling platforms. Out on the Sea of Okhotsk, ice floes drift much of the year, so the company is building heavily reinforced platforms designed to withstand ice collisions and even earthquakes: Sakhalin sits astride an active seismic zone. Icebreakers will remain on standby at each platform in case of emergency, an extra cost compared with most offshore operations, which rely on less expensive boats.

The pipeline system that Sakhalin Energy is building is no less complicated. Two conduits — one for gas and one for oil — are being buried in mountainsides and other rugged terrain and will cross about 1,000 streams and rivers on the way south. Many of the waterways are spawning sites for salmon, posing an environmental challenge. In special cases Sakhalin Energy uses sophisticated drilling to tunnel under streams. But the company has run into trouble with sloppy local contractors who rely on their instincts to do things their way, managers say.

Sakhalin’s environmentalists are tough to please. Dimitri Lisitsyn, an ex-carpenter who chairs the local Sakhalin Environment Watch, worries about the buried pipeline because a leak will be hard to detect. He criticizes Shell for being slow to respond to environmental concerns. “Exxon addresses issues much better,” Lisitsyn complains. He’s also concerned about endangered gray whales whose feeding grounds lie near a Sakhalin Energy field. After years of criticism, the company decided in 2003 to reroute one of its planned pipelines. This and other changes will cost $300 million. Lisitsyn still claims one platform will be too close to the whales.

Because Sakhalin lacks a high-tech local oil industry, Sakhalin Energy must import just about everything, including oil platforms built in South Korea and towed across the Sea of Japan. Shell had hoped to turn to Russian suppliers for pressurized tanks and other equipment, but these proved “useless,” says a senior Shell executive. Even so, Shell has channeled some $6 billion in work to Russian contractors for building roads, pipelines, and other jobs.

Sakhalin Energy is also responding to the demands of indigenous peoples. Numbering about 3,500, they live mainly in the north and protested vigorously against the company’s construction projects there. So Sakhalin Energy is spending $1.5 million to bolster enterprises, such as fishing and dog-raising. “In 20 or 30 years the companies will leave the island exhausted. But the indigenous peoples will still be here,” says Catherine Koralova, who represents them in the Sakhalin parliament.

Meanwhile, the local mayor of Korsakov, site of Sakhalin Energy’s LNG operations, is pressuring the company for subsidies. Gennadiy A. Zlivko led demonstrations and took the company to court to help win a tenfold rent increase on its LNG site to $500,000 a year. Now he wants Shell to gasify his town, which is heated by coal and only has an intermittent water supply. “I saw that this was our chance,” he says. “I have waged a cold war this year to catch up on what we have missed out on.”

Considering the billions that Shell stands to gain from Sakhalin II, the indigenous peoples and Zlivko are minor worries. The bigger issue is the Kremlin. Everyone from President Vladimir V. Putin on down is complaining about cost overruns. That’s because under the production sharing contract, signed in 1994, Russia will start making serious money only after Sakhalin Energy recovers its costs. Up to then, the company pays just a 6% royalty on revenues. After that, Sakhalin Energy will get 90% of the profits until the project shows a 17.5% return. Income taxes will be 32%. “If they can’t develop the project at the original costs, perhaps we should bring in another operator,” gripes Vladimir Efremov, chairman of the Sakhalin parliament.

His words may be local rhetoric, but the question is how high a price will Shell have to pay for its cost runup. Russia, like other oil countries, knows it has much more leverage than it did when it first inked its deal with Sakhalin Energy. Shell executives acknowledge some mistakes. “We were overoptimistic on budget and underestimated a number of things,” says Malcolm Brinded, Shell’s executive director for Exploration & Production. “If you are working in a frontier environment it is prudent to put more of a factor of uncertainty into your estimates,” he adds. Sakhalin Energy’s Craig maintains the costs of finding the oil and gas will be acceptable even after the cost overruns.

To smooth relations with the Kremlin and gain a strong local partner, Shell last year agreed to swap 25% of its controlling stake in Sakhalin Energy to the powerful state-owned gas giant, Gazprom. In exchange, Shell receives a 50% stake in a Gazprom field in western Siberia. Teaming with Gazprom should give Shell some political protection for now, but how much the government might want to up the ante later is a big question. Some seasoned observers, such as BP’s Miller, are cautious about Gazprom. “You have to be nervous as a Shell executive. They are stepping into an unknown,” he says.

Shell executives are mum about the Gazprom talks. But to Shell, teaming up with a strong Russian partner could be key to locking in its role on Sakhalin Island and ensuring long-term gains. The real money will come, says Shell’s Brinded, when other players begin to use Shell’s expensive LNG plants and terminals. “The goal is to create first-mover advantage and then expand,” he says. A big investment, a big bet. That’s the future for global oil companies.

By Stanley Reed on Sakhalin Island

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