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Stratfor: Sakhalin: That Sinking Feeling

February 21, 2006 17 23 GMT
Representatives from Royal Dutch/Shell and Japanese energy firms Mitsui & Co., Ltd., and Mitsubishi Corp. are meeting with Russian state energy major Gazprom to discuss the future of the Sakhalin-2 petroleum project. Before all is said and done, the Japanese will be out, Gazprom will control a very large share of the project, and Shell executives will be extremely depressed.
The three participants in the Sakhalin-2 petroleum project — supermajor Royal Dutch/Shell, Japan's Mitsui & Co., Ltd., and Mitsubishi Corp. — are meeting with Russian state energy major Gazprom on Feb. 21 to decide the future of their joint efforts in the Russian Far East.
The Sakhalin-2 project is an offshore oil and natural gas project to the east of Russia's Sakhalin Island that aims to provide liquefied natural gas (LNG) for export throughout the Pacific Rim. The project has been one of the single largest recipients of foreign direct investment in Russia, and the tripartite consortium behind it initially planned to spend $12 billion on its development.
At least that was the plan. In 2005, Gazprom, currently expanding its reach and tightening its grip over Russian energy resources, bullied its way into the project. Though the details are not finalized, Gazprom will soon take 25 percent of Shell's 55 percent stake. Mitsui and Mitsubishi will share the remaining 45 percent. In essence, Gazprom told Shell the same thing it is telling nearly every other foreign energy investor in Russia: Let us in, teach us the technology and pay our way — or we will have your project killed.
These are not idle threats. Gazprom Chairman Dmitry Medvedev is first deputy prime minister, guaranteeing the firm sizable pull with the Kremlin. In addition to being one of Russia's few oil majors, Gazprom is also the state-ordained natural gas monopoly, giving it all the market pull it needs. Some firms, most notably ExxonMobil, simply boarded up their Russian shops and left.
But not Shell. The Anglo-Dutch supermajor has suffered a number of defeats recently, but none more damning than a reserve accounting scandal that would leave even the Enron team impressed. Shell intentionally overstated its reserves by nearly a quarter — an offense that national regulatory bodies, not to mention shareholders, do not take lightly. To be summarily ejected from Sakhalin-2 would have poured fuel onto boardroom fires, and so Shell sued for peace. It accepted Gazprom's offer that it dare not refuse in exchange for a partnership with Gazprom at the Zapolyarnoye field on the Russian mainland that would boost the supermajor's overall reserve holdings.
The first catch came almost immediately. No one ever expected an offshore project in a region with no infrastructure and moving sea ice to be easy or cheap, and costs have spiraled from the initial estimate of $12 billion to $20 billion. Gazprom said this made its involvement in Sakhalin-2 financially questionable, and that it would require additional compensation.
The second catch arrived Feb. 9 when the Russian State Audit Chamber alleged that Sakhalin-2 intentionally selected inappropriate suppliers and contractors, cheating the Russian state out of $2.5 billion in the process — an amount the chamber suggested the Sakhalin-2 consortium should reimburse. Although the audit chamber's decision has no direct legal weight, it often is used by the Kremlin to float policy ideas just before their implementation.
All this proved too much for the Japanese. They wanted to get in on the ground floor of energy development in the Russian Far East in order to secure non-Middle Eastern supplies. Between cost increases, project delays (the first LNG shipment is now set for mid-2008), and Gazprom's pressure tactics, they see no reason to continue with an increasingly bad deal. That became doubly the case when Mitsui and Mitsubishi discovered that the project would have trouble getting financing even in Japan, where money tends to be no object. The Feb. 21 talks are all about how the Japanese can leave the Sakhalin-2 consortium with as much grace as possible (and ideally, still be able to purchase LNG cargoes).
The question now is who gets the Japanese shares. Public discussion of the topic from the firms involved indicates a sale to Shell is in the offing, something the supermajor can certainly afford. Gazprom, in contrast, is extremely cash poor, given that it is the Russian government's largest taxpayer.
But just because Shell is the likely purchaser does not mean it will end up holding all it buys. Gazprom has laid claim to Sakhalin-2, and is likely to bet that Shell's board remains in dire enough straits to capitulate once again. And Gazprom is probably right.

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