Bloomberg: Shell Slips on Sakhalin Ice, Costs in Fight to Boost Reserves

EXTRACT: Shell is drilling in the seas north of Japan as dwindling energy supplies force producers to venture into increasingly hostile locations. Costs for the Shell-led Sakhalin II project, the company’s biggest single investment, have doubled to $20 billion, undermining Shell’s effort to convince investors it can replace the oil it pumps, two years after overstating reserves.

THE ARTICLE

July 20 (Bloomberg) — The photos on Samer Slim’s office wall catalog the hurdles Royal Dutch Shell Plc must overcome on Russia’s Sakhalin Island: ice-choked drilling rigs, snowmelt swollen rivers and wilderness so remote supplies are dropped by helicopter. His T-shirt warns of another: “Beware of Bears.”

“You’ve got rivers, railways, mountains, swamps, seismic faults, everything, on this section,” says Slim, 35, supervising engineer for the southern reach of an 800-kilometer (497-mile) pipeline across the island. “The hardest time is the end and beginning of winter because of the rain and mud.”

Shell is drilling in the seas north of Japan as dwindling energy supplies force producers to venture into increasingly hostile locations. Costs for the Shell-led Sakhalin II project, the company’s biggest single investment, have doubled to $20 billion, undermining Shell’s effort to convince investors it can replace the oil it pumps, two years after overstating reserves.

“Shell, like its peers, requires access to resources,” says Craig Pennington, head of energy research at Schroders Plc, which manages $231 billion. “They claim to have learned a huge amount from Sakhalin and that it will give them the ability to take on equally large projects in the future. That remains to be seen.”

Sakhalin is crucial to Shell’s plans to boost production and prove that it can take on more projects in Russia, which holds the world’s largest natural gas reserves. Russia, where state- controlled OAO Gazprom and OAO Rosneft are increasing control of energy production, last year disqualified Shell from bidding for a share of Shtokman, a gas field in the Barents Sea that U.S., French and Norwegian companies are now vying for.

Reserves Scandal

Europe’s second-biggest oil company is struggling with rising costs for steel, equipment and labor on Sakhalin. Environmental groups seeking to protect whales and salmon have forced Shell to redesign and reroute pipelines, while the European Bank for Reconstruction and Development is reviewing Sakhalin II before approving loans for the project.

The Hague-based Shell is still recovering from the 2004 accounting review that forced it to reduce proven reserves by 5.63 billion barrels, or 29 percent. The cut cost Chairman Philip Watts his job and persuaded Shell to ditch its century-old dual- ownership structure.

Shell in May said it may miss its goal of replacing all the oil and gas it produces as rising prices for contractors and materials delay some projects. The company last year replaced only 67 percent of the proven reserves it pumped from the ground after exploration lagged behind its competitors. Larger BP Plc replaced 95 percent of reserves under U.S. accounting rules.

`Unconventional’ Projects

Chief Executive Officer Jeroen van der Veer now expects “unconventional” projects, which don’t show up in U.S. reserve calculations, to become increasingly important. Sakhalin II, oil sands in Canada and two deepwater fields in Nigeria and the Gulf of Mexico will produce the equivalent of 1 million barrels of oil a day in the next decade, a quarter of current output, Shell says.

“Oil companies have moved from doing projects that can be measured in hundreds of millions, to billions and tens of billions of dollars,” says Daniel Yergin, author of “The Prize: The Epic Quest for Oil, Money and Power,” which won the 1992 Pulitzer Prize. “The scale of the complexity has grown enormously. Companies are searching in much deeper waters or in much more remote locations.”

Sakhalin is one of Russia’s richest petroleum provinces, with as much oil and gas as the North Sea, attracting companies such as Exxon Mobil Corp., BP and India’s Oil & Natural Gas Corp. Shell’s venture is the most advanced.

Soviet-Era Outpost

The island, once dotted with Soviet-era prison camps and top-secret military bases, is also one of the harshest environments in which to drill for oil.

“A lot of the reserves that remain in Russia are in difficult locations like this,” says Ian Craig, CEO of Shell’s Sakhalin venture, known as Sakhalin Energy Investment Co. “Getting this to work is a key test of how you can develop those other deposits.”

Shifting pack-ice covers Sakhalin’s offshore fields for half the year, forcing Shell and Japanese partners Mitsui & Co. and Mitsubishi Corp. to build twin oil and gas pipelines to an ice- free port under construction at the island’s southern tip.

The port will include Russia’s first liquefied natural gas plant, which will cool gas to a liquid so it can be exported by ship. Deliveries are expected to start in 2008, with shipments rising to 9.6 million tons a year, equal to about a third of China’s gas needs. Almost all of the LNG has been sold on long- term contracts to buyers from Japan to California.

Earthquake Protection

Two offshore production platforms will be the first to include bearings similar to those used in California skyscrapers to help withstand earthquakes. Almost 2,000 people were killed in 1995, when a magnitude 7.6 quake struck northern Sakhalin.

“Project management is what the major oil companies like BP and Shell need to deliver if they want access to resources,” says Jason Kenney, an analyst at ING Wholesale Banking in Edinburgh, who has a “hold” recommendation on Shell.

Surging demand for oil in China and India have helped triple oil prices this decade, financing projects that weren’t considered economically viable a few years ago. Shell’s first- quarter net income rose 3 percent to $6.89 billion. The company reports second-quarter earnings July 27.

Shell’s stock fell 6 percent in July 2005 when Van der Veer said costs for the second phase of Sakhalin II had doubled and LNG exports would start eight months later than planned. The already completed first phase allows only summer oil exports.

The company’s Amsterdam-traded shares have fallen 1.2 percent to 26.66 euros since the cost overruns were announced, trailing a 0.9 percent gain at London-based BP and a 5 percent increase in the 22-member Bloomberg Europe Energy Index.

`Reasonable’ Expenditures

“Investors prefer companies that are focused on reasonable capital expenditure, so the cost increase was seen very negatively,” says Markus Ilg, a fund manager at WestLB Mellon Asset Management, which oversees $51 billion, including Shell shares, in Dusseldorf, Germany. “There are others that have a better track record on costs, like BP or Total SA.”

The cost overrun was criticized by Gazprom, which two weeks earlier had agreed to swap half of a Siberian gas field for some of Shell’s 55 percent stake in Sakhalin II. The government and Gazprom are discussing whether to alter terms of the deal.

“The scale of the challenge of onshore pipelines was underestimated,” Craig says. “There are a number of factors. We are using Russian contractors and they weren’t familiar with laying pipelines in these conditions, and to these standards.”

Rising costs for labor and steel, and a strengthening ruble have also played their part as high oil prices increase energy exploration around the world.

Oil Industry Inflation

Statoil ASA last year raised the cost of its Snohvit gas project in Norway to 58.3 billion kroner ($9.1 billion), almost 50 percent more than originally planned. BP in April said a pipeline that will carry Caspian Sea oil to the Mediterranean will cost 30 percent more than the $2.95 billion budgeted.

“The Russian government will need to look at other projects around the world,” says Stephen Craen, managing director of energy project finance at Societe Generale SA. “They’ll begin to get a feeling what the real costs should be or whether Shell has actually mismanaged the project.”

Sakhalin Energy may recover some costs if a project run by Exxon and Rosneft opts to use the venture’s pipelines for a fee.

Shell’s involvement in Sakhalin II has attracted the attention of activists who are pressuring the company to meet western environmental and safety standards.

Gray Whales

After a two-year battle with the World Wildlife Fund and local residents, Shell last year changed the route of an offshore pipeline to avoid a feeding ground for western gray whales. Only about 100 of the whales remain in the western Pacific Ocean, after they were hunted to extinction in the Atlantic during the 19th century.

“The long-term, irreversible impact of this project is if the western gray whale becomes extinct,” says James Leaton, a WWF policy adviser in London. “This coming summer will be Shell’s noisiest offshore construction period so far, which may deter the whales from their feeding area.”

On land, Sakhalin Energy has been buffeted by the demands of activists and the government, as both seek to protect salmon spawning grounds in more than 1,000 rivers and streams the pipelines must cross. Fishing accounts for about a third of the island’s economic production.

Shell prefers to bury pipelines in dry soil by restricting water flow with temporary dams, reducing the sediment kicked up by earthmoving equipment. Russian authorities often require the company to dig through wet streams to get the job done quicker.

`Mixed’ Success

Janet Lowe, an aquatic biologist and independent monitor of the river crossings, says Sakhalin Energy has had “mixed” success in protecting salmon larvae, which grow along the riverbeds during winter.

“The intent is to do a good job,” Lowe says as workers lay pipe near Dolinsk in southern Sakhalin. “They’ve been restricted by what the government agencies will allow.”

The EBRD, established to promote economic development in the former Soviet Union and Eastern Europe, is examining the project’s environmental and social record to determine whether it should lend Sakhalin Energy about $200 million.

The bank plans to make a decision by September, after determining whether winter work damaged salmon breeding grounds.

“This is part of energy security, but environmental standards have to be met,” says EBRD President Jean Lemierre.

The EBRD’s decision will influence commercial banks and loan guarantee agencies in the U.S., U.K. and Japan that have been asked to provide $7 billion in credit.

`Stepping on a Rake’

Dmitry Lisitsyn, an environmentalist in Yuzhno-Sakhalinsk, the island’s main town, says Shell has been too slow to improve its performance on issues ranging from pipeline safety to waste dumping and dredging in a bay near the LNG plant.

“Shell is constantly stepping on a rake and hitting itself in the face,” Lisitsyn, 38, says in his office, which is jammed with blue folders of government data on the project and sits above a marriage bureau.

The son of a geologist, Lisitsyn worked as a carpenter and seismologist before starting Sakhalin Environment Watch 10 years ago to preserve the island’s forests and wildlife. Shell should have realized earlier that its offshore drilling and dumping would disturb whales and fishing, he says.

Viktor Zotkin, 44, the owner of a cannery near the LNG terminal, says he slowed salmon processing because of dredge wastes dumped in the area.

“As Sakhalin Energy started constructing its piers and the LNG plant in the area of our main fishing, the catch sharply declined,” he says. “Our partners abroad and in Russia started to refuse products. The Japanese sent us a letter saying, `Folks, for God’s sake, don’t supply us fish from this area.”’

Jobs and Taxes

The island’s fishermen stretch nets from the shoreline into the sea to catch salmon, which return to the streams in which they hatched. Sakhalin Energy paid two fisheries closer to the plant, Calypso and Lembok Ltd., more than $1 million each for disrupting fishing.

The construction work meets Russian environmental standards, says Sakhalin Energy spokesman Ivan Chernyakhovskiy.

Balancing the potential for environmental damage are the jobs and tax revenue the project is creating.

Sakhalin Energy employs about 17,000 people on the island, 70 percent of them Russian. The venture projects taxes and royalties for Russia will total $50 billion over the project’s 40-year life, with most going to the federal government.

More Control

Profit-sharing and tax agreements for the project were signed in 1994 when oil prices were low and Russia was eager to encourage international investment. Now, Russia, Venezuela and other producing nations want more control over energy exports.

The government may yet pose the biggest threat to Shell’s Sakhalin profits — and the reserves the company can put on its books — should it demand a larger stake in the project.

“There is an element of nationalization in this industry,” says Roger Nightingale, a strategist for Millennium Global Investments in London, which oversees $4.3 billion. “If the reward to the company gets too high, the government comes along, changes the rules, and takes some of it away.”

To contact the reporter on this story:
Stephen Voss in London at  [email protected]