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The Observer: Moscow makes its power play

Last week, Russia threatened to scrap licences granted to Western companies in a bid to regain control of its energy resources. Can the West fight back? Oliver Morgan and Nick Mathiason report

Sunday September 24, 2006

It may have been flexing for some time, but the strong arm of Russia’s nationalist oil policy has now muscled its way into full view. A series of events last week called into question the rights of the world’s most powerful energy firms to develop oil and gas facilities across Russia, the clearest sign yet of President Vladimir Putin’s ambitions to wrest back control of his country’s resources. BP’s Lord Browne and Shell chief Jeroen van der Veer looked on impotently; for Exxon and Total the stakes are equally high.

But Russia’s power play is no crude smash and grab. A number of agencies, from the natural resources ministry to Siberian officials to Russian ambassadors overseas, gave a number of reasons – the environment, finances and time overruns – for threats to revoke licences granted years ago to foreign companies.

The moves affected Shell and Exxon projects in the giant 45-billion-barrel oil and gas field at Sakhalin Island off Russia’s east coast; BP’s joint-venture with TNK to explore for gas in the enormous (60-trillion cubic feet) Kovykta gas field in eastern Siberia; and Total’s operations in the Kharyaga oil field in the Arctic.

Behind the politicking sat Russia’s nationalised energy giant Gazprom, elbowing its way into the foreign-dominated ventures developing these areas.

For Shell, BP and Total, environmental concerns were cited by Russian officials. For Shell, which has 55 per cent of the Sakhalin-2 development on the south of the island (with the equivalent of 4.5 billion barrels of oil), this resulted in suspension of a licence to develop the field by the Natural Resources Ministry.

Environmentalists were quick to say they had been raising concerns, such as the threat to the rare grey whale for years, rubbishing claims that they were trumped up. But few were convinced. As one analyst said: ‘Who in Russia cares about the environment? This is about the government wanting control.’

While Western companies remained quiet in public, the moves attracted international condemnation. Japan, which will take gas from the Sakhalin-2 project and has two leading companies, Mitsui and Mitsubishi, holding 45 per cent of the venture, was stinging. Shinzo Abe, tipped as next Prime Minister, said the moves could delay Sakhalin-2, which would have ‘a negative influence on overall Japanese-Russian relations’.

In return, Russia’s ambassador in Japan, Alexander Losyukov, argued that a state-run company could speed along the project. He meant Gazprom, which has for several years been negotiating its entry into Sakhalin.

Last week, Gazprom said that talks with Shell on an asset swap, announced in July – that would give Gazprom 25 per cent of Sakhalin-2, plus some cash in return for 50 per cent of the massive Zapolyarnoye-Neocomian gas field on the mainland – had also been suspended.

Gazprom sources said the problem was cost overruns. A week after the asset swap was announced, Shell stated that development costs for Sakhalin-2 had doubled from $10bn to $20bn (with persistent rumours that they could reach $25bn). This was bad news for the government, because the deal signed a decade ago, allowing Shell and the Japanese to develop Sakhalin-2 was, known as a Production Sharing Agreement (PSA).

Under a PSA, the government retains ownership, letting the partners develop the projects (phase one started producing oil in 1999; the larger phase two, which is causing the current difficulties, is 80 per cent completed), and take revenue in early years to pay back their investment. After this, the government receives an increasing proportion of revenues up to 70 per cent. Cost overruns and delays mean that the government will get less money, and get it later.

Meanwhile, cost increases mean that Gazprom can claim a reduction in value of the 25 per cent of Sakhalin that it is acquiring, which means recalculating the asset swap. Thus it announced the suspension of the talks.

PSAs and cost overruns also affect Sakhalin-1, on the north of the island, where there are 2.3 billion barrels of oil and 17.1 trillion cubic feet of gas. Exxon is in the lead with 30 per cent of the project; its partners are two Russian companies, a Japanese one and ONGC of India.

Last week, it emerged that costs could increase there, from $12.8bn to $17bn. The Russian government reacted angrily, saying it would be deprived of income, and added that the operator, Exxon, could be stripped of its licence.

Meanwhile, Gazprom confirmed that it was in talks with ONGC about buying out its stake, giving it access to the two key projects on the island. Exxon reacted robustly, underlining that PSAs were internationally enforceable. But analysts suggest that, in both cases, the suspension of the licence on environmental grounds and the activities of Gazprom-Shell are linked. Meanwhile, Total faces the withdrawal of its licence for environmental reasons and failing to reach production levels set out in its PSA.

PSAs made sense to the Kremlin in the mid-Nineties when ownership of national assets by oligarchs and dubious rights to property meant investment was low, while the government was financially stretched and could not invest on its own account, or via companies such as Gazprom. From the companies’ viewpoint, PSAs make sense as they are governed by international law. This makes them unpopular in today’s Kremlin, which has seen its own coffers swell as the oil price has risen.

One Moscow analyst says: ‘PSAs are enforceable internationally. There is a feeling that Russia does not have sovereignty over its assets – a sense of humiliation.’ Others say the government wants to renegotiate PSAs and supports Gazprom, which wants to improve the terms on which it can get into the projects.

The government faces different questions over TNK-BP, which – as a joint-venture, not a PSA – is governed by Russian law. However, reports last week indicated that prosecutors in Irkutsk, the capital of eastern Siberia, had considered withdrawing exploration licences from the venture in the Kovykta gas field.

Sources indicated that, again, the move was orchestrated to increase Gazprom’s influence. BP sources were puzzled, saying that it needed clearance from Gazprom, as owner of the field, to develop Kovykta.

TNK-BP has already developed a small part of the field to meet domestic demand; however, its ambitions are to export gas to China and build a pipeline to do so. Here, negotiations with Gazprom have been problematic.

The explanation may be that the three owners of TNK can sell out their stake in the next two years. Gazprom is keen to secure this, but Rosneft, the oil giant that floated in London this summer (in which BP holds $1bn of shares), is also said to be interested. ‘There could be pressure being brought here to ensure BP makes the right decision,’ says one analyst.

Whatever the finer points, it seems clear that Gazprom and the government are intertwined in a carefully choreographed set of moves to exert pressure on foreign companies. The global outcry suggests there are risks to the strategy.

William Browder, the fund manager and activist Gazprom shareholder who was barred from Russia this year, says: ‘For Gazprom investors, this is a zero-sum game. If Shell shareholders lose, they win. But it does not say much for the Russian investment climate if this is the way it is done. I would rather Russia show respect for property rights, because that is fundamental to my safety in investing there at all.’

If this is representative of the international view, Russia may have slapped itself in the face with its own strong arm. and its sister non-profit websites,,,,,, and are owned by John Donovan. There is also a Wikipedia feature.

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