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The Times: Money at the root of Kremlin’s dislike of Shell deal

October 05, 2006
By Carl Mortished

FORGET whales, salmon and the preservation of the Siberian wilderness. The stand-off between Shell and the Kremlin over the giant liquefied gas project on Sakhalin Island is about dollars and cents, and not environmental permits.

A huge increase in the cost of the project, announced in July last year, has upset the Kremlin’s hopes of cashflow from gas sales, and a senior adviser to President Putin yesterday made clear that the overrun was unacceptable. “We want to keep the existing cost structure,” said Arkady Dvorkovich. 
The dispute between Shell and the Kremlin has been hugely damaging. It has poisoned the atmosphere for foreign investment and created huge anxiety in Japan and Korea, which have agreed to take most of the Sakhalin-2 gas. Several leading power companies, including Tokyo Electric and Kogas, are in a state of high anxiety over the risk that the first tankers of frozen fuel might not set sail as planned from Sakhalin in 2008.

Two factors are at the heart of this dispute: a contract that Russia’s Government resents deeply and Shell’s mishandling of costs of the project, which have doubled to $20 billion (£10.6 billion) from the $10 billion announced at the project’s launch in 2003.

Worse still, Shell revealed the full extent of the extraordinary cost inflation only a week after the company had signed an asset swap agreement with Gazprom. The Russian utility is desperately keen to acquire expertise in liquefied natural gas (LNG), a technology it lacks, and Shell agreed to swap 25 per cent of Sakhalin-2 for half of Zapolyarnoye, a western Siberian gasfield.

On July 7 last year, the ill- fated day of London bombings, Jeroen van der Veer, Shell’s chairman, shook hands with Gazprom officials at its London headquarters at a press conference. A week later, Shell revealed to the world and its astonished Russian partner that Sakhalin’s costs had doubled.

The embarrassment to Gazprom’s main shareholder in the Kremlin was compounded because Sakhalin-2 is regulated by a production-sharing agreement (PSA), a contract that ringfences the tax and legal regime that governs the project for its entire life. Used widely in developing countries, PSAs are favoured by oil companies seeking to avoid the risk of volatile Third World politics. Crucial to the PSA is the opportunity for the oil company to recover all its costs through oil and gas sales before any profit-sharing with the host government.

The PSA law was vigorously opposed by domestic Russian oil companies, which argued that foreign companies should be required to take the same political risk as local ones. According to Russian analysts, the Sakhalin-2 PSA was particularly generous in allowing the operator, Shell, the right to set its costs, a clause that the Russian Government profoundly regrets.

The Sakhalin project was budgeted and approved by a Shell management under the sway of its former chairman, Sir Phil Watts, who was removed after the disclosure that the company had misreported its reserves. Executives then involved in the project admit that the costs of operating in a remote Arctic environment were downplayed at a time of weak oil and gas prices. Supporters of Sakhalin-2 had to demonstrate that the project worked financially and they made sure that it did.

Costs ballooned because of soaring steel prices, skill shortages and difficult working conditions. A subsea pipeline was moved because of fear that it traversed the feeding grounds of a rare species of whale. Currency fluctuations played havoc with the numbers. Sakhalin is one of many mammoth oil and gas projects that have suffered cost inflation, but it is probably the most politically contentious.

The Sakhalin saga

May 2003: Shell signs 1.1 million tonne per year LNG sales agreement with Tokyo gas. Launches $10 billion Sakhalin-2 project with Mitsui and Mitsubishi

April 2004: The Times reveals $2 billion cost overrun at Sakhalin project

March 2005: Shell says that it will re-route its Sakhalin oil and gas pipeline to circumvent the feeding grounds of endangered western grey whales, following pressure from environmentalists

July 7, 2005: Shell agrees with Gazprom to swap 25 per cent of Sakhalin for half of Zapolyarnoye gasfield

July 14 2005: Shell admits that the budget of the Sakhalin project has doubled to $20 billion and that the first cargoes of liquefied natural gas will not be loaded until the summer of 2008, eight months later than expected

August 2006: Russia’s natural resources ministry says that it will go to court to halt construction of the pipeline because of concerns that it runs through an area susceptible to landslides

September 18: The Russian Government revokes an environmental permit for phase two of the project, provoking outrage from the Foreign & Commonwealth Office and the European Commission

September 19: Shinzo Abe, the Japanese Prime Minister, warned the Kremlin that diplomatic relations between Russia and Japan could be harmed if the Sakhalin-2 project’s permit was removed. Japanese power companies had agreed contracts to buy most of the Sakhalin liquified natural gas

September 26: The European Bank for Reconstruction and Development (EBRD) says that it will delay a decision on providing finance for the Sakhalin-2 oil and gas project, while the dispute with Russia over its environmental impact remained unresolved. The bank was expected to provide loans of €400 million (£267 million) to the Sakhalin Energy Investment Company, a consortium including Shell, Mitsui and Mitsubishi

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