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Tuesday, January 02, 2007

Russia adds insult to injury on Sakhalin-2

The Financial Times reports that the Kremlin has only just begun to steal:

Royal Dutch Shell and its two Japanese partners are to be made to share the burden of the huge cost overruns of Sakhalin-2, it emerged on Thursday, in news that cast a less favourable light on their deal to cede control of the project to Gazprom.

Just days after confirming that Russia would pay the companies $7.45bn to establish its controlling stake in the project, the government said it would require the three foreign owners to meet $3.6bn of the additional costs of Sakhalin-2 themselves.

Jonathan Wright of Citigroup said: "It depends on what you expect for oil and gas prices, but my figures suggest an internal rate of return for the project of 11 per cent. That's above the cost of capital, but not sufficiently above it, given the region and the risks involved, to be able to say this is an attractive project.

"This news is definitely not making a good project turn bad, but it is making a difficult project slightly worse."

He added: "This looks like payback for the negotiations last year, when Gazprom reached an agreement on taking a stake in the project, only to be told the following week that the costs had doubled."

Details of the extra costs to the three companies – Shell, Mitsui and Mitsubishi – in a confidential agreement apparently leaked by the Russians, show the three companies will have to increase risk exposure and reduce the value of this month's deal.

Earlier this month, they ceded control of Sakhalin-2 to Gazprom, Russia's state-backed gas giant, after months of sustained attack by government agencies on aspects of the project such as its rising cost and environmental record.

Shell, which owned 55 per cent of the project, Mitsui and Mitsubishi halved their stakes and offered Gazprom 50 per cent plus one share. On the day the deal was signed, the Kremlin said environmental issues would be resolved and agreed to a doubling of the cost to $20bn.

Sakhalin-2 is governed by a production sharing agreement that allowed foreign shareholders to recoup costs fully before sharing profit with the Russian state.

But it emerged on Thursday that foreign shareholders would recoup only about $15.8bn and have to put up $3.6bn themselves. Gazprom, as a new shareholder, would be exempt from this cost increase.

Andrei Dementyev, Russia's deputy minister for energy, told Vedomosti, a business daily partly owned by the Financial Times, that "foreign investors should take engineering risks upon themselves".

Shell declined to comment on the agreement. Observers say that Russia, by leaking the information to the media, was adding insult to injury.

The Russian government has now set its eyes on Kovykta, the massive gas field in Eastern Siberia controlled by TNK-BP. Alexei Miller, Gazprom chief executive, on Thursday met with Victor Vekselberg, one of TNK-BP's Russian shareholders, to discuss "co-operation" between the companies.

The Jamestown Foundation's Vladimir Socor takes the West to task for making facile, rose-colored assumptions about Russia as an energy partner:

The Kremlin’s confiscatory assault on Royal Dutch Shell and threats to other Western energy majors in Russia on Black Tuesday, December 12 (see EDM, December 13) is the latest in a series of moves disproving Western wishful thinking about Russia’s energy policy.

That wishful thinking burgeoned, ironically, in the wake of the January 2006 Russian gas supply cutoff to Ukraine, which rippled downstream in a number of European countries. While the “wake-up call” for coordinated Western energy policies resounded mainly in the editorial pages after that crisis, most Western governments and energy corporations embraced the set of illusory assumptions that are now being laid to rest by Moscow’s own actions.

Assumption One during 2006 held that Russia and Western consumer countries would benefit through strategic relations of “reciprocal access.” Namely, access by Western energy majors and “national champion” companies to Russian oil and gas deposits in return for Russian companies’ acquisition of Western infrastructure, distribution systems, and direct access to Western consumers. However, by the year’s second half, Russia embarked on a policy of excluding Western investors (most notably in the super-giant Shtokman gas field) and, by the year’s end, threatening confiscatory measures against existing Western projects in Russia (Shell, ExxonMobil, BP) under tax or ecological regulatory pretexts. Meanwhile, turning the “reciprocity” into unilateralism, Russia’s state energy companies rapidly acquired infrastructure and production assets in the West as well as in countries that traditionally supply the West with energy.

The year’s Assumption Two, equally popular and partly related to the first, spoke of “mutual dependence.” It held that the West’s growing dependence on Russian supplies is not particularly risky because it is offset by Russia’s dependence on revenue from Western importers of Russian energy. As the year wore on, this Western postulate shattered against Russia’s active planning for construction of oil and gas pipelines leading to the Asia-Pacific region, setting the stage for Moscow to play Western against Far Eastern consumers in a none-too-distant future. Moreover, the “mutual-dependence” assumption blithely ignored Russia’s advantage as a single-actor exporter versus a multiplicity of eager, uncoordinated, and often competing Western buyers, with ample scope for manipulation by Russian state companies. Mutual dependence might become possible between the European Union collectively and Russia, if the EU develops a common energy policy, which however does not seem to be on the cards for now.

Assumption Three during 2006 held that Moscow cannot afford to exclude or mistreat Western energy companies because Russia’s state companies do not have sufficient means to invest in energy projects on Russian territory. However, Moscow successfully challenged that proposition through the Initial Public Offerings of Gazprom, Rosneft, and other state companies, which quickly raised multibillion-dollar investment funds on Western capital markets. Those IPOs launched a process of transferring Western resources to Russia for energy projects under the Russian state’s discretionary control, and without a real say by Western consumer countries regarding future production levels or the export destinations. When Russian President Vladimir Putin announced the go-it-alone policy on Shtokman, he did so with the argument that Russia does not need to invite Western investors, as it can raise the necessary capital on Western financial markets. The Kremlin took that argument one step further in December by embarking on what is, in fact, a forcible divestment of Western energy majors involved in Russian projects.

The year’s Assumption Four clings to a hope that Russia’s ratification of the Energy Charter Treaty and signing of the attendant Protocol would help the West overcome its collective vulnerability on energy security. It envisages, primarily, that Russian state pipeline monopolies would provide transit of oil and gas from third countries via Russia to Western consumer countries. However, Moscow’s actions during the year showed how risky this proposition is. The Russian government shut off energy pipelines repeatedly in 2006, not only to Ukraine and Georgia early in the year, but also to EU member country Lithuania (adding to the earlier oil pipeline shutoff to Latvia); it blocked access for oil from Kazakhstan via Russian ports or pipelines to EU member countries; conclusively thwarted the Odessa-Brody oil transport project, which was an EU priority; it is attempting to kill the Nabucco gas transit project, also an EU priority; and is blocking the expansion of the Caspian Pipeline Consortium (CPC) line, threatening to transfer its section on Russian territory into Transneft’s control and imposing extortionate terms of transit on the ExxonMobil, Chevron, and other companies on that pipeline.

Thus, the idea of relying on Russia for transit under the Energy Charter Treaty and Protocol has been shown during 2006 to entail unacceptable risks. This idea is partly an excuse for not pursuing direct Western direct access by pipelines to the eastern Caspian basin. Moscow’s refusal to adopt the Treaty and Protocol is a blessing in disguise for the West and should re-focus attention on access to the Caspian basin.

Moscow actively cultivated that set of Western assumptions during most of 2006; but apparently felt strong enough to dispense with parts of that discourse in the latter part of the year, and to resort to overt bullying by the year’s end. The comfortable assumptions about Russia’s energy policy in 2006 should now come to the end of their 12-month lifespan.

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