After Sakhalin

Dec 13th 2006 | MOSCOW
From The Economist print edition

What does Shell's capitulation to Gazprom mean for the Russian energy industry?

Get article background

“GIVE me the man,” ran an old KGB adage, “and I will find you the crime.” A similar rule now seems to apply to energy companies in Russia. For Yukos, once Russia's top oil firm, the crime was allegedly unpaid taxes; with the giant oil and gas project led by Royal Dutch Shell on Sakhalin island, in the Russian far east, it was environmental violations. In both cases the outcome was broadly similar: state-controlled firms ended up taking control of prize assets.

The huge Shell-led project known as Sakhalin II would be unusual anywhere, and in Russia it is unique. It involves the country's first liquefied natural gas (LNG) plant, which will serve lucrative new markets in North America, South Korea and Japan. Sakhalin II is almost finished: it is already producing oil, and LNG shipments are supposed to begin in 2008.

Until this week, though, there were also some perilous peculiarities. Sakhalin II was the only big energy operation in Russia that did not involve a Russian firm: Shell's partners are Mitsui and Mitsubishi of Japan. (Rosneft, a state-controlled oil firm, has a stake in a rival Sakhalin consortium led by Exxon Mobil.) The Shell- and Exxon-led projects were the only two exceptions to the monopoly on gas exports held by Gazprom, the state-controlled gas giant. Along with a Siberian development led by Total, they were also the only projects governed by “production-sharing agreements” (PSAs), contracts signed with the government in the 1990s that some Russians now consider unfairly generous.

The “crime” needed as a pretext to rectify these peculiarities was not hard to find, or invent. The sea around northern Sakhalin, in which the project's offshore drilling rigs stand, freezes for half the year and is home to a rare whale. The twin pipelines that will deliver the oil and gas to the island's southern tip cross around 1,000 rivers and streams, many of which are used by spawning salmon. A few months ago, Russian environmental regulators began to complain and they have since suspended licences and threatened the Sakhalin II consortium with criminal action.

Gazprom was already negotiating for a stake in Sakhalin II when the consortium announced last year that its costs would nearly double, to around $20 billion. Under the terms of the PSA, that will reduce and delay the state's returns. The environmental pressure also raised the prospect of costly delays, to the ire of the customers who have pre-purchased much of the anticipated gas.

Shell has evidently decided that the threat of delays and obstruction was less palatable than cutting its Sakhalin stake. The cuts in proven reserves that will result are a heavy price for a company that is already short of oil. The deal is still being negotiated, but it emerged this week that Gazprom will probably end up with a controlling stake. In return, instead of a share of a Siberian gas field that was once on the table, Shell and its Japanese partners will get cash (though whether they would want more Russian assets must be open to question). The regulatory shenanigans are likely to continue until the price is agreed.

What will that mean for the salmon, the whales and the rest of Sakhalin's beautiful but fragile flora and fauna? Environmentalists have made common cause with the government, but they may find that, despite its failings, the consortium was greener than Gazprom will be. After all, unlike its new Russian partner, the consortium needed to secure loans from multilateral institutions and was sensitive to bad publicity. It will be interesting to see how the environmental regulators behave once Gazprom is installed. The massive tax debts attributed to Yukos's main production subsidiary were magically reduced by the courts after the unit was expropriated by the state and sold to Rosneft.

Shell's capitulation and the Yukos case exemplify the state's ever-increasing role in the energy industry. A second question is how far that trend will go. State-controlled firms look destined to get preferential treatment in the future allocation of extraction licences, and the role of foreign firms looks certain to be tightly circumscribed from now on. (Just how tightly will be partly decided by a new law.)

But what of Russia's existing private firms? Yukos's remaining assets seem likely to be redistributed in another fake auction. More controversial will be TNK-BP, an Anglo-Russian company that is half-owned by BP (foreign and therefore bad) and half by a clutch of tycoons (unpopular and therefore vulnerable). The firm has been hit with big tax bills and other misfortunes; persistent rumour has it that a change of ownership is likely next year. Russian history suggests that all this is unlikely to boost production.

Still, with the world's energy reserves distributed as they are—mostly in places at least as unstable and inhospitable as Russia—the oil majors will not be easily deterred. The enormous Shtokman gas field in the Barents Sea could be an early test of international sentiment. The Kremlin for years tantalised foreign companies and their governments with the prospect of a role in the Arctic project. Then, in October, Gazprom said it would go it alone.

Now Vladimir Putin says foreign partners might be welcome after all. Whether this confusion stems from extreme negotiating tactics or sheer disorganisation is unclear. Either way, as Sakhalin proves, the Kremlin evidently feels it can afford to dispense with the niceties.