Investment Risky in Russia As Politics Affects Profits

GENERAL INTEREST

Increasing scrutiny this year of in Kovykta and other indicators point to the TNK-BP’s Siberian natural gas assets and Kremlin’s tightening grip on the strategic actions subsequently taken follow unset- energy sector. These patterns of behavior tling patterns of behavior in the way the indicate a potentially unstable business Russian government has been running its environment for international investors. The gas business. following two case studies demonstrate The government has reneged on a some of Russia’s other seemingly under- number of previously signed business handed tactics used in dealing with interna- agreements with various companies and tional consortiums in order to achieve its threatened to halt multibillion-dollar, end goal of obtaining strategic control over internationally sponsored operations after the sector. significant amounts of time The Shtokman story and money had been Shtokman gas field, discovered in 1988 Investment risky in Russia invested in those projects. in Russia’s Barents Sea, is believed to have Russia’s Natural over 141 tcf of natural gas reserves, making Resources Ministry, claim- as politics affects profits it one of the largest gas fields in the world ing that TNK-BP was not (Fig. 1). producing enough gas from massive In the early 1990s, test results from a Kovykta gas field in Eastern Siberia, threat- feasibility study formed the basis for talks ened in late May to revoke the company’s that would allow a group of five Western license to develop the field, which report- companies to participate in the field’s edly has estimated resources of 2 trillion cu development. In 1992, however, the foreign m of gas in place (OGJ, June 4, 2007, p. consortium was pushed out by the ZAO 32). The move would create the need to Rosshelf consortium, a Gazprom subsidiary rebid the field in a competition that Russia’s that comprised 19 Russian companies state-controlled natural gas monopoly OAO mainly engaged in defense production. Gazprom doubtless would win. Observers According to Yevgenny Velikhov, saw the move as part of a continuing move vice-president of the Russian Academy of to return Russia’s oil and gas deposits to Sciences and chairman of Rosshelf, the state control. consortium would provide greater employ- In late June, TNK-BP (owned and ment in Russia. This was viewed as a key managed jointly by BP PLC and Alfa factor in Rosshelf’s victory over the West- Access Renova Group) announced an ern consortium. According to then-Russian investment alliance with Gazprom for President Boris Yeltsin, although the major long-term energy projects of at least country’s industrial policy favored Russian $3 billion in cost or a swap of global assets. companies and groups, the consortium was TNK-BP, the third largest oil company in encouraged to work with foreign companies Russia, agreed to sell to Gazprom a 50% and consultancies for their technical capa- interest in East Siberian Gas Co., which is bilities. building a regional gasification project, and However, Russia was neither techno- to sell its 62.89% stake in OAO Rusia logically nor financially prepared to take on Petroleum OJSC, the company that holds such a project solo, and in August 1995 the license for Kovykta field. Gazprom and Rosshelf signed a letter of TNK-BP reportedly may purchase a intent with Norsk Hydro of Norway, 25% plus one share stake in Kovykta later Conoco of the US, Neste Oy of Finland, at an independently verified market price and Total SA of France to evaluate the once specific criteria have been met, the possible joint development of Shtokman companies said (OGJ, July 9, 2007, p. 27). field. This acquisition of the majority interest Oil & Gas Journal / July 16, 2007 One challenge of the project was SHTOKMAN FIELD Fig. 1 trying to figure out the logistics of transporting the gas to its destina- tion. In January 1996, a St. Peters- burg company designed a $600 million floating liquefaction plant, which offered a potential solution to the problem.1 LNG would obviate the need for an underwater pipeline from Shtokman field through the Barents Sea. Plans to build the LNG plant, however, never came to fruition. Instead, in March 2000, Rosshelf began developing plans for production and construction of a natural gas pipeline, rather than an LNG plant, with potential foreign partners. These plans included building a pipeline from the field via Mur- mansk to Vyborg on the Baltic, then on to Peenemunde in Germany. pate in the consortium. Gazprom retain a 51% stake in the project and With such an undertaking the was in talks with ExxonMobil, select two foreign companies to project would require great financial ConocoPhillips, ChevronTexaco (to participate. backing. By May 2000, Gazprom a lesser extent), and Royal Dutch In September 2005, Gazprom had still not established the owner- Shell. short-listed five companies- ship structure of the $20 billion Because Shtokman was located Chevron, ConocoPhillips, Norsk Shtokman project. 342 miles from shore, analysts Hydro, Statoil, and Total. Gazprom Russian and Western partners anticipated that a number of techni- planned to announce the two shared an interest in developing cal innovations and solutions would winners on Apr. 15, 2006. That Shtokman field. The gas was be implemented in the effort. This announcement never came. destined to be piped directly to would push up development costs In June 2006, Gazprom began Europe, satisfying the growing and make the gas more expensive. suggesting that it might not include European demand for natural gas. As a result, some analysts were US companies in the list of winners. Russia would benefit by increasing skeptical of the project’s feasibility. According to Gazprom Chairman its business ventures with Europe. Click here to enlarge image Alexei Miller, “I can assure you that In June 2003, Russia reconsid- On June 20, 2005, Russia and Gazprom does not want to establish ered the possibility of adding an Norway signed a number of agree- a pattern of selecting particular LNG component to the Shtokman ments intended to finally pave the companies just because they come development project. This would way for development of Shtokman from a particular country.”2 allow Russia to direct supplies to field. France also signed a memo- WTO leverage? the US via LNG tankers. randum with Russia 8 days later, Analysts speculated that Russia By May 2004, despite the 1995 and in August 2005, Gazprom might use the tender as leverage in letter of intent with Norsk Hydro, received bids from nine foreign its talks with the US over its entry Conoco, Neste, and Total to evalu- companies to develop the field: into the World Trade Organization ate the possibility of a joint devel- ConocoPhillips, ExxonMobil, (WTO), which the Kremlin believed opment project, Gazprom had not Norsk Hydro, Statoil, Mitsui, was being held up by Washington. yet made a firm commitment on Sumitomo Corp., Shell, and Total. After the Group of Eight leading which firms would actually partici- Gazprom ultimately planned to Oil & Gas Journal / July 16, 2007 GENERAL INTEREST

economies summit in St. Petersburg after the US and Russia reached a revamps by Russia that could ended in July 2006 with no break- deal for the US to support Russia’s include a declaration for the Russian throughs made in Russia’s talks WTO membership bid, Gazprom government to take over fields with the US to join the WTO, said that there was still a chance of “considered of strategic impor- Gazprom further pushed back the opening the door to foreign compa- tance.” This concerned Japan decision on who would win the nies as stakeholders. The final greatly because Japan viewed project, while Russian President outcome of the project has yet to be Sakhalin gas and oil as part of its Vladimir Putin began hinting that determined as Russia changes its energy security policy. the Norwegian companies had a decisions. However, political under- Japan also was concerned about good chance of being selected.3 currents are apparent, especially a requirement to use Russian tech- The one saving grace for the US when viewed side-by-side with nology to build the LNG plant was that Russia required access to events unfolding around other major because it was Russia’s first lique- the American gas market. Norsk gas fields, such as the Sakhalin-2 faction plant, and the Russians had Hydro and Statoil had allegedly project. no experience with the technology offered stakes in Norwegian fields The Sakhalin-2 story required to complete the project and LNG gas export projects in successfully.5 Despite these pitfalls, The Sakhalin project, located their bids, while Conoco and Chev- Japan hung on. along Sakhalin Island on the eastern ron allegedly offered stakes in US On Feb.11, 2000, Sakhalin coast of Russia, is a massive, multi- LNG terminals in their bids.4 Energy Investment Co. Ltd., opera- phased project (Fig. 2). Phase 1, or Gazprom continued to hold back tor of the Sakhalin-2 project, began Sakhalin-1, was first declared its announcement of the winners. seeking bids to construct the LNG commercial in 2001 and began Then, in September 2006, Putin plant. Consortium members at this operations in October 2005. reportedly told French and German time were Marathon 37.5%, Mitsui Sakhalin-2 will include the world’s leaders that Gazprom was consider- 25%, Mitsubishi 12.5%, and Shell largest gas liquefaction plant and ing shipping some LNG to Euro- 25%.6 A few months later, Shell and will draw upon two fields. pean markets. While these com- Marathon signed a nonbinding letter The first, Piltun-Astokhskoye ments offered reassurances to of intent to transfer Marathon’s (PA), is primarily a massive oil Europe, it upped the stakes in an 37.5% interest in the project to field, with some associated gas, in already strained relationship with Shell, which gave Shell a control- the northern waters off eastern the US, and analysts began specu- ling stake in the project. Sakhalin Island. The second field, lating that US companies would be Lunskoye, is primarily a gas field Environmental Issues omitted from the list of winners. about 90 miles south of PA. Russia’s Natural Resources Then, on Oct. 9, 2006, Gazprom Click here to enlarge image Ministry approved the Sakhalin-2 stunned the gas industry by On June 22, 1994, Russia and feasibility study in 2003, and announcing that it would develop Marathon signed a production- construction on the LNG plant Shtokman alone, without any sharing contract for the Sakhalin-2 began. However, ecological organi- foreign partners, and ship the gas project. On Dec. 4, 1994, the deal zations began accusing Sakhalin directly to Europe via pipelines became official when Yeltsin signed Energy of harming the environment, rather than including an LNG the law covering production-sharing claiming the company’s project was component to export to North agreements (PSAs). Japan also damaging the population of gray America. Any foreign firms wishing signed on to be part of the consor- whales because the equipment was to participate in the project would tium. so close to their breeding grounds. have to do so as contractors rather Problems with Sakhalin-2 were Sakhalin Energy pointed out that it than equity stakeholders. inherent from its initial stages. For had spent $5 million since 1996 to Two months later Gazprom example, the 1994 PSA law raised a ensure that the project did not hurt changed its decision yet again, few issues with Japan. One, of the whales. In March 2005, Sakha- reexamining the possibility of major concern to Japan, was the lin Energy rerouted the offshore developing the project as an LNG possibility of unilateral contract pipelines to protect the whales. export project. Not coincidentally, Oil & Gas Journal / July 16, 2007 GENERAL INTEREST

In July 2005, Shell signed a Shell. of the Russian Academy of Sciences major asset swap with Gazprom. Russian state ecological experts claimed the “existing threat of oil The deal would cut Shell’s stake ruled in favor of proceeding with and gas pipeline destruction is the and give Gazprom a stake of up to construction of the Sakhalin-2 result of unqualified project deci- 25% in Sakhalin Energy in project. However, in August 2006, sions taken by Sakhalin Energy.” exchange for a 50% share of the Russian Natural Resources According to a Sakhalin Energy Gazprom’s Zapolyarnoye gas field Ministry dealt a serious blow to spokeswoman, however, the com- in West Siberia.7 One week after the Sakhalin Energy by seeking legal pany had not received any previous deal was announced, Shell reported action to cancel the environmental notice on the environmental that it had made a mistake in its license that permits construction. concerns from the Ministry. She previous calculation to construct The ministry cited a high risk of further noted that Sakhalin Energy, and develop Sakhalin-2. Shell now mudslides that could cause water having already been aware of increased the cost estimate by about pollution, equipment destruction, or potential risks associated with the $10 billion. This blunder caused fatalities.8 construction of pipelines, had Gazprom to pull out of the deal with A report by the Far East branch already taken into consideration

Fig. 2 construction solutions to prevent SAKHALIN ISLAND FACILITIES such damage from occurring.9 According to an environmental audit, only two minor infractions were cited.10 The first involved a breach of limits set for the discharge of water from one of the production platforms. The fine for this infrac- tion would not amount to more than $7,500. In the second violation, an audit conducted during March and November 2005 showed that the water near one of the floating storage units exceeded the maxi- mum permissible concentration of oil products in the sea. This amount was deemed “close to negligible.” Sakhalin Island had even experi- enced an earthquake with a magni- tude of 6.0 on the Richter scale, during which the Sakhalin-2 pipelines were nearly 90% complete, and there were no adverse effects, according to Sakhalin Energy.11 A few days later, the Natural Resources Ministry ordered Shell to stop work on the onshore pipelines and rework the design.12 Then, during the first week of September 2006, the Ministry dealt another blow to Sakhalin Energy when it revoked the approval it had granted in 2003 to proceed with the project.

Oil & Gas Journal / July 16, 2007 At this point, the project was about over $50 billion.16 According to therefore, bumping Shell from its 75% complete.13 Mitvol, “The construction cannot go position as controlling shareholder. The unfolding scenario had on. We must stop the project and Although Shell no longer has fingers pointing in opposite direc- start over again. We want criminal control over the project, it report- tions, with Russian officials describ- cases for every destroyed tree or edly retains management and ing their viewpoint as “pure busi- damaged river. If criminal cases are technical advisor status. Gazprom ness” and Western analysts accusing opened for everything, the company offered $7.45 billion in cash in the the Russian government of trying to will read the criminal code, come to deal. force a halt to the project to defend its senses and stop the barbarian In what hardly seems a coinci- its interests. Yuri Trutnev confirmed activity.”17 Mitvol denied he was dence, the environmental issues the Western assumption when he taking on Shell to assist Gazprom in disappeared once Gazprom became pointed out that Moscow had to achieving its goal of gaining a share a shareholder. Russia swept the “defend its interests” only after in the project. “I’m doing it for my ecological shortcomings aside. Shell last year doubled the project’s daughter and for the future of According to Putin, all ecological expected costs to $20 billion.14 Russia,” he declared.18 issues can now be considered Because the Sakhalin-2 project Next, Natural Resources Minis- resolved. “I’m pleased that our cost suddenly and unexpectedly ter Yuri Trutnev asked Rosprirod- environmental services and the increased by $10 billion, the Rus- nadzor to submit details of the investors have agreed on the way of sian government saw this as a company’s environmental violations resolving ecological problems,” financial blow. In addition, under to the prosecutor general’s office Putin said during a televised the PSA law, the cost increase within 2 weeks. The case could then appearance.20 would delay and reduce payments to be brought up to a criminal level With Gazprom the majority the Russian government. Suddenly, status. According to Trutnev, the stakeholder in Sakhalin-2, Russian the Russian government felt it was company violated at least five authorities geared up attacks on new being trampled upon by a consor- articles of the Russian criminal fronts. This time the attacks were on tium of foreign companies that were code. the TNK-BP’s Kovykta project, in given extremely favorable terms While Sakhalin Energy tried to which Russia threatened to have the under a PSA drawn up 12 years reach a solution, the project faced company’s license revoked. Addi- earlier. another environmental assault on tionally, Russia threatened to cancel Russia did not feel it was receiv- Dec. 7. The Ministry suspended Total’s Kharyaga project PSA. ing its due share of financial gain in permits held by Starstroi, the main Finally, environmental authorities a timely manner. According to one onshore contractor. This forced announced plans to “check up” on source, as of September 2006, $18 Sakhalin Energy to halt all work ExxonMobil’s Sakhalin-1 project.21 billion had been invested in the near river crossings for breaches of The real issue behind Sakhalin-2 three PSA projects-Sakhalin-1, water legislation.19 was cost overruns. The Russian Sakhalin-2, and Kharyaga, an oil Shell succumbs government’s lack of control over exploration and production venture the project further exacerbated the On Dec. 21, 2006, Shell operated by Total in the northern problem. According to Andrew succumbed to the environmental Timan-Pechora region. Meanwhile, Neff, senior energy analyst with and judicial pressure. After Gaz- the state had received only $500 Global Insight, there may have been prom had waged war with Shell for million in revenue.15 One account environmental violations-but not to over a year to gain control of the described this amount as “laugh- the extent stated by the Russians. Sakhalin-2 LNG project, it finally able.” In the long run, having Gazprom succeeded. Shell’s stake would be On Sept. 28, 2006, Oleg Mitvol, on the project may be better for reduced to 27.5%, Mitsui’s to deputy head of Rosprirodnadzor, Shell, although not ideal as was the 12.5%, and Mitsubishi’s to 10%. Russia’s environmental watchdog, original PSA deal, which is no Gazprom would now hold 50% plus announced that environmental longer an option. As of Sept. 6, one share in the company, making it damage caused by the Sakhalin-2 2006, the only options available the majority share owner and, project would cost Sakhalin Energy were either to see the project stall, Oil & Gas Journal / July 16, 2007 GENERAL INTEREST

have the license revoked and lose dependent on it for this resource. proprietary, before Russia assumes the entire investment, or concede. • A strengthening of its military. the upper hand in a project. At least the project will proceed, Russia is using energy as a tool to • Finally, future Western investors albeit less profitably.22 restore its world-power status. No must first be able to balance risk Strong foothold longer a military threat, Russia and reward. The risks are many. Russia has an abundance of could use the monies earned from Russia continues striving toward natural gas available and is just these development projects to complete domination of its industry, starting to come on board with the revamp its military. which likely will one day exclude ability to develop and produce these • Unfair control over pricing. foreign companies altogether. For resources. Western advanced tech- Russia could opt at any time to now, however, Russia will continue nology, financial strength and high increase its prices for natural gas to include foreign companies as demand, coupled with Russia’s lack during times of high demand. This long as it needs the technology they of capital and exceptional reserves not only would affect citizens of bring. seem to make the two countries other countries but also could References ideal partners. The Kremlin, how- impact local economies or even 1. “LNG floater eyes Shtokman ever, clearly intends to expand and global economies if the increases gas,” FT Energy Newsletters- maintain a strong foothold in its were substantial. International Gas Report, Jan. 19, energy sector. Russia’s reneging on Future deals 1996, p.10. international deals creates a chal- 2. “Gazprom may exclude US lenging and dangerous business Although Russian technology has firms,” Oil Daily, June 7, 2006. environment for potential Western been improving over time, it has yet 3. Elliott, Stuart, “Shtokman business partners. to achieve the same capability as reserves to rise,” Platts Oilgram As the number-one consumer of that of the Western majors. Know- News, July 25, 2006, Vol. 84, No. natural gas in the world and ing this, Western companies might 140, p. 4. possessing only 3% of world still find future deals attractive. 4. “Gazprom nears Shtokman pick,” reserves, the US needs to continue These companies need to be shrewd International Oil Daily, Sept. 5, to diversify its sources of natural in their business dealings with 2006. gas. The case studies described Russia, keeping in mind that at any 5. Stein, George, “Sakhalin-2 above are two examples that dem- time the tide can turn and politics partners eye 2/3 cutback in produc- onstrate the potential hazards of can play a key role in ousting them tion,” Platt’s Oilgram News, Feb. doing business in Russia. The from part or all of a project. This 14, 1996, Vol. 74, No. 32, p. 5. Russian government stands firm in could result in billions of dollars in 6. “Sakhalin announces LNG plant its desire to expand its monopoly on lost revenues. tender,” Interfax, Feb. 11, 2000. the natural gas sector and continues 7. Zapolyarnoye is a massive gas chiseling away at Western- Russia still has many unexplored field near Russia’s Urengoy field. dominated projects within its gas fields. Any Western company As a result of its proximity to borders. In addition to the negative willing to participate in exploration Urengoy, much of the infrastructure impacts stated in the case studies on of these fields should heed three is already in place, which would those Western companies currently warnings: make the cost of bringing Zapolyar- involved in these projects, Russia’s • First, companies must understand noye on stream a fraction of other growing monopoly comes with the differences between “Western development projects. “Russia other potential side effects: capital laws” and “Kremlin socialist poised to dominate European • Increased political leverage. As laws.” At any time, like Shell, they energy,” Strategic Forecasting, Oct. Russia’s monopoly on natural gas could be forced into a costly com- 11, 2001. grows, so too does its political promise. 8. “Sakhalin-2 faces new problem,” strength. The Kremlin will undoubt- • Second, Western companies must Oil Daily, Aug. 7, 2006. edly be able to use its tightening be prepared for Russia to take 9. “Sakhalin squabbles,” World Gas grip over natural gas as political advantage of capital and technology, Intelligence, Aug. 9, 2006. 31, leverage over countries highly some of which might even be 2006. Oil & Gas Journal / July 16, 2007 GENERAL INTEREST

10. It is unclear which agency conducted the audit that The author cited only two infractions, but it was not Rosprirodnad- zor, which oversees Russia’s environmental protection. Cindy Hurst is a political-military The two infractions might have been cited during an research analyst with the US Army’s internal audit. Foreign Military Studies Office. Her 11. Sharushkina, Nelli, “Moscow plans challenge to research is centered on various energy Sakhalin-2 over minor violations,” International Oil issues. She is a lieutenant commander Daily, Aug. 25, 2006. in the US Navy Reserve and currently 12. “Shell must rework Sakhalin-2,” Oil Daily, Aug. 31, is writing a book on potential implica- 2006. tions of LNG. 13. Isachenkov, Vladimir, “Russian environmental regulator files lawsuit against Pacific Island oil project Oil & Gas Journal July 16, 2007 led by Shell,” The Associated Press, Sept. 5, 2006. volume 105, issue 27 14. Bierman, Stephen, “Moscow pulls permit for Shell’s Author(s) : Cindy Hurst Sakhalin-2,” International Oil Daily, Sept. 19, 2006. 15. According to some independent experts, this sum was underestimated. However, the author of a Russian commentary placed the amount at no more than $700. “Production Redistribution,” The Russian Oil and Gas Report, Sept. 22, 2006. 16. There was limited press citing Oleg Mitvol’s accusa- tion of the environmental impact resulting in $50 billion worth of damage. However, later reports said damage estimates were $10-20 billion. 17. “Service to demand suspension of Sakhalin-2 project-Mitvol,” Interfax Financial & Business Report for Sept. 29, 2006, Sept. 29, 2006. 18. Ritchie, Michael, “Russian inspector details Sakha- lin issues,” International Oil Daily, Oct. 3, 2006. 19. Graham, Rachel, and Shiryaevskaya, Anna, “Russia pulls Sakhalin-2 contractor permits,” Platts Oilgram News, Dec. 8, 2006, Vol. 84, No 237. 20. “Gazprom deal ends claims against Sakhalin-2,” Platts International Gas Report, Jan. 15, 2007. 21. Neff, Andrew, “Gazprom secures controlling stake in Sakhalin-2 project in $7.45-billion deal,” Global Insight, Dec. 22, 2007. 22. Neff, Andrew, e-mail message to author, Feb. 2, 2007.