Shell-Led Russian Project In Jeopardy Following Cancellation of Environmental Permit

No Idle Threat

After months of criticism over Shell's upward revision of its projected budget for the Sakhalin-2 project in Russia's Far East, the past several weeks have seen Russian authorities mount a concerted, relentless pressure campaign on the Dutch/U.K. supermajor over its attention to environmental matters at the US$20-billion project. They have made it clear that they are unhappy with the doubling of costs under the production-sharing agreement (PSA) for Sakhalin-2, which will effectively cost the government US$10 billion in lost revenue since the PSA allows the Shell-led consortium to recoup its investment costs before the government receives any revenue from the project.

Various Russian officials have stepped up their criticism of Sakhalin Energy, the consortium developing Sakhalin-2, in the past few weeks, with the Natural Resources Ministry and Rosprirodnadzor, the Ministry's environmental watchdog agency, taking the lead. Yesterday, the Ministry followed through on its threat to cancel Sakhalin Energy's environmental permit for Phase 2 of the Sakhalin-2 project, which is geared to develop and liquefy natural gas for export to Asian and North American consumers. The Ministry said it was revoking the permit in order to "satisfy the arguments of the prosecutor's office", which alleged over the weekend that the Shell-led consortium had illegally received permission to develop the second phase of the project.

The cancellation of the environmental permit effectively brings the Sakhalin-2 project—the world's largest privately funded energy project—to a screeching halt. A Natural Resources Ministry spokesperson was quick to tell Dow Jones that the permit cancellation was temporary and did not equate to a cancellation of the entire project. However, Shell, which has a 55% stake in Sakhalin Energy, rejected the move, stating that while there have been "environmental challenges" at Sakhalin-2, the consortium "does not violate any applicable law. All concerns [of the ministry] are being addressed expeditiously in co-operation with the relevant authorities and do not constitute any ground for nullification."

One Step Closer to the Edge

Shell said that the cancellation of the permit would be "damaging" to Sakhalin Energy's LNG export plans, which have already been pushed back from the end of 2007 to mid-2008. Although the Natural Resources Ministry said that a new environmental permit could be re-issued in as little as one month, the timetable could be up to six months—or longer. Shell warned that the cancellation of Sakhalin Energy's environmental permit would add to the project's costs and mean further delays in the start of exports.

Of course, Russian officials are well aware that this will delay the start of Sakhalin-2 exports; indeed, that may very well be part of the government's strategy. While Shell and ExxonMobil—the operator of the Sakhalin-1 project, which is also under fire for environmental violations at its soon-to-be-launched DeKastri oil terminal on the Pacific Coast—have held their ground under mounting pressure from the authorities, their confidence that the government would not go so far as to revise their PSAs may be misplaced. Given the presidential administration (the Kremlin)'s focus on boosting Russian oil and gas exports to Asia, the state appears intent on exercising greater influence—if not outright control—over the development of oil and gas under the Sakhalin PSAs.

The government signed the Sakhalin-1 and Sakhalin-2 projects in the 1990s, at a time when Russia was seeking foreign investment to resuscitate its oil industry while international oil companies (IOCs) were eagerly seeking a foot in the door to Russia. Buoyed by the growth of homegrown oil majors, sustained high oil prices, and in view of rising global competition for access to oil and gas resources, the tables have turned, giving the government the upper hand in dealing with IOCs seeking to invest in the country. The move to bring the PSA operators to heel may be geared to redress the state's perceived "giveaway" to the IOCs in the 1990s. Indeed, the Natural Resources Ministry warned yesterday that the PSAs themselves could be revoked if the operators continue to fail to meet technical and environmental requirements under the agreements.

Outlook and Implications

The cancellation of Sakhalin Energy's environmental permit for the Sakhalin-2 project is one thing; the cancellation of the PSA itself is another thing altogether. Obviously, a revocation of the PSA for the Sakhalin-2 project (or the Sakhalin-1 project, for that matter) would be extremely damaging for the Russian investment climate—faced with mounting criticism over their environmental stewardship of the Sakhalin projects, both ExxonMobil and Shell are increasingly counting on the belief that Russia would not shoot itself in the foot by cancelling the PSAs outright.

Of course, the government is not so devoted to environmental protection that it would jeopardise the investment climate by cancelling the Sakhalin PSAs (and Total's Kharyaga PSA as well), but then the battle between the IOCs and the government has never really been about the environment. Rather, this is a battle for control of the export of Sakhalin's oil and gas riches, with the government using the environment as a convenient excuse to wage a campaign to secure a greater say in the development and export of oil and gas from Sakhalin.

There is widespread speculation that the pressure being applied to Sakhalin Energy is really about Gazprom's desire to get better terms from Shell in their July 2005 swap deal under which the Russian gas giant was to take a 25% stake in Sakhalin-2. That deal, however, has not been completed, as Gazprom has sought to re-work it, arguing that Shell's upward revision of the Sakhalin-2 project's costs means Gazprom's stake in the project is now less valuable. With the government increasingly annoyed by intransigence from the IOCs over the Sakhalin projects, the state appears to be motivated not so much by a desire for greater influence in the Sakhalin projects (Rosneft, the state-owned oil major, already has a 20% stake in Sakhalin-1), but instead outright control.

Considering that both Sakhalin projects are on the cusp of fruition in any case, a move to cancel the PSAs would actually have fewer negative repercussions for the government than might be expected. ExxonMobil and Shell have much to lose, but the government—which is already in the process of building up national champions in Rosneft and Gazprom and is seeking to limit foreign participation in the development of "strategic" oil deposits with pending changes to the company's subsoil legislation—is clearly less concerned about the impact on its investment reputation. Having paid off its Paris Club debt, and having sustained little long-term damage to its investment climate from the Yukos affair, Russia seems almost to have more to gain from pressuring the IOCs over the Sakhalin projects than it has to lose.

Rather than fighting what appears to be ultimately a losing battle, both Shell and ExxonMobil would be better served in the long run by seeking to accommodate the Kremlin. Instead of losing their investments in Sakhalin altogether, the supermajors would be better off if they were to recognise the changed dynamic in the power balance between the government and the IOCs. Russia holds the upper hand, and while the government may not be exactly eager to cancel the PSAs, it certainly does not appear to be ruling out the idea. The longer the IOCs hold out, seeking to deny the state its desire for greater control of the Sakhalin project, the more likely the Kremlin is to play its trump card.