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Equity and inequity in Sakhalin 1

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Energy security is believed to be synonymous with acquisition of overseas oil equity, a strategy aggressively followed by importers like China, Japan and India. But if developments in Sakhalin 1 are any indication, how good is overseas oil equity, either as an energy security measure or even as a sound commercial proposition?

Just one year after it commenced commercial production, Sakhalin 1, India's largest overseas investment, seems to be heading for stormy weather. Recently, Lev Brodsky, chief of Sakhalin Projects in Rosneft, announced that oil production from the project will peak in 2006 and begin to decline thereafter. Considering commercial production started only from October last year, one might wonder why peaking should occur so soon.

Not surprising, if you consider that Exxon, the operator of Sakhalin 1 - in which ONGC Videsh Ltd (OVL) has a 20% stake - had assumed it would be allowed to drill wells outside the contract area awarded to it under the production sharing agreement.

The company's estimates of reserves and production targets from Salkhalin 1 included these new wells. However, Russia has refused permission to expand the contracted area, throwing a spanner in the calculations of all the shareholders of the project.

The Inter-departmental Commission of the energy ministry of Russia has not only denied permission to Exxon to expand the licence area, but it also wants to auction the new discoveries to the highest bidder.

If Exxon is keen on acquiring these fields without going through the bidding route, the Russian government insists it will review the terms of the original PSA, something that is not in the interest of the project promoters.

After all, the two Sakhalin fields - Sakhalin 1 and 2 -have some of the best terms ever offered by Russia to any foreign investor in its oil sector. They were signed at a time when oil prices were low and Russia was desperate for financial resources as well as technology. Any review of the 'grandfathered' PSAs now is bound to result in rewriting the terms of the contract to the detriment of the foreign investors.

But that is not even the worst news for Sakhalin 1. After launching an extensive environmental audit of Sakhalin 2, which found Shell, its operator guilty of environmental violations, Russia's natural resources ministry has ordered an environmental probe into Sakhalin 1 as well. It wants Exxon to undergo more environmental checks at its De Kastri terminal before exports are resumed.

Shell has allegedly been found guilty of five violations for which the Russian government intends to file criminal charges against the company. It has already revoked the environmental licence awarded to Shell for operating Sakhalin 2 and has ordered the re-routing of a pipeline being built to ferry oil from Sakhalin island to the Russian mainland.

Russia's new green evangelism is widely seen as yet another weapon wielded by the Putin administration to tighten control over the country's mineral resources.

The two Sakhalin projects will comprise the single largest source of supply addition to the global oil markets in recent years and Russians seem eager to get a bigger share of the pie.

These developments are occurring at a time when the gas export question has not been resolved. In the summer of 2004, Russia had nominated Gazprom as the monopoly exporter for all gas supplies to Northeast Asia.

Vedomosti, Russia's financial daily, reported in April this year that Gazprom wants to buy all of Sakhalin 1 gas at wellhead price, for export to China and others. Whether Gazprom will buy this gas at the Russian domestic prices - which are a fraction of global prices - is the question that is unanswered.

On October 19, this year, Exxon signed a preliminary agreement with China National Petroleum Corporation on future gas supplies from its Sakhalin 1 project, but the final sales and purchase agreement will have to await the blessings of Gazprom. The US oil major is negotiating to supply eight billion cubic metres a year of natural gas to northeast China through a pipeline which will have to be built, possibly by Gazprom.

Whether the Russian government's manoeuvres to tighten state control over its energy industry projects has to do with the sudden increases in project costs proposed by the two operators of Sakhalin 1 & 2 is a pertinent question.

While Shell proposed a development cost increase from $15 billion in 2003 to $28 billion, Exxon, the operator of Sakhalin 1 has also claimed that its production costs will go up from $12.8 billion to $17 billion, proposals that Russians baulk at. Bigger project budgets imply less and delayed revenues for Russia.

Under the PSAs, the operator can first recoup its costs before profit share is paid out to the host government. Higher budgets also mean pushing back the date from which profits would accrue to host governments, by which time, the field may well be past its prime and the host government could well be left with smaller and dwindling profit shares from a declining field.

At its peak, Sakhalin 1 is expected to produce around 250,000 barrels of oil daily, but with the downgrade, it might be less. For now, OVL is getting its first consignment of equity oil - 90,000 tonnes - from Sakhalin 1 headed towards Mangalore port.

Physically ferrying Sakhalin oil to India is not exactly going to enhance India's energy security since the shipments will have to pass through the congested Malacca Straits, clogged with tankers ferrying energy to Japan, China and South Korea from the Persian Gulf and other parts of the world.

In fact, OVL is literally going against the tide in physically bringing this oil to Indian shores when energy importers in the region are looking to Sakhalin as a source of diversification precisely to avoid the sea lane congestion.

OVL might be content to argue that global oil and gas prices have skyrocketed since it acquired its stake in Sakhalin 1 and so the venture is still a profitable one. But that is a fortuitous development that has little to do with OVL's foresight. What is pertinent now is whether OVL will realise the full benefit of the oil price rise or are its gains being prised away by the claws of the Russian state and the games played by the operator of Sakhalin 1.

© The Economic Times

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