Oil and Gas Projects on Sakhalin Shelf

Sakhalin-3: Background. In December 1993 a consortium of Mobil and Texaco won the tender for a lease on the Kirin block. Although no exploratory wells have been drilled to date, according to seismic data Kirin is a very promising gas field. It is located some 50 km offshore in 150 m water, which dramatically increases the technical challenge and cost of building an ice-resistant platform to withstand environmental conditions. (Mobil has similar experience in the Hibernia project off Nova Scotia.) In 1998 Rosneft and Rosneft-SMNG were included into the project, which was a necessary condition before the Russian State Duma would approve a law granting the right to develop the Sakhalin-3 Kirin block under PSA terms. The partners formed an operating company called Pegastar.

Sakhalin-3: Current Status. Although the Russian State Duma passed the law by an overwhelming majority, the RF Government delayed in naming a delegation authorized to negotiate the final PSA. This, and other problems in implementing amendments made to the PSA Law in February 1999, caused Pegastar to miss its window for exploratory drilling in 2000. Now the Government’s negotiating team has submitted a list of almost 200 amendments to the draft PSA which, according to Pegastar, is little more than an attempt to re-negotiate the agreement already reached during the tender phase. This deadlock, plus the need to contract a deep-water exploratory rig well in advance, means that a Kirin exploratory well is unlikely before 2003. Texaco, a partner in Pegastar, has announced it will be bought out by Chevron, a company with significant experience working in Russia.

Joint Infrastructure. Sakhalin-3 might have played an important “spoiler” role in negotiating shared-cost joint transportation infrastructure between the Sakhalin-1 and -2 projects. However, the merger of two international oil giants Mobil and Exxon, announced by shareholders on 28 May 1999 and completed by year’s end, decisively shifted the balance of power leaving ExxonMobil in a position to decide what pipeline infrastructure it finds economic to build, largely independent of Sakhalin Energy. This has brought ExxonMobil into a test of wills with the Sakhalin Administration and Ministry of Energy, which are known to support the extensive onshore infrastructure (and associated job creation) of the Sakhalin-2 project.

Sakhalin-1: Background. The Sakhalin-1 consortium was formed in June 1995 by Rosneft (Russia-23%), Sakhalinmorneftegaz (SMNG) (Russia-17%), Sodeco (consortium of Japanese companies, including JAPEX, Itochu, Marubeni, JNOC-30%) and Exxon (US-30%). The consortium was granted a license to explore the Arkutun-Dagi, Chayvo, and Odoptu fields on the Sakhalin shelf, and its PSA was signed in 1996. Initially it was proposed that Sakhalin-1 development would begin with oil platforms at Arkutun-Dagi. However, a dry-hole exploratory well drilled in the middle of that field in the summer of 1997 sent engineers back to the drawing boards with a new understanding of that reservoir’s complex structure.

Gas Marketing. Exxon (Exxon Japan Pipeline Ltd) in early 1999 teamed up with interested Japanese firms to form Japan Sakhalin Pipeline FC Co., Ltd., which has prepared a feasibility study of a pipeline route sub-sea to Hokkaido, Niigata, and other points along the western coast of Japan. A second option for delivery of Sakhalin gas via pipeline along the Amur River valley and Khabarovsk to Harbin, China and markets in North China seems less likely, as China turns develops its own East-West Pipeline option. However, despite interest from Hokkaido, ExxonMobil reports the NE Asia pipeline gas market is still “soft” and may not “firm up” until after 2005.

Oil Rim Discovery at Chayvo. Early exploratory wells at Chayvo showed that field to be more promising for gas production than Arkutun-Dagi, and additional exploratory wells were ordered. However, Sakhalin-1 lost then entire 1999 drilling season when exploratory work at Chayvo was denied approval by the RF State Ecological Expertise Review (SEER). The SEER panel objected that Exxon’s plans to dispose of water-based muds and cuttings overboard into the Sea of Okhotsk, while permitted by international conventions and standard practice, were considered illegal according to one Russian law. Exxon was finally granted a water-use license for its 2000 drilling program, on condition of zero-discharge for this well only. (Sakhalin Energy continues to discharge at production wells in Piltun-Astokh, just a few dozen miles to the south, but plan to switch over to zero-discharge for future production drilling at Molikpaq). In September 2000, offshore appraisal drilling found a “sizeable” oil rim around the Chayvo gas deposit, and production tests show an encouraging inflow rate of 6,000 barrels/day.

Development Plans. Based on these results, ExxonMobil is prepared to start immediately, contingent on receiving key government assurances, on a $3.5 billion Phase 1 development that proposes the following: (1) early oil development from Chayvo via directional drilling from onshore (approx 12km to the feature), followed by (2) installation of a modified arctic drilling rig currently located in the Beaufort Sea, known as CIDS (Concrete Island Development System). Product would be delivered to market via (3) a $400-million onshore pipeline west across the Tatar Straits and on to DeKastri in Khabarovsk Kray, where the crude could be offloaded to tankers at an SMNG new 100kt/y export terminal that is substantially ice-free for 11 months of the year. Simultaneously, construction could commence on Phase 2 offshore gas pipelines to Japan, with first gas deliveries in 2006 ramping up to 1000MMscf/d by 2010.

Despite President Putin’s claims of encouragement for foreign investment, the Sakhalin Administration and Ministry of Energy have joined forces to oppose ExxonMobil’s development plans, preferring instead to “force” ExxonMobil to “cooperate” on joint infrastructure with Sakhalin Energy. Although the cost is three times higher, Sakhalin stands to gain significant jobs and collateral infrastructure development from a north-south pipeline and export terminal in Korsakov, as per the Sakhalin Energy development plan. Although the Ministry of Energy would prefer that ExxonMobil invest in new platform construction, Deputy Minister Garipov signaled some softening of their position against CIDS at a recent conference (just prior to his dismissal in December, 2000). The Russian side has delayed approval of operating budgets for Sakhalin-1 and –2 until January 2001, at which time ExxonMobil expects either to receive key assurances of government approval for this development plan, or to submit a drastically-reduced budget and go into “hibernation” to await the start of the gas market some years down the road.

Sakhalin-3 Ayyash/Odoptu. On 13 Jan 99, Exxon announced that it would permit Rosneft and Rosneft-SMNG to take part in the consortium to develop the Ayyash and Eastern Odoptu blocks of the Sakhalin-3 project, granted to Exxon as result of the Sakhalin-3 tender in 1993. Seismic data point to significant potential resources but appraisal drilling and prospecting will be necessary.  This step was viewed as necessary to the Russian State Duma approving these blocks as eligible for development under a PSA (“getting on the Law of the Lists”), which milestone was achieved in late 1999. The Russian Party (Sakhalin region and the Russian Federal Government) have concluded a PSA agreement with the developer, which is promised soon to be ratified by the Duma.

Sakhalin -2

Background. The Sakhalin Energy Investment Company Ltd. was established in April 1994 to develop the Sakhalin-2 offshore oil and gas project. Shareholders (until recently) were Marathon Sakhalin Limited (parent company U.S., 37.5%), Mitsui Sakhalin Holdings B.V., (parent company Japanese, 25%), Shell Sakhalin Holdings B.V. (parent company British-Dutch, 25%) and Diamond Gas Sakhalin B.V, (parent company Mitsubishi, Japan, 12.5%). Sakhalin-2 is the only Sakhalin offshore project with no Russian partner.

Sakhalin 2 produced first oil in July 1999, the first from any of the Sakhalin offshore oil and gas development projects, and the first in 1994 to sign a production-sharing agreement (PSA) with the Russian government.

Sakhalin-2 includes the Piltun-Astokh (oil and condensate) and Lun (gas) fields, located 15 km off the northeastern coast of Sakhalin. Together, these two fields contain about 140 mmt oil and 408 bcm gas. The $10 billion “full-field” development plan includes a 600-km gas-oil pipeline from offshore platforms to a 9 mmt/y LNG (liquified natural gas) plant and oil export terminal in the south of the island near Prigorodnoye on Aniva Bay.

The first phase of this development is a platform to tap the Astokh oil feature and export via shuttle tankers, prior to pipeline construction. In July 1999 Sakhalin Energy commissioned the Vityaz Offshore Production Complex (Molikpaq ice-resistant production platform, plus a 2-km subsea pipeline to a SALM/FSO offloading scheme using the 274-m long double-hulled 158,000 t deadweight “Okha” tanker built by Daewoo). When the $60 million Zima Highlands housing complex and a new six-story office building were completed in June 2000, Sakhalin Energy moved its corporate offices from Moscow to Yuzhno.

Oil Production. The Molikpaq was plagued by a variety of minor technical issues early on. A hawser on the Okha FSPO parted during high winds in September 1999, resulting in a hose disconnect that spilled about a half-ton of crude oil. Though shutoff systems and response plans worked flawlessly, the press uproar was tremendous, spilling by far more ink than oil and resulting in nearly $100,000 in fines to Sakhalin Energy. (Larger near-shore spills two weeks later in the same vicinity by a Russian oil company went unnoticed.) High gas temperatures caused problems with gas reinjection equipment, forcing flaring of associated gas. Production delays, plus continuing customs and border guards issues made 1999 a disappointing year for production. Production drilling in 2000 allowed Sakhalin Energy to reach nearly 80,000 bbl/day and offload some 1.4mmt, more than doubling the total annual oil production of Sakhalin region from a single platform and dramatically demonstrating the growth potential of offshore development projects. Sakhalin Energy also pushed the start of production season using navigation management techniques – ice-class tugs diverting bergs incident on the platform. Formation pressure problems forced engineers to move up installation of a platform waterflood module to 2001, prompting a hotly-contested fab tender among Russian companies and Alaska-Sakhalin JVs. Sakhalin Energy will move the entire Molikpaq platform in the 2001 season to a slightly better location over the feature, prompting a new tender for production drilling services, likely to go to a Russian contractor. Border Guards also announced a decision in late 2000, which permits Molikpaq-bound tankers to skip the two-day detour to call at Korsakov.

Shell Buys Out Marathon. In February 2000, incoming Marathon CEO Clarence Caselott and his team took a long, hard look at Marathon's cash-flow problems and suggested divesting some of its equity in the Sakhalin projects in favor of consortium member Shell. However, no one was prepared for Shell’s surprising counter-offer: we’ll take it all. Marathon agreed, announced the deal in June and completed the sale on 13 December 2000. Shell took Marathon's 37.5% interest in Sakhalin Energy in exchange for interest in Shell offshore projects in the United Kingdom and Mexico, plus reimbursement for current-year expenditures for the Sakhalin project. Mitsubishi Corporation (Japan) then announced that it would acquire an additional 7.5% share from Shell. This leaves the final distribution of shares in Sakhalin Energy Investment Co. as of December 2000 as follows: Shell –55%; Mitsui – 25%, Mitsubishi – 25%. The new Sakhalin Energy president is a Shell executive from offshore Gulf of Mexico, American Steve McVeigh.

Although Marathon's original strategy was commendable for its boldness, delays in PSA legislation caused them to miss the original 1996 start date for gas, and the market went soft after the 1997-8 Asian financial crisis. Strategic vision was not enough – and Marathon simply lacked the resources to risk for the very long haul.

Contracts. SEIC’s “personality” is changing rapidly, from American to European, with engineering now relocated to new offices in Rijswijk, near The Hague, and a potential incursion of North Sea contractors replacing Alaskans and Texans. Shell has the means and the intent to aggressively pursue LNG, ending a lull in development activity in 1998-99. In October 2000, SEIC announced the winner of a $10 million contract for development of technical specifications for design of a 9.6 mmt/y LNG plant at Prigorodnoye, awarded to a consortium of NIPIgazpererabotka (Scientific Research Institute of Gas Processing, Russia), Chiyoda (Japan), and Fluor Daniel (US). The new plant is expected to be the first LNG plant in the world to use the latest refrigeration technology from Shell. Approx $100 million in major contracts were awarded in December of 2000, including: (1) Starstoy (Russian-French JV) for design of offshore and onshore pipelines for oil and gas transportation, onshore pump and compressor stations, and oil export terminal; (2) AMEC Services, Ltd (UK) for design of offshore platforms; and (3) Parsons Engineering (US) for design of onshore infrastructure.  This announcement caps a tense behind-the-scenes standoff between SEIC, which had already fairly much decided in October on AMEC/Parsons for the bulk of this contract, and the Russian side which was unsatisfied when their calculations showed only 18% Russian content and insisted on a greater role for Starstroy. (The Energy Ministry was also concerned that “technical design parameters not be set such that foreign-manufactured equipment is favored over Russian.” Aggressive Russian content is truly the shape of things to come.)

Development Outlook. Final Plans of Development for Lun and Piltun-Astokh fields to be submitted to the Supervisory Board by June 2001. The Russian side has also insisted on a feasibility study and tender for a co-located oil refinery. By 2002, the waterflood module should be installed as an add-on to the Molikpaq. SEIC announced in December that it will conclude contracts for a general contractor for engineering, procurement and construction of the LNG plant and export terminal in April 2002.  Part of the contract will include construction of roads, buildings, development of management systems, mancamps, ultra-strong loading docks, large-scale facilities for gas processing, oil storage with capacity of about 350,000 cu.m., and facilities for loading tankers (150,000 tons and a loading speed of 8000 cu.m. per hour). Peak of pipeline construction is expected in 2004-2005, with first LNG deliveries by early 2006.

SAKHALIN-4 AND 5

Background. In late 1998 ARCO Sakhalin Inc. established a representative office in Yuzhno-Sakhalinsk and under a cooperation agreement signed in March of that year with Rosneft/SMNG shot 3-D seismic over the promising Astrakhan Block of Sakhalin-4 project (extreme north, to the west of Sakhalin island, see map). Rosneft/SMNG possesses the exploration license and PSA rights to the Astrakhan. ARCO had planned to participate with Rosneft/SMNG in the drilling an exploration well during the 2000 drilling season, but issues related to ARCO’s world-wide exploration strategies resulted in ARCO pulling out of the Astrakhan project just prior to the merger with BP Amoco in January of 2000. Within the year BP Amoco re-branded the company and is now known simply as BP.  In the summer 2000 drilling season Rosneft proceeded on its own with the appraisal drilling program on the Astrakhan Block. 

Current Status. BP is now aligned with Rosneft/SMNG under an Alliance Agreement to investigate opportunities in Sakhalin-5 block (located on the other side of the island from Saklhalin-4 site).  The agreement envisions a joint bid if and when Sakhalin-5 comes up for tender, with a 51/49 split of equity between Rosneft/SMNG and BP. In the summer of 2000 Dalmorneftegeofizika (DMNG) conducted a 2-D seismic surveys on this license area. As a result of the merger the local office of BP is now being re-registered in Yuzhno-Sakhalinsk as a Representative office of BPEOC Sakhalin Inc. (BP Exploration Operating Company). BP is also pursuing other long-term opportunities on Sakhalin and is poised to take equity positions in any other attractive projects that become commercially available.

SAKHALIN-6

Rosneft and Rosneft/SMNG with Texaco and ExxonMobil are rumored to have their eye on a future joint bid for Sakhalin-6. However, in September, the Alfa Group bought 95% of the shares of a small local oil company, Petrosakh, from Nimir Petroleum (Saudi Arabia), thus giving them a foothold on Sakhalin. Petrosakh's 200,000 t/y field refinery and onshore fields are adjacent to the Sakhalin-6 offshore block. To avoid the long lead time for a PSA, Alfa announced it would start directional drilling from onshore and platforms to develop near-shore Sakhalin-6 fields on commercial risk terms without signing a PSA if granted a license, a request for which has already been submitted to the Ministry of Natural Resources. The company hopes to increase production from 250,000 to 2.5mmt/y and ramp up its refinery to 450,000 t/y to deliver fuel directly to retail outlets that it will build in Yuzhno-Sakhalinsk. Alfa Group recently paid more than $1 billion for an 85% stake in Onako in the latest round of privatizations; Mikhail Fridman and Pyotr Aven are known as "good" oligarchs who enjoy warm relations with the Kremlin.

However, all this upstream/downstream investment activity in their own backyard was greeted with suspicion by SMNG. Shelf Dept officials announced that they will oppose the bid because Al’fa Group is interested only in one particular field, not in exploration of the entire Sakhalin-6 lease area. SMNG also began buying up storage tank farms in Korsakov and Aleksandrovsk, and announced construction of new filling stations in the south.

ONSHORE GAS FIELDS AT ANIVA

Gazprom has also made a very tentative beachhead on Sakhalin – in October 2000 ‘daughter’ company Vostokgazprom formed a ‘granddaughter’ company Sakhalingazprom, which may get involved in developing small onshore gas fields in the south of the island. Gazprom still expresses no particular interest participating in the large offshore projects, however.

Vostokgeologiya continued exploratory drilling of the Aniva onshore field not far from Yuzhno-Sakhalinsk, increasing reserve estimates up to 2-300 million cu.m./y.  A 28-km gas pipeline was laid in September-October from Aniva to a small village halfway to Yuzhno. The plan, according to Vice-Governor Anatoly Kholodin, is to continue the line to the 285MW TETs-1 co-gen power plant in Yuzhno-Sakhalinsk in 2001. Aniva reserves could supply up to one-third of all fuel needs and thus help to gradually transfer operations to gas from coal. After 2006, the line could be used as a feeder to carry natural gas from the main line which will pass through Yuzhno, back to Aniva.

LEGAL AND TAX STABILIZATION ISSUES

President Putin has taken an active role in pushing forward implementation of PSAs, in particular the Sakhalin projects. In August he personally directed German Gref, Minister of Economic Development to convene a first-ever inter-Ministerial working group at the Deputy Minister level. Shortly thereafter, Putin himself visited Sakhalin and attended the final day of the PSA 2000 conference on 3 Sep 00. (US Energy Secretary Richardson and US Ambassador to Russia Collins were also in attendance the first day.) Putin clearly called for an “end to the debate” about foreign investment, stating “PSAs are good for Russia.” He expressed his support for the measures proposed by the Gref working group, and by October at least two of these had borne fruit: a Border Guards decree simplifying border clearance for tankers calling at Molikpaq, and partial reimbursement of VAT that investors have paid in violation of PSA terms. Outstanding issues include categorization of the sensitivity of fishing grounds, creation of a Federal-level Russian content working group, amendments to the Law on Territorial Seas, approval of PSAs such as Sakhalin-1 Ayyash/East Odoptu, and most importantly, passage of urgently-needed Normative Acts (regulating cost recovery, VAT reimbursement, Russian content, etc.). Although the appointment of Gref created terrific resentment in the Energy and Natural Resources Ministries, Putin stayed the course and by year’s end hardline Deputy Ministers such as Valery Garipov (with years of experience in oil and gas PSAs) had been removed. It remains to be seen if Gref can, at last, make PSAs work to attract foreign investment into the oil and gas sector, as originally intended. (Not a single new PSA project was signed in the five years following passage of the original, flawed PSA Law.)

OTHER

In August 1998, Rosneft-SMNG achieved first oil from Sakhalin offshore deposits – using an onshore drilling rig! This was achieved using US-made Sperry-Sun directional drilling equipment, tapping the edge of the Odoptu North Dome feature, some 4km offshore in the Sakhalin-1 license area. A second rig of this type began drilling in 1999. If ExxonMobil get the go-ahead for early oil development, there will be even more opportunity for this type of drilling at the limits of present technology (12 to 15km). SMNG also owns the right to develop certain of its on-shore (and near-offshore) fields in North Sakhalin under PSA terms. This means that expensive secondary and tertiary oil recovery techniques can be made economic for fields that would otherwise be considered “depleted” using existing technology, resulting in opportunities for US exporters – for those companies, anyway, who are not afraid to risk selling to a Russian oil company.

Pro-development incumbent Governor Farkhutdinov was re-elected in October by a respectable margin to a new four-year term. The new 27-member Duma also contains a five-deputy “SMNG Bloc,” including SMNG General Director Stefan Zemlyuk and former SMNG Deputy General Director, Speaker Boris Tretyak.

RAO EES (United Power System of Russia) and its chairman Anatoly Chubais came to Sakhalin this August to promote the idea of selling “ready-made” energy to Japan via a $9.6 billion 4GW power plant burning Sakhalin shelf gas. The generated electricity would be delivered to Japan via DC undersea cables, and rectified back to AC on the receiving end. Japanese investors are reportedly interested in the mega-project, known as the “Energy Bridge.”

To one extent or another, all the Sakhalin projects by terms of their PSAs are required to contract with Russian companies whenever possible. Article 7 of the recently-amended PSA Law calls for 70% of the contracts for equipment and 80% of personnel to be Russian. As evidenced by recent tender awards, these numerical targets are jealously observed by the Russian side. The Sakhalin-2 consortium also automatically includes as part of its bid list the list of qualified Russian contractors submitted by the Shelf Department of the Sakhalin Regional Administration.

It would be disastrous for operator companies on tight production schedules to be forced overnight to rely heavily on Russian companies without offshore experience, without training in Western methods, without proven technology and lacking the financing to obtain it. However, the PSAs establish that a joint-venture with 50% or more Russian participation is considered a Russian company for PSA Russian-content counting purposes. This means that the oil consortia can hire Western companies they have worked with in the past – but preferentially those who form local joint ventures with established Russian, especially Sakhalin, companies. There have already been cases in which trusted and pre-qualified general-profile Western companies simply never received bid packages, because they are known to have no Russian partner.

“Waiting for a good tender to come along” is a dead-end strategy. The Sakhalin-2 consortium used to provide a public bulletin board of future contracts to be awarded that was chronically out-of-date and uninformative (and since the company moved to a new high-security office building, even that much is no longer available.) The fact is, once SEIC have enough pre-quals to count on receiving bids from a maximum of four to five companies with some Russian content, there is little need to cast the net further. Tenders will be published a few days before the submission deadline as a formality only. Moreover, the practice of signing service contracts means that new work can be let under previous tenders by simply attaching a work order to an existing contract, thus reducing the number of tenders that are let.

This news should discourage Western companies that send in brochures and passively wait to receive bid packages. For those for whom work in the expanding Russian oil industry is a long-term strategic priority, American Business Center Yuzhno-Sakhalinsk  (partially financed by USAID and the US Department of Commerce) is available to help US companies identify potential partners, study the market, address licensing and training issues, develop contacts and include description of their company and services in consortia and Administration databases. Demonstrate a long-term commitment to Sakhalin projects -- persistence will pay off.

 

Flexibility will be another important attribute of the successful contractor – the ability to quickly retool and offer a wide variety of services when and as they are needed.

 

Another aspect of flexibility and commitment is at-cost bidding on, e.g. infrastructure work for Sakhalin, in order to keep a high profile on the island and work out training, licensing, correspondence and other issues with Sakhalin partners well in advance of bidding on offshore work in the future. Considering the important role the Regional Administration will play in approving contracts via the mechanism of the Supervisory Board, it is not a bad strategy to have a positive local reputation. Moreover, Sakhalin has a hard-currency fund into which are paid oil bonus monies (some $20-25 million per year, half of which is devoted to infrastructure and long-range development projects), which makes the Region marginally more credit-worthy than most others in Russia.