Title:
JOURNEY TO SAKHALIN: ROYAL DUTCH/SHELL IN RUSSIA (A)
CASE STUDY REPORT

Contents Page 1. Executive Summary……………………………………………………………….…………………..3
2. Introduction…………………………………………………………………………….………..……….3 3. Analysis…………………………………………………………………………………..…………….……3 3.1 Foreign Direct Investment…………………..…………………………………….……………...3 3.2. Sakhalin………..……………………………………………………………………………………….…..4 3.3. Production-Sharing Agreement……………………………………………………………..….4 3.4. Approvals-TOEC…………………………………………………………………………………..…….5 3.5. NGO’s and the Environment………………………………………………………………..…...5 3.6. SEIC’s strategic moves……………………………………………………………………..………..6 4. Recommendations……………………………………………………………………………..……..7

1. Executive Summary:
In the following report the case study titled “Journey to Sakhalin: Royal Dutch/Shell in Russia” will be examined. A summary of the main issues that SEIC came across with, is analyzed including issues with the PSA and the political usage of Sakhalin II project, as means to an end. Other issues including late approvals, TOEC acquisition and nongovernmental organizations’ influence to potential buyers and lenders are also mentioned. Conclusively a recommendations section is created for the future of Sakhalin II project, that emphasizes on the PSA matter and the TOEC acquisition. 2. Introduction

In the period of 1997-1999 Russia faced a great economic decline with a massive fall in GDP and the proportion of Russians living under poverty raised from 2% to 50%. But Russia was endowed with enormous oil and gas reserves which dominated Soviet exports (75% of the total exports was gas and oil). Specifically Russia controls the largest concentrated supply in the world, constituting 30% of the world’s total reserves. Those reserves could prove a saving factor for the Russian economy, if handled correctly. Russia privatized state-owned energy firms which resulted in the emerging of private owned firms, dominated by businesspeople close to the Russian political establishment. Russian government also had a stake of 38% in Gazprom, the largest gas company in the world. This could mean that Russia’s efforts in funding or approving new companies to exploit other reserves would not be as objective as they should.

3. Analysis

4.1. Foreign Direct Investment:
Russia tried to attract foreign investors in the energy sector as billions of dollars were needed to exploit the massive reserves in Russian territory. One of the main factors that held foreign investors back from investing in Russia, was the substantial political risk. Furthermore the corporate governance scandal of BP, a western energy firm that invested in Russia, further enhanced foreign investor’s decision not to invest in an unstable Russia. In order to attract FDI, the Russian Parliament allowed production-sharing agreements or PSAs. PSAs were commercial contracts between a foreign investor and the host government that replaced the country’s tax and license regimes for the life of the project. The Sakhalin II project was the first to sign a PSA in Russia.

4.2. Sakhalin:
Sakhalin is a beautiful island just north of Japan’s northernmost island Hokkaido. The island has vast gas oil reserves which resulted in a feasibility study for two fields off its coast. The study resulted in the emergence of SEIC, a group of energy firms dedicated to exploit the reserves of Sakhalin. However the island suffers from extreme weather conditions making it impossible to work on especially in the winter. Furthermore the island is covered in mountains, rivers and lakes and rested upon a number of seismic fault lines. All these factors made the island a real challenge for SEIC in its efforts to exploit the island’s natural reserves. Moreover the island was constantly changing hands through cruel wars between Russia and Japan making it a dangerous land, full of war dead and unexploded ordnance. By 2004 the two countries had still not signed a peace treaty.

4.3. Production-Sharing Agreement:
As stated above, the Sakhalin II project was the first project to sign a PSA in Russia. The PSA was considered to be a win-win situation for both sides. SEIC is exempted from VAT, customs and property taxes. There is also 100% cost recovery for the PSA investors and a fixed profit tax rate. Title on project assets is held by SEIC until full cost recovery is achieved and then the title is transferred to the Russian federal government. A big gain for Russian economy is the preference to duly qualified Russian firms for contracts. SEIC had to put an effort to achieve 70% Russian content over the life of the project.
Unfortunately for SEIC the PSA required management. That management issue turned out to be the biggest issue SEIC had to face with the Sakhalin II project. The communist environment that dominated Russia created a bureaucratic nightmare for the managers of SEIC. Approvals that took ages to be issued, such as TOEC that will be explained in further detail later, customs exemptions challenged by customs officers and the absence of a mechanism for the tax ministry to refund VAT were only a few of the problems the staff of SEIC faced. Furthermore the politicization of the terms of the PSA and specifically the meaning of “Russian Content” ,which was seen as a mean for Russian government to save the Russian collapsing economy, created several efficiency problems because Russian industry had little or no expertise with offshore production facilities and no expertise with building LNG plants. The PSA was often challenged by members of the Parliament and made SEIC to keep a close eye to the political situation within Russia putting more obstacles in their way. It was obvious that the new Russian government wanted to change the legislation regarding the PSAs because it did not benefit industries within Russia. SEIC tried to hold on to the terms of the first PSA as it was of vital importance for the project’s future.

4.4. Approvals-TOEC
Management of approvals in SEIC was of vital importance, a demanding job that caught the attention of the senior executives only when things went wrong. The whole approvals issue had its roots mainly from the change of government from Yeltsin to Putin. In order to get the approvals needed for the smooth operations of Sakhalin II, SEIC’s managers had to work their way from the bottom to the top of the Russian hierarchy. Russia was in the phase of transition. Under Yeltsin the governance had become extremely decentralized and the local authorities called most of the shots. Under Putin a great effort was taken in order to re-establish central political authority in Moscow, and eventually the federal authorities took control of the situation.
The central challenge of approvals for SEIC was the acquisition of a technical and economic substantiation for construction (TOEC). TOEC was basically an official approval of SEIC’s plans for the Sakhalin II project, and it consisted of over 50 different approvals by local and federal Russian regulatory agencies. SEIC could not proceed with the project without acquiring TOEC and the shareholders insisted that the TOEC was in place before committing the $10 billion dollars to Sakhalin II. Russia’s harsh bureaucracy is once again illustrated in the 100000 pages application for the acquisition of TOEC. But the problems SEIC faced did not end with the completion of the TOEC forms. The fact that the approvals for TOEC were taking a lot longer than expected made it obvious that Sakhalin II and SEIC had many enemies within Russia. That was because Sakhalin II was not considered as a simple energy exploitation project but as a political strategy of the current government. Politicians used Sakhalin II to show the improvements it makes on Russian economy and that upset several groups within Russia. Managers within SEIC had to talk face to face with several regulatory authorities within Russia to explain them how the project benefits Russia in order to get the approvals needed. That of course took time and funds, two things that do not come cheap. SEIC therefore needed to focus more on how to manage these meetings in order to be more productive.

4.5. NGO’s and the Environment:
The political situation in Russia and the problems that came with it, were not the only things SEIC worried about. Sakhalin’s rivers and lakes were home to salmon and their yearly spawning. Furthermore the Western Gray Whale, an endangered species, migrated to summer feeding grounds off the northeast coast of the island. Thus SEIC had to keep its operations in such way that it did not disturb the natural balance of the island. This meant keeping a careful eye on the contractors, who were obliged to meet high standards on health safety and the environment.
Though SEIC put a great effort in not disturbing the island’s natural balance, many nongovernmental organisations (NGO) were not pleased and created new problems to SEIC including influencing buyers from Japan not to buy from SEIC and lenders from whom SEIC sought finance for Sakhalin II. As a result SEIC had to deal with several other problem-creating factors other than the political and approval issues in Moscow. 4.6. SEIC’s strategic moves:
Other than the main issues that SEIC had to respond to, during the Sakhalin II project it made some significant strategic moves. Firstly the approach of SEIC’s senior managers to engage the president and the prime minister for the matter of the PSA and TOEC. This resulted in a letter of assurance by the prime minister that the PSA signed was grandfathered by the government and had its support. This initiated the second phase of Sakhalin II.
Secondly the decision for an LNG plant instead of pipelines from Sakhalin to target markets. This decision made the distribution of gas a lot easier and it meant that it could be sold all around the globe since in a liquid form it could be transferred anywhere with ships. On the other hand, in order to create an LNG plant, SEIC had to construct pipelines towards the southernmost point of the island were the plant was planned to be built. Those pipelines had to pass through the harsh terrain of Sakhalin and in a land full war remains including unexploded ordnance.
SEIC established a really good relationship with the residents and the government of the island. This was a well-managed job that gave SEIC several connections in political offices in Moscow through the governor’s, who was in favour of Sakhalin II. In order to establish this relationship SEIC spent $241 million to upgrade a lot of the island’s infrastructure and hospitals. Furthermore grants were given to several other institutions such as newspaper folk groups etc.
Another good example of SEIC strategy was the decision not to sell in domestic market but only on exports. Since Russia had vast reserves of oil and gas, the price of those two sold in domestic markets would obviously be lower than the price sold in markets outside Russia.
Finally the several deals made with Gazprom, world leading gas company, could be considered as a part of Shells strategy. And since Shell had the greatest share in SEIC by buying out Marathon, this meant that any benefit gained from the good relationship that Shell and Gazprom had would benefit the Sakhalin II project as well. These benefits could include connections of Gazprom within the Russian government, since the government owned 38% of Gazprom.

4. Recommendations
By the above analysis it is quite cleared that SEIC main issue is the political situation within Russia. There are many enemies of the PSA that SEIC signed with the Russian government, but SEIC should insist on keeping up with its terms. The Russian prime minister sent a letter of assurance but it was not as conclusive as clear legislation. SEIC should try and formalize this assurance in clear legislation to prevent future drawbacks. Furthermore TOEC acquisition should be SEIC’s top priority. This will calm the shareholders and give SEIC a good proof of legitimacy for its operations.
Moreover keeping the established good relationship with the residents of Sakhalin should be set as a priority. The government within Sakhalin has helped a lot with its connections and it might be needed in the future.
Another factor that could be improved is the matter of NGO’s. By providing to the public sufficient evidence that the project does not interfere in any way with the island’s natural balance, it could limit the threads coming from NGO’s and raise the public opinion in favour of SEIC in this matter.
Sakhalin’s II aim was to extend the supply of energy sources from Russia to Asia. But with the construction of the LNG plant, gas can now be transferred worldwide therefore opening the way to new markets. Furthermore with the volatile environment in Middle East there are opportunities for other firms to exploit other resources in Sakhalin and use SEIC’s LNG. This will generate more profit for SEIC since the usage of the LNG plant will not come cheap.