The agreement between Royal Dutch Shell PLC and OAO Gazprom, the Russian state-owned natural gas company, under which Gazprom will become the majority shareholder in the Sakhalin-2 LNG project demonstrates that western oil companies will no longer be able to obtain majority stakes in major Russian hydrocarbon assets.
Under terms of the deal, Gazprom will purchase 50% plus one share of the project for $7.45 billion, thereby forcing Shell and its partners, Mitsui & Co. Ltd. and Mitsubishi Corp., to dilute themselves by 50% in order to accommodate their new partner (OGJ, Jan. 1, 2007, p. 29). As a result, Shell is being forced to give up majority control in one of its most lucrative assets after having invested over $6 billion to develop the project.
Immediately following the agreement, Russian President Vladimir Putin held a press conference at which he announced that the supposed environmental infractions, under the guise of which the project was halted by Russian authorities while Shell and Gazprom were negotiating, have been resolved to the satisfaction of Russian regulatory authorities. What are the implications of this deal for international oil companies (IOCs) in Russia and beyond?
Regulatory influence
First, the negotiations between Gazprom and Shell and the involvement of Russian regulatory authorities indicate that the regulatory organs of the Russian government are extensions of Gazprom and Rosneft, the two state-owned natural resources companies, and will be used on their behalf to muscle the companies’ way into lucrative projects. It is no longer possible to believe that the Russian regulatory authorities operate independently of the interests of the Kremlin, which has sought to bolster the state-owned natural resources giants in order to gain government control over hydrocarbon assets. Resolution of environmental issues after Shell agreed to allow Gazprom into the project cannot be mere coincidence.
Particularly worrying is the clever use by Russian authorities of a campaign waged by nongovernmental organizations (NGOs) against the project, thereby providing a semblance of legitimacy to the government’s actions. IOCs doing business in Russia must understand how to align their interests with Gazprom or Rosneft to avoid regulatory challenges as existing agreements and even the letter of the law will provide little protection for property rights. Given the prevalence of such NGO campaigns around the world, many governments may utilize the same tactic in the future.
Second, the Gazprom-Shell transaction indicates that Russia will no longer be a major source of reserves for IOCs. The basic point of the Sakhalin-2 deal is that major international oil companies will not be allowed to have majority control of any substantial or strategic assets in the Russian Federation. Moreover, the deal does not even imply that minority control is possible for substantial assets.
Rather, the new status quo is likely to be as follows: Companies that already control substantial assets, particularly in technically challenging projects, will be allowed to maintain minority shares in these projects after allowing Russian state-owned entities to acquire majority stakes. New investments are likely to be restricted altogether, and even current owners of assets that are not technically difficult or can be managed profitably by Gazprom could expect complete expropriation at below-market prices. This bodes particularly poorly for the BP-TNK joint venture as well as for a number of small projects under discussion between western firms and Russian authorities.
Early disruption of this new equilibrium is possible, of course. Because Russian policies tend to change drastically with changes in presidential administrations, a new policy regime could emerge after the 2008 presidential elections.
‘Exporting’ tactics
Perhaps most dangerously, Russia is likely to “export” to other countries interested in renegotiating deals with IOCs its use of regulatory organs and tactics such as environmental permit reviews and retroactive tax assessments to change contractual agreements and pressure IOCs into accepting new partners or different revenue splits. Frontier Strategy Group has observed that regulatory authorities in Latin America and Africa have paid careful attention to the Russian approach and see it as a successful new tool for increasing their governments’ portion of the profits from energy projects. IOCs can expect a more difficult operating environment not only in Russia but also in other developing countries that offer the best prospects for substantial discoveries of hydrocarbons.
Finally, the Sakhalin-2 deal, in combination with the decision by the Russian authorities to not seek western partners for the development of Shtokman natural gas field, has significant implications for the global LNG market. As LNG assets in Russia are placed under the control of poorly managed state companies, the production of LNG in Russia over the medium term is likely to fall far short of market expectations. The impact of this trend will be felt not only by gas-consuming countries, which may end up paying higher prices for LNG in the medium to long term, but also by companies currently developing LNG terminals whose profitability will depend on a steady supply of gas from key suppliers.
While the detailed implications of recent events in Russia on LNG supply and demand are beyond the scope of this article, corporate planning departments would be wise to revisit their assumptions about the likely development of this key energy market.
The saga of Sakhalin-2 is unlikely to be an isolated phenomenon and could have a substantial impact on the operating environment faced by IOCs and on global energy markets. Senior executives should study the implications and develop strategies to align the interests of their firms with state-owned companies and governments in order to maintain access to resources in emerging markets.
