A Global Perspective on Sakhalin Energy Investment Corporation (SEIC)
and the Sakahlin II Project

By

Richard A. Fineberg

[Abstract]

At this time development beyond the relatively modest oil production scheduled from the Molikpaq platform is uncertain; Molikpaq alone is unlikely to produce great oil riches. Nevertheless, the Sakhalin oil project is not a bad idea. Even if development of Sakhalin's off-shore natural gas does not come to fruition, the interim efforts of the potential developers provide some benefit to Sakhalin. Meanwhile, by providing limited revenue for its developers, the Sakhalin II oil project may enhance the chances for later development of a major gas project.

From a global economic perspective, it should be understood that the project is enticing not only to Sakhalin and Russia, but also to Marathon Oil, a mid-sized oil company - and to Japan, which has long craved access to Sakhalin's resources.

From the standpoint of the environment, the facts presented here underscore the need for Russia and Sakhalin governments to establish clearly:

    1. the terms and the limits of the liability of SEIC and its partners and
    2. the standards to which SEIC will adhere in design, construction and operation of Molikpaq and any subsequent development.

In a 1997 survey of the world's major potential natural gas projects prepared for the State of Alaska, Dr. Pedro Van Meurs of Calgary, Alberta (Canada), a widely respected expert on petroleum fiscal regimes, noted problems in the Production Sharing Agreement for Sakhalin II. From a public policy standpoint, Dr. Van Meurs noted that the Sakhalin II PSA was deficient in two respects: According to Dr. Van Meurs, the PSA fails to promote early gas development and fails to limit gold-plating, or the reporting of excessive costs to reduce the share of net profits that would otherwise go to Russia and Sakhalin.

To secure its fair share of revenue from its oil development on Alaska's North Slope, the State of Alaska has had to litigate to obtain approximately 10 per cent of its revenue. Sakhalin and the Russian Federation doubtless wish to avoid the kind of problems Alaska experienced while ensuring that Sakhalin and the people of Russia secure the full revenue to which they are entitled. To this end, it would be wise to review production arrangements to define ambiguous terms, to identify specific provisions that might lead to unwarranted goldplating and to make sure that the operating provisions include stiff penalties against incorrect payment calculations and an efficient mechanism for dispute resolution.

Global Perspective on Sakhalin II (Part One)

Income from oil and gas production on the Sakhalin Shelf will undoubtedly prove beneficial to Sakhalin and the Russian Federation. The purpose of this article is to provide economic background for understanding Sakhalin II, the first major Sakhalin Shelf project slated to enter production.

A platform from Canada named Molikpaq has been towed across the North Pacific to the Russian Far East, where it is being modified for installation. Later this year, it will be moved to the Piltun-Astokhskoye field. That field lies approximately 15 kilometers off the northeast coast of Sakhalin in water about 30 meters deep that is frozen for six months of the year.

Molikpaq is supposed to be in place for drilling this year, with oil production scheduled to begin in mid-1999. The oil will be transported a short distance by undersea pipeline to an off-shore mooring point, where it will be stored in a stationery tanker. From the storage tanker, oil will be transferred into tankers that will call every six days to pick up oil for delivery to refineries elsewhere in the world. In the initial phase, ice in the Sea of Okhotsk will limit operations to six months per year.

Sakhalin II is the project of the Sakhalin Energy Investment Corporation (SEIC), a consortium that now has four members: Marathon Oil (U.S.) - 37-1/2%; Shell Oil (Holland/Great Britain) - 25%; Mitsubishi (Japan) - 25%; and Mitsui (Japan) 2-1/2%.

The four companies increased their ownership shares proportionally last year after a former partner, McDermott International, pulled out of the project. According to trade sources, before Molikpaq was found, McDermott was to have played a major role in the design and construction of a new platform that was to be specially designed for the job.

Later stages of the Sakhalin II project may include:

According to SEIC, these additional stages may be linked to other

major Sakhalin Shelf natural gas projects such as Sakhalin I (Exxon) and Sakhalin III (Texaco-Mobil).

Other regions of the world hold large natural gas deposits that are competing with Sakhalin for selection to fill Asia's expanding need for natural gas. Therefore, the only certainty at this time is Molikpaq's oil production.

Molikpaq's Oil Revenues Will Be Limited

The oil production anticipated from the Piltun-Astokhskoye field and Molikpaq is small when compared to the vast quantities of oil that produce riches for the major oil producing areas of the world. The production planned from Molikpaq - approximately 120,000 barrels per day for six months of the year (22 million barrels annually) - amounts to less than five percent of the oil Alaska produced during the past twelve months.

It follows that the revenue Sakhalin can anticipate from Molikpaq also pales in comparision to the oil revenue produced from major fields in other regions. For example, in Alaska state oil revenues have averaged approximately $2 billion a year for the last 20 years. Royalties and bonuses from Molikpaq will pay Russia and Sakhalin during the "early production" phase of the project will total approximately $75 million per year.

At that rate it would take Molikpaq nearly 30 years to generate as much revenue for the people of Russia and Sakhalin as Alaska receives in one year. Under the terms of the Production Sharing Agreement (PSA) between the Russian Federation and the Sakhalin Energy Investment Corporation (SEIC) most of those early revenues will be split betwen Russia (40%) and Sakhalin (60%).

SEIC literature shows a division of wealth from the project with a long red bar representing the 32% share of net income from the project that goes to Russia and Sakhalin under a 1992 Production Sharing Agreement. But that portion of the riches that Russia and Sakhalin are supposed to receive applies to revenue generated only after the investors recoup all their costs - including a fair return on SEIC's investment.

In other words, during early production no proceeds will go to Russia and Sakhalin except the $75 million in bonus and royalty payments. Russia and Sakhalin will not receive additional revenue until SEIC is completely reimbursed for its investment.

It is not clear when that will be - if ever. The recent SEIC brochure says "it is expected that Sakhalin Energy will invest approximately $10 billion in the project." If oil prices average $20 per barrel, at planned production rates it would take more than 20 years to generate the $10 billion necessary to repay the investment so that Russia and Sakhalin could begin sharing revenue.

Even the limited revenue from the Molikpaq platform will be of great use to Sakhalin and the Russian Federation. Nevertheless, it should be recognized that the hopes of great riches for Russia and Sakhalin probably will not be realized from the Molikpaq platform's oil.

Natural Gas: Still in the Future

Sakhalin's main hope for great riches lies in the discovery of additional oil and the development of the huge natural gas on the Sakhalin shelf. The shelf's natural gas reserves - including those from Sakhalin II - are extensive, and Asian demand for natural gas is expected to grow dramatically. But these days it is more difficult to develop natural gas fields than oil fields. Natural gas exists in much greater supply than crude oil and natural gas requires special investment in a piped delivery system that can handle a constant flow of gas. To bring a major natural gas field into production, the developers must arrange long-term contracts to sell the gas, then arrange financing for the production and the transportation of that gas.

Alaska also has large quantities of undeveloped natural gas; its experience demonstrates the difficulties of bringing a major natural gas field into production. On Alaska's prolific North Slope, More than 20 years have passed since oil entered production; natural gas from the super-giant Prudhoe Bay field has yet to be brought to market.

A 1997 analysis for the State of Alaska by Dr. Pedro Van Meurs of Calgary, Alberta (Canada) examined nine major natural gas projects currently seeking to supply the Asian market, including Sakhalin II. Dr. Van Meurs is the highly respected author of the Barclay - World Bank study of international petroleum fiscal regimes. Based on analysis of the Production Sharing Agreement (PSA) between the Russian Federation and SEIC, Dr. Van Meurs ranked Sakhalin II's natural gas as one of the least likely major natural gas projects competing to fill the gap between current supply and future demand in East Asia.

In fact, Dr. Van Meurs ranked Sakhalin II eighth out of nine major projects in terms of the return it would provide investors at likely future natural gas prices. He noted that his findings were not definitive due to the many uncertainties in the natural gas market and lack of specific information regarding key terms of the PSA. Moreover, he noted that his analysis did not quantify the competitive boosts Sakhalin will receive from the early production of oil or the possible combination with later shelf gas projects. Nevertheless, his findings, because of his credentials his assessment must be accorded some weight.

If planned oil production is going to be relatively modest and natural gas development is problematic, why would oil companies tow a drilling platform all the way from northern Canada across the North Pacific to Russia and rebuild it for production in 30 meters of water, 15 kilometers off the Sakhalin coast in the Sea of Okhotsk?

SEIC and the Global Petroleum Industry

To answer this question, it is necessary to understand a bit about how the global petroleum industry works, and where SEIC's investing companies fit into the international picture. It is customary for oil companies to work together on specific projects; they often form joint ventures to share costs and increase their leverage for borrowing to finance the project.

One interesting fact about SEIC is that its operating partner, Marathon Oil, is considerably smaller than its other partners - Mitsui, Mitsubishi and Shell. The other three conglomerates are among the largest in the world. By comparison, Marathon ranks approximately 400th internationally in size (see table, "Data on Selected International and U.S. Oil Stocks," below).

Compared to other U.S. oil companies, Marathon is an intermediate-sized firm. In terms of assets, it is approximately one-tenth the size of Exxon, the nation's largest oil company. When the U.S. operations of international oil giants British Petroleum and Royal Dutch Shell are considered, Marathon ranks 14th in the U.S. in assets.

One reason for Marathon's interests may be that Marathon has been short on crude oil historically. The oil industry divides itself into what it calls "upstream" (exploration and production) and "downstream" (transportation, refining and marketing) activities. Upstream operations are concerned with crude oil supply, which is often said to be the lifeblood of an oil company. If a medium-sized company like Marathon is short of crude oil, control of an additional source of upstream supply can be an important incentive. The opportunity to produce oil from the Sakhalin Shelf - even in relatively limited quantities - is therefore particularly attractive to Marathon.

Shell, one of the world's largest oil companies, may have a slightly different perspective. In exploring, oil companies often seek the "elephant" or super-giant field that will provide its refineries with a stable supply of crude oil. Such discoveries are few and far between. Nevertheless, a major global firm such as Shell cannot afford to overlook a region such as Sakhalin, where a future discovery could provide its coffers with a stable source of income and its refineries with a stable supply of crude oil.

The interests of Mitsui and Mitsubishi lie partially in Japan's perennial interests in diversifying Japan's energy supply sources and tapping the resources of its neighbor to the north.

Environmental Concerns

All oil and gas projects carry some degree of environmental risk. The inherent riskiness of Sakhalin shelf development was sadly demonstrated by the tragic earthquake at Neftegorsk, less than three years ago. To minimize that risk, SEIC operator Marathon has touted its experience with offshore platforms in Alaska's Cook Inlet, as well as in the United States Gulf of Mexico and Europe's North Sea.

In Alaska, there are economic consequences to the fact that Cook Inlet's production is dwarfed by production from Prudhoe Bay and its adjacent fields, 600 miles away at the opposite end of the state. Alaska environmentalists have suggested that Marathon's record in Cook Inlet is far from exemplary. Because Alaska's Cook Inlet is frequently cited as the model for Sakhalin, it should be noted that most of Cook Inlet's offshore platforms are about 30 years old and are in late stages of production. For this reason, many of these platforms no longer operate profitably. Consequently, Cook Inlet platforms frequently request exemptions from environmental requirements that apply to coastal oil and gas development elsewhere in the United States.

Additionally, Cook Inlet's contribution to the public revenue stream is relatively small. At present, Cook Inlet's oil and gas production generates approximately $60 million per year, or three per cent of Alaska's oil revenues, compared to approximately $2.0 billion ($2,000 million) from the Prudhoe Bay region.

A lawsuit between Marathon's primary environmental contractor, Hartec Management Consultants, and its former chief Sakhalin representative appears to have deprived Sakhalin of some of the environmental expertise on which Sakhalin and Russia have relied. Following that lawsuit, Hartec recently filed for bankruptcy in Anchorage.

Conclusions

The primary conclusions of this article are that development beyond the relatively modest oil production scheduled from Molikpaq is uncertain - and that Molikpaq alone is unlikely to produce great oil riches. Nevertheless, Sakhalin II is not a bad idea. Even if development of Sakhalin's off-shore natural gas does not come to fruition, the interim activities of the potential developers provide economic benefit to Sakhalin. Meanwhile, by providing limited revenue for its developers, the Sakhalin II oil project may enhance the chances for later development of a major gas project.

From a global economic perspective, it should be understood that the project is enticing not only to Sakhalin and Russia, but also to Marathon Oil, a mid-sized oil company - and to Japan, which has long craved access to Sakhalin's resources.

From the standpoint of the environment, the facts presented here underscore the need for Russia and Sakhalin governments to establish clearly:


Continue on to Part II

[Part II addresses economic questions relating to the development of Molikpaq.]

 

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