A Global Perspective on Sakhalin Energy Investment Corporation: Part II

A Global Perspective on Sakhalin II: Part II

Insuring Sakhalin's Fair Share

by

Richard Fineberg

(Part II addresses economic questions relating to the development of Molikpaq.)

A Confusing Chart

A recent Sakhalin Energy brochure on its Sakhalin II project frequently blurs the distinction between the early phase of the project and later phases. The significance of this distinction becomes clear when one looks at the quantity of annual production planned from the Molikpaq platform, which is to be installed this year on the Piltun-Astokhskoye field off Nogliki. That platform - the one part of the project that appears relatively certain at this time - will produce approximately 22 million barrels of oil per year. In 1995 at least 24 nations around the world produced ten times more oil than that. It follows that the revenue Sakhalin can anticipate from Molikpaq will also pale in comparision to the vast oil revenues one might imagine.

A chart near the front of the Sakhalin Energy booklet underscores the importance of the distinction between early production and later development. The illustration is dominated by a long, red bar at the top that depicts the "Russian share" from Sakhalin II at high oil prices. Under this version of reality, those revenues are to be split between Sakhalin (60%) and the Russian Federation (40%).

In fact, the revenues pictured in the top bar may not materialize at all. In contrast to the "high oil price" scenario, the lower bar labelled "early production" does not contain a long, red bar of revenue for Sakhalin and the Russian Federation. Rather, during early production, Sakhalin and Russia receive only a 6% royalty share, plus bonuses. In this depiction, the smaller Russian share sits atop a box identified as "Sakhalin Energy Investment Cost Recovery." Since most oil forecasters anticipate that oil prices will only increase modestly in coming years, the lower bar probably reflects the anticipated revenues from Molikpaq more accurately than the top bar.

In terms of revenue, what will the lower bar's initial 6% royalty and additional bonuses mean for Sakhalin? It is anticipated that Molikpaq will produce 120,000 bpd for six months of the year. At $20.00 per barrel, the 6% royalty from that operation will generate approximately $25 million annually for the Russian Federation ($15 million to Sakhalin and $10 million to Moscow), plus about $50 million per year in bonus payments and repayment for past exploration costs.

Nestled between the reality of the "early production" and the hopes of "high oil price" in the Sakhalin Energy chart is a third bar, which is labelled "planned production." On that middle bar, the "Russian Share" is approximately equal to Sakhalin Energy's profit. Moreover, each profit share is depicted as approximately equal to Sakhalin Energy's cost recovery. In fact, after the developers recover their development and production costs, the Russian share comes to a maximum of 32% of the profits from the project. Sakhalin Energy's profit therefore should be 68% - more than twice as large as the Russian share. Therefore, Sakhalin Energy's share on both bars should be more than twice as long as the red bar labelled "Russian share."

An Uncertain Future

An additional source of confusion is the adjacent map of Sakhalin that shows an oil export terminal and liquified natural gas plant. These facilities will only be developed as part of the later phases of the project that are still under study. During the early production phase, there will be no on-shore facilities. Instead, Sakhalin Energy will use a subsea pipeline to an anchored storage tanker, which will then off-load to a calling tanker about once every six days.

When (if ever) will these facilities be built? The Sakhalin Energy brochure does not say. The major discoveries reported to date on the Sakhalin Shelf consist largely of natural gas - not oil. Production of natural gas deposits does not follow automatically from oil field development. On Alaska's North Slope, for example, the super-giant Prudhoe Bay oil field entered production 21 years ago, but Prudhoe Bay's extensive natural gas deposits have yet to be marketed.

According to Sakhalin Energy, further development on the Sakhalin Shelf depends, among other things, on the following factors: negotiations of long-term gas supply contracts, financing arrangements and agreements for sharing of production facilities with other projects. Before full development can take place, additional field appraisals, surveys of pipeline routes and design of production platform and on-shore facilities will be necessary. While the investors and the Russian and Sakhalin governments consider whether to proceed on these complex matters, other major natural gas deposits elsewhere in the world may be better candidates for early development.

In a 1997 study by international oil economist Pedro Van Meurs, the Sakhalin II project did not fare well. Compared to other major projects seeking to meet the expanding demand for natural gas in Asia, Sakhalin II ranked well down the list. In his report, which was prepared for the State of Alaska, Dr.Van Meurs ranked major gas deposits in Brunei, Indonesia, Malaysia and Vietnam as "Inner Circle - Low Cost" projects that could fill increases in Asian demand more economically than Sakhalin II.

In contrast to more economically viable natural gas projects, Dr. Van Meurs classified Sakhalin II as an "Outer Circle - High Cost" project. Other projects in that category included large gas deposits located in Alaska, Canada, Australia, the Middle East and Papua-New Guinea. According to Dr. Van Meurs' analysis, some of those projects presented more favorable opportunities for developers than Sakhalin II.

In one comparison of the economics of nine major projects, Dr. Van Meurs rated Sakhalin II eighth. From an investment perspective, he found all but the top three projects he reviewed "unattractive at this time." From this perspective, it appears that the development of Sakhalin Shelf natural gas in the near future may be unlikely rather than inevitable. In this regard, it is interesting to note that Alaska's North Slope oil went into production 21 years ago. The North Slope's vast quantities of natural gas have yet to be developed. Alaska's North Slope gas is one of the deposits that Van Meurs ranked ahead of Sakhalin, though still in the Outer Circle of economically marginal projects.

It should be noted that Dr.Van Meurs did not quantify the boost Sakhalin II will receive from the early production of oil; nor did he investigate the possible gains from combination with later Sakhalin Shelf gas projects. Nevertheless, his relatively pessimistic assessment of the project's potential must be taken seriously, if only because he is the author of a widely quoted study comparing the fiscal arrangements for petroleum production around the world.

Warnings for Sakhalin

In his study, Dr. Van Meurs offered some important comments on the structure of the Production Sharing Agreement (PSA) that governs the revenue split between the people of Russia (including Sakhalin) and the Sakhalin Energy investors. He warned that the Russian PSA is particularly susceptible to "gold-plating," or artificially increasing reported costs to reduce the profit base on which the government's share is calculated. In fact, he observed, under certain conditions it becomes attractive to make investments for the sole purpose of reducing payments to government. Under the terms of the Russian PSA, he warned, "the goldplating effects . . . are very difficult to suppress."

The significance of Dr. Van Meurs' comments can best be understood in terms of the chart discussed above. The gross revenues generated from Sakhalin Shelf production are determined by world oil prices. At any given price, as the size of the box labelled "Sakhalin Energy Investment Cost Recovery" increases, the bar labelled "Russian share" must decrease.

Another problem Dr. Van Meurs identified in the Russian PSA is that "the slower a project proceeds, the lower the profit share payable to the government." According to Dr. Van Meurs, the PSA for Sakhalin II "rewards companies for delaying their investments." If what Dr. Van Meurs says is true, if a major gas project does become a reality, the longer the investors delay, the smaller the eventual Russian share will be. Here again, the potential losers are the people of Sakhalin and Russia, who badly need revenue from this project.

Alaska's Experience

If the people of Sakhalin and Russia wish to obtain maximum revenue from oil and gas development on the Sakhalin Shelf, they should pay careful attention to the accounting measures by which those revenues will be determined. In this regard, it may be useful to take a fresh and independent look at the difficulties Alaska's encountered securing its fair share of production revenue from its North Slope. Although Alaska has profited handsomely from oil development, at the same time the State of Alaska has had to engage teams of lawyers and accountants to pursue more than 60 separate legal cases to obtain full payment of its oil taxes and royalties.

This is one aspect of Alaska's development that Alaskan officials seldom discuss publicly these days. One reason for their reticence may be that the current Alaska administration now seeks to promote oil development in Alaska through a policy of close "partnering" with the oil industry. It would be impolitic to accuse one's partners of misbehaving. For this reason, present Alaska officials often dismiss past disagreements as the result of simple misunderstandings or overly aggressive revenue collecting efforts.

These explanations ignore the basic fact that the company officials keeping the books and paying taxes and royalties owe it to their shareholders to hold those payments to the legal minimum. Unlike public officials, the industry employees know that they will be rewarded for their effectiveness, as measured by bottom-line profits. In this situation, I leave it to the reader to determine which party is more likely to be overly aggressive.

Leaving aside the causes of these disputes, since 1983 the State of Alaska has increased its oil and gas revenue by the remarkable sum of more than $4.8 billion through litigation with the industry. For the most part, this money represents payments in settlements of lawsuits alleging that the oil industry paid less than its required share of revenue from oil operations in Alaska, plus interest on those underpayments. In addition, other disputes between the State of Alaska and its producing companies are still outstanding, including at least one tax case over an estimated $1 billion. Additionally, Alaska officials believe that benefits from past litigation will add more than $3.3 billion to Alaska's future revenue stream.

In sum, payments to settle litigation have increased Alaska's oil revenues by more than ten per cent since the Prudhoe Bay field entered production in 1977. It should be noted that these figures do not include $2 billion that the State of Alaska did not have to repay because it prevailed against an industry's challenge of its income tax provisions. Nor do these figures include amounts the government of the United States has secured for underpayment of federal income taxes.

One example of the kind of accounting problems that need to be considered is the calculation of the costs for abandonment and removal of oil rigs. Those charges are legitimately included in investment costs, which investors are legitimately allowed to recover. But unlike drilling expenses or most other operating costs, actual outlays for abandonment will not occur until a future date. Accounting is therefore tricky.

On one hand, full allowance for abandonment costs is necessary for environmental protection. On the other hand, excessive allowance for future abandonment will increase producers' costs, thereby reducing the profit from which the people of Russia and Sakhalin will receive tax income (that long, red bar at the top of the chart discussed above). A December issue of the Oil & Gas Journal featured a special section on different accounting methods used to pay for the abandonment of oil platforms. According to that report, Russian abandonment costs were the highest in the world.

If major onshore facilities are built, Sakhalin and the Russian Federation will need to pay careful attention to the accounting for pipeline costs. The State of Alaska has had to invest millions of dollars to litigate pipeline disputes. Although the State of Alaska claims success in this area, a 1996 study of the Trans-Alaska Pipeline found that excessive pipeline charges will reduce Alaska's oil and gas revenues by an estimated $4.5 to $9.2 billion over the life of the pipeline, compared to the revenue Alaska's government would receive if pipeline charges were held to just and reasonable levels. (That study was conducted as a Master's Thesis in Economics at the University of Wisconsin, a highly respected institution.)

Conclusions

When the Sakhalin II is viewed from a global perspective, it becomes clear 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, 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.

At the same time, limited revenue from early oil production combines with the marginal economics of later gas development to make it necessary for the governments of Sakhalin and the Russian Federation to clearly establish:

* the terms and the limits of the liability of Sakhalin Energy and its partners and;

* the standards to which Sakhalin Energy will adhere in design, construction and operation of Molikpaq and any subsequent development.

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.

 


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