Showdown On The Energy Frontier

Russia's huge oil and gas fields test relations with foreign investors

Photo: Sergei Karpukhin/reuters

BIG STAKES

A worker inspects a segment of an 850-kilometer-long pipeline that Royal Dutch/Shell is laying on Russia’s Sakhalin Island as part of a huge oil and gas development program.

When it comes to oil and gas, things in Russia are large—very large. Russia controls more oil and gas reserves than any other single country and is the world’s largest natural gas producer and exporter. Two of the world’s three largest natural gas fields lie within its borders. And as Western Europe, the northeast Asian countries, and the United States maneuver to line up reliable suppliers for the next decade, Russia has gained enormous leverage.

The Russian Federation’s temporary suspension of natural gas shipments to Ukraine last winter, together with plans for a subsea gas pipeline to Germany that will bypass the Eastern European countries, have heightened concerns about whether Vladimir Putin’s government might manipulate energy supplies to achieve larger political objectives. At the same time, foreign investors have had plenty of reason to worry about whether the government is playing fair financially, as it seeks to renegotiate long-term development contracts on terms more favorable to itself. Recent moves by OAO Gazprom, in Moscow, the state-owned giant that is also the largest oil and gas company in the world, have riled Western energy companies already working in Russia [see photo, ”Tough Players”].

Two situations in particular have brought issues to a head: one involves development of gas reserves around Sakhalin Island, just north of Japan, the other in an area in the Barents Sea near Murmansk known as Shtokman, believed to be the third-largest natural gas field in the world. Because of these fields’ remote and hostile environments, Russia will need some of the most advanced technology in the world to exploit them. Major Western oil and gas companies expected a slice of Russia’s energy pie in exchange for their technical expertise and money. But newly rich Russia is proving it has the cash to buy these technologies from other sources and could shut out the West.

The area around Sakhalin Island, the site of a former penal colony and historically a major bone of contention in relations between Russia and Japan, has oil reserves estimated at about 14 billion barrels and natural gas reserves of about 2.7 trillion cubic meters [see photograph, ”Big Stakes”]. Two major combined oil and gas development programs make Sakhalin the target of immense foreign direct capital investment. Development at the field designated Sakhalin-I is controlled by a consortium spearheaded by Exxon Mobil Corp. Meanwhile, Royal Dutch/Shell Group and its partners are developing Sakhalin-II with plans to ship liquefied natural gas, or LNG, to the United States, among other destinations.

In mid-September the Russian ­government announced that Shell had violated environmental permits while developing Sakhalin-II, threatening to stall production. The controversy came on the heels of an earlier announcement from Shell that its production costs had ballooned to US $22 billion through 2014 from an original estimate of $12 ­billion. Agreements drafted in the ­turbulent early 1990s allowed Shell and other major oil companies to develop natural gas fields in Russia and specified that the Russian ­government would turn a profit from production only once the ­­­developers ­had paid off their investment. As a result, Shell had little incentive to constrain costs, angering the Russians.

The government’s environmental concerns may be genuine: Greenpeace and the World Wildlife Fund have raised strong objections to the damage inflicted on the island as a result of the energy companies’ operations. However, if the Russian government is challenging the companies’ environmental permits in Sakhalin solely to rework contracts to include Gazprom (as most analysts believe), the government is threatening the sanctity of all business relationships that bring in outside companies and capital. ”Law which is selectively enforced is no law,” said former U.S. Federal Reserve chairman Alan Greenspan, speaking at a recent New York City conference on investment in Russia.

Others agreed. ”These rather arbitrary ways of renegotiating these deals…is, I think, the central thing that haunts an otherwise fantastic economic story” of Russia’s rebound, said Michael McFaul, a senior fellow at the Hoover Institution in Stanford, Calif. Besides Sakhalin, the Russian government has also threatened to revoke a license for a giant project in eastern Siberia controlled by BP, the British energy company.

The question of foreign investment is not merely a matter of whether huge multinational oil companies are getting a fair shake from the Putin government, but also a question of whether Russia will be able to obtain advanced technology fast enough to develop reserves to meet global demand. The Shtokman disputes exemplify that dilemma.

The United States and Europe have been wrangling to win the bulk of Russia’s anticipated exports from Shtokman—a ­reserve estimated to be 3.2 trillion cubic meters. Until recently, Western companies had assumed that Russia would bring on board at least one outside company to assist in the numerous technical hurdles that lie ahead in developing an arctic field as challenging as Shtokman.

Photo: Sergei Ilnitsky/epa/corbi

TOUGH PLAYERS

Dmitry Medvedev, Russia’s first deputy premier and Gazprom chairman [right], and Gazprom CEO Alexei Miller arrive for a ­shareholders’ meeting in Moscow, on 30 June 2006.

According to Michael Cohen, an economist at the Energy Information Administration, a policy-neutral branch of the U.S. Department of Energy, only the Norwegian companies NorskHydro and Statoil have worked in offshore arctic waters, but even they have not worked as far from shore as the Russians will need to work at Shtokman. Drilling platforms will have to be ice-resistant, and ­workers will have to contend with a dense ice flow, factors that put the ­project in a league of its own.

While Russia has some experience operating barges and drilling platforms in the Arctic, it has struggled immensely, according to Nils Røkke, vice president of gas technology at The Gas Technology Center, in Tronheim, Norway, a joint research arm of the Norwegian University of Science and Technology and Scandinavia’s Foundation for Scientific and Industrial Research.

Ice is not the only problem; in winter, there is very little daylight at this latitude. Working in the dark makes it more difficult to manage the production’s impact on the environment and to avoid spills. Because gas must be transferred to shore across 550 ­kilometers of iceâ''laden waters, whether by ship or by pipeline, the project will have to contend with icebergs that could scrape along the sea bottom, severing a pipeline or damaging a drilling platform.

In order to send the natural gas down a pipeline, Gazprom will probably need to add agents, such as glycol, to the natural gas and water mixture ­(natural gas often is extracted with water). These agents lower the freezing temperature and ­prevent the water from reacting with the hydrocarbons to produce gas hydrates, which form at low ­temperatures and high ­pressures. The gas hydrates ­aggregate into a sticky snowball-like material that can clog a pipe. Once the gas reaches shore, the glycol and water have to be ­separated from the hydrocarbons. The presence of glycol hydrate inhibitors gives rise to other problems, however, such as greater risk of corrosion at the end of the ­transport system, adding a number of complications to the search for the ideal mix for each project.

The technology to pull this off at comparable temperatures and pressures so far has been explored only in the Snohvit natural gas field, a neighboring Norwegian project currently in development. ”[Snohvit] will be a record breaker, in such cold waters, and all kinds of steps are being made to make sure they don’t get plugging of the pipelines,” says Røkke. Many analysts believed that Gazprom would be obliged to take on a partner to mitigate the project’s risk and share the estimated $20 billion price tag for production.

But does Russia need foreign investment to get that kind of technology? Perhaps not. President Putin announced in October that Gazprom would proceed alone in developing the massive, hard-to-reach Shtokman natural gas reserve in the Arctic Ocean. The ­company scrapped a bidding process that had involved four prospective foreign partners, whose offers of stakes in other oil and gas projects had been deemed insufficient.

Awash in cash from high gas prices, Gazprom has proven itself capable of purchasing any technical expertise in the form of contractors, without ­having to give away stakes in its oil and gas projects. As Jonathan Stern, director of gas research and Gazprom specialist at the Oxford Institute for Energy Studies, in England, points out, Gazprom was able to cobble together $13 billion in a couple of weeks last year to buy Sibneft, another Russian oil and gas company. ”It’s taken a lot of people around the world a long time to get out of the ­traditional mind-set that Russia is poor. Forget it—that’s a world that passed by several years ago,” he said. It bears ­noting that even after Putin suddenly cut gas supplies to Ukraine last January, alarming almost everybody, foreign investment in Russia rose 42 percent during the first six months of 2006 over the comparable period of 2005, to more than $23 billion, according to the Moscow investment firm Renaissance Capital Securities.

Nonetheless, says Stern, foreign assistance will likely find its way into Shtokman. Gazprom faces large upcoming expenditures in developing its giant fields, laying vast swaths of new pipelines, and repairing an aging infrastructure, in particular the many pipelines that are reaching the end of their expected 25-year lifespan. Gazprom also has bought stakes in reserves around the world to gain footholds in projects less capital-intensive than its own. ”They are spending a lot of money to do anything but develop natural gas resources at home,” says the Energy Information Adminstration’s Cohen.

So while foreign partners may not be necessary, they may offer ­welcome assistance as Gazprom faces a future in which heavy demands are placed on its capital. The terms on which Gazprom chooses to develop Shtokman will be driven by how the oil and gas giant decides to fill its technological gap. In spite of the Russian government’s capricious handling of foreign companies’ rights, Western natural gas companies are still hoping for inclusion. As Kevin Petak, director of energy modeling and forecasting at the Arlington, Va.–based Energy and Environmental Analysis, puts it, ”At the end of the day, it still comes down to lots of gas reserve and resource potential. Russia is too big a player to ignore.”

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