An Island in Crisis
As a frontier region and part of the Russian North, Sakhalin's economy was heavily subsidised by the Soviet state. The collapse of the Soviet Union has left the Island isolated and unable to sustain its economy and population. All of its traditional industries-coal mining, oil and gas, forestry and fishing-have also experienced substantial decline. According to Goskomstat in Moscow, between 1990 and 1995 industrial production on the Island fell by 42%. Unemployment (as a percentage of economically active) stood at 0.8% in 1992, but had reached 12.4% in 1995. This was despite the fact that the Island's population has shrunk from 719,200 in 1992 to 631,800 in 1997, a drop of 12%.(2) Problems in the coal industry and the collapse of the Island's industrial base have resulted in a non-payments crisis and energy shortages as enterprises have not been able to pay their electricity bills. This has been aggravated by the fact that Khabarovskenergo has not been paying Rosneft-Sakhalinmorneftgas (Rosneft-SMNG) for deliveries of oil and gas and now owes 20 billion roubles, resulting in a substantial loss of tax revenue for the Island's administration. Furthermore, the Federal Authorities have not been paying the Local Administration the funds necessary to support the Island's infrastructure and Federal Agencies, such as the Army, are contributing to the non-payments problem. In early 1997 the Governor, Igor Fakhutdinov, threatened to stop making payments to the Federal Budget. A power-sharing agreement has been signed with the Federal authorities and most recently agreement has been reached with the Governors of Primorskiy and Khabarovsk Krays to address the payments problem and to co-ordinate their participation in the oil and gas projects.(3) The cost of living on Sakhalin remains high and while official figures suggest wages are high the widespread problem of non-payment means that there has been a substantial decline in living standards. The local population remains sceptical about the immediate benefits of foreign investment in offshore oil and gas development.
Current Production of Local Significance
Historically, Sakhalin's oil and gas production has been of limited significance, accounting for less the 0.5% of total Russian production. Oil production peaked at 2.6 million tons in 1985 and last year only amounted to 1.6 million tons.(4) Only a small amount of this production is processed on Sakhalin by the Russian-Saudi Arabian joint venture Petrosakh which owns a 'topping unit' which produces mainly diesel fuel. Recently Petrosakh have invested in infrastructure to enable crude oil exports.(5) The bulk of oil and gas production is shipped by pipelines to Komsomolsk-na-Amure in Khabarovsk Kray on the Russian mainland. Current production is confined to on-shore fields that are past their best and are limited in scale.
Furthermore, the Neftegorsk earthquake in May 1995 damaged much of the oil and gas infrastructure and the local oil company Rosneft-SMNG has benefited from federal tax breaks to help it reconstruct it operations. With onshore production in decline, it is Sakhalin's offshore oil and gas potential that is now the focus of attention. Hydrocarbon resources off Sakhalin are estimated at 700 million tons of crude oil and condense and more than 1 trillion cubic metres of natural gas.
On and Off Development
The exploration of offshore acreage dates back to the mid-1970s when, in the aftermath of the 1974 energy crisis, Japan sought to diversify its energy supply. Economic necessity led Japan to set aside its territorial dispute with the Soviet Union in the hope of securing resources closer to home. A number of large-scale compensation agreements were signed to develop the Soviet Far East's energy and forestry resources.(6) In 1975 the Japan National Oil Company and the Japanese government created a consortium of 18 Japanese companies under the name of the Sakhalin Oil Development Cooperation Co., Ltd or Sodeco. Under the terms of the compensation agreement the Japanese partners provided credits for the project to use to fund exploration. These credits would then be paid off once economically viable fields were discovered. Exploration between 1976 and 1983 resulted in the discovery of the large Odoptu and Chayvo offshore oil, gas and condensate fields with total reserves of 67 million tons of oil and 172 billion cubic meters of gas. Unfortunately, during the rest of the 1980s politics and economics conspired to put a break on exploration activities. Energy prices fell and the Japanese no longer felt the need for Sakhalin's energy. At the same time, the Soviet Union was in the throes of perestroika and more concerned with domestic economic woes. The project (Sodeco-1) was put on hold without the Soviet government repaying the loan, which by the beginning of 1987 stood at $ 276.6 million. Between 1983 and 1990 SMNG continued exploration activity without direct foreign assistance. This resulted in the discovery of new, larger fields, Lunskoye and Piltun-Astokhskoye, and later Arkutun-Daginskoye. However, in the late 1980s the USSR Ministry of Oil and Gas Industry lacked the funds and the technical know-how to develop these new fields.
Renewed Interest
In 1989-90 the former USSR Ministry of Oil and Gas Industry, in conjunction with McDermott (US) examined the feasibility of setting up a joint venture to develop the Lunskoye and Piltun-Astokhskoye fields. In late 1990 a proposal came forward from Palmco Co., (a US-South Korean joint venture) to develop the Lunskoye fields on a compensation basis. The project included commitments to transport gas to Sakhalin and to export a portion of that gas. This triggered local interest in the project and the Governor of Sakhalin, then Valentin Fedorov and the Sakhalin Oblast Administration became key actors in the bidding process. In May 1991 a tender competition was held to develop the offshore fields. Odoptu and Chayvo were not included in the tender as they were still the reserve of Sodeco-1. The Lunskoye and Piltun-Astokhskoye fields are located 13-16 km offshore north-east of Sakhalin in the Sea of Okhotsk. The two fields are estimated to contain recoverable reserves of 100 million tonnes (750 million barrels) of hydrocarbon liquids and 494 billion cubic meters (14 trillion cubic feet) of gas.(7)
And Then There was One
Six companies or consortia bid for the tender: Exxon (US)-Sodeco (Japan); Mobil (US), Royal Dutch Shell/Shell Group-Showa Shell Sekiyu KK (Netherlands-UK-Japan); BHP Petroleum (Australia)-Amoco (US)-Hyundai Heavy Industries Ltd. (S. Korea); McDermott (US)-Marathon (US)-Mitsui (Japan); and Idemitsu Kosan (Japan). The decision was to be announced in October 1991, however, this was delayed by the intervention of Governor Fedorov who placed a new set of requirements on the foreign companies which, among other things, required them to build various manufacturing and social facilities. A delayed decision was reached in January 1992 when it was announced by the Russian Government that the McDermott-Marathon-Mitsui (MMM) bid was the winner. This was against the wishes of the Governor Fedorov who favoured the EXXON-Sodeco bid. The Sakhalin Administration subsequently took legal action to overturn the decision. This proved unsuccessful, but the winning bid was downgraded to the right to complete a feasibility study, with development rights to be decided later. Thus, in March 1992 a Feasibility Study Agreement was signed. In September 1992 Shell (Netherlands-UK) joined the MMM group and in December 1992 Mitshubishi joined the then MMMS creating the MMMMS consortium.(8)
Sakhalin II
At the end of 1992 the MMMMS consortium submitted its feasibility study. In March 1993 a positive decision was received from both the Environmental and Economic Expertise Committee of the Russian Government. The following month the consortium created the Sakhalin Energy Investment Company Ltd. to manage the development, production, financing and marketing aspects of the project. In June the Sakhalin Energy Production Sharing Agreement (PSA) was signed and in December the "Law on Production Sharing" was passed by the Federal Duma and signed into law by President Yeltsin; however, much of the other necessary legislation, such as the Tax Law, had not been put in place. In May 1996 Sakhalin Energy notified the Russian party of the official Commencement Date for the project, but noted that legal framework for the PSA was still unresolved and that this would hinder development. Because of the reactivation of the Japanese Sodeco project, the Sakhalin Energy project is known as Sakhalin II, even though its PSA was signed ahead of Sakhalin I. Since project commencement in June 1996 Sakhalin Energy have been working on the first phase of development which involves the use of a mobile drilling and production unit known as the "Molikpaq" to produce oil from the Piltun-Astokhskoye field. First oil is predicted in 1999 at the earliest. The second stage will see the development of gas production from the Lunskoye field. At that stage it is proposed to bring the gas onshore and to pipe it south to an LNG export terminal near the port of Korsakov. In April 1997 McDermott International Inc. announced that it was withdrawing from Sakhalin II and that its share would be sold to the remaining partners in the project: Marathon Sakhalin Ltd. (37.5%), Mitsui Sakhalin Development Co. Ltd (25%), Shell Sakhalin B.V. (25%), and Diamond Gas Sakhalin B.V. (12.5%) (an affiliation of the Mitsubishi Corporation).
Sakhalin I
Renewed interest in Sakhalin's oil and gas potential in the early 1990s resulted in revival of the Sodeco project which is now known as Sakhalin I. In November 1993 a protocol was signed between Sodeco (Japan)/Exxon (US) and the Russian Government. The project is now referred to as Sodeco-2. According to this agreement, the Arkutun-Daginskoye field was added to the two fields of Chayvo and Odoptu. In return for this additional acreage, the outstanding debt of $ 276.6 million owed to Sodeco was counted as part of Sodeco's investment in Sakhalin I. The Sakhalin I project is operated by Exxon Neftegas Ltd. (an affiliate of the Exxon Corporation). The shareholders of Sakhalin I are: Exxon Neftegas (US) 30%, Sodeco (Japan) 30%, Rosneft-Sakhalin (an affiliate of Rosneft) (17%) and Sakhalinmorneftegas-Shelf (Rosneft-SMNG is 51% owned by Rosneft) (23%). Thus, unlike Sakhalin II, Sakhalin I has substantial Russian ownership. This is a result of the project's origins as a Soviet-Japanese compensation agreement. A feasibility study was approved in 1994 and Sakhalin I signed a PSA in June 1996. Both Sakhalin I and Sakhalin II have been "grandfathered" into the PSA law and are thus protected from subsequent amendments. In September 1996 Sakhalin I drilled the first test well in Russia under a PSA. The focus of early development is on oil production with gas following at a later date.(9)
A Cautious Approach
Under the conditions of their PSAs, Sakhalin I and II were required to commence operations within a certain period after signing.(10) Without the required legal amendments, the PSAs are still in conflict with aspects of Russia's tax and customs laws. This has meant that both projects have pursued cautious development strategies involving further delimitation of reserves and planning, rather than substantial commitments of funding. For example, in 1996 Sakhalin-1 spent about $ 30 million on the drilling of one exploratory well and 3-D seismic surveys. In 1997 Sakhalin-1 intends to drill a further 4 wells and to conduct further seismic surveys; total expenditure is estimated to be $ 140 million. Sakhalin-2 has planned no test drilling for the 1997 season. In the Spring of this year the Russian Government sought to alleviate the tax problems and customs problems by passing enabling legislation. This caused upset in the Federal Duma and while the law was passed it remains to be seen if the problems, that related to the charging of customs duties and VAT of equipment imported for the projects, have been resolved. Clearly, the foreign companies will have to be persuaded that the legislation surrounding their PSA will protect their investment before they put substantial capital investment into the development phases of their projects. Thus, while Sakhalin-1 and Sakhalin-2 are held captive to legal developments in Moscow.
Sakhalin-3
In mid-1993 the Russian Government launched a programme of tenders for Sakhalin 3. The tender included 4 blocks on the north eastern shelf. However, unlike Sakhalin 1 and 2, the nature of the reserves has yet to be determined, thus the first stage will involve exploration. Bids were received from 30 companies, including Gazprom (Russia), Royal Dutch Shell (Netherlands-UK), Arco (US), Chevron (US) and BHP (Australia). The winners were announced in January 1994: blocks 1 and 2 were awarded to Exxon and block 4, the Kirinsky Block, to a consortium set up by Mobil and Texaco. Block 3 was not awarded. Exxon is currently focusing on Sakhalin I and is unlikely to do much with Sakhalin-3 for the moment, although they are seeking PSAs for the two blocks. In May 1996 a protocol was signed for a PSA covering the block. Sakhalin-3 was not included in the list of PSAs approved by the Duma in the Spring of 1997. Meanwhile, Mobil has established a presence on Sakhalin and is lobbying locally and in Moscow in support of their PSA agreement. Substantial exploration activity is unlikely without the PSA , thus Sakhalin-3 is some way behind the other projects, but is leading the search for new oil and gas reserves.
Sakhalin Expects
Against the backdrop of economic crisis, it is no surprise that the Sakhalin Administration wishes to maximise its income from the oil and gas projects. At the same time, it does not trust Moscow to hand on moneys due from the projects. Equally, the population is sceptical that funds paid to the local administration will actually bring them direct benefit. As a response to the demands of local politicians that the foreign oil companies build some of the Island's social infrastructure, the PSAs for Sakhalin-1 and 2 have created the Sakhalin Development Fund. The aim of the Fund is to develop and improve the social and economic infrastructure of Sakhalin Island. Each project will pay $ 20 million a year for the first five years after commencement, totalling $ 200 million. The partners in Sakhalin-3 have also agreed to pay into the Fund. In addition, bonus payments were made when the Feasibility Studies were agreed and when the Commencement dates were declared. Further bonus payments will be made upon announcement of Development Dates for individual fields. Sakhalin Oblast receives all of the money paid into the Sakhalin Development Fund and 60% of the bonus payments. Finally, once production begins, the Oblast will receive a share of the revenue generated by Russian oil sales, as well as a share of royalties and profits. However, with first oil not due until 1999/2000 and gas production unlikely before 2005, the production-related income stream will take a decade or so to materialise. Here lies the crux of the matter for the Sakhalin Administration: the bonus payments and the Sakhalin Development Fund are insufficient to meet the numerous demands being placed on them for social infrastructure development. There appears to be a difference of opinion between the appointed members of the Oblast Administration, on the one hand, who wish to use these funds to support a number of key infrastructure projects - such as the modernisation of the international airport and the construction of a gas-fired power station-and to restructure the Island's traditional industries; and the elected members of the Oblast Duma who want to use the money to fund various welfare programmes and to plug holes in the Oblast budget. The result has been compromise and no clear strategy has been devised for using these revenues to promote economic recovery.
Russian Content Equals Joint Ventures
The PSA also includes a requirement that during the life of the project 70% of contracts should go to Russian companies and specialists.(11) Clearly, there are components of the projects that are beyond the technological capacity of Russian industry; equally, Russian companies must meet the requirements on quality, cost and scheduling. However, the intent is clear: to maximise the economic benefits accrued from a planned expenditure of $ 25 billion for Sakhalin 1 and 2 and at least a further $ 10 billion from Sakhalin-3. These benefits will be felt beyond the shores of Sakhalin; industry in Khabarovsk and Primorskiy Krays is clearly well-placed to bid for contracts. In fact the woeful state of Sakhalin's economy may well serve to restrict its ability to benefit from the Russian content clause. The solution to this situation is to promote the creation of joint ventures with foreign companies with experience of working on large-scale industrial projects. In fact Sakhalin 1 and 2 tender documents suggest that priority will be given to bids with Russian content. The early contracts awarded seem to be setting a logical pattern.(12) The geological survey arm of Rosneft-SMNG won a competitive tender to conduct the 3-D seismic surveys during the 1997 season. Kavaerner Oil & Gas Limited (Norway) has been awarded a contract for design engineering, procurement and construction management assistance for Sakhalin-1. Exxon has awarded the oil spill response contract to EcoShelf Ltd, a partnership between Alaska-based Hartec Management Consultants, the Moscow-based Main Directorate of the State Marine Pollution Control and Salvage Administration (SMPCSA) and the Sakhalin Basin Emergency Rescue Directorate (SakhBASU) based at Korsakov. The contract to develop Sakhalin-1's supply base was awarded to a consortium made up of International Development Services Inc. (IDSI) based in Alaska, Marubeni (Japan) and FEMCO (a division of Rosneft-SMNG). The consortium has created a new company, the Sakhalin Shelf Service Co. to run the base which is located in the north port of the port of Korsakov. According to an Exxon Press release, through June 1997 Sakhalin-1 had awarded contracts (including multi-year contracts) totalling more than $ 70 million to Russian and Sakhalin Oblast organisations. Sakhalin-2 awarded a $ 35 million contract to the Amursky Shipping Yard to build a base for the Molikpaq drilling rig. The work is being done in yards that previously constructed submarines. However, steel for the project has come from Japan as Russian suppliers proved too expensive. Daewoo Heavy Industries (South Korea) has been awarded a $ 90 million contract to refurbish the Molikpaq drilling platform. Sakhalin-2's housing tender has been awarded to a Russian-American joint venture made up of Off-shore Systems of Kirkland Oregon and Sfera, a Yuzhno-Sakhalinsk construction company. In June 1997 Exxon and Sakhalin Energy held a business opportunities workshop in Yuzno-Sakhalinsk, the aim being to provide interested Russian and American companies with information on the status of their projects and the procedures for bidding for tenders. As these projects progress trustworthy Russian partners will be in short supply and one can expect a frenzy of joint venture activity on Sakhalin and elsewhere in the Russian Far East.
Increasing Competition
Although the operators see these as international projects, American and Japanese companies clearly have a majority interest. Already the American government is supporting measures to insure that American companies get a fair share of the action. The Sakhalin projects have been a key agenda item for the Gore-Chernomyrdin Commission, an American Business Centre has been established in Yuzhno-Sakhalinsk and USAID is helping to fund strong links between the Government of the State of Alaska and the Sakhalin Administration. The University of Alaska's World Trade Centre has established the "Troika Alaska Program" which produces a weekly newsletter called the Sakhalin Oil and Gas Report and provides contacts for visiting businesses. Links are also developing with the Pacific Northwest and Alaskan Airlines has added Yuzno-Sakhalinsk to its service out of Seattle. Transaero also runs a direct flight from Moscow to Yuzhno-Sakhalinsk, clear evidence that Sakhalin's capital is established on Russia's business map. The Japanese have also responded to the competition. In the Spring they announced the decision to set up a Consulate in Yuzhno-Sakhalinsk. In July of this year a Japanese parliamentary delegation visited Sakhalin to promote Sakhalin-1. Sakhalin has also benefited from Japan's humanitarian assistance. However, projects of this scale are always global in scope. The EBRD has provided funding for Sakhalin-2 and the Dutch Bank ABN-AMRO is to provide Rosneft-SMNG with a $ 350 million loan to fund its participation in Sakhalin-1. While conditions on Sakhalin are similar to Alaska, offshore they are similar to the North Sea, hence Kaverner's success, and one can expect European oil and gas service companies to follow the major oil companies to Yuzhno-Sakhalinsk. The city's infrastructure is in a terrible shape and the Mayor can only cover 34% of his budget this year.(13) Nonetheless, one can expect a building boom if foreign companies move in any number.
Different Visions
Sakhalin now finds itself in the right place at the right time, offering energy resources to fuel the much-hyped Pacific Century. It is the Island's proximity to Japan and South Korea that make it so important. Within a Russian context, Sakhalin's gas provides a means to solve the Russia Far East's energy problems. However, the international market for Sakhalin's energy is unlikely to open up until 2005. While the Russian partners want gas as soon as possible, Sakhalin-1 and Sakhalin-2 want to produce oil as quickly as possible to generate income. The Sakhalin Administration are frustrated by this oil-first policy as they want gas onshore to generate cheap electricity and to heat houses in Yuzhno-Sakhalinsk. Local politicians are also lobbying for the construction of an oil refinery on the Island. The gasification of the Russian Far East is a key element of the Federal Government's Programme for the Economic Development of the Russian Far East and Transbaykalia, thus domestic demands seem at variance with the dictates of the international market. No doubt the foreign oil companies feel that it is up to Russian companies and the federal and local authorities to deal with the needs of the domestic market. In February 1997 Moscow approved an allocation of $ 20 million to Rosneft-SMNG for the continued upgrade of pipelines from Okha to Komsomolsk. The Khabarovsk Kray Administration recently announced its intention to extend the gas pipeline from Komsomolsk to Amursk (40 kilometres). However, these plans would seem dependent upon the early delivery of offshore gas. Given these different visions and the legal uncertainties surrounding the PSAs Sakhalin's future is still in the balance.
Michael Bradshaw
School of Geography
The University of Birmingham
M.J.Bradshaw@bham.ac.uk
Endnotes:
1 This article is based on research which is funded by a grant from the UK's Economic and Social Research Council, contract: L324253005.
2 Goskmostat, Rossiyskiy Statisticheskiy Ezhegodnik, 1996, Moscow, Goskomstat.
3 Sovietskiy Sakhalin, 19 July, p. 1.
4 Sakhalin Oil and Gas Report, 9 May 1997.
5 S. Stefanopolous, The Oil and Gas Industry of Sakhalin Island, 1997, Russian Far East Update, Seattle, pp. 3-4.
6 For a review of these developments see: P. Egyed, Western Participation in the Development of Siberian Energy Resources: Case Studies, 1983, East-West Commercial Relations Series, Research Report 22, Institute of Soviet and East European Studies, Carleton University, Ottawa; M. Bradshaw, 'Soviet Far East Trade', in A Rodgers (ed.) The Soviet Far East: Geographical Perspectives on Development, 1990, Routledge, London, pp. 254-59 and K W Paik, Gas and Oil in Northeast Asia: Policies, Prospects and Projects, 1995, Royal Institute of International Affairs, London, pp. 206-21.
7 For details on development during the early 1990s and the tender process see: A. A. Konoplyanik, S. Oganesyan and A. Retyunin, 'Sakhalin tender background detailed', Oil and Gas Journal, 23 March, pp. 128-29 and A. A. Konoplyanik, S. Oganesyan and A. Retyunin, 'Sakhalin tender process tortuous', Oil and Gas Journal, 30 March, pp. 34-36.
8 For detail on developments during the mid-1990s see: M. Sagers, 'Prospects for Oil and Gas Development in Russia's Sakhalin Oblast', Post-Soviet Geography, 1995, Vol. 36, No. 5, pp. 274-90; Stewart, Energy Security in North Asia: The Opportunity for Russian Gas, 1995, Global Sector Research, ING/Barings, London and E. Kiselyova, M. Castells and A. Granberg, The Missing Link: Siberian Oil & Gas and the Pacific Economy, 1996, Monograph 52, Institute of Urban and Regional Development, University of California at Berkeley.
9 Details on Sakhalin I and II can be found in Stefanopoulos, 1997.
10 This section is based on interviews conducted in Yuzhno-Sakhalinsk in May 1997, from company documentation and from the monthly newsletter Russian Far East Update and the weekly bulletin Sakhalin Oil & Gas Report.
11 For details on local content and the tender process see: Stefanopoulos, 1997. Details of contracts are published in the Sakhalin Oil & Gas Report which is published by the World Trade Center of the University of Alaska (e-mail: 102761.2127@compuserve.com).
12 Contract details are from various issues of Russian Far East Update.
13 From an interview with Fiodor Sidorenko the recently elected mayor of Yuzhno-Sakhalinsk.
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