User:Jhienno/sandbox

Journey to Sakhalin: Royal Dutch/Shell in Russia

Justice Owusu-Hienno

Introduction Royal Dutch/Shell is according to the article evolved as independent firms in the nineteenth century. Marcus Samuel inherited a stake in his father’s company in 1870, and the main business was the importation of seashells from Asia. Marcus Samuel foresaw opportunities in the energy business and began buying oil from Russia and selling Kerosene in Asia. In 1897, Samuel officially founded the Shell Transport and Trading Company and when oil was discovered in Sumatra, the Dutch partner Aelijko Ziljker formed the Royal Dutch Petroleum Company in 1890.

According to the article Rothschild’s in 1903 helped arrange collaboration between Shell and Royal Dutch and the two firms created a marketing alliance called Asiatic Petroleum. The two companies then joined together in 1907 to form the Royal Dutch/Shell group of Companies. The Royal Dutch owned 60% and Shell owned 40%. Shell currently employs 111,000 people around the World in 90 countries.

Royal Dutch/Shell Business and Strategy Shell organizes its business into Upstream, Downstream, Projects and Technology. The Upstream businesses are in charge of exploration of crude oil and gas, often in joint ventures with other international oil companies and market them. It is grouped into two organizational units: Upstream Americas and Upstream International, which covers the rest of the world with major interests in Europe, Asia/Middle East/Russia, Australia/Oceania and Africa (www.Shell.com ).

The Downstream organization in Shell converts crude oil into different ranges of products like fuels, lubricants and bitumen which are marketed worldwide. “The Projects and Technology organization provides technical services and technological capabilities for the upstream and downstream activities”. According to the Shell website, “Shell’s strategy seeks to reinforce their position as a leader in the oil and gas industry in order to provide shareholder return while helping to meet global energy demand in a responsible way”( www.Shell.com ).

Russia According to the article, Russia hoped for an improvement in their economy after the fall of the former Soviet Union when many Russians hoped for an improvement in their lives. But this was not materializing and between 1991 and 1998 Russia’s GDP fell by half, and Russians living below the poverty line increased from 2% to 50%. Additionally, the Russia’s Gini Coefficient, which measures inequality increased from 0.27 to 0.48. Many people therefore thought Putin who took office in 2000 would be able to improve the Russian economy.

Russia was however endowed with enormous oil and natural gas reserves. This is what the administrators in Russia use in the development of Russia. Russia has 1,700 trillion cubic feet of proven natural gas reserves and constituted 30% of the world’s total reserves. Energy was very important for the Russian economy and constitutes 20% of GDP, 55% of export revenues, and 40% of fiscal revenues.Moreover, according to the article, “several efforts by the Russian Government to privatize state-owned energy firms produced contrasting patterns” .The privatization exercise also produced a lot of firms like Sidanko and Sibnet which according to the article was dominated by business people close to Russian politicians.

On the other hand the Gas industry was more somehow straightforward and less problematic in terms of corporate governance. Gazprom was the most significant firm. The Russian Government has 38% stake in the company and it is the largest gas company in the world employing approximately 300,000 people. Gazprom is involved in 258 subsidiaries within and abroad and constitutes 20% of the world and 90% of Russia’s gas production. It is also responsible for 8% of Russia’s GDP.

Why shell seek out the Sakhalin Oil/Gas investment Shell sought to invest in Sakhalin because they saw an opportunity to tap the rich oil and gas resources that the island in Russia possesses. Sakhalin is a large elongated Russian island in the North Pacific. According to the article just off the coast of Sakhalin is some of the largest oil and gas reserves in the world. The island is undeveloped and has harsh weather conditions which present technical challenges in developing the reserves.

Shell‘s Business Strategy is to continuously establish themselves as the leader in the oil and gas industry in order to continuously provide shareholder value for their investors. Moreover, Shell need to maintain its top tier status and access to reserves affects a firm’s future plans and contributes to a firm’s market valuation. Moreover, the Production Sharing Agreement that was proposed by the Russian parliament was an incentive to foreign investors to do business in Russia. Shell then took advantage of the invitation by the Russian Government for companies to conduct feasibility report for the development of two fields off the coast of Sakhalin to join the consortium. In 1993, when the study was approved Shell and the other companies (Marathon, McDermott, Mitsui and Mitsubishi) formed the SEIC, which entered into Production Sharing Agreement to develop the estimated 4.6 billion barrels of crude oil and 24 trillion cubic feet of natural gas in Sakhalin.

Moreover, the “Reserve Replacement Ration (RRR) which measures the amount of proved reserves added to a company’s reserve base during the year relative to the amount of oil and gas produced. During stable demand condition environment a company’s reserve replacement ratio must be 100% for the company to stay in business long-term; otherwise it will eventually run out of oil” (www.investopedia.com ). This is an important metric used by investors in gauging the performance of an oil company. Shell’s RRR was falling as against Chevron and BP before the Sakhalin project.

According to the article in 2000 Shell bought Marathon’s stake in SEIC and then later in the same year sold 7.5% of its interest to Mitsubishi and left Shell with 55% interest in SEIC. Exhibit 5 shows the changing equity shares in SEIC from 1994-2003.

PSA Issues PSA is production-sharing agreement, which is “a commercial contract between s foreign investor and host government that replaces the country’s tax and license regimes for the life of a project”. PSA are common type of agreements in the petroleum exploration and development industry. It was first introduced in Indonesia in 1966 when after independence nationalists began attacking foreign oil companies. The main aim was to protect foreign investments.

Modeling Risks pose by Legal Conflicts There were challenges for foreign firms in investing in Russia’s energy sector. In the case of the Sakhalin project there were serious legal risks and complication that arose from conflicts between the PSA and other existing laws. Foreign firms wishing to do business in Russia must design innovative strategies to manage the risks that exist between the PSA and Russian laws. Dutch/Shell and other companies wanting to do business in Russia must set up implicit, self-enforcing agreements to provide a framework for cooperation. This could be an agreement in which both Dutch/Shell and the Russian Government benefit from the gains in the agreement. The only difficulty here is having the means to enforce the terms of the agreement. Additionally, companies seeking to do businesses in Russia can spread the risks of their investments by involving group of complementary firms in Russia and international companies outside Russia. A consortium share both risks and information.

Explain the projects requirements and expectations well to the government official as well as the civil servants. This will help them manage their expectations well. Firms can do this by working from the local level right up to the Russian government. Involve the local population in the project and seek their thought on issues that pertain to the PSA and the laws in Russia.

Finally, it is important for firms to identify where power lies in the state. Under Putin, the Federal authorities call the shots whilst under Yeltsin; the governor calls the shots. Gain some support in influential places to combat opposition and get competent legal advice.

Mitigating Risks of Future Legal Changes To mitigate the risks of future legal changes in Russia, it is important for firms to choose their venture partners carefully, they must also ensure that the company has firm grasp of the legal landscape and establish broad possible political foundation of support for the business .The company must also purchase Political Risk Insurance (PRI) to mitigate the risks posed by future legal changes that affects investments. This is because there have been stories of companies having lost investments in Russia against the swirling current of political power play.

Infrastructure Issues of SEIC and what should be done The Sakhalin II project was beset with many infrastructural and natural challenges. SEIC therefore began producing oil in the Piltun-Astokhskoe field in 1999 only during the summer months. The rest of the year the production complex was embedded in ice. To overcome the harsh weather conditions, Shell should used technology to design and install platforms that would be able to withstand the freezing temperature in Sakhalin. SEIC could use heat conserving methods on the pipelines to prevent them from freezing during the cold months. Moreover, Shell could also work to increase production during the warmer months when the weather is friendly.

The LNG plant at Aniva also faced several civil engineering challenges in order to be online. According to the article SEIC would have to build pipelines through many rivers to the southern tip of the island where the weather is better.SEIC needs substantial capital to undertake these investments. These could involve designing large compressor shelters with louvers on the sides and ceiling to allow maintenance under severe weather conditions. Moreover, the use of low temperature carbon steel which is more resistant to cold weather conditions.

Production-Sharing Agreement In an effort to encourage foreign corporations to do business in Russia and to invest in the economy, the Russian government created Production-Sharing Agreements (PSA’s) which were typically friendlier to foreign businesses than Russian laws were. The PSA’s would grant corporations favorable tax terms in exchange for preference on contracts given to Russian companies. For the Sakhalin II project, Royal Dutch/Shell negotiated what some believed to be the most favorable PSA that any foreign company signed with the Russian government. The major points of the PSA included the following: •	Preference for contracts given to qualified Russian firms. Best effort to achieve 70% Russian labor and materials on the project, measured by volume of materials and equipment and man-hours of services, not by monetary spend. •	Exemptions from taxes including Value-Added Tax (VAT) and customs, road users’, and property taxes. Benefits would extend to SEIC investors, contractors, and many of the projects subcontractors. •	Once 100% cost recovery for investors is achieved, remaining production to be allocated among SEIC and Russian federal and local governments. •	Russian Federal and Sakhalin oblast governments receive a royalty of 6% of the oil and gas production throughout the life of the project. •	Once full cost recovery is achieved, title for the projects assets will be turned over to the Russian government. SEIC will continue to retain exclusive use rights for as long as they deem the project to be profitable. •	The project will have a fixed profit tax rate. •	PSA will be governed by the law of New York, with arbitration in Stockholm under the United Nations Commission on International Trade Law rules.

This agreement was crucial to the success of the project for Royal Dutch/Shell and the company was intent on protecting it. However, because the agreement was so favorable for the company, there was growing concern that the Russian government would not honor the agreement.It clearly communicates the extremely favorable terms that SEIC was able to negotiate with the Russian government. Because of this, SEIC lobbied hard to get the Russian Parliament to pass legislation that would guarantee the PSA, but due to the time constraints of the project realized that it would be impossible to get that legislation in place prior to the deadline for the Final Investment Decision (FID) to proceed with Phase II of the project.

The FID for Phase II of the Sakhalin II development project had a hard deadline in place for May 15th, 2003. SEIC had decided that it would not proceed with Phase II if they did not have a guarantee from the Russian government that they would honor the terms of the PSA. When SEIC realized that they could not get the Russian Parliament to pass the required legislation before the deadline for the FID, they began to push for a “letter of assurance” from Russian Prime Minister Mikhail Kasyanov. This letter would essentially guarantee SEIC that the government was in full support of the PSA and the terms that were agreed to would be honored throughout the duration of the project.

SEIC officials received the letter of assurance from Kasyanov late in the afternoon on May 15th and immediately gave the go ahead for Phase II of the project. The problem with the decision to proceed is that there were requirements that had been set by SEIC shareholders that had not been met. One of which was that shareholders did not want to go forward with Phase II without revisions to the Russian legal code. While the letter of assurance was an important communication from the Russian government, it did not completely meet the requirement of the SEIC shareholders. There were a number of current and proposed laws in Russia that directly conflicted with the terms of the Sakhalin II PSA. These conflicts included the Anti-Monopoly Law, which gives the government the right to force third-party allocation into oil and gas facilities, and the Gas Supply Law which essentially allows the government to mandate to oil and gas companies that they must sell their products to third-parties at prices that are determined by the government. There was also a proposed law that would bar foreign ownership of oil and gas export pipelines. In addition, SEIC shareholders felt that the tax code for reimbursement of the tax benefits of the PSA needed to be clarified.

Outside of the legal stabilization that the SEIC shareholders were concerned about, there were a few other conditions that they required before going forward with Phase II. One of the major challenges of the project for SEIC was the acquisition of an approval for a technical and economic substantiation for construction (TEOC). At the deadline for the Phase II FID, the TEOC still had not been secured. The company also had very few long-term contracts for the liquefied natural gas that they were intending on exporting. The decision to go ahead with Phase II despite these issues was a risky and possibly deceitful one. SEIC investors had made it clear that these conditions must be met before proceeding with the next phase of the project.

References

Exhibit 1: Current Projects of Shell from 2010 to 2014 Source: Shell Five-Year Fact Book: Operational Information 2005-2009 Exhibit 2: World Gas Reserves by Country (2007) Source: RussiaProfile.org Source: Shell Five-Year Fact Book: Operational Information 2005-2009 Exhibit 4: Shell’s RRR in relation to other Oil and Gas companies before Sakhalin Project Source: http://www.scribd.com/doc/41903868/Group-2-Financial-Analysis-Presentation

Exhibit 5: Changing Equity Shares in SEIC from 1994-2003

Source: Abdelal, R. Journey to Sakhalin: Royal Dutch/Shell in Russia

Appendix A

Summary comparison of Sakhalin II PSA with common features of PSAs worldwide ‘Standard’ PSA	Sakhalin II PSA 1) Exploration risk carried by company	Hydrocarbons already found, so no exploration risk for SEIC 2) Costs recovered during ‘cost oil’ phase, then ‘profit oil’ shared between company and state	Cost and profits (17.5% IRR) go to SEIC before state receives any share 3) Annual cap on ‘cost oil’ during early years – so some share of surplus to state	No cap on annual cost recovery 4) Clear definition of what expenditures can and cannot be included in calculation of cost oil and profits tax	No clear limits to recoverable expenses 5) Typical royalty 10-20%	Royalty 6%

Source : “The Sakhalin II PSA – A Production “non-Sharing” Agreement” by Dr. Ian Rutledge http://www.bothends.info/mfi/dos3-SakhalinPSA.pdf

Appendix B

Sakhalin II oil and gas reserves

Oil (Mb)	Condensate (Mb)	Total Liquids (Mb)	Gas (Bcf) Piltun-Astokhskoye	660	100	760	6,463 Lunskoye	58.6	320	379	13,561 Total	718.3	420	1,139	20,024

Source: OAO Rosneft-Sakhalin Morneftegas, Development of the far eastern fuel and energy complex, Sakhalin I and Sakhalin II projects implementation, May 1997 p.3. Original figures given in million tonnes of oil/condensate and billion cubic metres of gas converted into million barrels (1 tonne oil = 7.33 barrels; 1 tonne condensate = 10 barrels), and 1 billion cubic feet (1 cubic metre = 35.315 cubic feet).

Endnotes www.Shell.com www.Shell.com www.Shell.com www.Shell.com Rawi Abdelal. Journey to Sakhalin: Royal Dutch/Shell in Russia. Harvard Business Review. June 2006 http://www.investopedia.com/terms/r/reserve-replacement-ratio.asp. Retrieved December 5,2010 Rawi Abdelal Bindemann, K., Production – Sharing Agreements: An Economic Analysis. Oxford Institute for Energy Studies Publication. October 1999. Retrieved from http://www.oxfordenergy.org/pdfs/WPM25.pdf Wagner, D. Russia in 2000: The Implications of Political Change in the New Millennium. Retrieved from http://www.irmi.com/expert/articles/2000/wagner03.aspx http://www.russiaprofile.org/resources/business/sectors/oil Rawi Abdelal. Journey to Sakhalin: Royal Dutch/Shell in Russia. Harvard Business Review. June 2006