A funny shade of green

The Economist
September 20, 2006

IT IS rare that Russia’s government receives wholehearted endorsement from the world’s leading environmental groups. But that unlikely turn of events followed the decision on Monday September 18th by Russia's ministry of natural resources to revoke environmental permits awarded to Sakhalin II, a huge oil and gas project led by Shell. The withdrawal of the licences, which could force the suspension of the $20 billion project, was met with delight by environmentalists who fear for the wildlife in a remote corner of Russia. Investors were far less happy. More worrying were reports the next day that TKN-BP, an Anglo-Russia joint venture, may run into similar problems with its exploration in a vast Siberian gas field. Western governments, sceptical of Russia’s new-found tree-hugging credentials, protested loudly.

Undoubtedly, Sakhalin II, Russia’s biggest single chunk of foreign-direct investment, has provoked environmental concerns. An offshore pipeline had to be rerouted to avoid harming endangered whales. Onshore pipes cross more than 1,000 rivers and streams on Sakhalin Island. Most observers ascribe the Russian government’s motives to matters closer to its heart than a deep concern for preserving nature.

Russia’s wish to keep tight control of its oil and gas resources has led it to use some dubious methods. Last year it effectively shut out most new foreign investment in Russian energy. The ugly dismemberment of Yukos showed that Russia had few qualms about how it maintained its grip on energy reserves. Russia keeps a close guard on an industry that provides most of its cash and which it can wield as a hefty weapon of foreign policy in a fuel-hungry world.

A likely explanation for the withdrawal of the licences is to put pressure on Shell to renegotiate a “production-sharing agreement”, whereby the state takes a share of the profits after the costs of Sakhalin II have been recouped. Shell's huge cost overruns have annoyed the Russian government. Moreover the terms of the deal were struck in 1993 when oil prices were low and Russia's weaker bargaining position forced it to accept what it now regards as humiliating terms.

Now Shell may be forced to bring in Gazprom, Russia’s state-owned gas giant, on more favourable terms. A long-standing agreement to swap 25% of Sakhalin II for a half share of one of Gazprom’s gas fields faltered as Shell’s costs escalated. The current status of negotiations is unclear but the licences will provide a useful bargaining chip. The two big Sakhalin projects (Exxon is involved in the other one) are the only exceptions to Gazprom’s gas-export monopoly. The state-controlled giant is keen to plug that gap.

Russia’s latest apparent attempt to ratchet up control of its energy assets has provoked diplomatic ire. Japan hopes to import more than half of the gas from Sakhalin II when production comes on stream in 2008. Indeed, two big Japanese firms own 45% of the project. Its government suggested that diplomatic relations would suffer because of the dispute. The European Commission and Britain’s government also expressed concern.

Yet Russia need not worry overly about foreign oil firms. The world needs Russian oil and gas. And big oil firms are desperate to invest in the large projects that will allow them access to untapped reserves. The prospect of retrospective wrangling may be grave, but there are similar—if not greater—risks to face in energy-rich trouble-spots elsewhere around the world. A bigger risk to Russia is the effect this may have on the foreign investment it so badly needs in other areas. Speculators may interpret these events as yet another example of unwarranted state interference that may yet spread beyond the energy business. And environmentalists may find their admiration for this champion is short-lived too.