Shell cedes control of Sakhalin-2 as Kremlin exerts its iron fist

Royal Dutch Shell is poised to radically scale back its stake in the world's largest offshore oil and gas project, Sakhalin-2, and possibly relinquish control altogether in favour of an increasingly proprietorial Kremlin.

Shell's move to step back from Sakhalin-2 in such a dramatic fashion follows months of sustained pressure from the government and loud complaints from Russian environmental inspectors that have led to prolonged delays and uncertainty.

The "climbdown" deal has yet to be finalised but significant concessions were reportedly made at a meeting in Moscow last Friday between Shell's chief executive, Jeroen van der Veer, and Gazprom's chief executive, Alexey Miller.

Gazprom, Russia's state-controlled energy giant, says it is now considering "several" different offers from Shell. It had previously broken off talks with Shell, arguing that there was nothing to talk about at a time when the Anglo-Dutch group was holding out the possibility of surrendering 25 of its 55 per cent stake in Sakhalin-2 as part of an asset swap deal.

Sources familiar with the new deal on the table have told reporters that the agreement will see Gazprom take a majority stake in the project, meaning that control of the largest single foreign investment in Russia will fall into the Kremlin's hands.

Early indications suggest that Shell has agreed to scale back its existing 55 per cent stake to around 25 per cent, handing Gazprom a 30 per cent share in the project. In return, Shell is expected to receive a hefty cash payment and a stake in one or more Gazprom assets.

Gazprom is then expected to take a further 20 per cent stake in Sakhalin-2 when the Japanese companies that own the remaining 45 per cent share - Mitsubishi and Mitsui - each reduce their own stakes by 10 per cent in Gazprom's favour.

The restructuring of such an important project and Shell's decision to surrender so much of its equity are being seen as a sign that Russia's foreign investment climate and its rules have dramatically altered.

In the frequently anarchic 1990s, lower oil prices, post-Soviet chaos and a weak central government meant foreign companies were able to take controlling shares in such projects on extremely favourable terms.

But President Vladimir Putin has sought to unite much of Russia's so-called commanding heights under Kremlin control and high oil prices are finally allowing Russia to exploit its own natural resources on its own terms. Shell has been under serious pressure to partially sell up in Sakhalin-2 ever since it disclosed that costs on the project in Russia's Far East have doubled from $10bn to $21bn. Under the terms of a 1993 production sharing agreement, such a severe cost-overrun would hit the Kremlin where it hurts: in its pocket.

Moscow is anxious to start taking its cut of the profits as soon as possible but Shell's cost overrun threatens to push back the day when the Russian Treasury claims its first rouble, a state of affairs that has seen President Putin personally lobby Shell to make way for Gazprom.

Sakhalin-2 is due to come on stream in 2008 and will be the world's largest offshore oil and gas project, with its energy earmarked for a booming Asia.

The Kremlin has argued that is only fair that it has some kind of a stake in such a high-profile project that draws on its own natural resources.

The past six years of Mr Putin's tenure have seen Russia adopt an increasingly nationalistic and proprietorial attitude towards its natural and "strategic" resources, with Kremlin officials making no secret of their desire to see control of Russian resources in Russian hands.

Yukos, an oil company once owned and managed by the oligarch Mikhail Khodorkovsky, now largely belongs to state-controlled Rosneft and its "disloyal" former boss is in a Siberian prison camp convicted of fraud. And Sibneft, an oil firm once controlled by Roman Abramovich, is now part of Gazprom.

The message is clear: the days of private majority stakes in the commanding heights are gone.

These days Kremlin Inc insists on and gets its 50 per cent stake plus one share. According to Dmitri Peskov, a Kremlin spokesman, this trend is a fair one. "The situation has changed dramatically, our companies [now] have the possibility of being the owners of natural resources themselves."

Foreign investors were welcome, he added, but on different conditions from those offered in the past. "They have to understand these are Russian oil and gas fields. There is not a country in this world that wants to give up its natural resources to foreigners."

More recently still, Russia has also discovered a newfound determination to protect the environment and Western energy firms have found themselves threatened with fines, project delays, licence removals and legal action unless they clean up their act. At the vanguard of Moscow's drive to hold Western energy companies accountable for their perceived environmental sins is Oleg Mitvol, deputy head of Russia's Environmental Watchdog. His frequently alarmist pronouncements have the power to send share prices tumbling and investors running for cover.

Moscow insists its sudden environmental awareness is sincere and that the same standards apply to Russian energy firms. The Kremlin's Mr Peskov said as much yesterday. "Ecology is extremely important. In the past, there was a certain passiveness in Russia, but that doesn't mean that we will continue that passiveness in future."

But Western analysts argue that environmental legislation has simply become another lever at the Kremlin's disposal which it can use to pile pressure on "awkward" Western companies.

And in his critic's eyes, Mr Mitvol is "the Kremlin's pitbull" whose bark is designed to bring even the most reluctant of Western firms to the negotiating table.

In Shell's case, he has found serious fault with the way it and the other members of the consortium have developed Sakhalin-2 and is due to issue a report on the subject tomorrow. His threats to date have been serious: to levy a $50bn fine, to jail wayward managers for up to seven years, to halt the project, and to pursue the Shell-led consortium through the international courts. His inspectors have argued that trees have been illegally felled, that breeding grounds for salmon have been destroyed, that rivers and coastal waters have been polluted, and that the consortium has generally ridden roughshod over the environment in its haste to turn a profit. They have angrily denied that their complaints are politically motivated.

One thing is sure: Shell's decision to scale back its stake in Sakhalin-2 will send a message to other foreign investors that the rules of the game have changed.

BP, whose TNK-BP oil firm is a 50 per cent joint venture with a group of Russian oligarchs, will also want to think hard about taking the path of least resistance. It currently has control of the giant Siberian Kovykta gas field, a field that Gazprom is known to covet so it can export gas to China and South Korea.

There too, Mr Mitvol's environmental inspectors have found fault and there has been talk of licence withdrawals. There has also been serious market speculation that Gazprom would like to buy the 50 per cent stake in TNK-BP currently owned by BP's Russian partners.

If Shell's decision is anything to go by, perhaps BP should be preparing for new partners.

Who owns what

* SAKHALIN-1

The venture, led by Exxon Mobil, is developing three fields, holding estimated reserves of 2.3 billion barrels of oil and 17.1 trillion cubic feet of natural gas. Production of 225,000 barrels per day could be delayed to the first quarter of next year.

* SAKHALIN-2

The Russian state gas monopoly Gazprom is taking control of this scheme from Shell after months of government pressure. This phase is set to tap fields holding 1 billion barrels of crude and 500 billion cubic metres of natural gas, which lie under the feeding grounds of endangered whales.

* SAKHALIN-3

Russia's Rosneft (which has 49.8 per cent) and China's Sinopec (25.1 per cent) began drilling exploration wells in August. Rosneft estimates the field holds 168 million tonnes of oil and 258 billion cubic metres of gas.

* SAKHALIN-4&5

Rosneft and BP signed agreements last month to develop East Schmidt block, estimated to contain 181 million tonnes of oil and 281 billion cubic metres of gas, and its western neighbour.