RUSSIAN ENERGY: PSAS -- THE VIEW FROM SAKHALIN AND

C O N F I D E N T I A L SECTION 01 OF 04 MOSCOW 010984

SIPDIS

SIPDIS

DEPT FOR EUR/RUS WARLICK, HOLMAN, AND GUHA
DEPT FOR EB/ESC/IEC GALLOGLY AND GARVERICK
DOE FOR HARBERT/EKIMOFF/PISCITELLI
DOC FOR 4231/IEP/EUR/JBROUGHER
NSC FOR GRAHAM AND MCKIBBEN

E.O. 12958: DECL: 09/28/2016
TAGS: EPET ENRG ECON PREL RS
SUBJECT: RUSSIAN ENERGY: PSAS -- THE VIEW FROM SAKHALIN AND
MOSCOW


Classified By: Amb. William J. Burns. Reasons 1.4 (b/d).


1. (C) Summary. From discussions in Moscow and Sakhalin this
week, Production Sharing Agreements (PSAs) may be out of
favor, but they are far from being driven out of business.
Shell (Sakhalin-2) appears to have dodged the bullet of
having its environmental license revoked, but still faces
tough negotiations with Gazprom and the GOR on asset swaps
and cost overruns, respectively. ExxonMobil (Sakhalin-1) is
getting splashed by the mudslinging surrounding Shell, but to
almost no effect; the first tanker loading from the De-Kastri
port is expected to go forward October 5. Putin and many of
Russia's elite seem to resent the PSAs as unwelcome reminders
of a weak moment in Russia's past, but the emerging line for
both supporters and opponents of PSAs is one of strict
adherence, for all sides. In practice, that means the GOR
will not try to annul existing PSAs, but PSA holders are
being clearly warned to strictly abide by the terms of their
agreements and Russian regulatory processes. The alternative
is unhappy since any move to annul one of the three existing
PSAs would certainly end up in Stockholm arbitration. End
Summary.


2. (C) This note reflects on a number of meetings the week of
September 25, including the Ambassador's September 27 meeting
with the head of the ExxonMobil's (EM) Moscow office, Ben
Haynes, and additional meetings between Econ M/C and
officials and company representatives on Sakhalin Island.
.
Sentiment Towards PSAs Souring
But Revocation Not An Option
--------------
.

3. (C) The upbeat mood in the Sakhalin Governor's office this
week was in stark contrast to the harsh rhetoric swirling
around the issue of PSAs in Russia's capital. The sour mood
in Moscow reflects an emerging, but deeply held view by Putin
and the key officials around him: the three PSAs signed in
the mid-1990s were good for Russia then, but are
"sub-optimal" by today's boomtown standards. Yet, while some
may dream of extracting better conditions from their PSA
partners by whatever means they can, it seems clear from our
conversations this week that there is no appetite in Sakhalin
to see existing PSAs overturned.


4. (C) In a September 25 meeting, Sakhalin Governor Ivan
Malakhov was explicit on this point, at times implying he was
not sure what his colleagues in Moscow thought they were
doing. He categorically opposes canceling existing PSAs, but
he also expects rights holders to comply fully with their
obligations under Russian law and the terms of their
contracts. Malakhov's position makes sense: his oblast has
begun to see a significant revenue stream since first oil at
Sakhalin-1 a year ago ($50 million so far),and there is more
to come once tanker loadings begin from the De-Kastri
terminal next week and export volumes rise to 250,000 barrels
per day (b/d). The biggest threats to future money flows
from this project to the oblast are regulatory setbacks, and
thus his expectation that the PSAs on the island are run
well, and regulatory issues be dealt with promptly.
.
Sakhalin 1 and 2 Perceived Differently
--------------
.

5. (C) Malakhov sees significant differences between the
management of the Sakhalin 1 and 2 projects. He praised EM
(the operator of Sakhalin 1) as "flexible" and "responsive,"
dealing with issues expeditiously, and maintaining a solid
dialogue with local authorities. About the management of
Sakhalin 2, Malakhov was less complimentary, criticizing
Shell for letting issues "pile up" and complaining that the
firms' local representation seems two-headed, by which he
meant both uncoordinated and lacking HQ-connected leadership.
Malakhov refused to be drawn out on whether he thought
Minister of Natural Resources Trutnev and other federal
authorities were acting "aggressively" with respect to PSAs
or Sakhalin 1 in particular, but he didn't leave the topic
without restating his conviction that while existing PSAs
should not be cancelled, neither should poor management
practices be tolerated.
.
The View Of/From Shell

MOSCOW 00010984 002 OF 004


--------------
.

6. (C) From discussions this week in Sakhalin, it appears
that Sakhalin 2 has had its share of problems, including
reportedly 18 job-related deaths, which one insider said was
a sure sign that there were other problems beneath the
surface: safety is usually the top priority in multinational
projects. It may be that Sakhalin 2 management, because of
the magnitude and tight timetable of the project has had a
hard time keeping on top of its numerous sub-contractors
(there are some 17,000 employees right now). It was a
subcontractor (now fired) that was responsible for the August
RosPrirodNadzor (RPN) negative inspection finding that
appears to have "triggered" the near-revocation of Sakhalin
2's 2003 State Environmental Expert Review (SEER)
certification. Sakhalin Energy (the Shell subsidiary running
the project) may also not be aware that its relationship with
local authorities is slipping -- "local government is very
supportive" top management told us confidently, only days
after the local government (who otherwise has nothing bad to
say about PSAs) had been upset enough about Sakhalin Energy
to complain openly to a foreigner about the firm's behavior.


7. (C) That said, it is unlikely that Sakhalin Energy has so
badly botched the job as to deserve the kind of reputational
pressure they have been put under this month. Project
Director, David Greer, told us September 27 that Sakhalin 2
has been subject to over 5,000 inspections over the past
year. The current problems with RPN, he believes, stem from
a summer trip to Sakhalin 2's nearly-completed LNG terminal
by DPM Dmitry Medvedev. According to Greer, after having
seen how close Sakhalin 2 was to starting LNG exports
(expected in 2008) Medvedev pushed to get the Gazprom-Shell
asset swap that has been on hold for a year moving again.
Like many analysts in Moscow, Greer believes the actions of
RPN are just noise intended to soften up Sakhalin 2
shareholders, driving down the perceived value of Sakhalin 2
in advance of their September 29 meeting with Gazprom.


8. (C) According to the British Embassy, Dutch PM Balkenende
reached out to Putin by phone this week to protest rumors
that Sakhalin 2's 2003 SEER had been revoked. Putin is
reported to have called the PSAs "colonial era agreements"
while agreeing to pull back the threat to the SEER. Putin
made a point, according to our British colleague, of urging
PSA management companies to be diligent in their adherence to
their obligations under Russian law.
.
And The View From ExxonMobil
--------------
.

9. (C) Exxon Neftegaz (EM's Russian arm) Executive VP Jim
Taylor related to us this week that a grudging sense of
unfairness seems to be what motivates watchdog agencies like
RosTekNadzor (RTN -- which some compare to OSHA) and RPN (an
agency within the Ministry of Natural Resources (MNR)
responsible for environmental issues in the energy sector) to
plow through piles of documents and examine endless miles of
pipe and facilities in search of fault. EM was investigated
some 60 times this year alone. Taylor said that Exxon
Neftegaz has been quick to address concerns raised in the
inspection process, preferring to keep Sakhalin 1 moving
forward rather than argue with the regulators.


10. (C) As an example, Taylor cited environmental issues
raised by RPN about the De-Kastri port, where tanker loadings
are expected to start on time October 5. The inspection
resulted, among other things, in the firm's extraordinary
paving over of a sewage basin -- a requirement not found in
Russian law, but raised by the inspectors. The announcement
last week of a relatively minor set of environmental issues
surrounding De-Kastri (including the already resolved issue
of the paved sewer basin) surprised Taylor somewhat. He
speculated that the inspector may have come under pressure to
say something publicly about Sakhalin 1 on the day Shell's
SEER appeared pulled -- even though the two events were not
comparable. Likewise, Haynes told the Ambassador that the
press had greatly exaggerated the concerns over the De-Kastri
oil terminal. He said RTN had, in fact, given the project
"rave reviews" for its environmental compliance. Haynes did
note with concern, though, that RTN head Pulikovskiy made
"sharp" public comments about both Sakhalin projects

MOSCOW 00010984 003 OF 004


subsequent to this.
.
With Time, GOR likely to Expand
Scope of Chayvo Field
--------------
.

11. (C) Exxon Neftegaz President Stephen Terni expressed
confidence in a meeting September 27, that the Chayvo field
problem, whereby a portion of the oil field was inadvertently
left outside the original PSA are, will eventually be solved.
Terni and Taylor maintain that granting Sakhalin 1 rights to
the parcel is just good field management practice for any
government, and that such a contingency was foreseen and
covered in their 1996 PSA. Rosneft VP Peter O'Brien (Rosneft
is one of Exxon's partners in the project) agrees, and both
sides confirm that Rosneft and EM have formed a united front
against the Ministry of Natural Resources. The heat behind
this issue -- which in many places around the world would be
considered routine -- appears tied (again) to general pique
surrounding PSAs. One of Malakhov's assistants told us after
the meeting with the Governor that this is a clear case of
the government not wanting to give the firm another chunk of
reserves at "1996 PSA price...no more cheap deals for
foreigners."


12. (C) Taylor believes that with time, the obvious mistakes
made by MNR in this case will fade in the collective memory,
allowing the project to move forward quietly. Taylor noted
that MNR had already ruled once in the firm's favor on this,
and thought they would do so again. Rosneft's O'Brien shares
Taylor's confidence that the situation is already on its way
to resolution, and while he would not go so far as to exclude
the possibility of the parcel coming (back) into the
consortium via auction, he doubted that outcome very much.


13. (C) Haynes was, perhaps, a little less sanguine on Chayvo
during his meeting with the Ambassador. Despite rebuffing a
suggestion at a recent meeting with MNR that re-opening the
PSA would help "resolve" the Chayvo issue, Haynes said that
he felt the Ministry was willing to work constructively with
EM. Nevertheless, Haynes said that some in EM are "very
close" to employing a dispute resolution mechanism included
in the PSA that would require taking the case to Stockholm.
He recognized, however, that such a move would be quickly
picked up by the press and may be unhelpful for some of their
other equities in Russia.
.
Cost Overruns?
Sakhalin 1 - A Little
Sakhalin 2 - Yes
--------------
.

14. (C) Last week, a story surfaced in the press that EM
faces significant cost overruns at Sakhalin 1. Haynes said
that these reports were generally inaccurate, maintaining
that the 2001 development plan foresaw spending of $12.1
billion in constant 2002 dollars. Factoring in foreign
exchange fluctuations since then, he said the consortium is
within ten percent of their per-barrel spending estimates.
Haynes maintained that this was an "extraordinary" result for
a project of such magnitude. According to Taylor on
Sakhalin, the discussion in any event is purely theoretical
at this point, as EM gas only spent $6 billion, and it will
take until 2012 (when the bulk of the project should be up
and running) to determine if the cost estimate was correct.
It was not clear to Taylor why this old bit of news was
surfacing now.


15. (C) The situation with Sakhalin 2 is different. Sakhalin
2 is near the end of phase II of a two-phase project, and the
cost overruns they cited a year ago in August were based on
actual, not projected, overruns. Sakhalin Energy agreed with
the GOR on a $9.6 billion price tag for the project in May

2003. In the meantime, explains Greer, approvals took
longer, steel prices rose, and contractor costs ballooned --
all of which put huge pressure on the budget. By early 2004,
it was already clear that costs would exceed $13 billion, and
that estimate rose by early 2005 to almost $20 billion. The
public announcement of the cost overruns in August 2005
(right after the Gazprom-Shell asset swap MOU was announced)
was driven by public disclosure requirements associated with
Shell acquisitions elsewhere in the world. Since Sakhalin 2

MOSCOW 00010984 004 OF 004


is a full-cost recovery PSA (unlike Sakhalin 1 which is on an
85 percent cost recovery basis and therefore is paying out
some to the GOR) the overruns will delay the GOR's expected
pay out date.
.
Comment
--------------
.

16. (C) It appears that EM's Sakhalin 1 project is much less
exposed to GOR pressure tactics than is Shell's Sakhalin 2
venture. Moreover, the latest interest in the PSAs
(including Total's Kharyaga project) is likely driven by a
host of factors: the perceived unfairness by the Russians of
the PSAs' terms, Gazprom's drive to get into these projects,
intra-governmental rivalries, and the fact that foreign
companies have majority control of significant energy
projects at a time when this sort of deal structure is out of
favor with the GOR. Despite all of this, according to the
people we have spoken to, this renewed attention will most
likely stop well short of PSA revocation. We are
consistently hearing from EM and Shell, and for now we agree,
that the best short-term course of action is to ride out the
current tempest calmly, with little public comment, while
continuing privately to let the GOR know we are watching. A
more aggressive strategy would be warranted if things take a
turn for the worse in coming weeks, such as over EM's
"dispute resolution" situation or over Shell's upcoming SEER
court cases that will unfold in coming weeks that could throw
Sakhalin 2 into crisis and embolden the Russian authorities.
BURNS