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A Gusher For Big Oil Is Drying Up


It's a new world for oil companies, as Royal Dutch Shell PLC (RDS.A), Exxon Mobil Corp. (XOM), and others are learning the hard way in Russia. In the mid-1990s, the country was in economic turmoil. So the Kremlin agreed to advantageous deals for Western oil majors, which agreed to use their capital and technology to expand oil and gas production into new areas, particularly the icy waters off Sakhalin Island in Asia.

Today, full of self-confidence -- and cash -- from sky-high oil revenues, Russia has a much stronger hand. So President V. Vladimir Putin's government is looking much less favorably on the agreements made with Big Oil. "The Russians feel they have provided the international companies with privileged positions," says an oil company source. That became clear on Sept. 18, when Russia's Natural Resources Ministry yanked its environmental approval of Sakhalin II. The $20 billion oil and gas project is being developed by Sakhalin Energy, a venture that's 55% owned by Shell. The ministry's decision could halt construction work on the development, which is 75% complete. "Russia and other oil producers now consider everything negotiable," says Julia Nanay, a Russia specialist at PFC Energy in Washington.

The oil majors in Russia find themselves in a tricky situation. They took big risks in return for what they thought were ironclad, highly lucrative deals, and they don't want to give ground. But they may not have a choice if they hope to be players in what has become the world's top oil producing country. "Long term, the market is going to drive global energy companies to find a different business model for investing in Russia," says Andrew Somers, president of the American Chamber of Commerce in Moscow.

A game of chicken is evolving. The Western companies are toughing it out while Russian authorities gauge how much they can afford to irritate investors. For now, the Russians are negotiating from a position of strength. They're awash in money, with oil and gas revenues expected to hit $170 billion this year. Moreover, national companies, led by gas giant Gazprom, want to dominate anything new and exciting in energy, especially liquefied natural gas (LNG). Sakhalin II is Russia's first LNG project and is expected to supply 7.5% of the world market. "Gazprom wants to get in, wants to understand LNG, and they also want to maintain its monopoly on exports," says Ronald Smith, head of research at Alfa-Bank in Moscow.

TIGHT SPOT

The concerns raised by environmentalists, including fears that pipelines could threaten salmon-filled rivers, are legitimate. But industry insiders say the Russians may be hitting Shell on the environment to force the company to make concessions elsewhere. One big issue has been the doubling in costs, to $20 billion, that Shell announced last year. Under Shell's 1994 agreement, the Russian government would foot most of the bill, since the deal allows Sakhalin Energy to recoup its development costs before sharing revenues with Moscow. Even then, Russia's share increases slowly, from 10% to 70%, only as certain profit targets are met. The disagreement over costs is complicating Shell's talks with Gazprom on a swap that would give the Russian company 25% of Sakhalin II in return for 50% of a Siberian gas field. Analysts say Shell might have to swallow some of the overruns and give Gazprom a sweeter deal.

Shell isn't the only company that could run into trouble in Sakhalin. ExxonMobil wants to extend the boundaries of its concession, called Sakhalin I, because the field extends beyond current limits. But the Russians are balking. The company says that under its agreement an extension should be automatic and that if Russia doesn't honor the pact, foreign investor confidence in the country could fall.

ExxonMobil may be in a better position than Shell because it hasn't had a "major screwup" such as the huge cost overruns, says one analyst. Still, as long as oil prices remain high and nationalism strong, all the Western oil companies are likely to face a tougher time in Russia.

By Stanley Reed and Jason Bush, with Mark Morrison in Austin, Tex.


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