Streetwise Professor

June 10, 2007

(Contractual) Revisionism

Filed under: Energy,Russia — The Professor @ 9:31 am

The Independent carries an article discussing the future of foreign energy investment in Russia. Overall, it is about as sympathetic a piece as you will read, outside of the rantings of Russian energy nationalists or their Russophilic Western fellow travelers.

There is one part of the article that deserves comment:

In fact, there are many in the international energy industry who, if asked, admit to seeing Gazprom’s takeover of Sakhalin-2 in a slightly different light. They have some sympathy for Russia’s view that Shell’s original deal was almost extraordinarily advantageous, if not actual theft, and reflected the special conditions of the Nineties. Russia was almost bankrupt; its leadership was weak, its energy industry was in disarray, and the international price of oil was $10 a barrel. It was a deal, they say, that could not last. That Gazprom is buying out Shell and shareholders will be compensated is, they argue, proof that times have changed. It is at least better than confiscation.

This is actually the woe-is-me conventional wisdom about Russian oil deals of the time, but it must be taken with a grain of salt–not to say a Siberian salt mine. Sure, Russia was in sad shape when the Sakhalin-2 deal was negotiated–but the world oil industry was in a pretty bad way overall. The quote above mentions $10/bbl oil almost in passing, but that is the salient fact that cannot be forgotten. Oil majors like Shell were facing lean times indeed with low oil prices, and no prospect for an improvement any time soon. They were sharply cutting exploration expenditures. They were also cutting headcount ruthlessly. Seasoned people left the business in droves, and they were not being replaced; this is reflected in the odd demographics of oil firms, which are laden with people on the brink of retirement and many new hires, but with a “missing generation” in the middle.

In this environment, oil majors were not swimming in cash to sink in Siberian wastes. Nor did they have a huge appetite for risk. And Sakhalin-2 presented substantial risks–both technological and political. Hence, no PSA–no dice. Russia was not in a great bargaining position, but Shell (or any other major for that matter) was not in a negotiating mood anyways. They weren’t looking for the upside in speculative ventures–they were only willing to commit capital under terms that strongly limited their downside risk. Russia didn’t have the cash to invest, and given the economic environment and shareholder pressure prevailing at the time, the majors were only going to put up the cash under terms like those in PSAs.

Put differently, it is highly unlikely that Russia would have had anything to expropriate but for the PSA. Shell invested at a time when the economics of big investments in oil were very shaky. The world changed in a big way, and now Russia wants to take the upside. Russia, and sympathetic ears like the Independent, and perhaps “many in the international oil industry” not too proud to smooch a little Kremlin keister to get on Vlad’s good side, emphasize only one part of the history of the time in order to
insinuate that any 90s deal bordered on theft–all in order to excuse a real theft.

I have written before that Shell did itself no favors with the cost overruns, and its failure to keep the Russians apprised thereof. Moreover, PSAs–which are effectively cost plus and option contracts–don’t provide the best incentives to control costs. But it is doubtful that anyone would have invested in Russia in the 90s when oil prices were at rock bottom without such a contractual guarantee that costs would be covered.

Furthermore, I might have more sympathy for the Russians if they had pursued their grievance against Shell in a more legally or commercially respectable way. Instead, they engaged in a shakedown that would have made any extortion racket proud. These illegitimate means–so redolent of the mafia style that pervaded (and pervades) so much of Russian political and economic dealings (read David Satter’s Darkness at Dawn if you doubt the veracity of this statement)–cast serious doubts on the legitimacy of the grievance.

So I’m not buying the revisionist line the Independent–and the Kremlin–are peddling.

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