Streetwise Professor

December 12, 2006

Sakhalin Shell Game

Filed under: Commodities,Energy,Russia — The Professor @ 6:26 am

I flew over Sakhalin Island on my way back to the US from Beijing this summer. During the trip I thought about the Soviet shootdown of KAL 007 over Sakhalin in 1983.

Sakhalin is back in the news for a completely different reason today. Under intense pressure from the Russian government, Shell has agreed to give a controlling stake in a gas production and liquified natural gas processing venture located in Sakhalin to Gazprom. The Financial Times’ coverage of the issue is outstanding; in addition to the linked article, there are several others. Robert Amsterdam has released a critical assessment of the deal.

Shell did itself no favors with the $10 billion cost overrun. This would have upset any residual claimaint–and under the terms of the original contract, the Russian government was a residual claimant, receiving payment only after the project’s revenues were sufficient to cover the original investment outlay. This does not mean that handing control to Gazprom is the best way for Shell to compensate the Russian Federation for any mis-management that contributed to the overrun. Gazprom has no expertise in such large and technically complex offshore projects. It can contribute nothing in terms of management or technical expertise. It can barely manage its sprawling–and somewhat decrepit and declining–existing collection of upstream and midstream assets. It has already announced that it would develop the Shtokman field in the Barents Sea–another project which it probably has no business doing by itself. If the economics of the Sakhalin project were already dicey (as the FT article suggests), Gazprom’s “contribution” will be to make them even dicier.

Some adjustment of the contract, such as requiring Shell and its Japanese partners to eat some of the overrun, would have been a more efficient way to handle the situation. But that wouldn’t have suited Putin and Gazprom. That would have resulted in money received down the road. They want control–now.

Moreover, the means by which the RF and Gazprom muscled their way into control is predictably shameful. Trumped up environmental problems–which again should have been dealt with and compensated for in other, more efficient ways–were the knout that Putin/Medvedev wielded this time to bludgeon Shell into submission. One day it’s taxes, the next day it’s environmental laws. As Roseanne Roseannadana used to say, it’s always something–and something always results in Gazprom walking away with the marbles.

This rent seeking makes some people wealthy, and some governments more powerful, but in the end is wealth destroying. It discourages investment, especially in “strategic sectors” that are most likely to be the next target of Putin’s predation. Moreover, it will result in the inefficient exploitation of Russia’s natural resources. Gazprom’s involvement can only cock up the already cocked-up operation of Sakhalin even more. And it is highly unlikely that Gazprom’s magic touch will enhance Shtokman’s productivity (sarcasm alert!). Russia’s taxation through expropriation creates enormous deadweight losses, but advances the interests of state power and the interests of the connected, who care more about the distribution of rents than the maximization of value.

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