Financial Times: Remote resource: Shell's Sakhalin task shows an industry its daunting future: "This is the biggest single project certainly that Shell has and, by most measures, that anybody has," says Chris Finlayson, Shell's Russia country manager. The project is burning through $100 a second…”: "I fully realise it has an impact on our reputation - certainly for this project - and then of course I'm concerned it will carry over to other things that we do," Mr Van der Veer said...": Monday 9 January 2006

By Thomas Catan

Published: January 9 2006

On a remote island off the eastern coast of Russia, encased in ice for nearly half the year, the future of the world oil and gas industry is beginning to take shape. And judging by the scale of the project that is coming into being around the bleak shores of Sakhalin, that future will be expensive, complex and, above all, big.

Off Sakhalin's north coast, two of the largest concrete structures ever built in Russia have been installed in the sea. As large as football fields and as tall as 15-storey buildings, the offshore platform bases have been towed in from 1,000 nautical miles away. Some 6,000 construction workers labour in temperatures that can reach minus 40 degrees laying 800km pipelines down the length of the island.

On the south side, Russia's first liquefied natural gas plant is being built in Aniva Bay. There the natural gas will be super-cooled into liquid form and shipped to Japan, South Korea and the US - markets that have never before had access to Russia's massive gas reserves.

Europe came to realise just how dependent it had become on Russia for energy after a new year spat between the Kremlin and Ukraine briefly threatened its gas supply. Now Asia and the US are about to join the club.

After decades of false starts, the big push is under way to transform Sakhalin into the world's latest oil and gas province. A consortium led by ExxonMobil started producing oil in October from its Sakhalin-1 project. Sakhalin-2, led by Royal Dutch Shell, has also been pumping oil in the summer months since 1999. But the second phase of Shell's project, now under construction, is of a wholly different scale. It is by far the largest direct foreign investment in Russia and one of the largest integrated oil and gas developments in the world.

"This is the biggest single project certainly that Shell has and, by most measures, that anybody has," says Chris Finlayson, Shell's Russia country manager.

The project is burning through $100 a second and occupying 60m person-hours a year. When complete, it will deliver up to 150,000 barrels of oil a day and 9.6m tonnes of LNG a year to Asia's energy-hungry economies. Future expansion could see a doubling of that capacity. But it is the scale of the technical task that has led Shell managers to call it "the Mother of all Projects".

For Shell, the development is central to its plan to recover from a difficult couple of years. The world's third largest energy company by market value has long lagged behind peers in the crucial business of finding and exploiting new reserves of oil and gas. That turned into a crisis in 2004, when the company was forced to admit it had exaggerated the extent of its "proved" reserves by around 40 per cent.

The admission triggered more than $150m in fines by financial regulators and the departure from the company of Sir Philip Watts, chief executive. The company has always argued that the reserves are still there - that it merely overstated how close they were to being brought to market. Big projects such as Sakhalin are therefore crucial if Shell is to develop more of the resources it has in the ground.

However, Sakhalin-2 has been anything but easy, testing Shell's management abilities to the limit. The project, of which Shell owns 55 per cent, has at times appeared to be slipping out of its control. (The other shareholders in Sakhalin Energy, the company that operates the project, are Mitsui & Co and Mitsubishi Corporation of Japan.)

When Shell first approved the development, the budget through 2014 was $10bn. Last July, the group admitted the cost had ballooned to $20bn. Although the industry as a whole is suffering from cost inflation, the scale of the increase suggested that Shell had greatly underestimated the difficulties of carrying out the project in such a tough environment.

The admission hurt Shell's hard-won reputation for being able to manage large and complex projects and stalled the turnround plan of Jeroen van der Veer, who took over from Sir Philip. It also complicated Shell's relationship with the government in Russia - a country it believes is key to rebuilding its energy reserves.

"I fully realise it has an impact on our reputation - certainly for this project - and then of course I'm concerned it will carry over to other things that we do," Mr Van der Veer said in an interview last year. Shell's chief executive believes the company's future lies in multibillion-dollar projects such as Sakhalin-2 - what he terms "elephant projects". At the moment, Shell has three elephant projects under way. In a decade's time, Mr Van der Veer wants Shell to have 10 such projects on the go concurrently.

For the moment, he has had to occupy himself with limiting the fall-out from the rising cost of Sakhalin-2. The Shell-led consortium is in talks with the Russian government over the revised budget but those are not proving easy. The higher price tag will delay the day when Moscow will start to see revenues from the project.

Russia will still get an estimated $50bn from the project over its lifetime but that has not stopped the government from piling on the pressure. On a recent state visit to the Netherlands, Vladimir Putin, Russia's president, personally made his displeasure about the cost overrun known to the Shell chief.

The events may have hurt Shell's ambitions in Russia. Since the announcement of the jump in costs, Gazprom, Russia's state-controlled gas monopoly, has denied Shell a stake in its giant Shtokman gas field in the Barents Sea, north of Europe. Russian officials have hinted that Shell's problems at Sakhalin were partly to blame.

To make matters worse, Gazprom was due to take a 25 per cent stake in Sakhalin-2 under an asset swap with Shell, announced only a fortnight before the size of the cost overrun became apparent. Gazprom is now driving a much harder bargain.

Although Shell has suffered uniquely during the difficult gestation of the project, it is not alone. With the easy pickings gone, the industry as a whole is having to look farther afield to develop oil and gas. Many of the new opportunities will lie in environments every bit as difficult as Sakhalin's.

"One of the challenges is, 'Where are you going to drill now?'" says Frank Harris, LNG analyst at Wood Mackenzie, the consultancy. There is further scope for exploration around the Barents Sea, he adds. But extracting it will be far from easy. Statoil, Norway's state oil company, has already run into problems at its ambitious Snohvit LNG development, which is running around a year late and 50 per cent over budget.

Shell can sympathise. "It was a lot easier when you could just get oil out of your backyard in Texas," says John Burn, the construction manager for Sakhalin Energy's northerly oil processing facility. "Now you have to come out to places like Sakhalin."

The list of obstacles faced by Shell and its partners is daunting. Sakhalin's arctic climate and remote location make it an inhospitable place to live, let alone build such an ambitious project. Winter temperatures average minus 24 degrees Celsius (minus 11 Fahrenheit) and the island is located in the middle of a typhoon area.

The platforms have had to be specially designed to withstand the massive ice floes that can crumple into their sides at speeds of more than 2 metres a second, as well as earthquakes that frequently shake the island. Ten years ago, a quake measuring 7.5 on the Richter scale killed 2,000 people in the town of Neftegorsk.

It is not the only danger. Sakhalin was long fought over by Russia and Japan and is littered with unexploded ordnance. Shell has already cleared around 900 rusting bombs from construction areas.

Sakhalin's pristine environment has meanwhile made Shell the target of campaigners around the world. An endangered population of only 100 western gray whales feed on Sakhalin's north-eastern shore during the summer months. The Shell development threatens their existence, environmental groups contend.

To allay concerns, Shell re-routed the undersea pipeline from one of its platforms to avoid the feeding ground, at a cost of more than $300m. Shell also devised a way to install the offshore platforms more silently to avoid scaring off the whales during the feeding season, again at greater cost.

Environmental groups also fear that the construction of the twin pipelines, which cross 1,000 rivers and streams, will interfere with salmon spawning and harm the island's fishing industry. "Salmon can't spawn in a dirty river," says Dmitry Lisitsyn, chairman of Sakhalin Environment Watch, showing pictures of mud-caked river banks where the pipeline has been built. "We have found many, many violations [of company procedures]."

David Greer, project manager for Sakhalin-2, says that some of the scenes captured by Mr Lisitsyn are "regrettable but very much in the minority". He says that procedures have since been tightened up.

The company is drilling under rivers that are held to be particularly sensitive and has sought to allay fears about its impact on the island's fishing industry. After some inhabitants objected that a new jetty would block the progress of salmon along Aniva Bay, the company installed three tunnels at a cost of $2m. Subsequent monitoring has found that the salmon merely swim around the jetty.

"From an environmental point of view, it's useless," concedes Harald Hansen, the site's environmental engineer. But he says that if such measures increase the confidence of the local population, they will have been worthwhile. So far, the fish appear to have been unaffected by the construction work - 2005 was a bumper year for salmon there.

A bigger concern is that the company does not have a plan for what to do in the event of an oil spill under ice. It says it is working hard to come up with one.

As if all of this was not difficult enough, foreign companies must contend with the difficulties of doing business in a country that retains much of its Soviet-era bureaucracy. The company has 45 people dedicated to securing permits and paperwork from up to 15 government entities. Many more people are involved in the process at any one time. "We've got permits coming out our ears," says Mr Greer. "There is a huge machine that you have to work with."

Shell makes clear it is not complaining, however. Given the dearth of opportunities for oil companies, the group knows it must make a success of projects such as Sakhalin if it is to turn itself around.

"This is what the big oil companies have to get right, because these are the opportunities of the future," says Ian Craig, Sakhalin Energy's chief executive. "That's the competitive niche that the Shells, the Exxons and BPs have to work at. A lot of the key opportunities going forward are going to be in these sorts of environments."

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