EXTRACTS FROM WOOD MACKENZIE JULY 2005 REPORT: Upstream Insights: Has Gazprom finally got a share of Sakhalin-2 LNG? (PUBLISHED BEFORE SHELL'S SHOCK $10 BILLION OVERRUN ANNOUNCEMENT) Posted 22 July 2005

The deal is progressing...but not yet concluded

After months of negotiation and speculation, Russian gas giant Gazprom and Shell signed a Memorandum of Understanding (MoU) on 7 July 2005 on swapping a 25% share of the Shell-led Sakhalin-2 project for 50% of the deep reservoirs at Gazprom's prize Zapoiyarnoye field. Whilst this is a major step forward for both sides, MoUs are far from conclusive and much significant detail is yet to be thrashed out.

The deal would give Gazprom a long sought after position in Sakhalin and the Russian Far East. Gazprom would gain a fast-track position into a world-class LNG project and key Asian and US markets - and finally there would be a Russian interest in the prestigious Sakhalin-2 PSA project. Meanwhile, Shell would gain an important position in a major asset in Gazprom's core region in northern West Siberia.

Wood Mackenzie currently values the Sakhalin-2 and Zapoiyarnoye shares at US$3,469 million and US$4 565 million respectively, indicating that, on a cash basis alone, Shell will need to contribute a further US$1 billion to secure the deal. If Sakhalin-2 capital costs increase to US$20 billion, as Shell has recently suggested, the value of the Sakhalin-2 stake could be reduced to US$2,490 million. This would require Shell to add just over US$2 billion of cash or other assets to secure the swap.

Although the deal represents a net gain of almost 1,600 mmboe of reserves for Shell, the deep section at Zapolyamoye is at an early stage of development compared to the much more mature Sakhalin-2, where reserves are already proven and construction of facilities is well underway.

The different risk profiles attached to each of the projects result in a complex valuation with diverse strategic implications, not only for Gazprom and Shell, but also for other players in the Russian sector.

What else could be on the horizon? This swap could lead into further joint activity in Russia (offshore Sakhalin or Shtokmanovskoye) or even projects abroad. Shell must surely think that it is about to reap the rewards of its years of persistence in Russia with entry into Gazprom's West Siberian heartland.

LNG and cash for Gazprom; reserves for Shell

Wood Mackenzie currently values the entire Sakhalin-2 project at US$13,877 million, equating to US$3,469 million for the 25% share proposed in this swap deal. This assumes a Brent price of US$48/bbl in 2005, US$38/bbl in 2006, US$32/bbl in 2007 and US$27/bbl in 2008 (flat in real terms thereafter).

At first glance, the Zapolyamoye development appears significantly more valuable, with a remaining project PV of over US$41 billion. However, three-quarters of this value lies in the massive Late Cretaceous (Cenomanian) dry gas development which does not form part of this deal. Zapolyarnoye's deeper Neocomian (Early Cretaceous) project, which is part of the deal, is valued by Wood Mackenzie at US$9,130 million (US$4,565 million for the 50% share proposed to be swapped).

Reports have indicated that any difference in value of the assets to be swapped will be agreed by both parties and compensated for in cash or other assets. Based on Wood Mackenzie's valuations, this would involve Shell parting with almost US$1.1 billion in cash or other assets.

From a commercial reserves perspective, Shell is the clear winner in this deal, gaining access to almost 2.5 billion boe of oil and gas at Zapolyarnoye's Neocomian development, compared to the 862 million boe it would be parting with at Sakhalin-2. This would be a major boost to the company's reserves base.

What is less clear is how the different risk profiles at Zapolyamoye and Sakhalin-2 will be accommodated. There is little doubt that the Sakhalin-2 project will be successfully completed. The reserves are there, the LNG facilities are in the process of completion and sales contracts for a large proportion of production have been signed. Admittedly, Shell may like the idea of reducing its exposure somewhat, but in comparison the risks at Zapolyamoye are much greater. The deeper Neocomian at Zapolyamoye is yet to be developed and the commercial terms are likely to be much more uncertain than at Sakhalin-2.

Zapolyarnoye is more price sensitive

The Sakhalin-2 project has much more robust economics which stand up well to a potential fall in oil and gas prices and to any capital or operational overspend (see Challenging times for Shell at Sakhalin, June 2004 Insight article). This is largely due to the PSC terms negotiated for the development, which provide some protection for the consortium at low prices, but also allow the State to capture the majority of any upside.

If Sakhalin-2 capital costs increase to US$20 billion, as Shell has recently suggested, the value of the Sakhalin-2 stake could be reduced to US$2,490 million. This would require Shell to add just over US$2 billion of cash or other assets to secure the swap.

Zapolyamoye, on the other hand, is much more sensitive to price. Wood Mackenzie's base case value of US$4,565 million for a 50% share assumes a European gas price of US$4.36/mcf in 2006. If the gas price assumption falls by 20% from 2006 (i.e. to US$3.49/mcf) the 50% stake in Zapolyamoye loses 43% of its base value (to US$2,600 million).

A significant step forward for Shell

A successful partnership with Gazprom in this deal could open up further strategic opportunities for Shell in the Sakhalin offshore (Sakhalin-3 licensing round) and West Siberia (Ob Gulf and Yamal developments). It could even place Shell ahead of the pack in negotiations on Shtokmanovskoye. There could be many potential long and shorter term opportunities that would help Shell build a strong portfolio in Russia.

This deal marks a further positive step forward for Shell following the 5.9 billion boe of reserves downgrades. In response to these high profile reserve re-categorisations (equivalent to 30% of Shell's proven reserves as of 31/12/2002), Shell launched an overhaul of its global strategy in 2004. Recognising the urgent need to re-establish upstream strength, the company initiated a major re-organisation of its upstream portfolio. Shell committed to increase the pace of non-core asset disposals in order to focus its portfolio on long-life growth opportunities which play to its competitive strengths. Shell has identified three principal strategic target growth areas: new material oil; global integrated gas and unconventional oil. Growth in Russia could meet any, and potentially all, of these targets.

Shell has made significant progress in implementing this re-vamped strategy to enhance its portfolio for long-term strategic growth, with the recent Qatari gas deals a case in point. As well as the Russian deal, the company has also made some positive steps in accessing new LNG opportunities in Libya and Nigeria. The challenge for Shell will be to demonstrate that it can make further progress in re-establishing upstream strength, leveraging its strong, diverse exploration portfolio and competitive advantage in the LNG, GTL and unconventional oil sectors.

Strategic implications

Not only could Gazprom gain access to a world-class LNG project at an advanced stage of development, it would also have a world-class partner with a wealth of operating experience. Beyond the obvious application of these new skills to Gazprom's other projects, it may be that Gazprom sees opportunities beyond Russia. For example, Shell has significant trading and re-gasification capabilities in the US which are likely to be of interest.

This deal is not such good news for other players in the global LNG market. Gazprom's inclusion in Sakhalin-2 is likely to facilitate development of additional LNG trains beyond the two supported by current contracts. If Gazprom does bring additional gas volumes to the Sakhalin LNG, economics could improve, thus increasing the competitive position of Sakhalin LNG.

If Shell can successfully conclude this deal, it will earn itself a pre-eminent position with Gazprom. Although other companies may be concerned that this may exclude them, Gazprom is likely to 'divide and rule1 by spreading its favours across the sector. Shell is making all the right moves but there will still be opportunities for others.

EXTRACTS FROM PRE-SHELL $10 BILLION OVERUN ANNOUNCEMENT: Wood Mackenzie Report: Has Gazprom finally got a share of Sakhalin-2 LNG?: PUBLISHED JULY 2005

The deal is progressing...but not yet concluded

After months of negotiation and speculation, Russian gas giant Gazprom and Shell signed a Memorandum of Understanding (MoU) on 7 July 2005 on swapping a 25% share of the Shell-led Sakhalin-2 project for 50% of the deep reservoirs at Gazprom's prize Zapoiyarnoye field. Whilst this is a major step forward for both sides, MoUs are far from conclusive and much significant detail is yet

to be thrashed out.

The deal would give Gazprom a long sought after position in Sakhalin and the Russian Far East. Gazprom would gain a fast-track position into a world-class LNG project and key Asian and US markets - and finally there would be a Russian interest in the prestigious Sakhalin-2 PSA project. Meanwhile, Shell would gain an important position in a major asset in Gazprom's core region in northern West Siberia.

Wood Mackenzie currently values the Sakhalin-2 and Zapoiyarnoye shares at US$3,469 million and US$4 565 million respectively, indicating that, on a cash basis alone, Shell will need to contribute a further US$1 billion to secure the deal. If Sakhalin-2 capital costs increase to US$20 billion, as Shell has recently suggested, the value of the Sakhalin-2 stake could be reduced to US$2,490 million. This would require Shell to add just over US$2 billion of cash or other assets to secure the swap.

Although the deal represents a net gain of almost 1,600 mmboe of reserves for Shell, the deep section at Zapolyamoye is at an early stage of development compared to the much more mature Sakhalin-2, where reserves are already proven and construction of facilities is well underway.

The different risk profiles attached to each of the projects result in a complex valuation with diverse strategic implications, not only for Gazprom and Shell, but also for other players in the Russian sector.

What else could be on the horizon? This swap could lead into further joint activity in Russia (offshore Sakhalin or Shtokmanovskoye) or even projects abroad. Shell must surely think that it is about to reap the rewards of its years of persistence in Russia with entry into Gazprom's West Siberian heartland.

LNG and cash for Gazprom; reserves for Shell

Wood Mackenzie currently values the entire Sakhalin-2 project at US$13,877 million, equating to US$3,469 million for the 25% share proposed in this swap deal. This assumes a Brent price of US$48/bbl in 2005, US$38/bbl in 2006, US$32/bbl in 2007 and US$27/bbl in 2008 (flat in real terms thereafter).

At first glance, the Zapolyamoye development appears significantly more valuable, with a remaining project PV of over US$41 billion. However, three-quarters of this value lies in the massive Late Cretaceous (Cenomanian) dry gas development which does not form part of this deal. Zapolyarnoye's deeper Neocomian (Early Cretaceous) project, which is part of the deal, is valued by Wood Mackenzie at US$9,130 million (US$4,565 million for the 50% share proposed to be swapped).

Reports have indicated that any difference in value of the assets to be swapped will be agreed by both parties and compensated for in cash or other assets. Based on Wood Mackenzie's valuations, this would involve Shell parting with almost US$1.1 billion in cash or other assets.

From a commercial reserves perspective, Shell is the clear winner in this deal, gaining access to almost 2.5 billion boe of oil and gas at Zapolyarnoye's Neocomian development, compared to the 862 million boe it would be parting with at Sakhalin-2. This would be a major boost to the company's reserves base.

What is less clear is how the different risk profiles at Zapolyamoye and Sakhalin-2 will be accommodated. There is little doubt that the Sakhalin-2 project will be successfully completed. The reserves are there, the LNG facilities are in the process of completion and sales contracts for a large proportion of production have been signed. Admittedly, Shell may like the idea of reducing its exposure somewhat, but in comparison the risks at Zapolyamoye are much greater. The deeper Neocomian at Zapolyamoye is yet to be developed and the commercial terms are likely to be much more uncertain than at Sakhalin-2.

Zapolyarnoye is more price sensitive

The Sakhalin-2 project has much more robust economics which stand up well to a potential fall in oil and gas prices and to any capital or operational overspend (see Challenging times for Shell at Sakhalin, June 2004 Insight article). This is largely due to the PSC terms negotiated for the development, which provide some protection for the consortium at low prices, but also allow the State to capture the majority of any upside.

If Sakhalin-2 capital costs increase to US$20 billion, as Shell has recently suggested, the value of the Sakhalin-2 stake could be reduced to US$2,490 million. This would require Shell to add just over US$2 billion of cash or other assets to secure the swap.

Zapolyamoye, on the other hand, is much more sensitive to price. Wood Mackenzie's base case value of US$4,565 million for a 50% share assumes a European gas price of US$4.36/mcf in 2006. If the gas price assumption falls by 20% from 2006 (i.e. to US$3.49/mcf) the 50% stake in Zapolyamoye loses 43% of its base value (to US$2,600 million).

A significant step forward for Shell

A successful partnership with Gazprom in this deal could open up further strategic opportunities for Shell in the Sakhalin offshore (Sakhalin-3 licensing round) and West Siberia (Ob Gulf and Yamal developments). It could even place Shell ahead of the pack in negotiations on Shtokmanovskoye. There could be many potential long and shorter term opportunities that would help Shell build a strong portfolio in Russia.

This deal marks a further positive step forward for Shell following the 5.9 billion boe of reserves downgrades. In response to these high profile reserve re-categorisations (equivalent to 30% of Shell's proven reserves as of 31/12/2002), Shell launched an overhaul of its global strategy in 2004. Recognising the urgent need to re-establish upstream strength, the company initiated a major re-organisation of its upstream portfolio. Shell committed to increase the pace of non-core asset disposals in order to focus its portfolio on long-life growth opportunities which play to its competitive strengths. Shell has identified three principal strategic target growth areas: new material oil; global integrated gas and unconventional oil. Growth in Russia could meet any, and potentially all, of these targets.

Shell has made significant progress in implementing this re-vamped strategy to enhance its portfolio for long-term strategic growth, with the recent Qatari gas deals a case in point. As well as the Russian deal, the company has also made some positive steps in accessing new LNG opportunities in Libya and Nigeria. The challenge for Shell will be to demonstrate that it can make further progress in re-establishing upstream strength, leveraging its strong, diverse exploration portfolio and competitive advantage in the LNG, GTL and unconventional oil sectors.

Strategic implications

Not only could Gazprom gain access to a world-class LNG project at an advanced stage of development, it would also have a world-class partner with a wealth of operating experience. Beyond the obvious application of these new skills to Gazprom's other projects, it may be that Gazprom sees opportunities beyond Russia. For example, Shell has significant trading and re-gasification capabilities in the US which are likely to be of interest.

This deal is not such good news for other players in the global LNG market. Gazprom's inclusion in Sakhalin-2 is likely to facilitate development of additional LNG trains beyond the two supported by current contracts. If Gazprom does bring additional gas volumes to the Sakhalin LNG, economics could improve, thus increasing the competitive position of Sakhalin LNG.

If Shell can successfully conclude this deal, it will earn itself a pre-eminent position with Gazprom. Although other companies may be concerned that this may exclude them, Gazprom is likely to 'divide and rule1 by spreading its favours across the sector. Shell is making all the right moves but there will still be opportunities for others.

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