Shell shakedown (cont.)

By Abrahm Lustgarten, Fortune

When Shell signed the Sakhalin production-sharing agreement in 1996, the oil company had the upper hand. The oil and gas reserves on the island had been identified, and there weren't any exploration risks, but Moscow didn't have the capital to get to them. Shell and its partners did. Details about the document are sketchy, and the company won't comment. But in effect, the agreement meant that the higher the cost of the project, the longer the Kremlin would have to wait to see any royalties.

Production-sharing agreements are common in the oil industry, but the Sakhalin contract broke new ground. "This one is particularly disadvantageous to the Russian party," Ian Rutledge, an economist with Sheffield Energy & Resources Information Services, wrote in a 2004 report. "SEIC has transferred most of the risks... to the Russian government."

At the time the deal was struck, though, says Sakhalin Energy CEO Ian Craig, Russia was too volatile an investment without the framework and the fiscal regime the agreement provided. "You can debate whether [the terms] are fair or not now," he says, pointing out that the $13 billion invested to date is all shareholder-funded. "But it's a debate about dividing up a share that simply would not exist, had we not set them up then."

Russia's patience ran out in 2005, when Sakhalin Energy announced that project costs had doubled. Much of the jump can be attributed to a 20%-a-year leap in the price of labor, rising costs of materials like the steel used for pipelines, and higher oil prices. "It cost me twice as much to fly from Moscow to Yuzhno as it did two years ago," Craig says. "We're living in a $60-a-barrel world, and that applies to everything."

But even if many of the extra costs can be rationalized, frustrated residents tend to focus on the ones that can't. Sakhalin Energy is said by contractors to be spending up to $15,000 a month to house the families of some staff. When one contractor's barge ignored storm warnings to leave port and broke apart, spilling 55,000 gallons of fuel, Madderom says the tab was about $60 million, just for the boat.

And when Sakhalin Energy rerouted the underwater portion of its pipeline in response to international criticism about the threat to endangered western gray whales - environmentalists say the original route was planned without thorough review - the shift cost nearly $300 million. The company says that was the pricetag for complying with environmental demands. It also denies spending extravagantly.

Still, there are the small things - the $4 pencils and $500 space heaters a customs officer says she saw listed on a Sakhalin import form, the flaunting of money by expatriate staff in downtown nightclubs, the waxed and polished Land Cruiser fleet lined up in an island parking lot - that give Sakhaliners a feeling of watching a party in their living room to which they haven't been invited.

If Sakhaliners think spending is out of control, that could explain why prices in Yuzhno also seem divorced from reality. The town stretches just a few square miles, with a neat grid of unremarkable streets bookended by a 25-foot statue of Lenin and an imposing Victory Square. The city center is for the most part architectural remnants of the communist era, while the suburbs contain acres of new middle-class housing developments - a reflection of the oil industry's impact on Sakhalin's economy. One of these houses can cost nearly $1 million, while a one-bedroom apartment can rent for $3,000 a month, comparable to New York City prices. A five-minute taxi ride costs $12, and lunch at a casual Indian restaurant starts at about $40 per person.

"I've spent time in Moscow, Tokyo, and Hong Kong," says an oil-well engineer for services company Schlumberger, who paid a $70 cover charge to walk into Yuzhno's newest nightclub, Schastie Project, only to fork over another $19 for a whiskey. "Yuzhno-Sakhalinsk is the most expensive town I've worked in."

Whether Gazprom or Shell owns Sakhalin Energy, the culture is probably not going to change. For one thing, as an analyst pointed out, Gazprom "might be omnipotent, but they still don't make LNG." That means Shell and many of its highly paid employees will stay on to manage the project, and staff may even increase as Gazprom brings in shadow workers to watch and learn.

One thing is certain, though: The deal stinks for Royal Dutch Shell, whose top executives declined to comment for this article. Its reserves will take a big hit, a tough swallow for a company already having trouble replacing its in-ground assets. Whether renegotiating a contract with a gun to its head was the smartest move for Shell is an open question. But now that the terms are settled in Russia's favor, oil majors around the world can expect their playing fields to tilt too.  Top of page

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Market indexes are shown in real time, except for the DJIA, which is delayed by two minutes. All times are ET. Disclaimer LIBOR Warning: Neither BBA Enterprises Limited, nor the BBA LIBOR Contributor Banks, nor Reuters, can be held liable for any irregularity or inaccuracy of BBA LIBOR. Disclaimer. Morningstar: © 2014 Morningstar, Inc. All Rights Reserved. Disclaimer The Dow Jones IndexesSM are proprietary to and distributed by Dow Jones & Company, Inc. and have been licensed for use. All content of the Dow Jones IndexesSM © 2014 is proprietary to Dow Jones & Company, Inc. Chicago Mercantile Association. The market data is the property of Chicago Mercantile Exchange Inc. and its licensors. All rights reserved. FactSet Research Systems Inc. 2014. All rights reserved. Most stock quote data provided by BATS.