September 13, 2007
Gas Negotiations Continue In Russia

Oxford Analytica

At the 11th oil and gas conference held on Sakhalin island on Sept. 3-4, Gazprom made it clear that the state expected the future gas production from the Sakhalin-1 project to be used domestically, to gasify the southern regions of the Russian Far East (RFE). This contradicts the plans by project operator ExxonMobil to export the gas to China.

Recently, Gazprom has unveiled an "eastern strategy" that aims to make Russia a major supplier of natural gas to northeast Asia over the next two decades:

--By 2030, the region should account for 30% of Russia's energy exports; its current share is about 3%.

--At the same time, the Kremlin is increasingly concerned about the poor economic situation in the RFE and sees the gasification of the southern regions as strategically important.

Thus, Gazprom and the federal government must balance two objectives:

--the desire to generate export revenue and gain geopolitical leverage in northeast Asia; and

--the need to ensure the effective occupation of the RFE.

Clearly, the two issues are interrelated: Russia's current lack of influence in the region is in part the result of the low level of economic development in its eastern regions.

Currently, Gazprom produces very little gas in East Siberia and the Far East, but this is set to change. The Kovytka field has the potential to gasify the southern regions of East Siberia, while next year the Sakhalin-2 project will start producing Russia's first liquefied natural gas (LNG). Yet Sakhalin-2 gas has already been pre-sold to export markets, while a very substantial amount of capital investment and construction time would be required to produce new gas for both the domestic and export markets. The quick fix in the RFE lies with the gas phase of the Sakhalin-1 project.

Sakhalin-1 has five major shareholders:

--U.S. ExxonMobil (nyse: XOM) (30%);

--Japan's Sakhalin Oil and Gas Development Company (30%);

--India's Oil and Natural Gas Corporation Videsh (20%);

--Russian Rosneft-Astra (8.5%); and

--Russian Sakhalinmoreneftegas-Shelf (SMNG, 11.5%).

This composition shows that Sakhalin-1 differs from Sakhalin-2 (prior to its takeover by Gazprom) in that it already has Russian ownership. In fact, previously, Rosneft and SMNG had owned 40% of the project but sold half of their share to ONGC in 2001. Last year, Sakhalin-1 completed Phase I of its development, and started delivering oil and gas to the Russian mainland. From there, oil is exported to the Asia-Pacific market, while the still modest gas production is consumed locally. The current disagreement is over the next phase of development that will see a substantial increase in gas production.

While the Sakhalin-1 project has suffered cost increases and has been subject to the same barrage of regulatory inspections as Sakhalin-2 and Kovykta, it has come up with a clean bill of health. This means that, unlike the conflicts with Shell over Sakhalin-2 and TNK-BP over Kovytka, there are no issues that give the state leverage over the shareholders of Sakhalin-1.

The federal government expects Gazprom to deliver on its program to gasify the southern regions of the RFE. At the Sakhalin conference, Vladimir Kozlov, the head of Gazprom's Sakhalin office, indicated that Russia's position was to give priority to the needs of Khabarovsk, Primorsk and Sakhalin regions. Gazprom's view is that Sakhalin-1 is the only source of gas for the Far East before 2016.

The decision on gas produced at Sakhalin-1 parallels concerns about obtaining a higher price from consumers in the former Soviet states. Gazprom and the Russian state have to juggle political and economic considerations to reach an acceptable solution for all parties. In the final analysis, it may be the ability of the various markets to pay a good price for the gas from Sakhalin-1 that decides the outcome.

ExxonMobil has always maintained that it will seek the best price for the consortium's gas and one that will be profitable to the Russian government. Currently, potential consumers in the RFE cannot afford to pay a "market" price for gas. However, domestic prices are increasing, and by early next decade they may be able to pay a "realistic" price that ExxonMobil would accept.

The price of gas has become a sticking point in Chinese-Russian energy relations. China would like to link the price of gas to domestic coal prices, but Gazprom (and the members of the consortium) want it to follow the price of oil. However, at the recent Asia-Pacific Economic Cooperation summit in Sydney, Gazprom's Deputy Chairman Aleksander Medvedev noted that the recent LNG deal between Australia's Woodside Petroleum (other-otc: WOPEY.PK) and China's state-owned PetroChina (nyse: PTR) signaled a willingness on the part of the Chinese to pay the market price for the LNG.

A gas pipeline to China seems unlikely, but a compromise solution could be reached whereby a portion of the output would be sold to the RFE and the remainder liquefied at Sakhalin-2. The high price achieved for the LNG would compensate for the lower domestic price fetched in Russia. Negotiations with Gazprom continue and a decision is promised soon, but this time it may have to be based on business sense rather than resource nationalism.

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Oxford Analytica is an independent strategic-consulting firm drawing on a network of more than 1,000 scholar experts at Oxford and other leading universities and research institutions around the world. For more information, please visit www.oxan.com.

(Source: Forbes.com)