Journey to Sakhalin

The Saline project was the first Russian production-sharing agreement (AS) with foreign corporations. A AS is a commercial contract between investor(s) who are willing to make a large, long term and high risk investments with the host country that has the natural recourses (usually oil and/or gas) to exploit. The terms behind AAAS are usually deferent than regular commercial contracts, as they usually bypass some of the regulations that the host country imposes on foreign Investments.

The agreements also last for the Lifetime of the project. Under the terms of the AS, the investing company gets the larger share of venues at the beginning of the contract to recoup the cost of investment. As time goes by, the net revenues (revenues after the cost of operations) are shared between the investment companies and the host country, usually a 20/80 split. AAAS are controversial In Russia because they bypass some of the taxes and licenses that a foreign company would have to pay.

Previous foreign companies had worked In Russia under the regular tax system, therefore It was argued that AAAS don't treat all businesses equally and create a sense of unfairness. Furthermore, AAAS apply only to Greenfield.. Greenfield are unexploited, undeveloped large pieces of lands with exploitable resources, and some circles felt that Russia should not cheaply bargain away these coveted lands. AAAS are agreements between the foreign direct investors (FED) and the federal Russian government; thereby limiting the power of the mid-level establishment, traditionally and politically a powerful group In Russian Pollock.

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At the time of the agreement, the local Saline Government, led by Governor Igor Verification, was a key player in the decision, mainly because Verification was politically influential and in favor of the project. After the fall of the communist regime, Russian GAP fell by 50% and up to half of the population was living below the poverty line. Oil and gas constituted the main export earnings of Russia, whose borders encompassed the largest supply of gas In the world (30%). Attempts by Russia to privative state-owned energy firms had mixed results.

The OLL Industry produced a number of vertically integrated firms such as Skidpan and Subnet, which formed the basics of a competitive environment. Conversely, prevarication of the gas industry produced a single, dominant company: Gazpacho. At times, it appeared that he Russian Government acted on behalf of Gazpacho due to the significantly higher impact this Industry had on the Russian economy, and because It was a 38% stakeholder In the company. As Gazpacho controlled 20% of the worlds gas production, tenure were gallants political Interests escalated Witt ten development of this industry in Russia.

Thus far, Russian's exports were mainly to Europe, as Russia had been unable to build pipelines to East Asia and Japan. The energy sector constituted 20% of GAP, and Gazpacho alone was responsible for 8%. The growing economies of the Far East, combined with Russian's need to exploit its oil and gas serves (both for economic reasons, as well as for political influence) helped push Russia to seek Foreign Direct Investment (FED). Russia also required foreign expertise, as transportation of gas to Asia would require a Liquefied Natural Gas (LONG) facility; something they did not have the technical ability to create.

Foreign partnerships then offered the fastest and most efficient way of developing previously inaccessible resource field as well as exporting to new markets. Previous administrative scandals (BP Amoco) showed Russia to be politically and financially risky, causing a decrease in FED. A AS agreement would prove a good faith gesture from Russia that it was ready to enter the world economy, and to overcome the bureaucratic history and corruption that has scared away foreign companies.

Shell would not have invested $108 in the Saline II project [exhibit 1] without a AS. Russia needed this first AS to attract future FED, and as such would likely be most generous with the terms of its first AS. Successful execution of a AS by Shell, could create future opportunities to exploit additional Greenfield development in Russia. Despite these advantages, there were several downsides. Protectionism by members of the Russian Dumb meant that this AS was rapidly becoming politicized and might face ongoing challenges..

One term of the AS was that Saline Energy Investment Company (SIC) needed to use 70% Russian labor and goods for the part of the project measured as measured man- hours and volume of material; however the oil industry in Russia was mainly functioning on ground and had very little experience with offshore activities as exampled by Russian's inability to build and maintain a Liquefied Natural Gas (LONG) plant. The terms of this part of the agreement were particularly vague, as it was roll defined what would be considered Russian "content" in the project.

Additionally, enforcement of the AS would be difficult due to the geographical remoteness of the project. * Investments in Saline did not Just include the production facilities, but also contributions to the local administration. SIC was responsible for the upgrade (or construction) of the island infrastructure as well as other wish-lists of improvements. The SIC also had to provide local community sponsorships of facilities, scholarships and grants as well as maintaining good relationships with environmental activists. Saline Island is a pristine environment.

In order to be successful, social and public relations have to be a priority, which could prove to be challenging since the business of exploiting oil and gas is usually brutal to the environment as well as the economic and social landscape of local communities. Care in negotiations had to be achieved in order to sponsor projects that would keep the local residents happy and friendly, and yet keep a tight control on spending for these projects and not inflame environmentalists. * Navigation of local politics was also a challenge.

In the first stages of a project like this, good relations with local government employees are sometimes more important than relations with politicians higher up in ten unlearning as most approvals are cone locally. As ten project progressed, Ethereal authorities became more important as Putting attempted to reinstitution central authority. Another obstacle was the legal system. Difficulties and delays in obtaining approvals for the Technical and Economic Substantiation for Construction (TCO) as well as a lack of stabilization in the Russian legal system endangered the project as it would not proceed as scheduled without them.

Without changes to the legal system, arms of the Saga's agreements that conflicted with current Russian laws could not be enforced and increased the risks associated with the investment. Despite these obstacles Shell should invest in Saline. There are very few Greenfield available with the production capacity of Saline. Exploitation of non-developed lands allows for the building of new technology instead of maintaining old equipment. This is more efficient and therefore more profitable. The initial costs are lower as there is no need to dismantle old facilities to build new ones.

It allows Shell to gain a foothold in Russia which has a large reserves of oil and gas. When at full capacity, Saline could produce up to 5% of the world LONG needs making this a critical strategic investment for Russia. Russia needs to rebuild its economy and is now ready to offer better deals then it would in the future. It does not have the technology to build offshore platforms and LONG producing capabilities. It needs these facilities to access new markets and the location of Saline in the Arctic has great potential in these regards.

The Saline II AS agreement has terms that will be difficult to match in the future and has the advantage of reducing the influence of the Russian oligarchy in the business dealings. Russia would not Jeopardize its standing as a 68 country and is motivated to have successful foreign investments. Of course one company to watch is Gazpacho. It is a major player in Russian politics and may feel threatened to have the East Asian market closed to them. Shell should be open to the idea of having Gazpacho be part of the Consortium.

To mitigate the risk, Shell should try to attract more investors to distribute the risk, at least at the beginning while costs are high, then buy the shares back once production brings in stable revenues. They should follow the given requirements very carefully and ensure that they keep maintain heir end of the bargain by hiring the requisite local contractors and labor force. Shell should behave as a good neighbor as much as possible by making sure that the environment is being taken care of.

Natural resource industries require large capital investments and are politically difficult to navigate. They have such a significant geopolitical impact that the Coos of these companies do not make agreements with the heads of other companies, but rather with heads of state. Their decisions do not just affect the shareholders of the company, but also the access of energy by their win country as well. If the political climate changes with a new government hostile to the home country of the company, no commercial contract can be legally enforced.

A company could lose all of its investments in the host country should they be removed from the operations while the plants and equipment remain. Depending on the level of hostility and the impact the resources of a country have on the global energy supply, escalation may involve military force to secure indispensable resources. Usually the countries with the companies that have the most technical expertise do to own the lands that contain the resources and the countries with the resources do not have the technical expertise to exploit them.

It creates a mutual (although wary) Interdependence. An 011 company cannot easily select to another site Ana move Its platforms, refineries and pipelines, while the host country cannot operate the equipment without the technical knowledge of the companies (which is the company's only leverage). Both sides need to do a a diplomatic dance, constantly negotiating give and takes on the exploitation of these resources. Exhibit 1: Saline 2 project

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