Sakhalin: Between a Rock and a Hard Place
Published on 11 September 2015 by Michael Bradshaw
The progress of Sakhalin’s oil and gas projects has always been held hostage to the fortunes of global energy markets and the intrigue of domestic politics and global geopolitical concerns. In fact, the projects themselves were born out of the resource crisis of the 1970s and were rejuvenated by the new opportunities created by the collapse of the Soviet Union. As delegates travel to Yuzhno-Sakhalinsk for the 19th Sakhalin Oil and Gas Conference they can reflect on a year of turmoil that at times promised much, but has ultimately left the prospects for future investment even more confused than a year ago.
Adjusting to Sanctions and Falling Oil Price
A year ago delegates were only just beginning to understand the consequences of the western sanctions on Russia’s oil and gas industry as part of a package of measures imposed on Russia for its annexation of the Crimea and assumed complicity in the instability in eastern Ukraine. At the time, it seemed that the focus on new oil exploration in deep-water, the Arctic offshore and tight oil meant that the Sakhalin projects would not be impacted. However, cooperation between Rosneft and Exxon Mobil in the Kara Sea and the Black Sea was specifically targeted. It is now apparent that financial sanctions have impacted on the ability of Rosneft and Gazprom to both raise finance and service debts on international capital markets. This has forced a new cost consciousness on the part of the state champions. Thus, an unintended consequence of Western sanctions is a more ‘business-like’ approach in the Russian oil and gas industry. At the same time, the Russian Government has prioritised an import-substituting campaign to reduce the industries’ reliance upon foreign (US and European) service companies and technology providers. It is too early to tell if this will succeed, but its long-term consequences could be a loss of future market opportunity for foreign companies in Russia and the emergence of a new source of competition from Russian service providers.
A year ago, the fall in the oil price and its consequences for global gas markets was a clear source of concern, and with good reason. The Sakhalin projects have no problem in finding buyers for their crude oil exports, but the price that they receive is now considerably lower than it has been (though its rouble value has grown as the rouble has fallen). The real concern is what a prolonged low oil price environment means for the global LNG industry and the prospects for building new LNG plants on the island. Traditionally, LNG projects have had to secure long-term contracts from buyers at prices that that are indexed to the price of oil. Although there is a growing role for the LNG spot market, and the prospect of Henry-Hub based LNG exports from the US has destabilised the situation, the fact remains that the build-rate of new LNG terminals is determined by future firm gas demand. An added problem, is that global LNG liquefaction capacity is growing significantly—as new projects come on line—just at a time when gas demand growth in Asia is slowing and demand in Europe is stagnant, at best. Thus, we have a perfect storm of falling prices (due to the low oil price), soft demand growth and substantial increases in LNG production. All of this means that there is likely to be a glut of LNG on global markets for the remainder of the decade. However, it is the prospects for demand in the early 2020s that will be the deciding factor for projects seeking to start construction in the next year or so. Here, the Sakhalin projects face stiff competition from expansion in Australia (and potentially Qatar) and new projects in North America (Canada and US), East Coast Africa and even possibly the Eastern Mediterranean. Thus, as ever, a discussion of current trends in global energy markets in general, and the LNG industry in particular, occupies a prime spot on the conference agenda.
Levelling the Domestic Playing Field
If the condition of global energy markets and the impact of sanctions were not sufficient, domestic politics and competition between Gazprom and Rosneft further complicate matters. Over the past year the two companies have been embroiled in a courtroom drama over access to the Transsakhalin gas pipeline, which Sakhalin Energy owns as part of the Sakhalin-2 project. Rosneft and its Sakhalin-1 partners want access to the pipeline to move gas to their planned LNG plant on the southwest coast of the Island. Gazprom has maintained that any spare capacity is needed for the expansion of their LNG plant. The summer before last the argument ended up in the courts with Russia’s Federal Antimonopoly Service also taking an interest. Initially, Gazprom seemed to be winning the argument, when the Commercial Court of the Sakhalin Region dismissed the lawsuit last February. In June the decision upheld by the Appellate Court in Vladivostok on the grounds that there was not sufficient certainty that the plant would be built. However, in early September the Federal Far Eastern District Court of Arbitration overrode and cancelled the decision of the Sakhalin Region Court of Arbitration as well as the decision of the appellate court to refuse Rosneft access to the Sakhalin-2 pipeline. The court has obligated Sakhalin Energy to provide Rosneft with access to the pipeline. The ruling takes into account transportation of up to 8 bcm of gas per year. Along the way there had been suggestions that the Sakhalin-1 project might build its LNG terminal on the Russian mainland at DeKastri—where its oil export terminal is located—which would cause great consternation on Sakhalin. The Sakhalin-1 project completed its third phase when oil production started at Arkutun-Dagi at the beginning of 2015.
Following prolonged court disputes, Rosneft have been granted access to Gazprom's Sakhalin-2 pipeline / Source: Gazprom
Given the delays, cost overruns and litigation, we are unlikely to see the same fanfare at the conference as accompanied the start-up of the Odoptu field a few years ago. The final phase of the project should see a return to the Chayvo field to develop its substantial gas reserves to supply the LNG plant. However, no final investment decisions have been made in relation to the LNG plant and Rosneft have indicated that because of market conditions (and the impact of sanctions) the plant will not be commissioned until after 2020. It remains to be seen if their recent court victory over pipeline access will change the timeframe for the LNG plant, but it might strengthening their bargaining position should they decide to sell their gas to Gazprom. It’s also worth remembering that Sakhalin-1’s initial gas development strategy was to build a pipeline to China, but this proved impossible because of Gazprom’s export monopoly.
For the past few years everyone at the conference has agreed that the expansion of the Sakhalin-2 LNG plant at Prigorodnoye in the south of the Island, which is also the subject of an annual pilgrimage for conference delegates, was a ‘no-brainer.’ The problem was that the Sakhalin-2 project did not have sufficient gas reserves to supply a third train. At the St Petersburg International Forum on 18 June Gazprom and Shell signed an Agreement of Strategic Cooperation to include global asset swaps that would enable Shell to acquire a share of the Yuzhno-Kirinskoye field in the Kirinsky block, also known as Sakhalin-3. The two companies also agreed on the expansion of the LNG plant at Prigorodnoye with the framework of the Sakhalin-2 production-sharing agreement, something they have been working on together for a number of years. Discussions are also underway between Gazprom and Sakhalin Energy’s two Japanese shareholders, Mitsubishi and Mitsui to expand cooperation in relation to LNG. Finally it seemed that things would start to move again.Then, at the beginning of August the US Government announced that it was extending its sanctions to include the Yuzhno-Kirinskoye field and that it would restrict exports, re-exports and transfers of technology and equipment. This is first time that sanctions have targeted a potential LNG project or indeed any single asset, as opposed to company or individual, in Russia. It is noteworthy that Novatek and Total continue to develop their Yamal LNG project in West Siberia. Gazprom’s website describes the sea depth of Yuzhno-Kirinskoye as ranging between 110 and 320 meters. This is significant because the US/EU sanction define ‘deep water exploration,’ which is subject to sanctions, as ‘oil exploration and production in water’s deeper than 150 metres.’ No doubt Gazprom’s and Shell’s lawyers are focusing on the detail to see if their project—which does have significant oil reserves—is subject to these sanctions. Meanwhile discussions on Sakhalin-2 expansion continued at the Far Eastern Economic Forum in Vladivostok in early September. All of this is happening just as Shell is involved in exploration drilling in the Chukchi Sea off Alaska and it will not want to do anything that attracts the disapproval of the US Government, especially as President Obama has been widely criticised for allowing this drilling activity.
Power of Siberia
Over the last 12 months it has become clear that Gazprom’s Vladivostok LNG project is not going to proceed anytime soon. Gazprom is busy building the Power of Siberia pipeline to deliver gas to China and has also been championing a second deal known as the Altai pipeline (or Power of Siberia 2) that would deliver gas from West Siberia, where Gazprom has surplus production. However, progress on the Altai deal has been slow and given the problems with Sakhalin-3 and sanctions, Gazprom is now considering an alternate destination for that gas, namely a pipeline to China (just as Sakhalin-1 had once proposed). During President Putin’s recent visit to China a Memorandum of Understanding was signed between Gazprom and CNCP to deliver Far Eastern pipeline gas to China. The Sakhalin-Khabarovsk-Vladivostok pipeline is already in place and can be expanded to deliver the additional gas. Two questions remain: first, can Gazprom develop Yuzhno-Kirinskoye without Western assistance; and second, what would this mean for the expansion of the Sakhalin-2 LNG plant? To a naïve observer, the obvious solution has always been for Sakhalin-1 to sell its gas to Sakhalin-2 to feed the expansion, and that is a undoubtedly topic for discussion at the conference.
On the basis of all that has been said above, it is clear that there is much to occupy delegates’ minds at the 19th Sakhalin Oil and Gas Conference this year. Given the current level of uncertainty in Russia and in the global oil and gas industry, few firm answers are likely to be provided, but, as ever, the conference remains the best place to find out what is happening on Sakhalin and what the prospects for the future might be.
Professor of Global Energy
Warwick Business School, UK