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Forbes Magazine
December 24, 2001
Energy's Eastern Front
By Benjamin Fulford

A desolate island off Russia is about to sop up $45 billion of Western money. How much oil and gas will come out of it? Over the years the island of Sakhalin in Russia's far east has been a Czarist prison camp, a Japanese colony and a top secret Soviet military zone. The few inhabited patches are scarred with derelict factories, nasty spills from years of ecologically disastrous oil drilling and assorted giant projects stopped in mid-swing by the abrupt end of communist rule. It's hard to imagine the place being the center of an energy boom capable of generating $500 billion in revenue before it runs dry.

Already, though, oil giants like Royal Dutch/Shell, ExxonMobil and ChevronTexaco are preparing to invest $45 billion to help turn desolate Sakhalin into a massive oil-and-gas hub serving China, India, Korea and other parts of Asia for the next half-century or longer. "This is going to be a second Prudhoe Bay," says Dan Berkshire, an Arlington, Va.-based consultant now in Sakhalin looking after some of the contractors getting started on this undertaking.

The plans call for building dozens of offshore platforms, liquefied natural gas plants, pipelines to China, Korea and maybe Japan (see box, p. 62), plus all the fixings to support these structures--like docks, bridges, roads and housing for workers. If even half the ambitions are realized, the combined projects would produce more oil than the 1 million barrels a day coming from Alaska's North Slope. They also contain more than twice as much as the 30 trillion cubic feet in the Hugoton embayment in Kansas, the largest contiguous gas field in North America.

"This is the most ambitious green-field project undertaken during my 30 years with Shell," Chairman Philip Watts said during a recent visit to the island. Even for Royal Dutch, which will have $192 billion or so in revenue this year, the commitment is considerable. It has a 62.5% share in a consortium that has invested $2 billion and plans to spend an additional $9 billion to develop what is known as Sakhalin II. Sakhalin II is just one of eight consortiums preparing fields off the island's north coast, which is slated for development; Sakhalin II is the only one of the eight now producing fuel. This one field has proven reserves of 20 trillion cubic feet of gas (roughly what the U.S. burns in a year) and 1 billion barrels of oil (an eight-week supply for the U.S.). Partners are Japan's Mitsui (25%) and Mitsubishi (12.5%) trading conglomerates.

The technical, logistical and bureaucratic obstacles are breathtaking. Shell is looking at making the largest-ever foreign investment in Russia. It must build ports and roads from scratch, as well as the country's first--and the world's largest--liquefied-natural-gas plant. It has already begun to operate Russia's first offshore oil rig.

The weather is treacherous, the risk of catastrophic fires and explosions ever present. But the biggest hazard of all is politics. Shell is gambling that Russia, after years of ripping off foreign investors, especially oil companies, has changed its ways and will stick to the first production-sharing agreement it has ever made. The bureaucracy alone, Soviet and after, was so problematic that it took from 1978 until 1999 to move from preliminary discussions to production. In a troubling move, Russian government officials have already been trying to charge a value-added tax, even though the contract explicitly exempts the Sakhalin projects, says an official at ExxonMobil.

Exxon knows all about bureaucratic "gotchas." It leads the Sakhalin I consortium, which was supposed to be up and running before Sakhalin II. So far not a drop has come out of that field. One reason: Exxon was initially not as successful as Shell in landing a clearance to dump drilling mud into the ocean. In a country like Russia, a vital government permit can be granted or refused rather whimsically, with judicial relief nowhere in reach.

But the immense potential rewards make the Sakhalin gamble seem worthwhile--the Indian oil producer OPJS Videsh has pledged $2 billion to the Exxon project. For Shell, Sakhalin is a key element in a long-term strategy of shifting away from oil and toward cleaner but harder-to-tame natural gas. One market for that methane is China. The government there is thinking of using natural gas to fuel the 100 million or so cars a year it could be producing within a few decades, says Koji Hasegawa, who oversees Toyota's China operations.

In the short term, with gas demand dropping 5% last year in Japan, Asia's biggest market, Shell may not begin construction of its LNG plant in 2002 as scheduled, says Michael Bradshaw, editor of the Pacific Oil & Gas Report. In the longer run, though, LNG demand in Korea, Taiwan, India and China is expected to triple over the next decade. That would put it, in 2010, at roughly the equivalent of 3 trillion cubic feet of unliquefied gas a year.

With political instability shutting down developed gas fields in Indonesia, turbulence ever a factor in the Middle East, and Australian fields far from their markets, consumer countries are planning a 2,500-mile network of pipelines linking the Russian east with the rest of Asia. Russia itself, with its halting economy and shrinking population, has only limited use for additional domestic energy production.

The main reason such a plum is going to foreign companies is that Russian oil and gas majors like Gazprom failed to show an interest and also lack the technical expertise to drill offshore, says Steven McVeigh, head of Shell's Sakhalin venture.

A visit to the 75,000-barrel-a-day Molikpaq oil rig 18 miles off the northeast coast of Sakhalin drives home what sheer technological wonder is at work. The rig, installed at a cost of $712 million, has been designed to withstand arctic ice packs, 100-foot waves and massive earthquakes, all while sitting atop trillions of cubic feet of highly volatile natural gas.

The safety precautions are tight. Visitors have their cigarette lighters and matches confiscated before boarding the Russian military helicopter that goes to the rig. Three types of alarms indicate varying levels of danger, imminent explosion being the most serious. Sensors everywhere keep such a vigilant watch that if a visitor decided to have, say, an unauthorized smoke in his room, a series of triggers and safety mechanisms would immediately shut down oil production, ceding $300,000 in revenue. Chief Safety Officer Darwin Storms explains the paranoia: All it took was a loose valve to cause the Piper Alpha oil rig in the North Sea to melt down within 14 minutes in 1988, killing 167 people.

The technical wizardry does not stop at safety. The rig can send 34 pipes as far as 4 miles in each direction to suck oil and gas out of the ground. All the while extreme measures are needed to prevent the gas and oil from blowing out and creating a human and environmental disaster potentially equal to a dozen Exxon Valdezes. Environmental standards are strict enough that the rig was recently shut down when a slick of oil that turned out to be from an old polluted drilling site on the Sakhalin mainland drifted toward the rig.

Part of the deal Shell has struck involves training Russian technicians in all the methods needed to run the rig. Over the 30-year course of the project, 70% of the work has to go to Russian companies. Greater technological challenges lie ahead once gas production starts. The gas has to be piped 1,000 miles from the gas field in the north of Sakhalin to an ice-free port on the extreme south of the island. There it will be compressed to 1/600th its normal volume and loaded into special tankers costing $200 million each to build.

With engineers on Sakhalin who come from dozens of nations and have already coped with hardships from the swamps of Nigeria to the deserts of Syria, Shell does not face any insurmountable challenge, says McVeigh.

If he is right, and if this project paves the way for a full-scale entry by foreign oil concerns into Russia, they can look forward to sinking at least $100 billion (on top of the $45 billion pledged so far) into these rough seas, says Bradshaw in the energy newsletter. The world's mightiest companies have met their match.

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