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. Last Updated: 07/27/2016

Sakhalin Investors Await Clearer Laws

The international consortium to develop the Sakhalin-1 oil field has begun the last phase of drilling to appraise the field's reserves, but Western investors will wait to move to full-blown production until Russia clarifies the rules of the game, analysts say.

Preliminary drilling began last month at the Arkutun-Dagi deposit, the last of three fields to be appraised in the $15 billion Sakhalin-1 project. The consortium unites the Exxon Corp. and the Japanese Sakhalin Oil Co., or Sodeco, with Russian partners Rosneft and Sakhalinmorneftegaz in the quest to recover the vast reserves of oil and gas that lie locked beneath the icy waters off the wild island in Russia's Far East.

A dozen foreign oil companies are jockeying to be included in several government-appointed projects to excavate the rich reserves of Sakhalin.

But while foreign investors are eager to sign up for Sakhalin projects, they are not committing to heavy investment in production until the Russian government clarifies, and in some cases changes, laws that govern the production-sharing contracts.

Taxation, rights to land use and arbitration procedures are some of the question marks still facing foreign companies involved in the agreements, said Stephen O'Sullivan of MC Securities in London.

"There are substantial amounts of expenditures now on exploration which show the companies are willing and committed. But they are also concerned about the absence of a legal framework, so it's kind of a halfway house they're in," O'Sullivan said.

Production-sharing agreements, or PSAs, allow foreign companies to export profits in the mining of Russian oil and mineral deposits in exchange for their investment and technological expertise. Many of the oil fields and gold mines targeted for PSAs are located in frigid climates and other high-risk areas.

Drilling off Sakhalin Island, for example, requires specially designed oil rigs that can withstand the pressure of the ice that covers the water in the Sea of Okhotsk for half the year, said Robert Olsen, president of Exxon Neftegaz, Exxon's operating unit in the Sakhalin-1 project. Sakhalin Island is also located in an active earthquake territory.

Although PSAs promise to bring Russia badly needed revenue from reserves it might not be able to excavate on its own. The State Duma, hesitant to hand over Russia's prized assets, has approved only seven PSAs to date. Sakhalin-1 and Sakhalin-2, separate projects involving foreign oil producers, are allowed to operate without Duma approval because project negotiations began almost 20 years ago. Four additional Sakhalin projects are awaiting approval.

Exxon Corp., the investor in Sakhalin-1 responsible for running day-to-day operations, says it is moving ahead with appraisal of its fields but must jump a number of hurdles before beginning production.

"We will need support from the government in a number of areas before the agreement on a development plan for the field can be reached," said Olsen. Production is expected to begin in 2001.

The company is awaiting permission to use nearby land for processing facilities and export sites, Olsen said. All Sakhalin projects will send their oil through pipelines to a planned port on the southern tip of the island. Oil will then be shipped in tankers to promising markets in Southeast Asia.

The Sakhalin-1 partners also want to see a more definite tax system in place for PSAs.

A draft law before parliament could put all the necessary pieces in place. The law seeks to amend 11 existing Russian laws that conflict with the law "On Production Sharing Agreements" and have already thrown a wrench in the Sakhalin-1 project.

The Sakhalin-1 partners were promised exemption from Russia's value-added tax and import duties on equipment necessary to develop the project, taxes Russia's customs authority this year tried to levy nonetheless. A special decree from President Boris Yeltsin was necessary to unravel the confusion.

Sakhalin foreign investors also are counting on amendments to be made this fall to the PSA law itself. The original law, passed Dec. 30, 1995, provides for arbitration of disputes only in Russian courts, while foreign companies want to air their grievances in arbitration panels outside Russia, O'Sullivan said.

The law also allows the Russian government to "reopen" negotiations on PSA contracts, a clause that could prove dangerous if Russia decides it wants a bigger percent of revenues than originally negotiated.

Percentages split among Russia and the participating oil companies are based on the size of the reserves and the amount of investment required to extract them, according to a report on the Sakhalin project issued by Moscow investment bank Troika-Dialog. The more money the partners invest, the higher percentage of revenue they receive.

Exxon's Olsen said the Sakhalin-1 reserves should be approved by March and will determine the commercial viability of the project.

"We are pursuing this project as rapidly as we think we can," Olsen said. "Any decisions on development must naturally follow the appraisal activity.