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. Last Updated: 07/27/2016

It's Hell In Sakhalin

Big oil companies are facing huge climactic, geographical and regulatory hurdles as they try to develop promising oil fields in Russia's Far East.

'This is not an obvious winner that makes you... start spending.'

Joseph Carlson

'It's very critical that all these projects start and keep their momentum going.'

David Loran

When Anton Chekhov visited the Far East island of Sakhalin in 1890, he described it as hell. Sickness and poverty ravaged the desolate strip of land, used during tsarist times as a penal colony for Russia's worst cutthroats.

Today Sakhalin's rolling green hills are crawling with Texans and sport utility vehicles as the world's biggest oil companies survey the island's vast oil and gas deposits.

Sakhalin's offshore energy riches, thought to rival those of the North Sea, have long been the most coveted in Russia. As multinational energy companies from Exxon to Mobil to Royal Dutch/Shell promised $40 billion to develop the oil through special contracts with the Russian government, the fish-shaped island came to symbolize big oil and big money.

Lately, however, oilmen are beginning to agree with Chekhov's assessment. Sakhalin's severe climate conditions and unpredictable oil and gas deposits are proving tough to conquer, while legislative hurdles raised by Russia's government are making it impossible for most companies to begin investing real money.

The one group charging ahead with production -- an international consortium called Sakhalin 2 -- provides a measure of hope. If it stays on schedule, the group will be the first to start producing oil off Sakhalin next spring.

But Sakhalin 2 is counting on Sakhalin 1 and 3 to help shoulder the massive investments needed to build pipelines and other infrastructure on this wild, volcanic island. The other two projects, meanwhile, are years away from producing, if they make it that far at all.

Development of Sakhalin oil could mean billions of dollars in revenue for Russia's foundering federal budget and a new lease on life for the impoverished island, where the standard of living is the lowest in Russia's Far East.

But patience is running out. Mobil, the lead company in Sakhalin 3, has been camped out on the island for five years without drilling a single hole. The consortium is still waiting for the State Duma, or lower house of parliament, to grant the project a production sharing agreement, or the contract guaranteeing an investor stable tax and investment conditions.

"We're willing to take the risk, but Russia has got to open its arms and say we want you to be here," said David Simerka, president of Mobil Sakhalin Neftegaz. "After five or six years, if we can't (start producing), there comes a point where it's better to invest your money somewhere else."


Foreigners were first invited to Sakhalin in the 1970s, when the Soviet Union struck an unusual bargain with Japan to jointly explore Sakhalin's offshore deposits.

The Soviets had been mining Sakhalin's onshore oil since 1928 but lacked the money and technology to tap the much bigger reserves offshore. The Japanese-Russian team managed to begin exploration, but a fall in oil prices in the mid 1970s killed the project.

Mining the underwater riches is no easy task. The waters off the lush, green island are covered six months of the year with thick sheets of fast-moving ice that threaten to crush even the sturdiest of oil rigs.

High winds and frequent seismic activity pose further complications. Rubble still litters the streets in the northern town of Neftegorsk, where a 1995 earthquake killed 2,000 people.

Recognizing that producing Sakhalin oil required expensive technology, Russia in the early 1990s began auctioning reserves to consortia dominated by foreign companies, which combined are prepared to plunge $40 billion into Sakhalin's icy waters.

But big money can't conquer all obstacles. Sakhalin 1, the consortium owned by Exxon, Russian oil producer Sakhalinmorneftegaz, or SMNG, and a group of Japanese companies called Sodeco, isn't yet sure whether the fields it's exploring will be profitable to produce.

The group was shocked last year when it drilled a dry hole while exploring what it thought was the richest sector of an oil field called Arkutun-Dagi. Coming up empty caused serious concerns about the worth of Sakhalin 1's reserves.

"This is not an obvious winner that makes you want to just jump out and start spending all the money at one time," said Joseph Carlson, public affairs manager at Exxon Neftegas, lead company in Sakhalin 1. "The geology is more complex than that. We're still trying to figure out whether we think this thing is going to be commercial."

Exxon this year will widen its search for oil by drilling deeper wells in new locations, but the consortium is beginning to suspect its fields contain a high level of gas, which adds an extra layer of complication to the project.

Gas is phenomenally expensive to export. While oil can be pumped out of the ground and sold by the tanker, gas must be delivered to the buyer through pipelines or liquified at a costly processing plant and shipped in containers.

To justify spending billions on pipelines and a processing factory, the Sakhalin producers must first find buyers for the gas. Sakhalin 1 and 2 are stepping up negotiations with buyers in China, Japan and Korea, but the consortia need an exact read on their gas reserves before customers will sign multi-year contracts.

"You have to be sure you have not just gas, but a lot of gas," Carlson said. "And that's what we're trying to confirm."


Any talk of serious development is academic, however, until Russia's parliament passes long-awaited laws guaranteeing the safety of foreign investment. Oil companies' biggest fear lies 10 years down the road, when an unprotected investment project is repossessed by the Russian government.

As Russia struggles with rampant tax evasion and a foundering federal budget, it would seem to have a vested interest in helping the Sakhalin projects along. Under most production sharing agreements, or PSAs, the Russian Federation receives half of the billions in oil revenue, while federal and local budgets enjoy millions more in tax payments.

But Russia's communist-dominated State Duma, hesitant to give precious resources to foreigners, has awarded only seven PSAs to date and has delayed passing key legislation needed to secure PSAs already in place. Communist Party deputy Vladimir Semago is one of the most outspoken critics of PSAs.

"I have a son who is 14 years old, and I want there to be something left in Russia during his lifetime," Semago said. The deputy, who owns a casino in Moscow, says he is not a knee-jerk communist but a businessman basing his views on economics. "If foreign investors wanted to build factories and invest in production, I would kiss their feet. But if they are taking unrenewable resources and walking away, this is a threat to national security."

Sakhalin 3, still waiting to be granted a PSA, is one of the Duma's most obvious victims. The consortium is itching to hire an oil rig and get it registered for exploration drilling next year, but it won't fork over the money until it sees progress on the PSA front.

"It's the federal Duma that's holding us up," Mobil's Simerka said from his office in Yuzhno-Sakhalinsk as storm clouds rolled over the green hills beyond his picture window.

Mobil and partner Texaco have spent $30 million running the office and conducting preliminary field studies since they won the license to a block of oil and gas fields in 1993.

The duo recently took on a Russian partner, Rosneft subsidiary SMNG, with the hope it would speed PSA approval. SMNG ownership may change this summer, however, if Russia succeeds in privatizing Rosneft.

Local leaders have pushed the Duma to act and say they are frustrated by the delays. "For people who lead the economy of the island, the shelf is one of the most important ways to develop Sakhalin. It will provide a powerful jolt," said Alexander Nadsadin, deputy director of the region's department of offshore oil development.

Sakhalin 1 and 2, already granted PSAs, will also be delayed until a bill is passed to amend existing Russian legislation to comply with tax breaks and other provisions granted in PSAs. "We think these things need to be resolved before production can start on a large scale," Carlson said.

Instead of passing that long-awaited bill, called the enabling law, the Duma this month passed measures that will further complicate the already elaborate procedure for securing a PSA.

"I get the feeling they are not too anxious to see the Yeltsin government succeed," Simerka said.


The one project plowing ahead despite the odds is Sakhalin 2, a consortium led by U.S. company Marathon and including Royal Dutch/Shell, Mitsui and Mitsubishi.

The project, which will begin producing oil in the spring of 1999, is succeeding because it's willing to take risks and because it's sure of its reserves, said David Loran, a Marathon veteran serving as regional director of the project.

"Back in 1992 we did our big drilling study and took a little more risk than Sakhalin 1 and 3" by investing early, Loran said from the red easy chair in his office. "We are sure about our reserves now, so we can go ahead and invest."

Loran says he isn't worried about the fate of PSA legislation. "We would like to see the enabling law passed but it's not critical," he said.

But the consortium has clearly hedged its bets by choosing the cheapest possible plan for its first phase of production. Sakhalin 2 combed the globe to find a second-hand oil platform able to withstand Sakhalin's ice forces and found one in a hulking red structure called Molikpaq, the Native American word for "Big Wave."

Sakhalin 2 plucked Molikpaq out of the Arctic waters north of Canada for $300 million and spent $200 million more in repairs. Other oil executives on the island snicker at Molikpaq and compare it to a used car, but Sakhalin 2 argues it would have spent up to $5 billion building a new platform. "It accelerated our production, lowered our investment significantly and allowed us to begin generating revenue quickly," Loran said. "We've established the faith that we can do a project in Russia successfully, which will help us later in our marketing efforts for LNG," or liquified natural gas.

Sakhalin 2 is willing to risk the cost to put one platform on its oil field, called Pilton-Astokhskoye, but adding more oil platforms and tackling the massive Lunskoye gas field will depend on the state of oil and gas prices and whether Sakhalin 1 and 3 come online and help share infrastructure costs.

"It's very critical that all of these projects start and keep their momentum going," Loran said.


Sakhalin Island is brimming over with nature. Herds of barking sea lions crowd the shoreline, while thousands of fat salmon flip through the island's crystal rivers. Oil may be Sakhalin's future, but fishing is its number one industry today.

Preserving the island's motherlode is a priority for federal officials and for Sakhalin's indigenous people, who rely on fishing and reindeer herding for their livelihood.

The land surrounding the eastern town of Nogliki, where the oil consortia are building a base camp, is a primary dwelling area for the Nivkhi indigenous people, according to Antonina Nachetkina, a native Nivkhi and chairman of the committee on indigenous people in the regional duma.

"We are only just beginning to study this issue," Nachetkina said, noting that offshore oil development had rendered little environmental impact so far.

But the people are concerned that planned construction of pipelines down the length of the island could scare away animals and fish, she said. "If there will be some kind of ecological damage to areas of traditional land use, we will want compensation for this. Part of the revenue should go toward the economic good of the people of the north."

Federal authorities are most concerned about damage to the sea and have made drilling procedures a sticking point. Exxon won't get its drilling permits this year until it makes peace with federal watchdogs on how it disposes of its so-called drilling mud, or the synthetic lubricant used to drill through the rock-hard ocean floor.

Exxon wants to discharge it into the ocean, which it says is standard practice all over the world. "The kinds of drilling muds we use are water based and in our view not harmful to the marine environment," Carlson said.

The federal environmental protection committee feels otherwise.

"To allow pollution is not world practice -- if it is, it's bad practice," said Nikolai Shugaipov, a Sakhalin representative of the committee. "It is impossible to consider this question settled."

An alleged oil spill off one of Sakhalin 1's drilling rigs may leave the consortium in a weak bargaining position. The federal marine inspectorate this spring won an initial court victory over Exxon partner SMNG, which it accused of spilling 1.5 metric tons of oil during exploratory drilling last September. SMNG was fined 185,000 rubles ($31,000) for the alleged spill, under the ruling that the Russian oil company is contesting in an appeal.


The receptionist at Exxon's Sakhalin office is perhaps the most chipper in the Russian Federation. This could be because she's earning a steady wage in a region plagued by unemployment, where 33.7 percent of the population lives below the subsistence level.

Sakhalin, like many Russian regions, has fallen on hard times since the collapse of the Soviet Union. Seven of the region's 11 coal mines have been shut down, leaving 30,000 miners unemployed. Almost all local industry has come to a halt.

Sakhalin Governor Igor Farkhudinov and other regional leaders are big supporters of foreign investment, and with good reason. If they all get underway, the international consortia will create 10,000 permanent jobs on the island.

"Real jobs have already been created -- it's visible. You can walk around and see them," Farkhudinov said, ticking off the hundreds of office and oil rig workers and the builders constructing new office buildings and lodging.

The governor points to Dalmorneftegeofizika, a local exploration company rescued from ruin when it formed a joint venture with a Norwegian firm and began to work for the Sakhalin consortia.

"Until 1996, our oilmen couldn't give them any assignments," Farkhudinov said. "Now it is already in its second year of working successfully and will be taken care of for many, many years."

Many other local companies have benefitted. Sakhalin 1 through the first quarter of this year awarded $125 million to Russian contractors, 80 percent of which went to companies on the island.

Sakhalin 2's awards include $35 million to a Russian shipbuilding yard in the Far East; $50 million to a U.S.-Russian construction joint venture; and $100 million to a Russian-U.S.-Swedish joint venture for the use of tankers and buoys. Those already earning salaries from the oil projects are fans of foreign investment.

"It's good, steady work and people are happy for it," said Vladimir Shevyakin while giving a tour of the offshore drilling rig he manages for Sakhalin 1. "We hope that in the future this work gives people a good standard of living." Shevyakin earns $1,000 per month and says the average oil rigger earns $600 to $700. The average monthly wage in Russia is 1,055 rubles ($175).

Local officials like to compare Sakhalin with the U.S. state of Alaska, where every resident receives yearly payments from a fund supported by oil revenues. In that vein, Sakhalin 2 has started a $100 million fund to finance repairs of the island's crumbling infrastructure. The local budget also will gain millions in taxes once production begins.

Still, many local residents laugh off the idea that they'll benefit from Sakhalin's oil. "All the money will go to Moscow, or to foreigners. Sakhalin people won't see a kopeck," said one gypsy cab driver as he swerved around a pothole on a pock-marked street.

Communist deputy Semago agrees. "More than anything it bothers me when they say people will benefit," he said. "This benefit will go to a small circle of leaders who think only about themselves."

The oil consortia say they know they're being watched carefully. "We're going to have to perform and do what we said we would do," Loran said.

But like the prisoners in Chekhov's time, Sakhalin's oilmen have almost no choice but to stick it out.

"All the easy oil around the world has been found," said Exxon's Carlson. "What you're down to now is the hard stuff."