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. Last Updated: 07/27/2016

Rendering Sharing Agreements Unproductive

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At a news conference last week, Industry and Energy Minister Viktor Khristenko said there were no grounds for annulling existing production sharing agreements, or PSAs, in Russia. But apart from earlier ecological concerns, a rise in the projected cost of developing the Sakhalin-2 project to $1.6 billion is also causing problems.

The scandal surrounding Sakhalin once again demonstrates not only the government's lack of understanding when it comes to the idea of the inviolability of contracts, but in the area of direct investment in resource development in general.

The government tends to see this investment as a state expenditure, even though not one kopeck of budget money has gone into the project.

None of the PSA projects has yet reached its projected production capacity -- the main part of the Sakhalin-2 project (for gas production and liquefaction) will only be completed at the end of 2007 and production at Sakhalin-1 only began last October. Total revenues for the Russian side within the framework of the project, according to estimates by Sakhalin Energy, should be about $40 billion --$300 million per year until the project's development costs have been covered and $2 billion per year after construction expenditures have been recouped. There might have been hope that these numbers would be higher, but there are certain realities that can't be escaped: production levels, transport conditions, the quality of refining, external economic conditions, cost dynamics and so on.

Projects developed jointly on the basis of PSAs are operating successfully in over 60 countries, including China, Argentina, Vietnam, India, Egypt, Nigeria, Kazakhstan and Azerbaijan. This means that PSAs are used by net importers, and exporters and by Third World countries and those aspiring to great power status. Natural Resources Minister Yuri Trutnev's comment that "PSAs are for countries that are in bad shape and don't have the money" is completely out of line with reality.

PSAs are a good fit for any project: The state can earn significant revenues from rich fields and smaller sums from less promising ones without limiting the relative attractiveness of investment in the development of fields with significantly different characteristics. In 2003, PSAs were marginalized and the idea remains that they are only useful in dealing with the most difficult projects, such as the Shtokman field in the Barents Sea. Are we to believe that the first two Sakhalin projects are simpler.

The grievances against Sakhalin-2 only began to arise after Sakhalin Energy reported that cost estimates for the project had risen from $12 billion to $21.9 billion. "It was clear that Russia would never agree to this proposal," said Arkady Dvorkovich, a senior economic aide to President Vladimir Putin. But why? Perhaps they discovered some method hitherto unknown to economists to rule out increases in costs of production -- metal prices, pay raises, services and so on -- over the life of the project.

But the estimates of the cost for the Nord-Stream pipeline that will run along the bottom of the Baltic Sea to transport gas to Germany have gone up. Costs have risen for Transneft's project to build a pipeline from Taichet to Skovorodino. When officials explained the rise in costs as the result of higher prices for pipe, no one was surprised.

So what's happening on Sakhalin Island? Investors are spending billions of dollars on the purchase of Russian and foreign equipment and materials. After their investment has been recovered, everything that has been built becomes Russian property. This means offshore drilling platforms, on-shore oil and gas refineries, 1,600 kilometers of pipelines and a giant plant for the production of liquefied natural gas, along with the modernization of the island's infrastructure, including roads and railways lines, bridges ports, airports and healthcare facilities.

There is no way the state can lose in the end. These facilities will provide the foundation not only for future oil and gas projects, but also strengthen the fishing, logging, tourism and recreation sectors. Is the money being spent by these investors really not in Russia's interests?

The rise in costs for the investors also means an increase in the value of orders for Russian contractors, who have already made $8 billion from the two projects. And these orders generate a chain reaction, increasing investment, incomes and tax revenues in a number of economic sectors. The PSA also means the creation of production and transport infrastructure, urban construction and the development of liquefaction as an industry. So the increased expenses can be justified as contributing to the diversification of the economy -- one of the government's main goals.

The industrial production index for Sakhalin grew at a rate 50 percent higher than for the country as a whole between 2004 and 2005. This means that even before the two projects come completely on line they have already contributed to development on the island. All of this happened without any sort of supernatural effort on the part of governmental agencies or additional outlays from the federal budget.

As for the higher expenses, the threat they pose to final profits inevitably is an issue for investors as well. The idea of investors craftily inflating costs assumes that they are interested in incurring losses as well. Every investor is responsible to its own shareholders, who in turn enjoy a broad range of options for influencing decisions through the company's board of directors. They are not going to tolerate unnecessary increases in expenses if they reduce their dividends.

PSAs also allow the state to exercise significant control over projects. In addition to deciding whether licenses are granted, the state also has representatives on the boards of directors for the various projects, so they also have a say in controlling costs. The government can also order audits: In 2006 three different examinations of expenditures for the Sakhalin-2 project have been conducted.

The foreign partners in a PSA also look for outside financing for the projects, so their creditors also monitor costs, since their reputations are also on the line. As soon as the environmental complaints against Sakhalin-2 surfaced, the European Bank for Reconstruction and Development postponed a decision about whether to grant credits for the project.

Finally, there is a group of companies involved in every PSA, and each of them monitors the work of the others. So the members of the consortium developing the Kashagan field in Kazakhstan, including Total, Royal Dutch Shell, ExxonMobil and ConocoPhillips recently decided to switch from one contractor, Italy's Eni, because they were unhappy with rising costs. Has Total been inflating costs without Norway's Hydro noticing or that ExxonMobil been pulling the wool over the eyes of India's national oil company.

Put simply, complaints about increasing costs within a production sharing agreement are, in the best case, an attempt for whatever reason to shift profits for the investors into the federal budget or, in the worst, an unscrupulous approach to competition.

Mikhail Subbotin is director of the CRP-Ekspertiza consulting company. This comment was published in Vedomosti.