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A New Energy Age in Pacific Russia:

Lessons from the Sakhalin Oil and Gas
Projects
a
Michael Bradshaw
a
University of Leicester
Published online: 15 May 2013.
To cite this article: Michael Bradshaw (2010) A New Energy Age in Pacific Russia: Lessons from the
Sakhalin Oil and Gas Projects, Eurasian Geography and Economics, 51:3, 330-359
To link to this article: http://dx.doi.org/10.2747/1539-7216.51.3.330
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A New Energy Age in Pacific Russia:
Lessons from the Sakhalin Oil and Gas Projects
Michael Bradshaw1
Abstract: A noted British specialist in Russia’s economic geography and the Far East region
presents a comprehensive account of the development of the onshore and offshore oil and gas
deposits of Sakhalin. Following a review of early multinational activity in geological surveying
and exploration during the 1970s, he charts subsequent changes in the entities formed to develop
and exploit the deposits (Sakhalin-I and -II) later in the Soviet period and during the first two
decades of Russian independence. These changes have responded to improved knowledge of
the geology of the deposits and changing relations between the Russian central government and
Downloaded by [University of Birmingham] at 08:31 27 September 2013
Sakhalin regional authorities. Also analyzed are efforts by the Russian side to overturn or other-
wise modify terms of previous agreements deemed unfavorable, and maneuvering by China
and Japan to secure increasing sources of supply for their markets. With Sakhalin’s two core
projects now entering the active production phase, the author distills a number of key issues
that have shaped the development of the island’s offshore hydrocarbon resources and will have
a bearing on prospects for a future generation of less spectacular new projects (incremental
development); he also outlines wider lessons that have been learned over the life of Sakhalin’s
projects. Journal of Economic Literature, Classification Numbers: F210, L710, L950, P330,
Q400. 4 figures, 2 tables, 45 references. Key words: Russia, Sakhalin-1, Sakhalin-2, oil, gas,
pipelines, LNG tankers, Japan, China, production-sharing agreements, Rosneft’, Gazprom,
McDermott, Marathon, Mitsui, Exxon, British Petroleum, Shell, Mitsubishi, ENL, SEIC.
INTRODUCTION
A midst the turmoil of the global economic crisis, which has impacted Russia severely
(Gaddy and Ickes, 2010; Nefedova et al., 2010), the year 2009 was particularly signifi-
cant for energy exports from Pacific Russia.2 On February 18, 2009 Russian President Dmitriy
Medvedev attended the opening ceremony of Russia’s first liquefied natural gas (LNG) plant
at Prigorodnoye (southern Sakhalin Island), constructed by the Sakhalin Energy Investment
Company (henceforth SEIC, or Sakhalin Energy) as part of the Sakhalin-2 project (Fig. 1).
Less than one year later, in late January 2010, SEIC marked the delivery of its 100th LNG
cargo since the plant began operations. Those LNG deliveries totaled almost 5.5 million met-
ric tons (7.48 billion cubic meters [bcm]), 50 percent of which were destined for Japan, with
the rest going to South Korea, India, China, Kuwait, and Taiwan.
Prigorodnoye is also the terminus for SEIC’s oil pipeline (Fig. 1), making possible year-
around export of oil produced offshore. Between 1999 and 2009 SEIC had exported oil from
1
Professor of Human Geography, Department of Geography, University of Leicester, University Road, Leicester
LE1 7RH, United Kingdom (mjb41@le.ac.uk). The author acknowledges support of the UK’s Economic and Social
Research Council and the British Academy for funding his research on Sakhalin and IBC Global Conferences for
funding attendance at the Sakhalin Oil and Gas Conference and the Leverhulme Trust for the award of a Major
Research Fellowship that is funding his current research on global energy security.
2
In this paper, Pacific Russia refers to the southern regions of East Siberia and the Russian Far East.
330
Eurasian Geography and Economics, 2010, 51, No. 3, pp. 330–359. DOI: 10.2747/1539-7216.51.3.330
Copyright © 2010 by Bellwether Publishing, Ltd. All rights reserved.
MICHAEL BRADSHAW 331
Fig. 1. Oil and gas fields, major pipelines, shipping terminals, processing facilities, and exploration
blocks, Sakhalin Oblast.
its Molikpaq production platform (in the offshore Piltun-Astokhskoye field), but exports were
restricted to the summer months.3 Year-around exports began in December 2008 and since
commercial production began in 1999 Sakhalin-2 has exported over 126 million barrels (17.2
million tons [mt]) of crude oil to customers in the Asia-Pacific region. And since 2005, the
3
These details of SEIC’s operations can be found on its website (www.sakhalinenergy.com).
332 EURASIAN GEOGRAPHY AND ECONOMICS
Fig. 2. Production of oil from Sakhalin Oblast, 1990–2010. Figures for 2009 and 2010 are
estimates. Sources: Compiled by the author from Sagers (2006, p. 508), Rosstat (2009, p. 638), and
Demidov (2009).
Sakhalin-1 project, operated by Exxon Neftegas Limited, has delivered over 4.6 billion bcm
of gas to Khabarovsk Kray and since 2006 over 30 mt of oil has been exported from a new oil
export terminal at De-Kastri on the Russian mainland (Taylor, 2009) (Fig. 2).
As a result of these developments, Sakhalin’s offshore oil and gas is now being exported
to energy-hungry economies in the Asia-Pacific region. These exports originate in close prox-
imity to market, avoiding the key shipping chokepoints of the Straits of Hormuz and the
Straits of Malacca (e.g., see Thomson and Horii, 2009, p. 648), thus making a significant con-
tribution to energy security in the region. Gas deliveries also are expected to supply nearby
domestic markets; gasification of the southern regions of the Russian Far East has been a long-
standing strategic objective for the Russian Government and should provide a major impetus
for the economic development of the region. On July 31, 2009 Prime Minister Vladimir Putin
attended a ceremony to launch the construction of the Sakhalin–Khabarovsk–Vladivostok
(SKV) gas pipeline. This 1,140-mile (1,830 km) pipeline will deliver natural gas from off-
shore to domestic consumers in Khabarovsk and Primorskiy krays and may also provide the
basis for an additional LNG plant in the Vladivostok region. Russia’s Gazprom natural gas
company estimates that local demand for gas in Khabarovsk Kray is 3 bcm annually, Sakhalin
Oblast 4.5–5 bcm, and Primorskiy Kray 5 bcm. The initial capacity of the SKV pipeline will
be 7 bcm a year and will eventually be expanded to 28 bcm, providing a substantial surplus
that can be exported abroad (Blagov, 2009). Prime Minister Putin has demanded that natural
gas be available in time for the 2012 APEC summit in Vladivostok. However, the cost of the
pipeline seems very high and the time frame for construction extremely ambitious.
EASTWARD SHIFT IN RUSSIAN OIL AND GAS?
Sakhalin is not the only oil- and gas-producing region in Russia with the potential to
supply Asian markets. Construction of the East Siberia–Pacific Ocean oil pipeline (hereafter
ESPO) began in late 2004, and the pipeline provides a new export route for established pro-
duction in West Siberia, as well as new fields in East Siberia and Sakha-Yakutia (e.g., the
Verkhnechonskoye field being developed by TNK-BP and Rosneft’ and the Talakan field by
Surgutneftegaz).4 The pipeline runs 1,700 miles (2,750 km) from Tayshet in Irkutsk Oblast to
Skovorodino railway station in Amur Oblast (Fig. 3). At that point, the oil (300,000 barrels/
day) is transhipped to railcars and moved a further 1,300 miles (2,000 km) to a newly built
oil export terminal at Kozmino in Primorskiy Kray.5 Construction on the second stage of
the ESPO from Skovorodino to Kozmino is scheduled start in early 2010 with completion
in 2012, although considerable uncertainty remains about the precise timetable. In February
2009, China announced an agreement to lend Rosneft $15 billion and Transneft $10 billion to
help finance the pipeline and the development of oil fields in East Siberia. In return Russia has
agreed to supply China with 15 mt of oil per annum for 20 years (Blank, 2009). To facilitate
this, a spur will be built by the end of 2010 from the ESPO to the border with China, where
it will link to a pipeline to Daqing (Fig. 3). This agreement echoes the earlier compensation
agreements between the Soviet Union and Japan, when Japanese capital investment was pro-
vided against future deliveries of resources.

Gazprom also has grand ambitions for exports to China and the Asia Pacific region from
eastern Siberia. Its Eastern Gas Program envisions an export pipeline via the Altay region to
China and a gas version of the ESPO that would link Siberian production with new fields in
Sakha-Yakutia that would then join the SKV pipeline; the total cost of Gazprom’s Eastern Gas
Program is estimated at $80 billion (Thornton, 2009, p. 29). Gazprom officials have stated
that they intend to start construction of the pipeline from Sakha-Yakutia to the SKV pipeline
in 2012.
All of this activity in Pacific Russia is aligned with Russia’s energy strategy that aims to
develop an export market in Asia to balance the stagnation of oil and gas demand in Europe.
Slack European demand, coupled with Gazprom’s problems in conforming with European
Union energy policy, limit prospects for export growth in Europe (Poussenkova, 2009). At the
same time, Gazprom’s recent decision to postpone the development of the Shtokhman field
in the Barents Sea (Shtokhman, 2010) is, in part, a consequence of the growth of unconven-
tional gas (in deep shale formations) in the United States, which has reduced prospects for
LNG exports from Shotkhman to the east coast of the U.S. Instead, Gazprom has announced
that it will develop new gas fields in Sakha-Yakutia and that it expects its deliveries to Asia to
eventually reach the level of those to Europe.
This approach makes sense, as it is widely recognized that the majority of future oil
and gas demand growth will come from non-OECD countries in Asia, principally China and
India (IEA, 2009). In its 2003 Energy Strategy to 2020, the Russian Government set a target
of increasing the share of oil exports to the Asia-Pacific region from 3 percent to 30 percent
(Itoh, 2008).6 The cost of this Pacific energy strategy will be high; thus far, a back-of-the
envelope calculation would suggest that over $80 billion has already been committed (more
than $22 billion for Sakhalin-2, at least $12.8 billion for Sakhalin-1, $11 billion for the SKV
pipeline, $14 billion for the first stage of the ESPO with another $12 billion required to
complete it, plus $10 billion that needs to be invested by the oil companies developing new
fields in East Siberia). But the question remains: can Russian oil and gas exports herald a new
energy age in Asia?
4
See Dienes (2004), Sagers (2006, pp. 523–524), and Poussanova (2007) for differing assessments of East
Siberia’spot ential.
5
The pipeline has a capacity of 30 million tons a year and is estimated to have cost $12.1 billion, plus a further $2
billion for the port at Kozmino (Rosner, 2010).
6
This target proved unrealistic, and was revised in Russia’s latest version of the Energy Strategy to 2030, approved
in August 2009. The targets now set are for 22–25 percent of Russian oil exports and 19–20 percent of gas exports for
oil and gas exports to come from East Siberia and the Far East (Minenergo, 2009).
334
EURASIAN GEOGRAPHY AND ECONOMICS
Fig. 3. Route of the East Siberia–Pacific Ocean oil pipeline and existing and proposed gas pipelines constituting Gazprom’s Eastern Gas Program.
To answer this question, this paper analyzes lessons learned from the development of the
first generation of Sakhalin offshore oil and gas projects (Sakhalin-1 and Sakhalin-2). The
Sakhalin experience is relevant for three reasons. First, further development of the Sakhalin
offshore, and the Sea of Okhotsk more generally, is a crucial component of future Russian
energy strategy in the region. Second, as Russia’s largest post-Soviet greenfield develop-
ments, the projects provide insight into the demands of frontier oil and gas development,
including the Arctic offshore. And third, the Sakhalin experience highlights the challenges
confronting foreign investors in the Russian oil and gas industries. This paper draws on over
15 years of research on Sakhalin, involving more than 10 field visits to Yuzho-Sakhalinsk;
discussions with oil company executives and with policymakers and academics in London,
Moscow, Washington, Seoul, and Tokyo; and participation in 12 of the 13 Sakhalin Oil and
Gas Conferences that have been held to date. The objective is to identify the key issues that
have influenced the progress of the first generation of Sakhalin projects and that will likely
influence the future pace and scale of oil and gas development in Pacific Russia.7
This is of more than parochial interest, as the eastward shift of Russia’s oil and gas pro-
duction and its export profile is a crucial component of its energy strategy, and the fortunes of
Russia’s oil and gas industries are central to its economic prosperity and standing in the world
(Gaddy and Ickes, 2010). Equally, the supply of substantial amounts of Russian oil and gas to
Asian markets has the potential to make a significant contribution to global energy security.
This has been the case for more than two decades, and the corollary is that if Russia continues
to fail to realize that potential (see Moe and Kryukov, 2010), then increasing Asian demand
will have to be met by further imports from the Middle East and Africa, increasing compe-
tition for consumers in North America and Europe, which will have a deleterious impact
on global energy security (Bradshaw, 2009b). Furthermore, failure to develop the region’s
energy potential will have a negative impact on its economic fortunes (Bradshaw and Kirkow,
1998), undermining Moscow’s strategic desire to occupy effectively its sparsely populated
and economically underdeveloped eastern regions.
The discussion that follows is divided into three parts. The first section reviews the devel-
opment of the Sakhalin projects that have recently culminated in year-around export of oil
and gas. The second part draws on that history to identify the key factors that have shaped
the pace of progress: the shifting political and economic influences on the projects, project
financing and environmental issues, the consequences of the reassertion of state control over
the Russian oil and gas industries, and the role played by international oil companies in mak-
ing the Sakhalin projects a reality. Central to this discussion is an assessment of whether or
not Russia’s national oil companies have the capacity (both technological and financial) to
develop the oil and gas potential of Pacific Russia without substantial foreign participation. A
third and concluding section uses the lessons derived from the Sakhalin experience to evalu-
ate the prospects for a new energy age in Pacific Russia.
HISTORY OF THE SAKHALIN OIL AND GAS PROJECTS
There has been oil production on Sakhalin since 1928, when a joint Russian/Japanese
venture discovered oil onshore, and the local oil company Sakhalinmorneftgas (SMNG) has
been producing oil since the 1930s. However, it was not until 1975 when a compensation
7
For earlier analyses, see Bradshaw (1998, 2007), Bradshaw and Kirkow (1998), and Stern and Bradshaw
(2008).
agreement was signed between the governments of Japan and the Soviet Union that a
substantial exploration program got under way.
Exploring the Shelf, 1975–1991
Initial discussions between the Soviet Union and Japan on what was then known as
the Sakhalin Continental Shelf Project began in 1973–1974 as part of a broader scheme of
large-scale and long-term compensation agreements between Japan and the Soviet Union
(Bradshaw, 1990, p. 252). These agreements aimed to secure access to natural resources in
the Soviet Far East for Japanese industry, and the Japanese Government advanced credits
that were used to finance resource development and purchase machinery and equipment for
such development. The Sakhalin project received an initial investment of $100 million from
Japan’s Ex-IM Bank (a further $70 million was provided in 1979). Once the development
phase was reached, the Japanese partner would provide half of the investment required, at
that time $600-800 million, and in return would have rights to 50 percent of the oil and gas
produced. To facilitate oil and gas exploration, a consortium of 18 Japanese companies led
by the Japan National Oil Company created the Sakhalin Oil and Gas Company (SODECO),
which joined with SMNG and the Far East Marine Company (FEMCO) to carry out explora-
tion activity (see Egyed, 1983 for details).
The seismic surveys and exploratory drilling soon resulted in the discovery of hydrocar-
bons, first at the Odoptu field in 1977 and then at Chayvo in 1979 (Fig. 1). Unfortunately for
the Japanese side, the exploration phase discovered far more gas than oil, which complicated
the plans for development, as gas is far more difficult and costly to bring to market. During
1984 it was agreed in principle to build an LNG terminal on the Russian mainland at De
Kastri to better transport this gas, but by the mid-1980s the project, having survived U.S.
sanctions on equipment deliveries (stemming from the USSR’s 1979 invasion of Afghanistan)
and generally deteriorating East–West relations, fell afoul of a fall in oil prices and depressed
demand for LNG. In fact, the Japanese partner had not participated in exploration activities
since 1983, leaving an outstanding debt to the Japanese Government of $276.6 million.8
Despite the withdrawal of Japanese Government support, SMNG and FEMCO continued
to explore, and by 1999 the Dalmorneftegeophysica Trust (a joint venture with Norway’s
Petroleum Geo-Services known as DMNG-PGS) had acquired over 150,000 km of 2- and 3-D
seismic data (PRIG, 2001, p. 5). This led to the discovery of substantial oil and gas reserves,
including the Lunskoye field in 1984, Piltun-Ashtokhskoye in 1986, and Arkutun-Dagi in
1989 (Fig. 1). Thus, by the end of the 1980s the offshore oil and gas potential of Sakhalin had
been delimited, but with the Soviet Union in crisis, the domestic oil and gas industry lacked
both the capital and technology required to develop that potential.
Yet the reforms introduced in the name of perestroyka had opened the Soviet economy
to joint ventures and foreign investment. In 1989–1990 the USSR Ministry of Oil and Gas
Industry, in conjunction with McDermott (U.S.), Marathon (U.S.) and Mitsui (Japan) exam-
ined the possibility of creating a joint venture to develop the Lunskoye and Piltun-Astokhskoye
fields (discovered by SMNG outside of the agreement with SODECO). By late 1990, Exxon
Corporation (U.S.) (hereafter Exxon) had also shown interest and a rival proposal was forth-
coming from Palmco (a U.S.–South Korean joint venture) to develop the Lunskoye field on a
compensation basis. In May 1991 a tender competition was held to develop the non-SODECO
8
Based on an interview with SODECO, Sagers (1995, p. 278) reported that the U.S. Government had asked Japan
to stop work on Sakhalin’s offshore until rival projects in Alaska could be studied.
offshore fields. Six companies or consortia bid for the tender.9 The new Russian Government
reached a decision in January 1992, just weeks after the collapse of the Soviet Union, awarding
the tender the McDermott-Marathon-Mitsui (MMM) bid. This was against the wishes of Val-
entin Fedorov Governor of Sakhalin,10 who had favored an Exxon-SODECO bid. His efforts
to overturn the decision resulted in the award being downgraded to the right to complete a
feasibility study. Thus, by early 1992 a consortium was in place to develop two of the fields
(Lunskoye, Piltun-Astokhskoye) discovered by SMNG (constituting the core of a project that
ultimately became identified as Sakhalin-2), but it had no Russian participants.
Tenders, Production-Sharing Agreements, and Early Oil: 1991–1999
From SODECO-II to Sakhalin-1. The heightened interest in Sakhalin’s offshore

resulted in the rejuvenation of the SODECO project that still held the rights to the Chayvo and
Odoptu fields discovered in the 1970s. In November 1993 a Memorandum of Understanding
was signed between SODECO, Exxon, and the Russian Government in relation to a project
then called SODECO-II, but soon became known as Sakhalin-1. According to this agreement,
the Arkuktun-Dagi field, discovered by SMNG in 1989, was added to fields allocated to the
project for development.11 The initial shareholders of the Sakhalin-1 project were Exxon (30
percent), SODECO (30), Rosneft’-Sakhalin (a Rosneft affiliate; 17), and SMNG-Shelf (23
percent). Thus, from the onset Sakhalin-1 had significant Russian participation. The operator-
ship was assigned to Exxon Neftegas Ltd. (ENL), an affiliate of Exxon. The project’s feasi-
bility study was approved in 1994 and the Sakhalin-1 consortia signed a production-sharing
agreement12 in June 1996.
Creation of Sakhalin Energy. During 1992, the membership of the Sakhalin-2 consor-
tium expanded further, with Shell (Netherlands-UK) joining in September and Mitsubishi
(Japan) in December. In March 1993 the Russian authorities reached a positive decision on
the Sakhalin-2 feasibility study. In April 1994, the Sakhalin Energy Investment Company
(SEIC, as noted above) was created to manage the development, production, financing, and
marketing aspects of the project. On June 22, 1994 SEIC signed Russia’s first PSA and in
1996 was granted a licence to develop the Piltin-Astokhskoye and Lunskoye fields.
Although PSAs are common in the international oil and gas industry, the fledgling
Russian Government had no experience in negotiating them and the terms of the Sakhalin-2
PSA were later assessed by outsiders (Rutledge, 2004) and by President Putin as being far
too generous to the foreign investors (see also Abdelal, 2006, pp. 7–8). However, the invest-
ment environment in Russia at the time was very uncertain and the Russian Government was
anxious to attract foreign investment. The PSA provided the foreign investors with protection
against future changes in legislation, which itself was still in its infancy in Russia.13 Neither
Sakhalin PSA is a public document, but we know that the terms of the two documents are
9
For details, see Bradshaw (1998, p. 153) and Sagers (1995)
10
Fedorov had intervened in the tender process, demanding the eventual winner to invest in Sakhalin’s wider
socio-economic infrastructure.
11
In return for this additional field, the outstanding debt of $276.6 to the Japanese government was counted as part
of SODECO’s investment in the project.
12
A production-sharing agreement (PSA) is a contract between an investor and the state that specifies terms
and conditions applicable to the development of the resource, and replaces a regular tax and licensing regime with
contractual provisions governing the sharing of production revenues throughout the life of the project or during a
specified period.
13
Russia’s initial PSA legislation was finally approved in 1995, after the Sakhalin-2 PSA had been signed, but
before the Sakhalin-1 PSA.
different and that the Sakhalin-1 PSA is generally viewed as better deal for the Russian side.
In 1999, the State Duma passed legislation harmonizing the 1995 law on PSAs with existing
Russian legislation, and the Sakhalin PSAs were “grandfathered,” meaning that their terms
cannot be changed by subsequent legislation.
Fiscal and legal instability. The PSA framework is complex, and when added to Russian
bureaucracy and the fact that Russia’s fiscal and legal system was in constant flux during the
1990s, the result was a field day for lawyers as there were constant conflicts over the relation-
ship between the PSA to the latest change in the law (PRIG, 2001, p. 40). On Sakhalin, the PSA
legislation empowered the Sakhalin Oblast Duma and the Sakhalin Oblast Administration,
as their support was required for the PSA projects to make progress. Consequently, they
have representation on the Supervisory Committee that oversees Sakhalin-2 as well as the
Authorized Government Body that performs a similar role for Sakhalin-1. These arrange-
ments made it vitally important for the project operators to maintain good working rela-
tions with the political elite on Sakhalin as well as the relevant ministries in Moscow. Both
project operators found themselves charting new territory and seeking approvals, permits,
and licenses for actions that had no precedent; thus, the administrative burden of developing
Sakhalin’s offshore was immense and added considerable time and cost.
Sakhalin-1’s Troubled Start. Although both projects were based on fields known to
have sizeable hydrocarbon reserves, further development activity was required. In the case
of Sakhalin-1, the appraisal process began in the summer of 1996 and by 1998 the consor-
tium had drilled six exploration wells in the Arkutun-Dagi field and DMNG-PG conducted
3-D seismic testing on both the Arkutun-Dagi and Chayvo fields.14 Continuing uncertainty
over the extent of the oil and gas reserves made it very difficult to devise a development
strategy for the project. But, as the consortium’s geologists gained a greater understanding of
the fields, it became clear that Chavyo was not just a gas play, but contained substantial oil
reserves. In 2000 the consortium drilled at Chayvo-6 and found significant oil accumulations,
changing the game plan of the project to an “early oil” strategy based on Chayvo.
Sakhalin-2 Phase I. Since its discovery in 1986, the Piltun-Astokshskoye field has been
the site of 17 test wells and 14 development wells (SEIC, 2002, p. 9). This higher level of
exploration explains why SEIC was able to proceed with its Phase-I development ahead of
Sakhalin-1.15 In 1998 a commercial oil discovery was made at the Piltun-Astokhskoye field,
and a first phase of development was based on early oil production from the Astokh structure.
Phase-I of Sakhalin-2 was “Russia’s first offshore oil and gas development, the first project to
come into operation under a PSA …” (SEIC, 2002, p. 9), and was based on the installation of
the Molikpaq (“giant wave” in the Inuit language), previously operated as an ice-class drilling
rig in the Beaufort Sea. The offshore production complex was named “Vityaz” after a mythi-
cal Russian hero, and in addition to Molikpaq consisted also of a short sub-sea pipeline from
the rig to a mooring buoy for loading tankers. Molikpaq was installed in August 1998 and the
following year produced Russia’s first offshore oil.16As was the case with exploration activ-
ity, the harsh operating conditions offshore restricted production to a short summer season
(June 15–October 15, the period when the complex was accessible by tankers). During its first
14
The harsh winter conditions offshore meant that exploration activity was limited to the period between June 1
and October 15 (Exxon Mobil, 2007, p. 22); regulatory problems resulted in the loss of a drilling season in 1999 and
a substantial fine.
15
In 1997, McDermott left the Sakhalin-2 project and the other shareholders absorbed its 20 percent holding.
16
Strictly speaking, Russia’s first “offshore” production occurred a year earlier, when an SMNG land-based rigs
accessed an offshore field using horizontal drilling techniques.
season Vityaz produced one million barrels of oil, reaching 25,000 barrels a day by the end of
the season (PRIG, 2001, p. 11).
Sakhalin-3. In 1993 the Russian Government held a tender for three blocks that have
become known as Sakhalin-3. Two blocks—Vostochno-Odoptinksy and Ayashskiy—were
awarded to Exxon and the Kirinskiy block (Fig. 1) was awarded to the Pegastar consortium
that eventually comprised Mobil (U.S.; operator), Texaco (U.S.), and Russia’s Rosneft’ and
SMNG. From the onset, the Sakhalin-3 projects were different because they were longer-term
“exploration projects”; their geological parameters were less well known and thus these areas
did not experience the more rapid pace of exploration characterizing the first-generation proj-
ects.17 The bigger problem was that they were not yet the recipients of PSAs. In 1999 Exxon
and Mobil merged, and all of the Sakhalin-3 blocks came under the control of the newly
formed Exxon Mobil.
Year-Round Oil and Gas Exports: 1999–2009
Russia’s financial crisis in the summer of 1998 is seen as a decisive moment in the trans-
formation of the Russian economy, but for the Sakhalin projects it was the Asian financial
crisis the year before that threatened their development. The drop in demand for energy in the
Asia-Pacific region raised questions about the market for Sakhalin’s gas exports. Domestic
gas prices were far too low to justify the investment of billions of dollars in expensive off-
shore production. Furthermore, at the onset of the developments, it had been expected that the
Sakhalin-1 and -II would share an export infrastructure. But, as the timelines of the projects
diverged, this became increasingly less likely. Sakhalin-2 project stuck with its LNG-based
export strategy, whereas Sakhalin-1 began to consider a pipeline to Japan and/or China.
Sakhalin-2 Phase II.18 In December 2000 Shell officially assumed the operatorship of
the project and acquired an additional 37.5 percent of the project that previously had been
held by Marathon Sakhalin Ltd. This increased Shell’s share of the project from 25 percent to
62.5 percent. Shell then sold 7.5 percent of its interest to Mitsubishi, leaving it with a 55 per-
cent shareholding. At this time, Sakhalin-2 still had no Russian participation. In 2001 SEIC
presented an integrated plan for the development of the Piltun-Astokhskoye and Lunskoye
license areas that called for year-around production of oil to begin in 2005 and LNG in 2006.
The first phase of the project was projected to cost about $1.5 billion, and the much bigger
second phase at just under $10 billion. The final decision to implement Phase II was taken
in difficult circumstances. For reasons that became clear later, Shell was anxious to start the
project and book its reserves, despite the unstable investment environment in Russia at the
time.19
Shell officials described Sakhalin-2 as the largest integrated oil and gas project in the
world. It was certainly the largest single foreign investment in the Russian economy. Phase II
had four distinct elements (Fig. 4): (1) offshore production, involving the installation of two
specially constructed gravity production rigs—Lunskoye-A in 2006 (to develop the Lunskoye
17
Kirinskiy, for example, was far offshore and in deeper water, thus posing a more substantial and costly develop-
ment challenge (similar to Mobil’s offshore Hibernia field in eastern Canada).
18
Technical details for this section are derived from SEIC’s Annual Overview reports, which have been produced
since 2002 and can be found at the project website (www.sakhalinenergy.com).
19
Abdelal (2006) details how, in the absence of satisfactory legislation, Shell wanted a “letter of assurance” from
the then–Russian Prime Minister Mikhail Kasyanov that the terms of the Sakhalin-2 PSA would be upheld. At the
final hour, the letter was provided and in May 2003 SEIC announced the commencement of Phase-II.
Fig. 4. Major components of Phase-II development of Sakhalin-2 and their location. Source:
adapted from SEIC.
gas field) and Piltun-Astokhskoye-B in 200720—linked to the onshore pipelines and onshore
processing facilities by sub-sea pipelines; (2) onshore processing of natural gas and con-
densate coming onshore from Lunskoye and of oil and gas from Piltun-Astokhskoye, and
its preparation for pipeline transportation south to Prigorodnoye;21 (3) the construction of a
trans-Sakhalin onshore pipeline system, consisting of one oil and one gas pipeline, each over
800 km (500 miles) and sharing a common corridor traversing numerous faults, streams, and
rivers (some salmon-spawning with high commercial importance); and (4) a LNG plant and
oil export terminal at the pipelines’ southern terminus at at Prigorodnoye on Aniva Bay (Figs.
20
The Molikpaq rig was designated as Piltun-Astokhskoye-A.
21
The onshore processing facility (OPF) went into operation in 2008.
1 and 4).22 On December 12, 2008 oil from the Molikpaq was offloaded onto the first tanker
at the oil export terminal and on December 26 the first Molikpaq gas was delivered to the
LNG plant.
The year-around export of Sakhalin-2 oil and gas was achieved some three to four years
later than initially envisaged, and the project ended up costing over $22 billion (as opposed
to the originally projected ca. $10 billion). Along the way SEIC has faced some monumental
challenges: on Sakhalin in terms of the operating environment, in Moscow in terms of the
changing geopolitics of oil and gas, and globally in terms of an well-orchestrated environ-
mental NGO campaign directed against financing for the project. These issues are considered
below in greater detail.
Sakhalin-1 Phase I. In September 2000, Sakhalin-1 completed its exploration phase,
having drilled seven appraisal wells and acquired more than 1,200 km2 of 3-D seismic data.
In early 2001, Rosneft’ and SMNG agreed to sell half of their 40 percent holding to the
Indian Oil and Natural Gas Corporation, Videsh Ltd. (ONGC), enabling them to raise funds to
finance their continued involvement in the project. The Chayvo field was now identified as the
best place to start the development of the Sakhalin-1 License Area. Drilling costs would be
high, so cost efficiency was paramount. Initial indications were that two offshore production
platforms would be installed at the Chayvo field, However, when the consortium declared
the project commercial on October 29, 2001, the plan was for a combination of onshore and
offshore drilling that Exxon Mobil believed would accelerate development, lower costs, and
reduce the project’s environmental impact. The Russian partners in Sakhalin-1 already had
experience of using extended-reach drilling techniques (ERD) to access oil fields offshore of
Sakhalin.
Sakhalin-1’s Phase I production plans received technical approval from the Russian
Government in 2004, when full-scale construction of project facilities began. An initial stage
enabled delivery of oil and gas to customers in the Russian Far; a second yielded year-round
export of crude oil. In October 2001, ENL awarded a contract to the Parker Drilling Company
(U.S.) to construct what was then the world’s largest and most powerful land drilling rig to
carry our ERD operations at Chayvo. Less than two years later, on June 6, 2003, the Yastreb
(hawk) began its first ERD well. During its development program at Chayvo, Yastreb drilled
15 wells, including 12 of the world’s 16 longest ERD wells. Once drilling was under way,
work also began on the infrastructure necessary to get oil and gas to market.23
The use of modular construction saved considerable time and money; the onshore
processing facility went from design to loading tankers at De-Kastri in 34 months.24 It is
connected to the oil export system via a 225 km (140 mile) pipeline and the route includes
a 19 km (12 mile) crossing of the Tatar Strait. Although a much more modest undertaking
than Sakhalin-2’s Trans-Sakhalin pipeline system, the pipeline crosses 90 streams and three
fault lines. A short gas pipeline was also built to connect the onshore processing facility
22
The LNG plant is designed to produce 9.6 mt of LNG a year, and the associated LNG jetty is capable of han-
dling LNG tankers ranging from 18,000 to 145,000 cubic meters in capacity. The oil export terminal comprises two
storage tanks with a total net operating capacity of 1.2 million barrels. Crude oil is exported via a tanker loading unit
located approximately 5 km offshore. At its peak, the new port of Prigorodnoye is expected to serve approximately
150 LNG tankers and 100 Afrimax oil tankers annually.
23
The entire complex includes a gravity-based offshore platform, the Orlan (Sea Eagle), that is winterized for
drilling and production; an onshore processing facility; and pipelines to the Russian mainland, including a pipeline
to the oil export terminal at De-Kastri (Fig. 1).
24
To utilize the initial production that became available in 2005, a smaller interim processing facility was erected
(Exxon Mobil 2007, 39), allowing for early sales to Khabarovsk Kray (and thus gaining regional political support)
and providing invaluable experience for the main construction phase.
to Rosneft’-SMNG’s gas pipeline for early sales to Khabarovsk Kray. On August 29, 2006
the first oil flowed from Chayvo to the permanent onshore processing facility at De-Kastri,
and the first tanker was loaded on September 30. Earlier trials had already demonstrated the
viability of using icebreakers and ice-strengthened tankers to oil transport year-around and by
early 2007 a tanker left De-Kastri on average every three to four days.
In addition to the massive scale of Sakhalin-1, the harsh conditions, lack of pre-existing
infrastructure, and the very uncertain investment environment, the regulatory demands were
also immense. According to Exxon Mobil (2007, p. 45), the technical approvals (TEOC)
and the State Environmental Expertise Review (SEER) documentation amounts to more than
40,000 pages contained in 120 three-inch-thick binders. In total, over 30 regulatory bodies
played a role in the process, two-thirds at the regional level and one-third at the federal level.
As with Sakhalin-2, the project required regulatory innovation, as it was attempting to do
many things for the very first time in Russia. The TEOC/SEER process was completed in 15
months, a record for a large oil and gas project.
Sakhalin-1 Phase II. The Sakhalin-1 consortium is rightly proud of what has been
achieved in Phase I of the project. After just three years of operation, the project passed cost
recovery and is no doubt proving very profitable for all involved. Exxon Mobil maintains
that since project start-up, over $2.5 billion in taxes, royalties, and the state’s share of oil and
gas has been provided to the Russian Federation, including $630 million in revenues to the
Sakhalin Oblast budget (Taylor, 2009). Unfortunately, there is uncertainty about what comes
next. According to the Sakhalin-1 website (http://www.sakhalin1.com/en/project/future.asp),
future phases of the project include the development of the Odoptu oil and gas field, Arkutun-
Dagi oil and gas development, non-associated gas development at Chayvo, and late-life gas
development (Fig. 1).
Current activity is focused on oil extraction at Odoptu. When drilling ended at Chayvo
in 2008, the Yastreb drilling rig was disassembled and moved 75 km north to a site from
which it will drill wells to the Odoptu field.25 The wells at Odoptu are the same distance out
as at Chayvo, but less deep. Drilling at Oduptu began in February 2009 and by year-end two
of seven planned ERD wells had been completed and construction was under way on a new
onshore oil and gas treatment facility and a flowline to link that to the onshore production
facility at Chayvo. Oil production from Odoptu will in part compensate for falling flow rates
at Chayvo (production fell 14 percent in 2009) and also use the additional capacity built into
the OPF and De-Kastri facilities. Production at Odoptu is expected to commence in the sec-
ond half of 2010.
Sakhalin-1 currently has far more gas than can be consumed locally. The local gas market
is very small, even if (as ENL predicts) it will reach 3 bcm a year in mid-2011. Consequently,
the gas-related developments (of Arkutun-Dagi field and a return to Chayvo for nonassoci-
ated gas) only make commercial sense if a market can be secured for additional gas produc-
tion. Early in the project’s development, the consortium considered building a gas pipeline to
Japan, ultimately concluding that it was technically feasible but impractical for a number of
reasons. ExxonMobil now wishes to build a gas export pipeline to China, something they say
that they are permitted to do within the terms of their PSA. In 2006, an agreement in principle
was signed with the China National Petroleum Company (CNPC) for Sakhalin-1 to supply
natural gas by pipeline. As part of this strategy, ENL has started work on the development of
the Arkutun-Dagi field, which is 25 km offshore, east of Chavyo, and in 35 meters of water.
25
Details of the Yastreb move are from a presentation by Scott Sandlin of ENL at the 13th Sakhalin Oil and Gas
Conference in October 2009.
They plan to install an ice- and seismic-resistant offshore platform and to carry out ERD radi-
ally up to 7 km from the platform.
However, since Gazprom arrived on Sakhalin in late 200626 it has shown increasing inter-
est in acquiring Sakhalin-1 gas to fill the SKV pipeline. At the last three Sakhalin Oil and
Gas Conferences, held in Yuzhno-Sakhalinsk each fall, Gazprom representatives have spoken
about Sakhalin-1 gas as if they already owned it. Representatives from ENL, often on the
same platform, have been asked by the press about their gas marketing strategy, and each
time they have simply responded that they are “considering all options.” In the press Gazprom
representatives regularly state that they are optimistic that an agreement can be reached on
the purchase of Sakhalin-1’s gas, but time is running out if they are to deliver natural gas
to Vladivostok by 2012 (Bradshaw, 2009a). In response, ENL and ExxonMobil maintain
that they have to get the best price for their investors and the Russian Government, which
one can assume is unlikely to mean selling all of it on the domestic market. So a stalemate
has been reached, a “game of chicken” between Gazprom and ExxonMobil.27 The Russian
Government and Gazprom thus have a different plan for supplying gas to China via pipeline,
and it does not include gas from Sakhalin-1. In the summer of 2009, the Russian Government
insisted that Sakhalin-1 gas should not be exported to China, suggesting that it is willing to
accept lost revenue in order to deliver the strategic benefits of cheap gas to consumers in the
Russian Far East (Kupchinsky, 2009).
Next-Generation Sakhalin Projects
Tables 1 and 2 show the progression of activity on Sakhalin during the first decade of the
21st century. While at the beginning of 2004 nine projects were active offshore of Sakhalin,
by late 2006 the Sakhalin-3 blocks were no longer in play, and currently five projects are
active: Sakhalin-1 and Sakhalin-2; Rosneft’s Veninskiy and Gazprom’s Kirinskiy projects
(involved in exploration programs); and the Rosneft’-BP Sakhalin project (experiencing a
“lull” in activity while exploration results are re-assessed).
While the first generation of Sakhalin projects were forging ahead, the hope was that a
new generation would gain momentum, creating a conveyor belt of new projects that would
turn the region into a major oil- and gas-producing province. This has not occurred, largely
due to the actions of the Russian Government. By the late 1990s, the Sakhalin-3 Kirinskiy
project had stalled because of a lack of a PSA, and then in 2004 the Russian Government
annulled the three licenses held by Exxon Mobil, halting any further progress on this promis-
ing area. In 1993–1994 a tender organized for Sakhalin-4 failed, but Rosneft’ and SMNG later
applied for an exploration license for the Astrakhanovskiy structure (Table 1). The Russian
companies started some initial exploration work with ARCO, but this never progressed to a
drilling program.
For some time BP had wished to become involved in Sakhalin, and in 1998 BP Exploration
and Operating Company (BPEOC) formed an alliance with Rosneft’ to explore for oil and gas
offshore of Sakhalin. Under the terms of the agreement, BPEOC agreed to fund exploration
activity in return for a 49 percent interest in future licenses. The two parties have undertaken
joint exploration of the Sakhalin-5 block and in 2003 created a joint venture known as Elvary
26
This refers to Gazprom’s acquisition of a controlling share of the Sakhalin-2 project in December 2006
(describedbe low).
27
Coincidently, for the past two years Sakhalin-1 has experienced more problems than usual getting its budget
approved (under the terms of its PSA, the “Authorized Government Body” must approve its budget annually), and in
early 2009 actually suspended operations for two months while awaiting approval of a revised budget.
Table 1. Status of the Sakhalin Projects as of September 1, 2006

344
Recoverable Project
Project Fields/blocks Participants
reserves status
Sakhalin-1 Chayvo, Odoptu, Arktun- PSA/operator: ENL 307 mln t of oil Phase 1: early oil. First oil in October
Dagi Exxon Mobil (U.S.) 30 pct. 485 bcm of gas 2005. First exports October 2006
SODECO Ltd. (Japan) 30 pct.
ONGC Videsh Ltd. (India) 20 pct.
SMNG-Shelf (Russia) 11.5 pct.
Rosneft-Astra (Russia) 8.5 pct.
Sakhalin-2 Piltun-Astokhskoye, PSA/operator: SEIC 600 mln t of oil Phase 1: early oil in 1999
Lunskoye Royal Dutch Shell (Netherlands/UK) 55 pct. 700 bcm of gas Phase 2: Gas/LNG in 2007-08
Mitsui (Japan) 25 pct.
Mitsubishi (Japan) 20 pct.
Sakhalin-3 Kirinskiy Operator: Pegastar 453 mln t of oil Exploration project suspended due to
ExxonMobil (U.S.) 33.3 pct. 700 bcm of gas loss of exploration rights
ChevronTexaco (U.S.) 33.3 pct.
Rosneft (Russia) 33.3 pct.
Sakhalin-3 Vostochno Odoptinskiy, ExxonMobil (U.S.) 66.6 pct. 167 mln t of oil Project idle and now suspended due to
Ayashskiy, Rosneft (Russia) 33.3 pct. 67 bcm of gas loss of exploration rights
Sakhalin-3 Veninskiy Rosneft (Russia) 51 pct. 51 mln t of oil First drilling season summer 2006
Sakhalin Oil Company (Russia) 24 pct. 578 bcm of gas
Sinopec (China) 24 pct.
Sakhalin-4 Astrakhanovskiy offshore Rosneft (Russia) 51 pct. 89 bcm of gas Project stopped by Rosneft’
structure BP (UK) 49 pct.
Sakhalin-5 Vostochno-Shmidtovskiy Joint Venture: Elvary Neftegas 600 mln t of oil First exploration well drilled in summer
EURASIAN GEOGRAPHY AND ECONOMICS
and Kaigan/Vasyukan (and Rosneft (Russia) 51 pct. 600 bcm of gas 2004, second in 2005 and two planned
Zapadno-Shmidtovskiy) BP (UK) 49 pct. for 2006.
Sakhalin-5 Lopukhovskiy Gazpromneft (Russia) 100 pct. 130 mln t of oil Sibneft acquired block from TNK-BP.
5 bcm of gas Gazpromneft was created in late 2005
when Gazprom purchased Sibneft
Sakhalin-6 Progranichniy Urals Energy (Russia) 100 pct. 200 mln t of oil Acquired when Urals Energy purchased
Alfa Echo
Source: Compiled by the author from the oil and gas industry press, oil company websites, and press releases.
Table 2. Status of the Sakhalin Projects as of February 1, 2010
Recoverable
Project Fields/blocks Participants Project status
reserves
Sakhalin-1 Chayvo, Odoptu, PSA/operator: ENL 307 mln t of oil Phase 1: early oil. First oil in
Arkutun-Dagi Exxon Mobil (U.S.) 30 pct. 485 bcm of gas October 2005. First exports
(oil and gas) SODECO Ltd. (Japan) 30 pct. October 2006
ONGC Videsh Ltd. (India) 20 pct. Phase 2: development of
SMNG-Shelf (Russia) 11.5 pct. Odoptu underway
Rosneft-Astra (Russia) 8.5 pct.
Sakhalin-2 Piltun-Astokhskoye PSA/operator: SEIC 600 mln t of oil Phase 1: early oil in 1999
(oil), Lunskoye Gazprom (Russia) 50 pct. + 1 share 700 bcm of gas Phase 2: Gas/LNG in 2008–
(gas) Royal Dutch Shell (Netherlands/UK) 27.5 pct. 2009
Mitsui (Japan) 12.5 pct.
Mitsubishi (Japan) 10 pct.
Sakhalin-3 Kirinskiy, Gazprom (Russia) 100 pct. 453 mln t of oil Exploration program started in
Vostochno 700 bcm of gas 2009, production planned by
Odoptinskiy, 167 mln t of oil 2012
Ayashskiy 67 bcm of gas
MICHAEL BRADSHAW
Sakhalin-3 Veninskiy Joint venture: Venineft 51 mln t of oil Drilling program started in
Rosneft (Russia) 74.9 pct. 578 bcm of gas 2006 and is on going
Sinopec (China) 25.1 pct.
Sakhalin-5 East-Schmidtovskiy, Joint venture: Elvary Neftegas 600 mln of oil Drilling program began in
Kaigansko- Rosneft (Russia) 51 pct. 600 bcm of gas 2004 and is currently sus-
Vasyukanskiy BP (UK) 49 pct. pended while basin geology is
reassessed, licenses extended
to 2013
Source: Compiled by the author from the oil and gas industry press, oil company websites, and press releases.
345
Negtegaz (51 percent owned by Rosneft and 49 percent by BP). The Sakhalin-5 acreage is
much further out and in much deeper water, which presents significant development chal-
lenges. In 2002 Rosneft’ obtained a license for the Kaigansko-Vasukanskiy blocks in the
southern part of the Sakhalin-5 license area and in 2003 licences for the East Schmidt and
West Schmidt tracts of Sakhalin-4 and -5 were obtained. In 2004, the alliance drilled its first
well at Pela Lache in the Kaigansko-Vasukanskiy block, representing the first new offshore
exploration program in Sakhalin in two decades. The drilling was a success and further test-
ing and data gathering took place in 2005, when a second well was drilled at the Udachnaya
structure in the same block (and again hydrocarbons were discovered). Two further wells
were drilled in 2006 and in March 2007 a discovery certificate for the Kanansko-Vasukanskiy
field was received. In 2008 further seismic work was conducted and the license for the block
extended until 2013.28 Despite such positive results, at the 2007 Sakhalin Oil and Gas Confer-
ence, a presentation from Elvary Neftegas made it clear that the commercial development of
Sakhalin-5 was not possible under the prevailing tax regime. Thus, for fiscal as much as geo-
logical reasons, in 2008 BP announced that the project would experience a “lull”; BP closed
its representative office on Sakhalin and only time will tell if Sakhalin-5 moves beyond the
initial stages of exploration.
Elsewhere in the Sakhalin-3 license area, Rosneft’ in 2003 acquired a prospecting and
exploration license for the Veninskiy tract and in 2005 singed a interim financing agreement
with the China Petroleum and Chemical Corporation (SINOPEC). Under the terms of the
agreement, SINOPEC will cover 75 of the expenditures during the exploration phase. In 2007
Rosneft’ created a joint venture (Venineft’) with SINOPEC, with the Russian company hold-
ing a 74.9 percent share in the venture and SINOPEC 25.1 percent. The first well was drilled
in 2006 and since then the focus has been on the areas nearest to shore. According to Rosneft’
(Brodsky 2009) there are now sufficient reserves to start thinking about development.29 Thus,
Veninskiy seems the most likely source of new offshore production in the near future.
After the Exxon Mobil licenses for Sakhalin-3 were annulled in 2004, there were various
announcements about a new auction, but it never transpired (Bradshaw 2006, pp. 148–149).
Finally, in May 2008 Gazprom was granted a licence without a tender being held. Subse-
quently, in June 2009, Gazprom obtained licences for all remaining blocks in Sakhalin-3
(except for Veninskiy, assigned to Rosneft’; Table 2).30 Exploration activity commenced in
the summer of 2009 and Gazprom’s initial target was to start production in 2014. However,
in October 2009 it announced that the start-up would be brought forward to 2011 or 2012.
This is in part because Gazprom needs to fill the SVK pipeline and also because they are in
negotiations to deliver pipeline gas to China in 2014–2015, if a pricing formula can be agreed
upon.31 Whatever, the outcome, the timetable for Kirinskiy seems unduly optimistic; it is
unlikely that Kirinskiy gas will be available to fill the SKV pipeline by 2012, which would
have reduced the pressure on Sakhalin-1.
28
The Elvary joint venture has subsequently allowed the licenses for both the East Schmidt and West Schmidt
tracts to lapse, but retains the rights to the Kaigansko-Vasukanskiy field.
29
The most likely development strategy is EDR drilling from onshore, keeping costs down. Oil and gas can then
be brought onshore and fed into the existing Sakhalin-1 and/or Rosneft’ SMNG infrastructures.
30
Exxon Mobil and its partners had already spent $60 million on development activity and the Pegastar consor-
tium had planned a six-year exploration program.
31
Earlier in 2009, Prime Minister Putin met with senior Shell executives and invited then to participate in the
Sakhalin-3 project (Sakhalin-4 was also mentioned). Shell responded enthusiastically, but no further announcements
have been forthcoming. As they already cooperate in SEIC, Shell, Mitsui, and Mitsubishi would seem the obvious
foreign partners for Gazprom.
As ever, developments on Sakhalin are in a state of flux, and this is largely due to devel-
opments beyond the island, in such locations as Moscow, Beijing, Houston, and The Hague,
to mention a few. The next section stands back from the detail to identify and discuss the key
issues that have shaped and continue to shape the progress of Sakhalin’s offshore oil and gas
projects.
KEY ISSUES32
Elsewhere I have employed the concept of “power geometry” to identify and analyze the
different actors and scales of action that have shaped the progress of the Sakhalin projects
(Bradshaw, 1998, 2007). I do not intend to repeat that analysis here, but rather to focus on
four issues: shifting center–region relations, project financing and environmental impacts,
reassertion of state control over the oil and gas industry, and the role played by international
oil companies.
Center–Region Relations
In the early 1990s, the collapse of the Soviet Union left a void that Russia’s new fed-
eral government struggled to fill. However, even in the late Soviet period on Sakhalin there
were signs that Moscow was losing its control and influence. Sagers (1995, p. 280) main-
tained that the Soviet Government had conceded significant decision-making power to the
Sakhalin Oblast Administration when it came to the tender for the Sakhalin-2 blocks and
that the new Russian Government had tried to reassert control. Even so, throughout the
1990s the Governor of Sakhalin, the Oblast Administration, and the Oblast Duma exerted
considerable influence over the projects, seeking to ensure that the Island benefited as much
as possible from these multi-billion dollar investments. Sakhalin’s economic infrastructure
was in ruins and Governor Igor’ Farkhutdinov’s view of the Russian content requirement
was that it obliged foreign contractors to partner with Sakhalin-based companies and hire
Sakhalin residents (the island’s limited economic capacity and skills base of its workforce
notwithstanding).
By the mid-1990s, as the capacity of the federal government was compromised by the
economic situation, many federal government agencies on the island came to be supported by
the local administration or engaged in various forms of “rent seeking” to cover their costs. A
“battle of laws” ensued, as regional authorities introduced legislation that encroached in areas
of federal jurisdiction. At the same time, a constantly reorganizing federal government con-
tinued to devolve new responsibilities to the regions without the resources to implement them
(the problem of “unfunded mandates”). Foreign companies thus found themselves caught in
the middle of a growing center–region dispute. Unsure of who had authority for what, one
response was to get signatures from everyone.
The situation was further complicated on Sakhalin by the fact that most foreign com-
panies operated out of the capital, Yuzhno-Sakhalinsk, where conflict had emerged between
the oblast Governor and the mayor of the city. Furthermore, as large parts of their operations
were located in other rayons in the oblast, operators also had to accommodate rayon officials’
desire for a share of the rents generated by construction activities.
32
This section is based in part on research conducted as part of a British Academy–funded project entitled Learn-
ing from Sakhalin: Ggeographies of Knowledge in the Oil Exploration and Production Industry.”
Thus, during the 1990s the SEIC and ENL found themselves not only courting favor
and support from a several levels of government on the island, but also engaged in a careful
balancing act between Moscow and Yuzhno-Sakhalinsk. As the Sakhalin-2 project progressed
through Phase I, SEIC increased its presence on the island to handle the day-to-day bureau-
cratic demands of running the project, but a great deal of time was spent shuttling between
Sakhalin and Moscow to get the necessary approvals. The legal instability surrounding the
PSAs also required that the parent companies run sizeable offices in Moscow to monitor and
lobby the Government and Federal Duma.
When President Putin came to power in 2000 he set about reasserting federal author-
ity over Russia’s regions. A set of federal districts was created and in each a Presidential
Representative was given the task of monitoring the regions and ensuring their compliance
with federal legislation. Changes to the tax system re-centralized control and made the regions
even more dependent on transfers from the center. After the tragedy at Belsan in 2004, Putin
halted the election of governors, and since then they have been presidential appointments.
All of these actions reduced the autonomy of the regions and made the governors highly
dependent on support from Moscow.33 At the same time, the authority of the federal minis-
tries in Moscow was strengthened and federal agencies in the regions bolstered. According to
the Sakhalin Administration, the Federal Government had reneged on a previous agreement
concerning the sharing of royalties from the projects, leaving the Oblast with only a minimal
share. At the same time, the high level of industrial activity on Sakhalin that was the direct
result of the projects had the result of reducing the level of federal transfers to the oblast’s
budget.
This swing back to Moscow changed the operating environment on Sakhalin, as sud-
denly many of the key decisions were being taken in the federal capital and Sakhalin’s politi-
cal elite was losing influence. All of this happened as SEIC was embarking on Phase II of
Sakhalin-2 and ENL was launching Phase I of Sakhalin-1. At one level, the reassertion of
federal authority helped to clarify lines of responsibility, but on Sakhalin it created problems
as local politicians looked to the projects to solve their economic problems. For all the reasons
discussed above, it became commonplace for the Governor to come to the Sakhalin Oil and
Gas Conference to complain about the fact that the region was not getting a fair share of the
revenues being generated by the projects. There was nothing that the foreign companies could
do about Moscow’s change of attitude, but they did share the reputational risk associated with
the poor economic situation on Sakhalin.
In 2000 President Putin had attended a conference on Sakhalin entitled PSA 2000, at which
he stated that “PSAs are for us the most important mechanism for the attraction of investment
into our economy, especially in the crude materials sector” (Ministry, 2000). Unfortunately,
all subsequent events served to undermine the prospects for a new round of PSAs and a
new generation of Sakhalin projects. No new PSAs have been signed in Russia, and the two
new exploration projects that have been active—Sakhalin-3 Veninskiy and Sakhalin-5—are
joint ventures operating on a tax and royalty basis. In fact, as is discussed below, with high
oil prices prevailing in the second half of the decade attitudes toward foreign investment in
the oil and gas sector hardened in Moscow, even while the first-generation Sakhalin projects
were proceeding smoothly and the economic situation on Sakhalin improved greatly against
a backdrop of economic recovery in Russia. Although one might decry the erosion of local
democracy and accountability, the investment environment was far more stable in the absence
33
In 2007, for example, Sakhalin’s Governor Ivan Malakhov was removed from his post following criticisms of
his handling of the Nevelsk earthquake.
of center–region power struggles than it had been in the 1990s, and from the perspective of
the foreign investor this was a positive development. Problems affecting the projects during
this period, rather than originating in Yuzhno-Sakhalinsk, reflected actions taken elsewhere in
Russia and on the world stage.
Project Financing and Environmental Impacts
Given the scale of the Sakhalin-2 project and the uncertain investment climate in Russia
in the late 1990s, it is not surprising that the shareholders in SEIC decided to spread the risk
by seeking project financing. For the first phase of Sakhalin-2, SEIC obtained a $348 mil-
lion loan from a combination of the European Bank for Reconstruction and Development
(EBRD), the Japanese Export-Import Bank, and the U.S. Overseas Investment Corporation
(OPIC). At the time, environmental nongovernmental organizations (ENGOs) did raise con-
cerns about the environmental impacts of the project, in particular its oil spill response mea-
sures, and changes were made as a condition of the loan. However, it was not until the turn of
the millennium, when SEIC approached the same institutions, plus the UK’s Exports Credit
Guarantees Department (ECGD) for a $5.4 billion loan package in relation to Phase II, that
the environmental movement mounted a global campaign against the project.
Oil and gas projects the size of Sakhalin-1 and Sakhalin-2 are bound to have significant
environmental impacts and it is the duty of investors to assess the nature of these impacts and
presents plans to mitigate them. A rigorous impact assessment of Phase II was required by
Russia’s State Environmental Expert Review (SEER) and an Environment and Social Impact
Assessment (ESIA) and related Action Plan by the international financial institutions (IFIs).
Furthermore, a good deal of environmental benchmark research had already been conducted
before Phase II began. The Sakhalin-2 SEER was approved in 2003, as was required before
construction could commence. Although the ENGOs had no direct leverage against SEIC,
except to appeal to the shareholders’ sense of corporate responsibility, they were able to exert
their influence on the international financial institutions, in particular on the EBRD.34 Thus,
even though it was lending only a modest share of the $5.4 billion, the EBRD assumed lead-
ership on the environmental and social impacts of the project. This provided ENGOs with a
convenient platform to voice their concerns about the project.
The central theme of the ENGO campaign was that public money should not be used to
finance the project because it was in violation of the guiding principles of the IFIs that relate
to sustainable development and environmental impacts. The ENGOs staged protests at EBRD
headquarters in London and EBRD Annual General Meetings across Europe, they engaged
in letter-writing campaigns, and produced numerous documents alleging environmental
violations.35 The main concerns of the NGO campaign were that: (1) installation and opera-
tion of offshore platforms and associated pipelines would threaten the endangered western
grey whale, whose summer feeding grounds were offshore of northeastern Sakhalin; (2) con-
struction and operation of the Trans-Sakhalin oil and gas pipelines would damage important
34
As a World Bank institution, the EBRD is bound by International Finance Corporation (IFC) guidelines on
environmental protection and World Bank directives on the rights of indigenous peoples. The EBRD prides itself on
being a “green Bank” and open to civil society concerns in the transition economies.
35
At the height of the campaign, some 122 NGOs were involved, led by high-profile ENGOs such the World
Wildlife Federation, International Fund for Animal Welfare, and Friends of the Earth; as specialist NGOs such as
Pacific Environment, CEE Bankwatch, and the Wild Salmon Center; and the local ENGO Sakhalin Environment
Watch. A detailed examination of the ENGO campaign is provided in Bradshaw (2007) and Lee (2005). Most of this
activity took place outside of Russia and on the Internet.
salmon spawning grounds and might be at risk from seismic activity; (3) construction activity
related to the Prigorodnoye LNG plant endangered the ecology of Aniva Bay and the safety
of the population living in nearby Korsakov; and (4) Sakhalin-2 would have a negative impact
on the indigenous peoples living in the northern part of the island.
In 2003 the EBRD had deemed the SEIC Phase-II environmental impact assessment
unfit for purpose. As a result, SEIC worked closely with the EBRD and its consultants to
address the areas of concern, committing itself to an Indigenous Minorities Development
Plan and creating a Western Grey Whale Monitoring Panel to advise the company on how
best to minimize impacts on the whale population. It also had agreed to re-route some of its
sub-sea pipelines to avoid the whale feeding ground, adding $300 million to its cost (Krysiek
2007, 20). Meanwhile, the ENGO network stepped up its actions and began to pay particular
attention to the quality of the construction work on the pipeline. An independent assessment
for the EBRD in late 2005 had criticized the quality of the crossings strategy and the work
being carried out by Russian contractors. The SEIC reviewed and revised its activities and
launched a major public relations campaign to convince the EBRD that the necessary reme-
dial actions had been taken. In sum, over 2004–2005 the SEIC spent an immense amount of
time and money to convince the EBRD to approve its revised Health, Safety, Environmental,
and Social Action Plan. This expenditure was not required by Russian legislation, but rather
had more to do with managing Shell’s reputational risk than project implementation.
Despite the global campaign against the project, the implementation of Phase II contin-
ued. As a part of that process, regulatory inspections by the Russian authorities continued, and
in the summer of 2006 SEIC admitted that issues remained and that it was working through a
number of required actions. Meanwhile, there was still no decision from the EBRD (promised
for 2006). Meanwhile the attitude in Moscow toward the project took a turn for the worse,
with the Ministry of Natural Resources adopting a much more hostile approach. This paral-
leled President Putin’s criticism of the terms of the Sakhalin-2 PSA, which he later described
at a meeting with foreign journalists during the G8 Summit in St. Petersburg (June 2007) as a
“colonial project that had nothing to do with the interests of the Russian Federation” (Russian
President, 2007). The Kremlin had been angered by cost overruns, the failed negotiations
with Gazprom the previous summer, and delays that had set back the date when the Russian
party would begin to see significant income.36 All of this led to an increasingly political cam-
paign against Sakhalin-2 on the part of the federal authorities, who threatened to revoke the
SEER, an action that would have brought the project to a halt. In the West, politicians and the
media criticized what they saw as the cynical use of environmental regulations to pressure the
shareholders of SEIC to change the terms of their investment in Russia. Throughout the fall
of 2006 the rhetoric mounted; the SEER was never actually revoked nor were charges brought
against SEIC for violations, and in the following year a revised Environmental Action Plan
(and in 2008 a Biodiversity Plan) was approved by Russian regulators.
The final outcome of the Russian Government campaign against Sakhalin-2 is discussed
in the next section. It is sufficient here to note that in early 2007 the EBRD announced that it
was no longer considering financing the project. Soon thereafter, in October 2007, the remain-
ing potential lenders to the project received an independent consultant’s report on SEIC’s
HSESAP that gave the project a clean bill of health. On June 16, 2008, SEIC, the Japan Bank
for International Cooperation (JBIC), and an international consortium of commercial banks
signed a $5.3 billion agreement to finance Phase II of Sakhalin-2. In late 2009, a further $1.4
36
It is no coincidence that an ENGO-sponsored critique of the Sakhalin-2 PSA had been translated into Russian
and had found its way onto the desks of politicians in Russia.
billion was provided by a consortium of international commercial banks, insured by Nippon

Export and Investment Insurance (NEXI), an export credit agency owned by the Japanese
government. Clearly, for the Japanese Government at least, the energy security benefits of
Sakhalin-2 outweigh any potentially negative environmental impacts. The ENGOs now have
moved on to new campaigns and would claim, with some justification, that their actions
forced SEIC to make improvements to the project that otherwise would not have been imple-
mented. Sakhalin-1 has not been subject to the same pressures for the simple reason that it
has never sought project financing and has focused on meeting the regulatory demands of the
Russian Government.
Reassertion of State Control over the Oil and Gas Industry

If President Putin’s first term was spent regaining control over Russia’s regions, his
second term was dominated by reassertion of state control over the oil and gas sector, the
government’s most important source of revenue. I do not examine that process here in detail
(rather, see Bradshaw, 2009c; Goldman, 2009; and Hanson, 2009); it is sufficient to note
that since 2004 the Kremlin apparently decided that because of the strategic significance of
the oil and gas industry and its importance to the national economy, the state should have a
controlling influence. Along the way Gazprom and Rosneft’ has been elevated to the status
of national champions and have been given privileged access to the state’s natural gas and oil
reserves, respectively.
No doubt, Shell and its partners in Sakhalin-2 watched the approaching tide of resource
nationalism with growing apprehension. Unlike Sakhalin-1, Sakhalin-2 had no Russian par-
ticipation and was an obvious target for the Kremlin. In July 2005, Shell and Gazprom reached
preliminary agreement on an asset swap under which Gazprom would acquire a 25 percent
share in Sakhalin-2 in turn for Shell receiving a 50 percent share of the Zapolyarnoye gas field
in West Siberia. However, no sooner was this agreement made public than Shell was forced to
disclose substantial cost overruns on Sakhalin-2: its cost was now $22 billion, instead of the
“more than $10 billion” previously stated by SEIC. At the same time, the start of LNG exports
from Sakhalin-2 was pushed back from mid-2007 to third-quarter 2008. Not surprisingly, the
agreement with Gazprom fell through. The cause of the cost overruns is complex. Globally,
the oil and gas industry was experiencing considerable cost inflation as a result of a shortage
of materials and labor. There were also exchange rate issues, as the ruble strengthened against
the dollar.37 However, it is also the case that Shell underestimated the cost of developing
Phase II and failed to manage those costs effectively.
The cost overruns fueled already growing Russian criticism of the Sakhalin-2 PSA. Under
the terms of the PSA the Russian state only receives modest profit tax and royalty income
until the investors’ full costs have been recovered. Thus, the cost overrun had the effect of
pushing back the date of cost recovery, delaying income to the Russian state. A growing sense
that the Sakhalin-2 PSA was not a good deal for Russia, coupled with the mounting sentiment
of resource nationalism, clearly provided the rationale for the campaign against Sakhalin-2
in the summer of 2006. And the regulatory problems that SEIC experienced in relation to
the work of contractors and subcontractors on the pipeline (noted in the previous section)
provided the Kremlin with the opportunity to exert pressure on Sakhalin-2’s shareholders.
37
Sakhalin-1 was subject to the same pressures, but Exxon Mobil has not released figures on the anticipated total
cost of the project; various accounts in the press have suggested that its costs have risen from $12.8 billion to over
$15 billion.
Although the foreign investors made no offer to revisit the terms of the PSA, neither did the
Russian Government seek to overturn the PSA (in both cases, at least not in public).
The Sakhalin-2 campaign came to its inevitable conclusion on December 21, 2006, when
a meeting was held in the Kremlin between President Putin and the CEOs of Gazprom, Shell,
Mitsui, and Mitsubishi. At the meeting it was announced that the three foreign companies
would reduce their shareholdings by half, providing Gazprom with 50 percent, plus one share
to give it a majority. In return, Gazprom agreed to pay the consortium $7.45 billion. The very
public nature of the agreement was necessary to make it clear to all of the regulatory agencies
involved in the campaign against Sakhalin-2 that the issue had now been resolved. A few days
later, the Russian Government leaked a document suggesting that the three foreign partners
would absorb $3.6 billion of the cost overruns outside the terms of the PSA (this would serve
to bring forward the point of cost recovery).38 Gazprom formally assumed control of SEIC in
April 2007. Not surprisingly, the regulatory pressures disappeared and the project has since
won accolades for its environmental record.39
The campaign against Sakhalin-2 and the similar action against BP and Kovytka served
to redefine the terms of engagement for foreign companies investing in Russia. New legisla-
tion on the sub-soil and on foreign investment in Russia’s strategic sectors have relegated
foreign companies to the status of minority partners and given Gazprom and Rosneft’ priority
access to Russia’s offshore resources.40 Gazprom has been given the Sakhalin-3 blocks and
it is rumored that Rosneft’ will soon be offered further Sakhalin acreage. This does not mean
that foreign companies cannot be involved; it is worth remembering that Exxon Mobil has
never had more than a 30 percent share of Sakhalin-1, but it is the project operator. How-
ever, one of the more troubling aspects of the current situation is that companies involved in
exploration have no guarantee that if they are successful and find commercial reserves they
will subsequently retain the development rights.41 Furthermore, both Russian and foreign
companies have made it clear that the current tax regime (see Alexeev and Conrad, 2009),
based on production rather than profit, and the lack of sufficient incentives to encourage
high-cost exploration and development, means that new offshore developments are not an
attractive proposition.42 In the absence of PSA legislation, there appears to be no investment
vehicle providing sufficient stability and protection to encourage substantial new investment
in Russia’s frontier regions.
In a dramatic about-face, on September 24, 2009, Prime Minister Putin invited a group
of foreign energy company executives to a meeting at Salekhard in West Siberia, where he
invited them to consider investing in the development of the Yamal Peninsula and promised
“transparency” and “stability” as the basis for new contracts (Kramer, 2009). Since then,
Russian legislators have been busy re-working pieces of recently introduced legislation,
such as the Subsoil Law, to make them more investor friendly. Since that meeting no major
agreements have come to light, although Gazprom has announced the postponement of its
Shtokhman project that also involves Total and Statoil Hydro, citing adverse market condi-
tions. To understand why the Kremlin is now so anxious to encourage foreign involvement
38
For details, see Bradshaw (2007, p. 274).
39
After Gazprom took control, the EBRD decided that it was no longer appropriate to be offering a loan to a state-
controlled company, and in January 2007 withdrew from the financing negotiations.
40
In the Arctic offshore (including Sakhalin), the state must have a 50 percent interest.
41
For details on the licensing process in Russia from oil exploration through production, see Moe and Kryukov
(2010).
42
Although tax incentives have been introduced to encourage investment in East Siberia and the Sea of Okhotsk,
the Ministry of Finance is seeking to remove them given Russia’s current financial predicament.
in the Arctic offshore, it is instructive to consider the role that the international oil companies
have played in the development of Sakhalin’s offshore.
The Role of the International Oil Companies
Perhaps the major reason why foreign companies have been involved in the development
of Sakhalin’s offshore oil and gas potential is that from the onset the domestic oil and gas
industry (despite having a a wealth of knowledge about the oil and gas fields) has lacked the
capital, technology, and offshore experience to develop them on its own. It is also the case
that without the PSAs the international oil companies (IOCs) would not have been prepared to
invest billions of dollars in frontier oil and gas development. If IOC officials are asked what
it is about their participation that has been crucial to the success of Sakhalin, they will typi-
cally cite the ability to draw upon their global experience to find technological and manage-
rial solutions to the challenges posed by local conditions. And indeed they have encountered
many of those challenges elsewhere: lack of infrastructure, sub-Arctic conditions, sea ice,
seismic risk, and political instability. Yet what makes Sakhalin unique is that it poses all of
those challenges simultaneously.
A large integrated oil and gas project is a network of contractors and subcontractors that
is organized by the project operator. Both Shell and Exxon Mobil have brought with them
to Sakhalin contractor and subcontractor relations that have developed as part of their global
operations. Many companies followed the IOCs to Sakhalin because they work with them
elsewhere in the world. However, the nature of the PSA for Sakhalin-2 complicated such
arrangements because of a “Russian content” clause that mandates that 70 percent of “man-
hours of service provided and volume of material delivered” should come from Russian legal
entities (SEIC, 2006, p. 55). One of the key roles of the Sakhalin-2 Supervisory Committee
is to review major contracts and track performance in relation to Russian content. Sakhalin-1
is not contractually bound to a Russian content clause but has verbally agreed to match the
terms of the Sakhalin-2 PSA. Both operators have devised strategies to maximize Russian
content, including the creation of a Russia-wide database of companies with the expertise and
capability to bid for contracts. From the onset both project operators made it clear to the com-
panies that they work with elsewhere that the preferred entry vehicle for involvement in the
Sakhalin projects was to create a joint venture with a Russian partner (and if at all possible a
Sakhalin partner) or to create a “Russian” subsidiary that would qualify as Russian content.
Although no rigorous third party research has been conducted into the strategies employed
to qualify as “Russian,” there are many success stories of joint-venture partnerships that have
helped create new capacity on Sakhalin, in the mainland Russian Far East, and elsewhere in
the country. There are also examples of ingenious design solutions developed to maximize
Russian content.43 Both project operators have gone out of their way to highlight the high
levels of Russian content that have been achieved. Between 1998 and 2006 SEIC (2006, p.
55) maintains that approximately 78 percent of the total labor costs of Sakhalin-2 and 91
percent of the overall volume of materials supplied derived from Russian content. By the end
of 2008, the total value of Sakhalin-2 contracts awarded to Russian companies was $10.9
billion. In the case of Sakhalin-1 Phase I, ENL has maintained that Russian companies have
received almost 70 percent of the third-party contracts (Taylor, 2009). Both operators have
43
For example, the use of concrete substructures for the Sakhalin-2 rigs enable a good deal of Russian content to
be obtained (from concrete made at Nakhodka), as opposed to using specialized steel that would have to be imported
from Japan or South Korea.
commissioned in-house economic impact assessments, so an independent cumulative assess-

ment of the economic impacts of all of the Sakhalin projects remains to be conducted. None-
theless, from the anecdotal evidence (numerous accounts of new companies being formed or
spun off from formerly state-owned enterprises to service contracts created by the projects)
it is clear that the Russian content requirement has played a major role in maximizing the
economic impact on Sakhalin and neighboring regions of the Russian Far East.
The project operators themselves have also brought key technological solutions to the
Sakhalin offshore. In the case of ENL, the use of ERD and modular construction can be cited
as examples of cutting-edge technology and innovative logistics and management that have
reduced development costs and environmental impacts, as well as accelerating the pace of
development. The Sakhalin-2 project also boasts numerous technological innovations, includ-
ing the construction of Russia’s first LNG plant, the installation of Russia’s first purpose-built
Arctic drilling and production rigs, and the equipping of offshore rigs with special bearings
to cope with seismic activity. In addition, one should not overlook the success of marketing
Russia’s first LNG exports to markets in Asia and North America, such that Sakhalin-2 was
effectively sold out well before the LNG plant was completed.44 Given their Sakhalin expe-
rience, it is clear why Shell and Exxon Mobil maintain that they are in a strong position to
develop Arctic offshore oil and gas potential elsewhere in Russia and the Arctic. Shell, for
example, has taken a strong position in exploration of the Chukchi Sea offshore of Alaska.
In addition to the direct impacts (e.g., employment in oil and gas production), the proj-
ects also have hired thousands of workers during the construction phase, many of them from
Sakhalin. During peak construction, Sakhalin-2’s Phase II employed nearly 25,000 workers.
In fact, at the height of the construction phase there was an acute shortage of local skilled
workers and both projects invested heavily in training programs to create a cadre of local
specialists. In its operations phase, SEIC and its contractors will create 2,400 permanent jobs.
The challenge now is keeping that skills base on Sakhalin, as these workers could easily find
employment elsewhere in the global oil and gas industry.
The increased demand for goods and services, housing, hotels, etc. generated by the
projects have been both a blessing and a curse. Undoubtedly, they have created new opportu-
nities for local businesses, but it has also inflated the cost of living, causing problems for the
local population living on much lower incomes. Again, there has been no systematic research
into the socio-economic impact of the projects on local living standards. Both operators have
developed social programs as part of their corporate social responsibility policies. Many of
these problems are short term, as the projects have now completed their construction phase
and the number of workers on the island has fallen dramatically.
But this creates another problem synonymous with oil and gas projects—the boom and
bust nature of the economic activity associated with them. Along the way the operators have
paid various bonuses to the Russian Government and some of this has been shared with the
Oblast. Upon reaching the commercial development stage, both projects paid $100 over a
five-year period into the Sakhalin Development Fund, which the local administration has
used to plug holes in its budget and develop key infrastructure projects. Both projects have
also invested directly in the development of infrastructure (ports, airports, roads, hospitals,
oil spill response, etc.) to support their projects. According to the project websites, the total
infrastructure expenditure by SEIC is reportedly $600 million and by ENL $150 million.
44
At the 2009 Sakhalin Oil and Gas Conference, Ian Craig, then CEO of SEIC identified the key challenges of
operating on Sakhalin as the ability to conduct many phases of the operation within a short seasonal window (six
months annually); winterization of offshore rigs to operate year-around; and the need to operate in different types of
ice conditions and have a strategy to deal with oil-spill response under ice.
Between 1995 and 2006, SEIC (2006, p. 51) has calculated that it made payments to the
Russian Government totaling $552 million, and by 2008 this had increased to $800 million.
Since start up Sakhalin-1 has paid $2.5 billion in royalties, the state’s share of oil and gas and
taxes, plus $100 million to the Sakhalin Development Fund and $60 million in production
bonuses, for a total of $2.66 billion (Taylor, 2009).45 Unfortunately, all that money is long
gone, and it remains to be seen if the oil and gas projects can provide the basis for sustainable
economic development on Sakhalin.
A project the size of Sakhalin-2’s Phase II is unlikely to be replicated any time soon,
and Sakhalin-1’s gas phase will see limited infrastructure construction on the island. Many
of the companies that came to work on the first generation of Sakhalin projects are leaving.
Although some new opportunities are being created to support oil and gas production and
ongoing exploration activity, there is local concern about Gazprom’s corporate culture of
internalizing its business within its own network of subsidiaries, which might reduce the
number of contracts available for local companies that emerged in tandem with the first-
generation Sakhalin projects. Thus, there is once again uncertainty surrounding the future of
Sakhalin’s economy. One positive aspect of Gazprom’s arrival is its agreement to supply gas
to the southern part of the island, which will greatly improve air quality in Yuzhno-Sakhalinsk
(the current power station burns coal) and provide a much more secure energy supply. The
first generation of Sakhalin projects are now at the start of a production phase that will last
more than 30 years and will generate billions of dollars for the Russian Government. Assum-
ing a forward oil price of $50 a barrel, SEIC maintains that the Russian take from Sakhalin-2
will be $80 billion over the life of the project.46 According to the Sakhalin-1 website (http://
www.sakhalin1.com/en/project/overview.asp), over its lifetime the project will provide $50
billion in revenue to the Russian state, but no information is provided on how this value
derived. It now remains to be seen whether Moscow will share a sufficient portion of that
income to guarantee Sakhalin a prosperous future; given the perilous state of the finances of
the Russian Government, there is limited room for optimism.
CONCLUSIONS: LESSONS FROM SAKHALIN
The Sakhalin saga is long, complex, and still far from concluded, but some key lessons
already can be drawn.
Prospects for Pacific Russia
The Russian Government has ambitious plans for the development of the oil and gas
potential of Pacific Russia. If nothing else, the experience on Sakhalin provides a cautionary
tale that suggests that this development will take longer than expected and will cost much
more money than initially envisaged. In assessing future prospects, I would make a distinc-
tion between onshore development in East Siberia and Sakha-Yakutia and offshore develop-
ment in the Sea of Okhosk (and by analogy the Arctic offshore). Onshore the challenges are
related to remoteness and a lack of infrastructure. Here the domestic industry has sufficient
experience and it is more a matter of time and money. The construction of the ESPO provides
the transport infrastructure to get the oil to market.
45
The higher level of payment from Sakhalin-1 reflects the differing terms of its PSA, which has resulted in pay-
ments from oil and gas production (profits) to the Russian side since start-up.
46
At $70 a barrel the take is $120 billion
However, the higher costs involved with such development need to be compensated
for in the tax regime; otherwise it will not be profitable to invest in new production. This
requires revisions to the current fiscal regime and is a key issue for all companies involved
in frontier exploration and development in Russia. Development of entirely new oil and gas
producing regions under “market conditions” is an entirely new challenge for Russia. If the
incentive system can be created, then the domestic industry (including TNK-BP) can develop
the resource base, although they may continue to need the financial support of national oil
companies and financial institutions in neighboring energy importing countries such as China,
India, and Japan.
The cost considerations are even more significant in relation to offshore development,
where drilling a single exploration well costs more than $100 million and development costs
are in the tens of billions. The Sakhalin experience demonstrates the key role of the IOCs
in providing capital and technology. All of the companies (domestic and foreign) operat-
ing on Sakhalin have made it clear that the current tax and royalty system is not attractive,
and tax breaks have been offered. However, secure property rights are also necessary, as
well as the fiscal and legal stability that PSAs provided to the first-generation projects. The
actions against Sakhalin-2 and the ongoing conflict between Gazprom and Exxon Mobil over
Sakhalin-1 gas do not inspire confidence in the security of property rights. Equally, the cur-
rent instability surrounding key legislation is also a cause for concern. Although this may
have limited short-term impact on Sakhalin, it is a barrier to substantial IOC investment in
the Arctic offshore. Rumors are now circulating that Russia’s legislators may return to PSAs
as a vehicle to attract investors. If this is the case, they will need to be far more effective than
in the 1990s, when years were wasted in conflict over the terms of the agreements. Based on
the lessons learned on Sakhalin, there is no reason why Russia could not develop an effective
PSA regime to encourage frontier oil and gas development should it wish to.
On Sakhalin the infrastructure is now in place to enable year-around export of oil and
gas. This means that the likely next stage is one of incremental growth, rather than new
large integrated projects. Sakhalin-2 has the potential to increase the capacity of its existing
infrastructure and to add a third train to the LNG plant. This means that if Gazprom develops
Sakhalin-3 it can use the existing infrastructure (plus the SKV pipeline) to deliver produc-
tion to both domestic and export markets. Sakhalin-1’s additional gas production is likely to
become part of that scenario, with the additional gas being exported to China and/or used to
supply an additional LNG plant in the Vladivostok region. An LNG-based strategy probably
means partnering with Shell, whereas the pipeline route might be part of a deal with Exxon
Mobil. Additional oil production from Sakhalin-3’s Vensinsky field will be absorbed into the
existing Rosneft’–Sakhalin-1 pipeline system for domestic consumption and export. China’s
SINOPEC is providing the majority of the funds for the exploration phase of Veninsky and
presumably will bankroll development in return for deliveries of oil.
Thus, over the next 5–10 years one can expect to see the development of Sakhalin-3 and
the continuation of exploration activity, but substantial new developments, beyond a possible
third train at Sakhalin-2, are not on the horizon. In part, this is because Gazprom is invest-
ing in new production in Sakha-Yakutia that will complement Sakhalin’s production and
increase gas supplies for export. Gazprom is unlikely to seek substantial foreign involvement
to develop Sakha-Yakutia, which means that its Eastern Program will create few opportuni-
ties for IOC involvement beyond Sakhalin-3’s Kirinskiy block and an agreement with Exxon
Mobil over Sakhalin-1 gas.
Wider Lessons
Russia’s need to develop East Siberia and the Arctic offshore are part of a wider story
that is often summarized as “the end of easy oil.” This notion refers to the fact that much of
the world’s readily accessible oil (and gas) reserves are fast running out. Thus, to keep pace
with growing demand, the global oil and gas industry needs to develop new fields in more
challenging locations, such as the Arctic and deep water offshore. In a Russian context, this
means that as the more accessible fields in West Siberia are depleted new production will have
to come from fields farther north (Yamal) and east (East Siberia, Sakha-Yakutia) as well as
offshore (Sakhalin, Shtokhman, Yamal).
“The end of easy oil” also refers to the changing geopolitics of oil and gas. Today more
than 80 percent of the world’s oil and gas reserves are held by national oil companies, a
marked turn of events from the 1970s when the IOCs were the major reserve holders. Thus
for the IOCs gaining access to reserves means striking agreements with the reserve-holding
states and partnering with their national oil companies. This is clearly what is happening in
Russia and it is what has shaped events over the past decade on Sakhalin. However, to gain
access to those reserves the IOCs also have to deal with a whole range of “above-ground”
problems—i.e., all the political, economic, social, and environmental issues that shape the
progress of a large oil and gas project. These issues have increased the cost and time taken to
develop Sakhalin’s oil and gas reserves, but are not unique to Sakhalin, as similar problems
exist elsewhere in the world (e.g., at Kashagan in Kazakhstan). Therefore, the IOCs recognize
that coping with these issues, as well as “below-ground” geological risks and technological
challenges of working in extreme environments, is how things will be in the future. Thus,
while Sakhalin demonstrates the particular challenges of IOC involvement in frontier oil and
gas development in Russia, it is also part of a broader process of confronting the difficulties
that lie ahead in developing the oil and gas potential of the Arctic offshore. This raises the key
question of whether such high-cost production can be profitable given the potential impact of
climate change policy and uncertainty over the future demand for oil and gas. If the answer is
no, this has serious implications for the future of oil and gas production in Russia, which in
turn has implications for the Russian economy and for global energy security more broadly.
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EASTWARD SHIFT IN RUSSIAN OIL AND GAS?

vided against future deliveries of resources.

HISTORY OF THE SAKHALIN OIL AND GAS PROJECTS

Exploring the Shelf, 1975–1991

Tenders, Production-Sharing Agreements, and Early Oil: 1991–1999

From SODECO-II to Sakhalin-1. The heightened interest in Sakhalin’s offshore

formed Exxon Mobil.

Year-Round Oil and Gas Exports: 1999–2009

Next-Generation Sakhalin Projects

Table 1. Status of the Sakhalin Projects as of September 1, 2006

Table 2. Status of the Sakhalin Projects as of February 1, 2010

Project Financing and Environmental Impacts

billion was provided by a consortium of international commercial banks, insured by Nippon

Reassertion of State Control over the Oil and Gas Industry

The Role of the International Oil Companies

commissioned in-house economic impact assessments, so an independent cumulative assess-

CONCLUSIONS: LESSONS FROM SAKHALIN

Prospects for Pacific Russia

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