Russia's Great Gas Grab

The global economy is held together by silken threads of trust, the belief that contracts will be honored once signed. Without the assurance that governments will honor their agreements, individuals and companies would be reluctant to advance the substantial sums necessary to undertake large scale projects, such as drilling for oil or natural gas.

The ability of the world to generate sufficient energy supplies depends on the willingness of investors to take huge risks in exploring and developing new oil and gas fields overseas. Often, that development must take place in lands not fully integrated into the modern capitalist economy. When the technical risks are amplified by the addition of the risk of arbitrary government actions, energy development will naturally slow down. Supply will be constrained, and prices will rise even higher.

Russia is in effect muscling in on the highly promising but very expensive natural gas field Shell Oil and its Japanese partners Mitsui & Company and Mitsubishi Corporation have developed off Sakhalin Island, east of Siberia and north of Japan. Much of the construction work is done, but further work has been delayed by administrative considerations. The project had experienced substantial cost overruns. [Full disclosure: the author has worked as a consultant for both Mitsui and Mitsubishi over a considerable period of years in the past.]

The Project

Sakhalin 2, as it is known, is an offshore natural gas field, set to purify, cool and condense gas to about 1/614th of its volume at atmospheric pressure, and ship it to Japan , South Korea and the US on highly specialized expensive cryogenic LNG tankers, where the gas will be warmed and fed into distribution via conventional gas lines. LNG projects are of necessity large, expensive, and technically challenging.

The very first large scale LNG project opened in Algeria, in 1964, supplying Britain and France. Since then, large projects have opened in countries like Indonesia, Brunei, Qatar, Malaysia, Nigeria, and others, including the United States.

At present, it is estimated that $22 billion (or more) will be the final cost to complete development of Sakhalin 2, with Shell owning 55% of the project, Mitsui 25% and Mitsubishi 20%. Russia, via its giant monopoly natural gas company Gazprom, has let it be known over the past several months that it wanted a chunk of the project, probably a controlling interest, for itself. In effect, having earlier lured the companies into pouring billions of dollars and huge amounts of effort into the project, once the project appeared to be a success, Russia has moved to grab a bigger share of the pie, previous agreements be damned.

Playing Hardball

Natural resource industries have a sordid history of exploitation by both companies and governments. In the past bribery and highly imbalanced terms sometimes gave companies the upper hand as resources were wantonly plundered. But since the 1960s, states with potentially lucrative natural resources have played harder to get.

The monopoly on the legitimate use of force enjoyed by states usually gives them the ultimate bargaining leverage in the contest. They can send in soldiers and take over whatever physical installations exist, and companies, aside from those few which have hired mercenaries in the past, are powerless to stop them, at least in the immediate time frame. Soldiers command territory with "boots on the ground," whether in the copper mines of Katanga or the oil fields of Libya.

But operating a natural resource extraction facility, especially a large one, requires many specialized inputs, and also requires smooth handling of the output. If skilled manpower, technology, transport, spare parts, distribution channels, financing, and many, many other necessities are denied to an expropriated property, governments have a hard time profiting from them.

But when governments forego the military option and merely use regulatory pressure, they can often avoid the most unpleasant consequences of outright physical expropriation, including the sort of retaliatory denial of necessary inputs. They prefer to incrementally inflict costs on the companies, to demonstrate that a little "protection" is in order, otherwise matters could become even more unpleasant.

One of the means of extortion Russia has been using is environmental regulation. From the Moscow Times

The Natural Resources Ministry has mounted a campaign of inspections by its environmental inspectorate and threats of administrative sanctions against Sakhalin-2, the only big energy project entirely in foreign hands.

Partly as a result, a deal is taking shape for Gazprom to buy into the scheme that includes the world's biggest liquefied natural gas project, which is due to start supplying Japan, South Korea and the United States in mid-2008.

The water resources agency has suspended 12 water-use licenses held by Sakhalin-2's main contractor -- Russian-Italian joint venture Starstroi -- and given it two on Wednesday, Interfax quoted the agency's head, Rustam Khamitov, as saying he doubted that the contractor could rectify the violations and that the licenses would be suspended.

This would prevent the group from finishing pipelines linking gas fields in the north of Sakhalin with the liquefaction plant in the south.

Analysts say pressure from the state, notably from environmental inspectorate official Oleg Mitvol, is part of a wider drive to increase Kremlin control over the strategic energy sector.
It is, of course, extortion. In its defense, Russia points out that the West has been extorting large sums form oil companies itself, over environmental issues. One has to admit they have a point.

But it is all perfectly legal (states make the laws, after all), and sometimes almost a genteel-seeming process. Guys in three thousand dollar suits engaging in extortion observe certain niceties of language and protocol, but the underlying process can be almost as brutal as sending in the troops. Thus, for instance, last week, the head of Shell, who met with the head of Gazprom over the terms of the extortion, issued an almost flowery statement, as reported in the New York Times:
A Shell spokesman, Maxim Shoob, confirmed today that Mr. van der Veer met last week with the chief executive of Gazprom, Aleksei B. Miller. Mr. Shoob said the talks were "quite positive and very constructive," but offered no details.
Why Russia Needed Shell, Mitsui and Mitsubishi

Russia possessed a large domestic oil and gas industry in the Soviet era. It was, however, notoriously behind the technical levels of the West, and following the collapse of the USSR, foreign technologies were believed capable of substantially improving production. For a period of time, foreigners have been allowed to invest in oil and gas, so as to bring with them the technology (and capital) Russia lacked.

But in the long run, Russia's leader Putin seems fully determined to ensure that Russia be able to supply all important oil and gas technologies from a domestic manufacturing and engineering base. To be dependent on foreign suppliers for production technology weakens the overall bargaining position of the Russian state. Should push come to shove, Russia does not want to be crippled by any cutoffs coming in retaliation for its flaunting of agreements.

The aggressive move on Sakhalin 2 confirms that Russia is moving toward a far more confrontational posture toward the rest of the world. Russia has shown a willingness to cut off gas supplies to Europe, as it demonstrated on Ukraine, using energy as a political weapon to intimidate other states. Putin knows that Russia's energy resources are a trump card in his effort to restore his native land to the status of superpower.

But there are limits. Russia still wants foreign companies to play a role, albeit one not so prominent as originally envisioned in Sakhalin 2, 100% foreign owned. There is more development scheduled off Sakhalin, with other companies, like BP, involved.  They, too, must now factor in a great political risk in their calculations of the returns necessary to justify their investments.

Shell and Russia have not agreed on terms of separation, as it were. They have to negotiate, a lop-sided exercise at best. In the end, Gazprom will probably in theory "buy" approximately half the stakes of foreigners, out of "royalty income." But in practice, it will be a form of expropriation, intended to give Russia operating control of something built and paid for by others. With this control, Russia can better master the complex technologies, and make them its own, as it were.

Shell, Mitsui and Mitsubishi have no choice but to make the best of it. They will smile and talk about great progress being made, hoping that Russia will allow them to achieve some return on their investment, in order to keep their resources available in the future.

We often carelessly assume that the march of progress will continue inevitably, secured by the triumph of market economies. While it is true that capitalism provides a demonstrably richer life for its beneficiaries, many powerful forces in the world do not find themselves advantaged by it. Russia, Islamofascists, and certain Euro-Socialists would rather see market forces confined and a greater number of important decisions in the hands of state or religious bureaucrats.

Russia's move against the Shell consortium is a blow against the regime of international capitalism, in the end. By itself, it is not a major affair, but as a harbinger of things to come from Russia, it is as chilling as the Sakhalin LNG whose shipment will now be delayed by Russia's hardball tactics.

Thomas Lifson is the editor and publisher of American Thinker.
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