Sakhalin as a Global Energy Power Play

In the new issue of Condé Nast Portfolio, there’s a great extended feature and photo slideshow about Vladimir Putin’s ambitions with the energy reserves of Sakhalin Island, which have brought outstanding prosperity to some islanders while leaving others in the lurch. A fairly standard item of magazine journalism of a provincial backwater going through vast and rapid economic changes, but some excellent images are offered. Some highlights after the cut. The LNG plant of the Sakhalin II energy site. (Photo: Donald Weber) Steve Burt, a Sakhalin Energy manager in charge of part of the ambitious trans-island pipeline project, has one of the hardest construction jobs on earth. The pipeline crosses 1,100 waterways and 21 seismic zones along its roughly 500-mile route. (Photo: Donald Weber)

From Portfolio:

European leaders issued nary a peep when Shell gave in to Gazprom, and with good reason: Russia provides Western Europe with a quarter of its gas and oil. Putin could flip a switch and families from Paris to Milan would go to sleep with their coats on tonight. On New Year’s Day 2006, Gazprom chief Alexei Miller did more or less just that, cutting gas supplies to Ukraine amid a price dispute. The message to Europe was, in inimitable Kremlin fashion, at once oblique and menacing; look at a map and you can see that the gas Russia sells to Europe is routed in large part through Ukraine.Not only Europe took note. Once Sakhalin II opens its pipelines next year, close to 20 percent of the island’s natural gas will find its way to the United States and another 20 percent will be sent to South Korea. The remaining 60 percent will go to Japan. “This is the project that’s going to make Russia an Asian power,” says Rawi Abdelal, a professor at Harvard Business School who has written a series of case studies on Sakhalin II.Thanks to energy and the new Russian brand of “state capitalism” it supports, Putin has returned his country—not long ago considered the invalid at Europe’s doorstep—to center stage. He has revived Russia’s military, maneuvered Russia toward admittance into the World Trade Organization, blocked United Nations sanctions against Iran, and cut deals with Venezuelan president Hugo Chávez and North Korean leader Kim Jong Il, to name two of the West-irking politicians he has cozied up to. The country’s energy economy has allowed Putin to exert an ever-tightening grip on Russia, creating what some fear may become a kind of totalitarian republic. He has rendered the Russian Federal Assembly impotent, centralized control of the media, and jailed or exiled tycoons—all part of what the Kremlin, with its dependable flair for ominous understatement, calls “managed democracy.” Vast energy resources have also allowed Putin to set about making genuine governmental reforms, root out corruption, and pour money into social services.And all of it—his despotism and benevolence alike—has left him wildly popular. While George W. Bush endures approval ratings of about 30 percent as his presidency sputters to a close, approval ratings for Putin, who is due to step down in March, hover around 70 percent.To many observers both inside and outside Russia, the Kremlin’s dependence on energy is precisely the danger. A great deal of the country’s future is pegged to steadily rising oil and gas prices, but as history has shown, what goes up always comes down. The path the Russians are on is “a pretty risky one,” says Ed Chow, a senior fellow at the Center for Strategic and International Studies in Washington. “What else do they have to sell besides energy? There are only so many fighter planes you can sell to China.”“There is gross inefficiency in the way the Russian energy market functions,” Burgansky, the analyst for Renaissance Capital, concedes. Inefficient or not, Russia has the advantage. The second-largest gas reserves in the world are in Iran, and those are roughly half the size of Russia’s. A Gazprom official in Moscow points this out with glee. “Who can be a bit more reliable,” he asks, the Russians or the Iranians?…Quality control is a big problem. “We’re trying to build this to Western standards,” Burt tells me, but “the Russians don’t have any of these standards—or any standards, really. You can see, every day, pipelines blowing up in Russia. There are whole areas of Russia contaminated from leakage. They have all the regulations. They’re just not using them. We had a guy from Gazprom come in. He said to me, ‘If we were doing this, it would be done by now. The problem is you’re trying to do it legally.’ ”Still, Russia did not hesitate to invoke regulations to muscle its way into Sakhalin II. Environmental groups had been on Sakhalin Energy’s case since it began operating in the late 1990s, but the Russian government mostly ignored them. Then in 2006, after negotiations to give Gazprom a minority stake in Sakhalin II fell apart, Russian authorities began citing Sakhalin Energy for alleged violations. One example: Excessive logging of the pipeline corridor and poor terracing of its perimeter were creating severe erosion problems all along the pipeline route. And international environmental groups, the World Wildlife Fund among them, complained bitterly that Sakhalin Energy’s construction activities in Aniva Bay, including an undersea pipeline, had disrupted fish and whale populations. Using such charges as leverage, Russian authorities revoked permits and demanded work stoppages. According to a Sakhalin Energy employee, Yuzhno-Sakhalinsk police set up shop outside the company’s headquarters and checked work visas. Shell was threatened with a $50 billion lawsuit.It was from the Kremlin, everyone suspects, that an offer came: Sell majority control of Sakhalin II to Gazprom and the trouble will cease. So that’s exactly what Shell did. It handed over half its shares to Gazprom, which also acquired half the shares of Shell’s Japanese partners, Mitsubishi and Mitsui & Co., giving Gazprom 50 percent of Sakhalin Energy plus one share. (No one can accuse Putin of being overly greedy in this case.) Gazprom agreed to pay $7.45 billion for its stake. As part of the deal, Shell reportedly agreed to pay millions in cost overruns and will face new taxes. “I would be surprised if Shell got any cash out of Sakhalin II,” says one U.S. analyst working in Russia.For Shell’s part, a spokesperson says, “This is an acceptable deal for us. We have a major stake in the world’s largest oil and gas export project, with Gazprom as a strong partner.” As for the environmental accusations, the spokesperson adds, “Sakhalin Energy has always stated that all environmental impacts are short-term and reversible.”Shell’s problems, however, haven’t totally evaporated. As part of its contract, the oil giant agreed to pay for infrastructure projects and social programs on Sakhalin. According to Sakhalin Energy, Shell spent more than $390 million building and paving roads and putting in an airstrip (improvements that benefit Sakhalin Energy as much as they do Sakhalin Island). But the permanent housing Shell promised to residents of Korsakov who live near the plant hasn’t been completed, fueling further resentment among locals, many of whom were previously upset about environmental issues. The Shell spokesperson contends that Sakhalin Energy has stimulated the local economy and “provided benefits to the local community in terms of direct and indirect employment, local taxes and revenues, and social development programs.”Perhaps part of the resentment is a feeling that Sakhalin Energy takes care of its own in lavish style. It has built a gated community south of Yuzhno-Sakhalinsk for its international executives. The mini-suburb has roads lined with colonial-knockoff homes and manicured lawns, as well as its own school. Sakhalin Energy says these amenities are necessary to attract professionals to the island and keep them safe. But the luxuries have also contributed to massive cost overruns. Sakhalin II’s original budget was $10 billion. It’s now more than double that. Shell lays much of the blame for being over its budget on the rising costs of energy and energy-related services. Many experts find this explanation laughable. For one thing, Shell never saw fit to disclose its overruns to Gazprom in the early stages of negotiation. “The Russian guys were understandably furious,” says Abdelal, the Harvard Business School professor. Perhaps even more galling to the Russians was that Shell seemed to be counting on turning a profit no matter how much it spent. This confidence stemmed from the highly favorable contract Shell had with Russia….Gazprom headquarters aren’t in central Moscow, as one might expect, but in Cheryomushki, a bland district of huge apartment blocks and wide boulevards in the southwestern corner of this churning city of 11 million. To get there, you have to take the metro and then a bus. Once you arrive, however, there’s no question that you’re in the right place. Gazprom’s offices, hulking buildings encircling a cement-and-blue-glass skyscraper, loom like the Aniva Bay plant.Gazprom has 430,000 employees, but only a few of them are permitted to talk to journalists. And the Gazprom official who finally agrees to meet with me isn’t one of them, so he can’t be identified. He speaks careful and labyrinthine English. Although Gazprom owns media outlets and has little need of the outside press, the representative is still polite and patient. And inscrutable.“What will happen to Gazprom if global energy prices go down?” I ask as we sit down at a table in a sterile cafeteria.“That is not predicted,” he answers, with a smile. What is predicted, he says, is that Gazprom’s market capitalization will reach $1 trillion not too long from now. (It recently surpassed $290 billion.)“But what if the global credit crunch gets worse, and foreign firms decide to pull their money out of the historically volatile Russian market?”“Right now the reality does not seem that it will be so,” he says.“What if Europe decides to start diversifying its gas supplies?”“Why?” he counters. Outside Russia, the biggest reserves are in Iran and Qatar. “That’s why it’s good having Gazprom fulfilling these contracts,” he adds.His confidence is understandable. Forged from the state gas ministry in the early 1990s by Viktor Chernomyrdin, Yeltsin’s prime minister, this “natural monopoly,” as Russian officials like to call it—again, the beautiful phrasing—would be almost unthinkable in the West. Gazprom controls close to 90 percent of the Russian gas market and maintains the largest distribution system anywhere in the world—a 97,500-mile network of pipes that stretches from the Baltic Sea to the Pacific. In 2006, the Duma, the lower house of Russia’s Federal Assembly, passed a law essentially making Gazprom the only legal exporter of Russian natural gas. And what an exporter it is: Russia provides an estimated 26 percent of France’s gas, 30 percent of Italy’s, 43 percent of Germany’s, 70 percent of Austria’s, and 100 percent of Finland’s. Measured by reserves, Gazprom is the biggest energy company in the world.Considering how natural gas is quickly becoming the fuel of choice for industry and government services, these figures seem even more significant. Natural gas is cheaper than oil and, in an increasingly carbon-conscious world, cleaner than oil or coal. Between 1990 and 2004, natural-gas demand in Europe grew 66 percent; in the Pacific, it increased 76 percent. In China and India, the world’s two fastest-growing economies, it has more than doubled.Gazprom owns or has a stake in more than a hundred subsidiaries throughout Russia, Europe, and Central Asia. It has its own bank. It has vast holdings in manufacturing, media, real estate, electricity, and just about everything else. Gazprom also maintains a private army to guard its pipelines. Yet even as the West grows increasingly fearful of this state within a state, it is aiding Gazprom’s rise. Former German chancellor Gerhard Schröder now works for Nord Stream, a Gazprom pipeline project that will link Russia and Germany. Banks in the U.S. and Europe (particularly in Germany, where Putin, who was a K.G.B. agent in Dresden in the 1980s, has deep connections) fund its deals. The American firm Ketchum is among the companies handling Gazprom’s public relations, and Washington lobbyists work for some of its trading partners.Then there is Gazprom’s Kremlin clout. Chairman Dmitri Medvedev also happens to be Putin’s first deputy prime minister and, until recently, was mentioned as a front-runner to succeed him as president. German Gref, Putin’s former minister for economic development and trade, sits on the board, as does Viktor Khristenko, minister for energy and industry. Igor Sechin, chairman of the Rosneft board, is Putin’s deputy chief of staff. Many of them are old Putin cronies from St. Petersburg, where Putin worked in the mayor’s office after leaving the K.G.B. It was there that Putin assembled his inner circle of siloviki, the former intelligence officers and men with military training who share his nostalgia for the Russian empire and now fill the upper ranks of the Kremlin and most of the state-controlled conglomerates. Gazprom’s Kremlin ties are also a selling point for Western banks and investors who want assurances of stability.Gazprom claims that although half its shares are owned by the state, about 500,000 private investors own the rest. The question on many Russians’ minds is just who all those investors are. Gazprom actually consists of a mind-boggling patchwork of holding companies and subsidiaries, and speculation swirls around Moscow about suspect offshore-investment vehicles controlled by various siloviki. Putin’s own stake in the company is a matter of speculation. There is no way to determine the precise figures in Russia, where corporate governance—to say nothing of transparency—is a new and impertinent idea. “Putin is the C.E.O. of Gazprom,” a U.S. diplomat working in Russia tells me.