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Reference ID Created Released Classification Origin
06MOSCOW10984 2006-09-28 14:34 2011-08-30 01:44 CONFIDENTIAL Embassy Moscow

DE RUEHMO #0984/01 2711434
O 281434Z SEP 06

C O N F I D E N T I A L SECTION 01 OF 04 MOSCOW 010984 
E.O. 12958: DECL: 09/28/2016 
Classified By: Amb. William J. Burns.  Reasons 1.4 (b/d). 
1. (C) Summary.  From discussions in Moscow and Sakhalin this 
week, Production Sharing Agreements (PSAs) may be out of 
favor, but they are far from being driven out of business. 
Shell (Sakhalin-2) appears to have dodged the bullet of 
having its environmental license revoked, but still faces 
tough negotiations with Gazprom and the GOR on asset swaps 
and cost overruns, respectively.  ExxonMobil (Sakhalin-1) is 
getting splashed by the mudslinging surrounding Shell, but to 
almost no effect; the first tanker loading from the De-Kastri 
port is expected to go forward October 5.  Putin and many of 
Russia's elite seem to resent the PSAs as unwelcome reminders 
of a weak moment in Russia's past, but the emerging line for 
both supporters and opponents of PSAs is one of strict 
adherence, for all sides.  In practice, that means the GOR 
will not try to annul existing PSAs, but PSA holders are 
being clearly warned to strictly abide by the terms of their 
agreements and Russian regulatory processes.  The alternative 
is unhappy since any move to annul one of the three existing 
PSAs would certainly end up in Stockholm arbitration.  End 
2. (C) This note reflects on a number of meetings the week of 
September 25, including the Ambassador's September 27 meeting 
with the head of the ExxonMobil's (EM) Moscow office, Ben 
Haynes, and additional meetings between Econ M/C and 
officials and company representatives on Sakhalin Island. 
Sentiment Towards PSAs Souring 
But Revocation Not An Option 
3. (C) The upbeat mood in the Sakhalin Governor's office this 
week was in stark contrast to the harsh rhetoric swirling 
around the issue of PSAs in Russia's capital.  The sour mood 
in Moscow reflects an emerging, but deeply held view by Putin 
and the key officials around him: the three PSAs signed in 
the mid-1990s were good for Russia then, but are 
"sub-optimal" by today's boomtown standards.  Yet, while some 
may dream of extracting better conditions from their PSA 
partners by whatever means they can, it seems clear from our 
conversations this week that there is no appetite in Sakhalin 
to see existing PSAs overturned. 
4. (C) In a September 25 meeting, Sakhalin Governor Ivan 
Malakhov was explicit on this point, at times implying he was 
not sure what his colleagues in Moscow thought they were 
doing.  He categorically opposes canceling existing PSAs, but 
he also expects rights holders to comply fully with their 
obligations under Russian law and the terms of their 
contracts.  Malakhov's position makes sense: his oblast has 
begun to see a significant revenue stream since first oil at 
Sakhalin-1 a year ago ($50 million so far), and there is more 
to come once tanker loadings begin from the De-Kastri 
terminal next week and export volumes rise to 250,000 barrels 
per day (b/d).  The biggest threats to future money flows 
from this project to the oblast are regulatory setbacks, and 
thus his expectation that the PSAs on the island are run 
well, and regulatory issues be dealt with promptly. 
Sakhalin 1 and 2 Perceived Differently 
5. (C) Malakhov sees significant differences between the 
management of the Sakhalin 1 and 2 projects.  He praised EM 
(the operator of Sakhalin 1) as "flexible" and "responsive," 
dealing with issues expeditiously, and maintaining a solid 
dialogue with local authorities.  About the management of 
Sakhalin 2, Malakhov was less complimentary, criticizing 
Shell for letting issues "pile up" and complaining that the 
firms' local representation seems two-headed, by which he 
meant both uncoordinated and lacking HQ-connected leadership. 
 Malakhov refused to be drawn out on whether he thought 
Minister of Natural Resources Trutnev and other federal 
authorities were acting "aggressively" with respect to PSAs 
or Sakhalin 1 in particular, but he didn't leave the topic 
without restating his conviction that while existing PSAs 
should not be cancelled, neither should poor management 
practices be tolerated. 
The View Of/From Shell 
MOSCOW 00010984  002 OF 004 
6. (C) From discussions this week in Sakhalin, it appears 
that Sakhalin 2 has had its share of problems, including 
reportedly 18 job-related deaths, which one insider said was 
a sure sign that there were other problems beneath the 
surface: safety is usually the top priority in multinational 
projects.  It may be that Sakhalin 2 management, because of 
the magnitu
de and tight timetable of the project has had a 
hard time keeping on top of its numerous sub-contractors 
(there are some 17,000 employees right now).  It was a 
subcontractor (now fired) that was responsible for the August 
RosPrirodNadzor (RPN) negative inspection finding that 
appears to have "triggered" the near-revocation of Sakhalin 
2's 2003 State Environmental Expert Review (SEER) 
certification.  Sakhalin Energy (the Shell subsidiary running 
the project) may also not be aware that its relationship with 
local authorities is slipping -- "local government is very 
supportive" top management told us confidently, only days 
after the local government (who otherwise has nothing bad to 
say about PSAs) had been upset enough about Sakhalin Energy 
to complain openly to a foreigner about the firm's behavior. 
7. (C) That said, it is unlikely that Sakhalin Energy has so 
badly botched the job as to deserve the kind of reputational 
pressure they have been put under this month.  Project 
Director, David Greer, told us September 27 that Sakhalin 2 
has been subject to over 5,000 inspections over the past 
year.  The current problems with RPN, he believes, stem from 
a summer trip to Sakhalin 2's nearly-completed LNG terminal 
by DPM Dmitry Medvedev.  According to Greer, after having 
seen how close Sakhalin 2 was to starting LNG exports 
(expected in 2008) Medvedev pushed to get the Gazprom-Shell 
asset swap that has been on hold for a year moving again. 
Like many analysts in Moscow, Greer believes the actions of 
RPN are just noise intended to soften up Sakhalin 2 
shareholders, driving down the perceived value of Sakhalin 2 
in advance of their September 29 meeting with Gazprom. 
8. (C) According to the British Embassy, Dutch PM Balkenende 
reached out to Putin by phone this week to protest rumors 
that Sakhalin 2's 2003 SEER had been revoked.  Putin is 
reported to have called the PSAs "colonial era agreements" 
while agreeing to pull back the threat to the SEER.  Putin 
made a point, according to our British colleague, of urging 
PSA management companies to be diligent in their adherence to 
their obligations under Russian law. 
And The View From ExxonMobil 
9. (C) Exxon Neftegaz (EM's Russian arm) Executive VP Jim 
Taylor related to us this week that a grudging sense of 
unfairness seems to be what motivates watchdog agencies like 
RosTekNadzor (RTN -- which some compare to OSHA) and RPN (an 
agency within the Ministry of Natural Resources (MNR) 
responsible for environmental issues in the energy sector) to 
plow through piles of documents and examine endless miles of 
pipe and facilities in search of fault.  EM was investigated 
some 60 times this year alone.  Taylor said that Exxon 
Neftegaz has been quick to address concerns raised in the 
inspection process, preferring to keep Sakhalin 1 moving 
forward rather than argue with the regulators. 
10. (C) As an example, Taylor cited environmental issues 
raised by RPN about the De-Kastri port, where tanker loadings 
are expected to start on time October 5.  The inspection 
resulted, among other things, in the firm's extraordinary 
paving over of a sewage basin -- a requirement not found in 
Russian law, but raised by the inspectors.  The announcement 
last week of a relatively minor set of environmental issues 
surrounding De-Kastri (including the already resolved issue 
of the paved sewer basin) surprised Taylor somewhat.  He 
speculated that the inspector may have come under pressure to 
say something publicly about Sakhalin 1 on the day Shell's 
SEER appeared pulled -- even though the two events were not 
comparable.  Likewise, Haynes told the Ambassador that the 
press had greatly exaggerated the concerns over the De-Kastri 
oil terminal.  He said RTN had, in fact, given the project 
"rave reviews" for its environmental compliance.  Haynes did 
note with concern, though, that RTN head Pulikovskiy made 
"sharp" public comments about both Sakhalin projects 
MOSCOW 00010984  003 OF 004 
subsequent to this. 
With Time, GOR likely to Expand 
Scope of Chayvo Field 
11. (C) Exxon Neftegaz President Stephen Terni expressed 
confidence in a meeting September 27, that the Chayvo field 
problem, whereby a portion of the oil field was inadvertently 
left outside the original PSA are, will eventually be solved. 
 Terni and Taylor maintain that granting Sakhalin 1 rights to 
the parcel is just good field management practice for any 
government, and that such a contingency was foreseen and 
covered in their 1996 PSA.  Rosneft VP Peter O'Brien (Rosneft 
is one of Exxon's partners in the project) agrees, and both 
sides confirm that Rosneft and EM have formed a united front 
against the Ministry of Natural Resources.  The heat behind 
this issue -- which in many places around the world would be 
considered routine -- appears tied (again) to general pique 
surrounding PSAs.  One of Malakhov's assistants told us after 
the meeting with the Governor that this is a clear case of 
the government not wanting to give the firm another chunk of 
reserves at "1996 PSA price...no more cheap deals for 
12. (C) Taylor believes that with time, the obvious mistakes 
made by MNR in this case will fade in the collective memory, 
allowing the project to move forward quietly.  Taylor noted 
that MNR had already ruled once in the firm's favor on this, 
and thought they would do so again.  Rosneft's O'Brien shares 
Taylor's confidence that the situation is already on its way 
to resolution, and while he would not go so far as to exclude 
the possibility of the parcel coming (back) into the 
consortium via auction, he doubted that outcome very much. 
13. (C) Haynes was, perhaps, a little less sanguine on Chayvo 
during his meeting with the Ambassador.  Despite rebuffing a 
suggestion at a recent meeting with MNR that re-opening the 
PSA would help "resolve" the Chayvo issue, Haynes said that 
he felt the Ministry was willing to work constructively with 
EM.  Nevertheless, Haynes said that some in EM are "very 
close" to employing a dispute resolution mechanism included 
in the PSA that would require taking the case to Stockholm. 
He recognized, however, that such a move would be quickly 
picked up by the press and may be unhelpful for some of their 
other equities in Russia. 
Cost Overruns? 
Sakhalin 1 - A Little 
Sakhalin 2 - Yes 
14. (C) Last week, a story surfaced in the press that EM 
faces significant cost overruns at Sakhalin 1.  Haynes said 
that these reports were generally inaccurate, maintaining 
that the 2001 development plan foresaw spending of $12.1 
billion in constant 2002 dollars.  Factoring in foreign 
exchange fluctuations since then, he said the consortium is 
within ten percent of their per-barrel spending estimates. 
Haynes mainta
ined that this was an "extraordinary" result for 
a project of such magnitude.  According to Taylor on 
Sakhalin, the discussion in any event is purely theoretical 
at this point, as EM gas only spent $6 billion, and it will 
take until 2012 (when the bulk of the project should be up 
and running) to determine if the cost estimate was correct. 
It was not clear to Taylor why this old bit of news was 
surfacing now. 
15. (C) The situation with Sakhalin 2 is different.  Sakhalin 
2 is near the end of phase II of a two-phase project, and the 
cost overruns they cited a year ago in August were based on 
actual, not projected, overruns.  Sakhalin Energy agreed with 
the GOR on a $9.6 billion price tag for the project in May 
2003.  In the meantime, explains Greer, approvals took 
longer, steel prices rose, and contractor costs ballooned -- 
all of which put huge pressure on the budget.  By early 2004, 
it was already clear that costs would exceed $13 billion, and 
that estimate rose by early 2005 to almost $20 billion.  The 
public announcement of the cost overruns in August 2005 
(right after the Gazprom-Shell asset swap MOU was announced) 
was driven by public disclosure requirements associated with 
Shell acquisitions elsewhere in the world.  Since Sakhalin 2 
MOSCOW 00010984  004 OF 004 
is a full-cost recovery PSA (unlike Sakhalin 1 which is on an 
85 percent cost recovery basis and therefore is paying out 
some to the GOR) the overruns will delay the GOR's expected 
pay out date. 
16. (C) It appears that EM's Sakhalin 1 project is much less 
exposed to GOR pressure tactics than is Shell's Sakhalin 2 
venture.  Moreover, the latest interest in the PSAs 
(including Total's Kharyaga project) is likely driven by a 
host of factors: the perceived unfairness by the Russians of 
the PSAs' terms, Gazprom's drive to get into these projects, 
intra-governmental rivalries, and the fact that foreign 
companies have majority control of significant energy 
projects at a time when this sort of deal structure is out of 
favor with the GOR.  Despite all of this, according to the 
people we have spoken to, this renewed attention will most 
likely stop well short of PSA revocation.  We are 
consistently hearing from EM and Shell, and for now we agree, 
that the best short-term course of action is to ride out the 
current tempest calmly, with little public comment, while 
continuing privately to let the GOR know we are watching.  A 
more aggressive strategy would be warranted if things take a 
turn for the worse in coming weeks, such as over EM's 
"dispute resolution" situation or over Shell's upcoming SEER 
court cases that will unfold in coming weeks that could throw 
Sakhalin 2 into crisis and embolden the Russian authorities. 


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