Oil Lights The Way

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Since the Soviet fall, Sakhalin Island, off Russia's eastern edge, has seen more than its share of ebullient executives from Western oil giants prospecting for black gold. But few have kept their confidence for long. Most have endured frustrating years waiting for deals to be signed, as bureaucracy, xenophobia and corruption combined to thwart their dreams of bringing Sakhalin's well-known oil riches to the outside world. But in recent months, the oilmen have turned almost giddy--buoyed in equal measure by the high price of crude and President Vladimir Putin's pledge to build a legal foundation for the West's multibillion-dollar oil bet on Russia.

The country boasts world-class oil and gas reserves, on a par with those of the largest OPEC producers. The problem is getting the oil out of the ground and to market. Years of Soviet mismanagement and underinvestment have taken their toll. Russia's oil fields are in dire need of rehabilitation; Sakhalin's north and much of Siberia are littered with rusting derricks ringed by porous labyrinths of old pipelines. Local environmentalists, pointing to the recent spill near the Galapagos Islands, worry about the potential damage to Sakhalin's rich ecosystem caused by toxic drilling waste.

Before Russia's 1998 economic crisis, when the ruble collapsed, local oil moguls were certain of their ability to lure Western companies into developing the long-neglected fields. They know better now. "Russia has learned its lesson," says Glenn Waller, head of the Petroleum Advisory Forum, an association of Western energy majors invested in Russia. "It can't rely on old fields. It needs to develop new ones. And to do that it needs capital and expertise."

In recent years, however, Russia has seen its foreign capital pool drain as wildcatters turned to more welcoming political and economic situations in Asia, Latin America and even other former Soviet republics. Since 1987, oil production in Russia has fallen from 11.8 million bbl. a day to an estimated 6.3 million in 2000.

If the decline is to turn around in the near future, Sakhalin is where change will begin. Once a czarist penal colony, then little more than a Soviet air base, Sakhalin is now home to the largest foreign investment projects in Russia. These deals, totaling some $26 billion, are long-term oil and gas Production Sharing Agreements--PSAs, in the argot of the oilmen--that offer the legal framework that Western companies require if they are to make major capital outlays in developing Russia's oil, gas and mineral deposits. The deals grant foreign companies export rights and tax breaks, while Russia gets a share of the petroleum flow.

The leading PSA, known as Sakhalin 2, is run by Sakhalin Energy, a consortium led by Royal Dutch/Shell, Europe's largest oil company, with a 55% stake. At $10 billion, it is Russia's largest single foreign investment project. It is also the market's first and only success story to date. It required more than 1,000 permits, but last year Sakhalin Energy's Molikpaq rig produced 1.6 million tons of oil, more than 80,000 bbl. a day, during the ice-free season from June to December.