Coming Out Negative in the Balance

Russia’s temporary halt to oil supplies through the pipeline crossing Belarus earlier this month was the latest in a sequence of public relations disasters for the Kremlin. The West’s romance with President Vladimir Putin’s Russia ended with the Yukos affair and since then Russia has generally gotten bad press, even when it had a good case. The Sakhalin-2 affair is a good example.

Early in December, Royal Dutch Shell announced that it had sold Gazprom a majority stake in the project to develop the Sakhalin gas field. In its Dec. 8 edition, The Economist magazine accused the Russian state of using “minor environmental infringements” to force Shell and its partners to sell out to Gazprom at the moment when they stood ready to receive a “flood of revenues.” Such “loutish” behavior was incompatible with Russia’s claim to be a reliable energy partner. The Russian case for action, based on the impact of Shell’s cost overruns on the expected revenue of the Russian state, was simply ignored.

The key point of the original deal signed in 1994 was that the Russian state would only start receiving a share of revenues from extracted oil and gas once the Sakhalin Energy Investment Company — now Royal Dutch Shell, Mitsui and Mitsubishi — had recovered its costs and made a 17.5 percent real rate of return. The contract had no cost cap nor any indication of what costs were non-recoverable. This left Shell with no incentive to exercise cost control. In fact, the opposite was the case: By inflating its costs and keeping its rate of return just under 17.5 percent it could prevent the Russian state from sharing any of the revenues until some indefinite point in the future.

This became more than a theoretical possibility when Shell announced a 20 percent, or $2 billion, overrun in 2004, and a further overrun of $10 billion in 2005. The issue became one of whether costs have escalated because of inherent difficulties with the project (as Shell has argued) or whether they have been artificially inflated to postpone payments to the Russian state (as Russian officials claim). Either way, the revenue about to come on stream was not headed in Russia’s direction.

After several failed attempts to revise the contract, the Kremlin cut the Gordian knot by “persuading” the Sakhalin Energy Investment Company to sell a majority stake to the state gas company Gazprom for $7.5 billion. That way the Russian state secures control over costs and a share of the revenues as soon as they arise. Legal harassment over environmental violations was part of the “persuasion.” Western media have focussed attention on these dubious legal tactics to force a sale, rather than on the nature of the original deal.

The opinion on the Russian side is that Shell took advantage of Russia’s weakness and corrupt government in 1994 to negotiate an extremely favorable contract for energy extraction at a ridiculously low price. The exploration had already been done; the profits were assured. The only real risk for Shell was political risk — that the Russian government would renege on the deal. This was already discounted in the price. So the forced sale of shares in the consortium should not be seen as a windfall loss to the shareholders — it is just the realization of the risk that Shell and its partners willingly assumed. This is apart from the fact that Shell received a fair price for the sale.

Shell’s defenders say that the contract did not reflect political risk but economic risk: The price reflected the unforeseen hazards of the project and the fact that the Russians lacked the technology to attempt the extraction themselves.

This is the nub of the question, but you will not see it discussed in the Western press. Instead, most of our commentators have argued that the Sakhalin-2 “seizure” is part of a deliberate Kremlin policy to exclude foreign investment and management from its “strategic sector.” This is clearly untrue. Gazprom is open to foreign investment; China got a share of the recent sale of Udmurtneft. And as for the supposed effect of the Russian action in discouraging foreign investment, it was announced Jan. 11 that Gazprom had reached a deal with Chevron, the giant U.S. energy company, to explore and pursue a range of oil projects in Russia. Shell is likely to remain the operator of the Sakhalin-2 project, because Gazprom has no experience at all in producing liquefied natural gas. The issue is one of control, not ownership, of strategic resources. The problem is that the Kremlin has not so far defined what it means when it says “strategic sector.” It includes the natural resource sector, but is apparently not limited to it. This creates uncertainty in the area of property rights.

Despite the defense that can be made of its actions in relation to Sakhalin-2, Russia’s energy policy is not coherent. The Economist is right to note the contradiction between Russia saying that it will be a “reliable” energy supplier for Europe and using oil and gas as a political weapon. It would be far better if the market for energy were depoliticized. In actual fact, consumers the world over seek security of supply, while producers look to extract maximum advantage from control over a scarce, non-renewable resource. It is rather hard to demand that Russia uniquely abstain from this game.

Let me return to the question of why Russia gets such bad press. First, many of the actions of the Russian state can and should be criticized — as much by Russians as by those in the West. The country has no understanding of the meaning of the rule of law. It uses legal devices to obtain political objectives. This makes it look shifty and vindictive. Secondly, journalists are often just lazy. It is much easier to compile lists of misdemeanors and assert trends than to dig into the circumstances of particular cases.

Finally, Russia’s behavior is often crude. It badly needs to launch a charm offensive. Most of its officials sound as if they have never heard the word diplomacy. Yes, they often talk and act as bullies. But the Kremlin usually has a better case than it knows how to present. Partly as a result, the Western media nearly always attribute the worst motives to Russian behavior. A modicum of grace would help bridge the gap between perception and reality.