Can Pipe Dreams Turn Into Reality?

A few years ago, this spindly island that Russia wears like a holstered gun on its eastern hip was as close to nowhere as anyone could imagine.

Eight time zones from Moscow, Sakhalin Island was best known for the day in 1983 when a South Korean airliner strayed too close to a top-secret Soviet military installation and got shot out of the sky. Playwright Anton Chekhov had a one-word description when he visited in 1890: “Hell.”

That was before capitalism hit Russia, and before oil hit $40 a barrel.

These days, Yuzhno-Sakhalinsk is a boomtown that makes Deadhorse, Alaska, look like yesterday’s news. The southern bit of the island is awash in gravel trucks, roughnecks and more cash than anybody has seen for a long time. The hotel near a liquefied natural gas plant site is booked up for the next three years. Next door to Royal Dutch/Shell Group’s headquarters downtown, the Kona Bar is full of North Sea brogues and Texas drawls at happy hour, which starts at 5 and ends when there’s somewhere else to go in Yuzhno-Sakhalinsk, which is never.

“We are spending money this year at the rate of $100 a second,” said David J. Greer, project director for Royal Dutch/Shell’s Sakhalin Energy Investment Co., which is building the world’s largest liquefied natural gas plant on the island and two oil platforms offshore. “This year alone, we will spend $3 billion. Everything about this thing has got lots of zeroes on the end of it. It’s just huge.”

This is what happens when a country as big as Russia decides to go global in the oil and gas business. Although the former Soviet Union has pumped crude for years, only recently has Russia emerged as the world’s second-biggest oil exporter and -- if the Bush administration has its way -- a potentially important new supplier of both oil and gas to the United States.

Russia’s crude oil production rivals that of Saudi Arabia, and analysts say its reserves could provide the output answer for the United States, China, South Korea and Japan, which have grown increasingly wary of their dependence on producers in the Middle East.

“Our goal is to diversify our access to energy exports from around the world, and we would very much like to see the opportunity for the U.S. to have access to larger amounts of Russian exports,” U.S. Energy Secretary Spencer Abraham said in a visit to Moscow last month.

Formidable obstacles stand in the way of Russia’s becoming a big new supplier to the U.S. anytime soon. Among them is Russia’s inability to export more oil until it builds new pipelines, and Moscow’s ambivalence about the U.S. market when customers in Japan and China are closer, possibly more voracious in the long run and ready to strike better deals.

Capacity Tapped Out

Russian oil production is expected to grow from 8.9 million barrels a day to 10 million by 2010. But the state-owned company that has control of Russia’s oil transportation network, Transneft, says it has hit a ceiling with shipments of slightly more than 4 million barrels a day and can’t sustain production growth without major new pipeline capacity.

Japan recently stepped forward with major financing guarantees for a $12-billion, 2,500-mile pipeline that would carry Siberian oil to the eastern Russian city of Nakhodka, from where it would be shipped to Japan.

The United States would prefer that a new pipeline run westward to Murmansk at the Barents Sea. Washington has offered to conduct a feasibility study on such a line -- an offer the Russians coolly said was not what they meant when they said they were interested in “foreign participation.”

Sergei Oganesyan, chief of Russia’s Federal Energy Agency, said last month that the U.S.-preferred route was third on the government’s list of priorities, behind expansion of the existing oil transit line to the Baltic Sea and the proposed route to Japan and possibly China.

A ray of hope for the United States appeared last week when Transneft President Semyon Vainshtok suggested that a shorter, cheaper Barents Sea pipeline could be built if it terminated at the port of Indiga, instead of Murmansk. The price tag would be about $6 billion, compared with as much as $15 billion for the Murmansk route, he said.

The pipeline issue has been an undercurrent in the U.S.- Russian political dialogue, especially when it comes to the troubles of Russian energy giant Yukos Oil, whose former chief executive, Mikhail Khodorkovsky, is on trial in Moscow on fraud and tax evasion charges.

U.S. officials repeatedly have raised concerns that Khodorkovsky’s arrest in October -- and the conceivable bankrupting of Yukos itself with a more than $6-billion tax bill recently affirmed by a Russian court -- could undermine foreign investor confidence and raise questions about the rule of law and security of private investments in Russia.

The geopolitical subtext goes deep. Before his arrest, Khodorkovsky was said to be negotiating the sale of a big stake in Yukos to ChevronTexaco Corp. or Exxon Mobil Corp., which would transfer key decision making for the engine of the Russian economy to a boardroom in California or Texas.

Khodorkovsky also was promoting the idea of a pipeline on the U.S.-preferred route through northern Russia and lobbying for private construction and ownership of new pipelines -- a plan that would eliminate the government’s most important lever of control over a resource that is, thanks to the market reforms of the 1990s, mostly in corporate hands.

“Pipeline ownership is the single most efficient and the cheapest way of controlling the entire Russian oil sector,” said Steven Dashevsky, senior oil and gas analyst with Aton Capital Group. “While it probably has not single-handedly determined the whole Yukos affair, it clearly had a very, very significant impact. Khodorkovsky

The oil delivery issues became so thorny that American diplomats earlier this year pronounced the U.S.-Russian energy dialogue essentially “stalled.”

Eyeing Natural Gas

Another hydrocarbon -- natural gas -- has put new life into the exchange, and Russian and U.S. officials are making optimistic predictions that a good part of Russia’s estimated 47 trillion cubic meters of gas reserves soon will begin arriving in the form of liquefied natural gas to the United States.

The Russian state-owned oil giant Gazprom is looking at exporting to the United States from Siberia’s Yamal Peninsula as well as a $15-billion project to develop offshore gas deposits in the Barents Sea -- an endeavor U.S. officials are seriously discussing financing, through the United States Export-Import Bank. That production could be marketed on the U.S. East Coast.

Not surprisingly, Gazprom is trying for a piece of the action in Sakhalin -- a potential supplier to the U.S. West Coast -- where Royal Dutch/Shell is scheduled to begin the island’s first exports of liquefied natural gas, or LNG, in 2007, with Exxon Mobil not far behind.

Sakhalin producers already have signed contracts for 3.4 million tons a year of LNG deliveries to Japan, about a third of Shell’s expected production, but also are conducting negotiations for deliveries to other Asian countries and the U.S. West Coast, only 11 to 12 days’ sail away.

An LNG import terminal proposed for the Baja California coast near Ensenada would receive Sakhalin deliveries; another terminal is under discussion at Long Beach.

“I firmly believe that somewhere between Seattle and San Diego, two to three LNG terminals will be built,” Andy Calitz, Sakhalin Energy’s commercial director, said in a recent interview.

LNG technology has transformed the delivery of natural gas around the world; supercooling allows it to be compressed and transported in tankers like oil, creating an international gas market that never existed before. Sakhalin Energy’s sprawling plant on the coast of Aniva Bay will be the largest of its kind, producing 9.6 million tons a year.

Sakhalin’s development is massive in almost every other way. Enormous new offshore oil platforms are being built in the Sea of Okhotsk, so big they can withstand the heavy load of ice that will encase them half the year.

Undersea pipelines will be built to carry oil and gas to shore, where it will be funneled into 500-mile pipelines, now under construction, and transported from the north end of Sakhalin to the south end, to Shell’s planned new oil and gas export terminal.

Shell has committed $300 million to local infrastructure improvements, but it is not universally viewed as a good cor- porate citizen. Trucks hauling fill material to the LNG plant site chewed up the roads so badly this spring they had to be closed in some places. Aniva Bay, one of the most productive fishing zones in the Russian Far East, has been loaded with silt since Shell began drilling 1.5 million tons of gravel from the seafloor near the LNG plant and dumping it in the middle of the bay.

On the island, housing prices have shot skyward, but most Sakhalin residents have seen little so far from the bonanza. Although unemployment is at 2% now, most high-paying jobs have gone to foreigners. In fact, under new tax legislation, the local region will realize only about 1/12 of the royalties it had once hoped to earn from oil and gas development, with most of the bounty going to Moscow.

For all that, Sakhalin officials say the future looks bright: The island is getting important new infrastructure improvements and high-tech training that will provide residents with prospects more diverse than fishing and a horizon more distant than the shores of the Sea of Okhotsk.

“Two to three years ago, no one had any faith in the Sakhalin projects.... No one thought the implementation of such large-scale, hugely expensive and grandiose projects such as these could ever be possible in such an unpredictable country as Russia,” said Galina Pavlova, director of the Sakhalin region’s Department of Oil and Gas.

“But my department has been working with what I tenderly call the sharks of imperialism for 10 years now,” she said. “A tremendous energy infrastructure is being built which will stretch from the south end to the north end of Sakhalin. And our kids have started to have a future.”

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Oil leaders

Russia and Saudi Arabia are the worldÕs leading producers of crude oil. (In millions of barrels a day) March 2004 Russia: 8.7 Saudi Arabia: 8.4 United States: 5.6 Iran: 4.0 China: 3.4 Mexico: 3.3 Norway: 3.0 Nigeria: 2.5 Venezuela: 2.5 Canada: 2.4

March 2003 Russia: 7.9 Saudi Arabia: 9.5 United States: 5.9 Iran: 3.8 China: 3.4 Mexico: 3.3 Norway: 3.0 Nigeria: 2.0 Venezuela: 2.4 Canada: 2.2

Source: Energy Information Administration