The Sakhalin Energy project, a massive undertaking to exploit some of the largest undeveloped oil and gas deposits in the world, is the largest single foreign investment into Russia to date.

Superlatives surround the Sakhalin Energy consortium’s project to develop the oil and gas deposits on Russia’s far eastern island: the biggest integrated oil and gas project in the world; the largest single foreign investment into Russia; massive gas deposits; and the most extreme weather conditions imaginable.

Work on developing Sakhalin’s huge deposits, untouched by the Soviets, has been going on since the mid-1990s, but progress has been hindered by more than temperatures so cold that the sea freezes down to the seabed. Most investors have baulked at the huge amount of money needed to get at some of the largest undeveloped oil and gas deposits in the world. That was until recently.

In May, the consortium announced that it was committing itself to the $10bn of financing needed to build a liquid natural gas (LNG) plant that would allow Sakhalin Energy to sell Russian gas worldwide.

The commitment does not mean that the consortium – which is made up of Japanese trading houses Mitsui and Co Ltd with a 25% stake, Mitsubishi Corporation with 20% and Royal Dutch/Shell, which is the operator and holds the remaining 55% – already has the money. Its shareholders have just started to raise the financing. But, with collectively deep pockets, the shareholders have committed themselves to seeing the second phase through. As Sakhalin Energy is a specially formed legal entity set up to produce a single product that needs intensive capital investment at the start before eventually enjoying strong cash flows, it is a text book candidate for project financing.

“The shareholders have decided to fund the project, but asked the company to look into raising project financing. It is the obvious step for this kind of project,” says Michael Clark, head of project financing at Shell.

On paper the project looks like a winner. Altogether the gas and oil fields under licence contain an estimated 1.2 billion barrels of crude oil (Russia currently produces about 8 million barrels a year) and 500 billion cubic metres of natural gas (Gazprom produced 530 million cubic metres last year). When the LNG plant goes online in 2007 it will produce 9.6 million tonnes of liquid gas a year.

Japan deal

Two deals signed in May pushed the shareholders to promise to finance the project: the consortium signed 20-year supply contracts with the energy hungry Tokyo Gas and Tokyo Electric Power Co. Inc. for more than 2.3 million tonnes of LNG a year.

Talking to reporters in Tokyo following the Tokyo Gas deal, Sakhalin Energy commercial director Andy Calitz said: “Of the 20 light bulbs in this room, three will be lit by power generated from gas from Sakhalin island.”

Liquid gas can be shipped all year round from the ice-free bay of Prigorodnoye in the south of the island. Japan, the biggest customer, is only 40km away and transporting by ship means that it is still profitable to send LNG as far as south-east Asia or to the west coast of North and Central America.

Mitsubishi has already committed itself to building California’s first $385m LNG terminal in Long Beach, which could receive 5 million tonnes a year and may become a customer. America’s production of natural gas has been declining and talk has start of an “American gas deficit” if new supplies are not found soon.

The downside to the project is simply its size. Nothing on this scale has been attempted before and international bankers, whose interest in Russia only revived about two years ago, are still nervous. To reassure investors the consortium is talking to the various export credit agencies (ECAs) that supplied $348m of the $1bn raised in 1996 to fund the first phase and their involvement will bring a great deal of reassurance.

“The commercial banks are reluctant to lend long-term without multilateral support; this kind of project needs the political risk insurance,” says Mr Clark.

Project financing

Project financing in Russia is still only possible with the support of the multilateral agencies. The European Bank for Reconstruction and Development (EBRD), Japanese Bank of International Co-operation (JBIC) and America’s Overseas Development Investment Corporation (OPIC) split the $384m loan between them. Shell is now trying to raise $5bn to put towards the second phase.

“Sakhalin Energy is a single asset company and the credits are limited to a single asset. In this sense, the $5bn we are trying to raise is a classic piece of project financing,” says Mr Clark. “A project financing structure provides an umbrella but the debt comes ultimately from a variety of sources: bank credits, bonds or the ECAs. How this is arranged will depend on the appetite for the project’s risks and the market conditions at the time of asking.”

One option that Shell is looking at is project bond issuance (which would be another first for Russia), secured entirely on the projected cashflow from the eventual production. Something of an exotic bond, the advantages are the flexibility, while the disadvantage is that everything depends on the bond market’s perception of the project.

And perceptions tend to change fast in Russia. Structural reforms are far from complete and, despite the $40bn-$50bn in tax and other revenues, the government will earn over Sakhalin Energy’s working life, political risks remain real. President Vladimir Putin has promised to step down in 2008 but with no clear successor – or even a mechanism for choosing one – and lending over the 25-year-plus duration of the project still feels like shooting in the dark.

Solid foundations

Sakhalin Energy has about as secure a foundation as it is possible to have in Russia thanks to a production sharing agreement (PSA), signed with the government in the early 1990s, that sets its taxes and share of the profits in stone. One of only three PSAs in Russia with a “grandfather clause”, the terms of the deal cannot be changed retroactively. While analysts agree that there are unlikely to be any more PSAs, Sakhalin’s provides stability and predictability that should reassure creditors.

“There are a whole bundle of issues, not just the judicial and political risks,” says Mr Clark. “But when the shareholders took the decision to fund the project and move ahead they believed that these risks were manageable. There is some uncertainty, but they feel comfortable with it.”


All fields are mandatory

The Banker is a service from the Financial Times. The Financial Times Ltd takes your privacy seriously.

Choose how you want us to contact you.

Invites and Offers from The Banker

Receive exclusive personalised event invitations, carefully curated offers and promotions from The Banker

For more information about how we use your data, please refer to our privacy and cookie policies.

Terms and conditions

Top 1000 2023

Request a demonstration to The Banker Database

Join our community

The Banker on Twitter