by Simon Pirani
The $8.5 billion Sakhalin II (second phase) project financing, due to come to market in the next year, is the main course in a mouth-watering feast being laid on by bankers for the Russian oil and gas sector. The recent EBRD deal for Lukoil-SeverTek is perhaps the most enticing hors d’oeuvres served so far, but not the only one on the menu. Other, bigger, Russian-western projects are expected, underpinned by warmer US-Russian political relations. Russian oil companies are being offered plenty of side dishes – eurobonds, long-tenor structured export finance and a range of hybrids – but they, too, will need to tuck in to project finance if they mean what they say about serious, long-term investment.
Pride of place in Russian hydrocarbons financing belongs to the mammoth Sakhalin II (phase two) deal, which will be the world’s largest ever non-recourse project financing. It will provide for an integrated oil and gas development, whose focus is a 9.6 million tpy LNG plant at Aniva Bay, south Sakhalin, and an 800km onshore pipeline to feed it. Sakhalin Energy hopes in the near future to put in place gas sales contracts in Japan, South Korea and China, that will underpin the deal.
Sakhalin Energy (the project company owned 55% by Shell, the operator, 25% by Mitsui and 20% by Mitsubishi) is talking with the multilateral lenders who helped finance phase one of the project – the European Bank for Reconstruction and Development, the US Overseas Private Investment Corporation and the Japanese Bank for International Co-operation – about the shape of the project finance package, which will be taken to the commercial bank market later this year or early next. Peter Firmin, director of CSFB’s global energy group – which along with Linklaters has been advising Sakhalin Energy since December 2000 – said: “This is the only LNG transaction of any significant size directed towards the world’s biggest market for LNG.”
Phase one of the project brought the Piltun field into production in July 1999. So far it has produced 4 million tonnes of oil. Sakhalin Energy invested about $1.5 million in phase one, while a $348 million project finance loan was provided in three equal shares by the EBRD, OPIC and JBIC. This relationship is the starting point for project financing phase two, said a source at Sakhalin Energy, adding that “OPIC has maintained its interest although the departure of Marathon Oil meant that there is no longer a US partner.”
Although Sakhalin II will sell into the Far East, has a Dutch-based multinational operator and Japanese partners, it remains a Russian project and its success is testimony to the improving business environment there. That point was underlined by Shell chairman Phil Watts during a visit to Moscow in April, when he publicly invited the Russian state gas monopoly Gazprom to join the project. One market observer noted: “Gazprom would love to accept. It just has to work out where to get the money from.”
Sakhalin II may be big, and imminent, but it’s far from being the only course served at this dinner. The Russian oil companies have the money to invest, the desire to expand, and actual or potential partnerships with western majors, to revive projects that languished during post-Soviet economic chaos or make new ones possible. US political strategy helps: it sees Vladimir Putin’s Russia not only as a strategic partner but also as an alternative source of hydrocarbons to the Middle East. Thus the US-Russian governmental memorandum issued in May on co-operation on oil.
The possibilities are exemplified by the EBRD financing of the SeverTek project, a 50-50 joint venture by Russia’s largest oil company, Lukoil, and Fortum of Finland, expected to be completed in the last week of June. The EBRD board has sanctioned a senior loan of $100 million, and a syndicated “B” loan of $100 million is to be underwritten by Hypo Vereinsbank. Lukoil and Fortum will provide a further $155 million themselves. SeverTek will develop the South Shapkino oil field, 70km north of the Arctic Circle, and build a 98.5km pipeline to connect with KomiTek’s Kharyaga-Usinsk line. The six-year deal is structured so that the lenders have recourse on the project partners until oil starts flowing, and then the recourse falls away. A banking source said the “notable innovation” of the deal was that it is collateralised on short-contract or spot sales of oil rather than a long-term offtake contract.
And this could be just the start, according to Moscow-based bankers. Other projects under consideration jointly by Russian and western oil companies include:
** Development of vast deposits in eastern Siberia by Yukos, Russia’s second-largest oil company. Last month BP’s country manager for Russia, Peter Henshaw, said that BP had been in talks with Yukos since March about strategic issues, including the east Siberian deposits. BP executives have been to Evenkii autonomous district to see the Yurobchenko deposit, which has more than 1 billion tonnes of estimated recoverable oil reserves and stands at the forefront of Yukos’s growth plans. Oil from the field, and potentially from others in Yakutia and Irkutsk that Yukos hopes to develop, would be sold in China. Yukos has been in talks with the Russian oil transport monopoly Transneft and the Chinese energy company CNPC about building a 30 million tpy pipeline from east Siberia to China’s main markets, and says the three parties intend to start a feasability study on the line “in the near future”. Yukos opened the door to developing the Evenkii deposit in April by resolving a long-running dispute with the state over shareholdings in the Eastern Oil Company, which holds the licence; Yukos now holds 70.15% of Eastern. Although a BP spokesman stressed that the talks with Yukos had been only preliminary, market observers point out that such a project would be ideal for the western-Russian alliance both sides want to build.
** The Kovykta gas project in east Siberia. The licence is held by Rusia Petroleum, a project company owned jointly by BP (the operator, with 31%), the Russian oil company TNK, the financial group Interros and the Irkutsk regional administration. The field is one of east Siberia’s largest, with gas reserves of about 1.9 trillion cubic metres, sufficient for annual production of 40bcm. The project is directed to the Chinese market, and a framework deal for the pipeline was signed between Russia and China in 1997. There have been complications – such as China’s insistence that the line take a 1200km detour to avoid Mongolia, and a competing project being pushed by Yukos to take gas from the Sakha region in Yakutia to China – which were no doubt discussed in mid-June, when Russian deputy prime minister Viktor Khristenko visited Beijing for talks about the overall east Asian gas picture. A feasability study covering production, transport and marketing, by Rusia and CNPC is due to be completed this year.
** Development of western Siberian production assets returned to Sidanco after a bitter ownership battle that ended with TNK taking control of the company. BP, which has a three-year management contract for Sidanco running from mid-2001, confirmed its commitment to Sidanco in April by raising its stake from 10% to a blocking stake of 25% + one share. Sidanco is now at an advanced stage of talks with the EBRD about a project finance deal similar to the SeverTek loan. The background is an incredible turnaround in BP’s fortunes that exemplifies the changes in Russian oil. Sidanco, in which BP bought a 10% stake in 1997, effectively went bankrupt during Russia’s 1998 financial crisis. A bitter struggle followed between TNK, whose west Siberian fields are adjacent to Sidanco’s, and Interros, Sidanco’s former owners. BP also clashed with TNK – but the two sides resolved their differences, both took shares in Sidanco, and for the last year worked so well together that gossips suggest BP might buy TNK.
** The Zapolyarnoe gas field, to be developed as a joint venture between Shell and Gazprom. The project covers the Neokom pool, which has oil, gas and gas condensate reserves of 750 million tonnes of oil equivalent. The field can produce more than 14bcm a year, and is crucial to Gazprom’s strategy for replacing declining capacity in its main west Siberian gas fields. The project has suffered several delays, but Shell chairman Watts reiterated the company’s commitment to it during his Moscow visit. A Shell spokesman said that a joint venture company to seek financing is expected to be established this year.
** The Sakhalin I project, on which Exxon-Mobil, the operator, last year announced a $10.5 million programme of investment. The project – which is owned 30% by Exxon-Mobil subsidiary Exxon-Neftegaz (30%), 30% by the Japanese consortium Sodeco, 20% by subsidiaries of the Russian state oil company Rosneft and 20% by the Indian national hydrocarbons company ONGC – is some way behind Sakhalin II, but may eventually generate significant financing requirements. There have always been questions about how the Russian portion will be paid for. Some of these were answered in February last year, when ONGC bought 20% of the project from Rosneft subsidiaries, and committed itself to cover the costs for the remaining 20% in Russian hands up to break-even point in 2005 – estimated at between $750 million and $1,000 million. The deal was notable for being the first and biggest fully non-recourse transaction in the Russian market.
** Other joint projects on longer or less well-defined time scales include the Shtokman gas project in the Barents Sea, with a pipeline via the Kola peninsula and the Baltic to European markets, in which Gazprom holds 50% and the remainder is held by TotalFinaElf, Fortum, Norsk Hydro and Conoco; a joint development by Lukoil and Conoco of fields in the Timan Pechora region of the Arctic; and an oil project in the Russian sector of the Black Sea, at the Shatsky block off Tuapse, where Total Fina Elf and Yukos agreed in April to undertake exploration together.
The multilaterals’ role
Kevin Bortz, head of the EBRD’s natural resources team, said that the bank’s involvement in Sakhalin II, and the Fortum/Lukoil-Severtek deal, showed that there is “still a role for the EBRD in the Russian oil sector”. From privatisation in the early 1990s to consolidation of the vertically-integrated holdings in the mid 1990s, Russian oil had now moved to a third phase in which the leading Russian companies want to become international players and their western counterparts are ready to work with them, he said. “The EBRD can play a role in encouraging this co-operation. Russia is still a complicated place to do business and we have valuable experience.” Siobhan Walker, head of structured and general lending in Russia at ING Bank, welcomed the SeverTek loan as “exactly what the EBRD should be doing: looking at ground-breaking deals and pushing the market forward”.
Among export credit agencies, US Ex-Im bank has taken the lead. Ex-Im bank vice chairman Eduardo Aguirre said: “The upturn in the Russian economy and the US government’s recent designation of Russia as a market economy are good signs that we will be able to support an increasing number of US exports to this market, particularly in the oil and gas sector.” The bank’s $518 million guarantee for a syndicated loan made to TNK in April 2000, to develop the Samotlor oil field and refurbish the Ryazan refinery, remains a post-1998 landmark. Like most of US Ex-Im’s support for the sector, that deal was done under its Oil and Gas Framework Agreement – but Paul Tuminia, who heads the bank’s Russia team, emphasised the bank’s remit is much wider. “Besides the OGFA deals, there is scope to provide guarantees on small- to mid-size projects under our credit guarantee facility (CGF)”, Tuminia said.
Earlier this year an unsecured $28 million Commerzbank (New York) made a $28 million unsecured loan to Lukoil-Leasing, a subsidiary of the oil company, backed by the facility, which acts as a line of credit for the purchase in the US of oilfield equipment, unspecified on disbursement of the loan.
The changing climate
Project financiers looking to cook something up for the Russian oil and gas sector are aware of the huge array of other goodies coming out of the kitchen, from eurobonds to structured export deals with long tenors. Rosneft was first to return to the eurobond markets since 1998, with a $200 million deal last August. A Sibneft bond, issued in November and raised to $400 million in March, wowed the markets. As for structured loans, no sooner had ING and Raiffeisen set a new benchmark with a $300 million, four-and-a-half year deal for Lukoil in March than the clients were seeking five-year money. Sibneft and TNK have had that already, and even Tatneft, the largest regional producer, has mandated CSFB for a similar deal. Unsecured elements are appearing in these deals, while Yukos and Lukoil are looking at share issues on western markets.
Cynics insist that they sense a herd instinct developing among bankers, and that restraint is needed to avoid a 1998-style meltdown. Their opponents reply that, quite apart from the fortuitous boom in oil prices, there is no denying that the largest Russian oil companies have changed beyond all recognition in the last three years. Lukoil is already a serious international player and Yukos is becoming one, investing in central Asia, eastern Europe and the Middle East out of its huge cash pile. Lukoil, Yukos and Surgutneftegaz are snapping up gas assets and while the government dilly-dallies with gas market reform. And these three leaders, like TNK and Sibneft, have leaped forward in terms of corporate governance and financial transparency.
All this means that the defences provided by production sharing agreement legislation – which made possible succesful western investment in Sakhalin I, Sakhalin II and the Total Fina Elf-Norsk Hydro project at Kharyaga in the Arctic – is no longer seen as a vital prerequisite of project financings. These three “grandfathered” PSAs had their terms written into law, but subsequent PSAs are covered by a general law that requires normative acts to specify tax levels and other crucial issues. Parliament and government are close to agreeing on these normative acts, but have taken so long about it that, in the meantime, the very Russian risk against which the law was supposed to provide comfort has diminished significantly.
Yukos chairman Mikhail Khodorkovsky recently suggested that it was actually easier to finance projects outside the PSA framework. Stephen O’Sullivan, oil and gas analyst at United Financial Group in Moscow, commented: “PSA legislation still seems to be a requirement from financiers of the big offshore projects. But onshore, Khodorkovsky may well be right. Approaches are changing. Some US oil companies, who historically have been less flexible than the Europeans on this, are concluding that if they are going to invest in Russia, PSA is not necessarily the only way.”
Gazprom, like the oil companies, has changed – but has quite different problems to overcome. The new chief executive, Putin loyalist Aleksei Miller, has pretty well ended an era of senior management corruption and politicking. But gas industry reform challenges such as domestic price liberalisation, access to export pipelines and turning Gazprom into several manageable corporate entities are not going to be met overnight. And Gazprom will want Zapolyarnoe, Shtokman and other similar projects to move forward to help staunch the steady decline of its output.
Is there a fly circling around the soup? Of course: oil prices. The very factor that has helped the Russian industry leap out of its mid-1990s doldrums could yet undo some of the most impressive plans. But if prices stay strong, this banquet should have a few more courses to it yet.