In March, Sakhalin Energy announced that production sharing began within the Sakhalin 2 energy project. Starting in April, Russia will be receiving its share of profit production on monthly basis. The sharing has started earlier than planned, Sakhalin Energy CEO Andrei Galayev is quoted as saying. The total sum of reimbursed expenditures from the implementation of Sakhalin 2 stands at $24.5bn. The figure includes capital and operating expenditures on the first and second stages of the project. It is expected that in 2012, the Russian side of the PSA will receive about RUR500mn ($17.1mn) worth of profit production (excluding the profit tax and royalty) if oil costs around $100 per barrel.

The Sakhalin projects are among the largest international direct investments in Russia. They serve as an example of how advanced technological solutions are applied to meet worldwide energy demand. During their years of operation, the projects exhibited pattern operational, environmental, and safety performance and have provided benefits to foreign investors, the Russian state, and its citizens.

The Sakhalin Island exploration initiative includes four separate projects and a variety of international sponsors. Sakhalin 1, located offshore, is an international consortium that started with Exxon Neftegas (30%), Japan’s Sodeco (30%), Sakhalinmorneftegas-Shelf (23%), and Rosneft-Sakhalin (17%). The PSA for the project was approved in 1995. Sakhalin 2, valued at $15 billion, has two fields off the coast of Sakhalin, Astokhskoye and Lunskoye. Sakhalin 2 originally involved Sakhalin Energy Investment, a joint venture comprised of Marathon (30%), Mitsui (20%), McDermott (20%), Shell (20%), and Mitsubishi (10%). The PSA was approved in 1995 and the consortium started producing oil in 1999. Sakhalin 3 was awarded to the Mobil/Texaco consortium, but the production has not yet begun. Its PSA was approved on May 31, 1999. Finally, the Sakhalin 4 tender took place in 1994, and the field is estimated to contain 200 million metric tons of oil and 60 to 70 billion cubic meters of natural gas.

Western oil companies, including Exxon and Marathon Sakhalin Energy, have developed the most promising Sakhalin projects. These companies were pushing forward the development of the Sakhalin 1 and 2 projects.

The Russian government entered into three PSA agreements when its economy was still emerging and oil prices were low. The tremendous investment of the foreign companies facilitated the exploration of these remote locations. The impact was significant as the potential payouts were vast: Sakhalin 1 contains an estimated 2.5 billion barrels of oil and 17.1 trillion cubic meters of natural gas; Sakhalin 2 contains 1.2 billion barrels of oil and 18 trillion cubic feet of natural gas. The PSA arrangements also brought modern technologies to Russia, including the construction of the most powerful land-based drilling rig in the industry and the first liquefied natural gas (LNG) terminal and export facilities constructed in Russia. The PSA arrangements created an opportunity for a vast potential payout to both the Russian government and foreign investors. Prior to the enactment of the PSA law, foreign investment in Russia was not that significant. This law was designed to create a regulatory reform and contract-based security that the companies desired. The interest shown by many foreign corporations subsequent to the PSA’s enactment suggested the future for foreign investment in the Russian energy sector was secure and growing and that the financial benefits to both Russia and foreign investors would be great.

However, the Russian government has shown a reluctance to expand PSAs beyond the original three awarded in the 1990s. The government has denied ExxonMobil the rights to develop tracts adjacent to Sakhalin 1, instead giving the contract to Rosneft, the state-owned company that swallowed up the remnants of Yukos’s production company Yuganskneftegaz.

In 1993, ExxonMobil began talks with the Russian government on another plot in the Sakhalin region, known as Sakhalin 3. These negotiations ended when the government annulled the tentative PSA in 2004. The Russian government decided to offer the rights to Sakhalin 3 at a new auction, even after ExxonMobil offered to license Sakhalin 3 under a regular tax regime instead of a PSA.

The reluctance to negotiate new PSAs with foreign investors may involve more than just concerns for protectionism. It also is likely due to changes in the expected payout that the Russian government will receive from the PSAs. The PSAs allow a compensation period for companies to regain their investments before paying significant revenues to the Russian government. Therefore, if a company involved in a PSA experiences cost overruns and consequently raises its projected costs, the period necessary to recover those higher costs will be longer, leading to a delay before the profit period commences. This leads to less revenue and later payment dates to the Russian government. Due to construction delays, particularly those related to cost overruns on an LNG plant, the Sakhalin 2 project has doubled its expected costs for phase II of the project. The Sakhalin 1 project led by ExxonMobil also has experienced significant cost overruns totaling nearly $17 billion.

Cost overruns are not unexpected in the construction of such large, complex facilities in such a remote location, but these cost overruns delay profits to Russia and only increase the government’s motivation to push foreign companies out of the market. The Russian government’s successful efforts to force Gazprom into Sakhalin 2 represent one more action on the road to the renationalization of the oil industry, and it is unlikely that Russia will grant any new PSAs.

Strategies to reduce a risk of expropriation

Even in the absence of the PSA model, there are some strategies that companies can use to reduce the risk of expropriation. Multinational corporations can spread risk by involving a group of complementary firms and international banks in each project. A consortium shares both risk and provides information security. Reputation is a powerful mechanism for enforcing contracts, because a host country that lives up to agreements and provides a transparent framework of business law gains access to international capital markets on favorable terms. Another strategy to reduce the risk of expropriation is a mechanism that will allow holding each other’s assets in escrow in order to guarantee successful performance. For example, revenues from energy sales can be held as a bond, or a domestic firm may build its income as equity in a foreign firm. In other cases, the investors can commit resources gradually so that a host-country’s short-run incentive to expropriate will be offset by the long-run incentives to gain access to future finance, technology, and know-how.