Sakhalin II, potentially the biggest project financing ever, should still happen - by the end of this year, according to optimists. But sponsor Royal Dutch Shell will have to sweat on it: recent reports that the total project cost has risen to $12 billion from $10 billion could not have come at a worse time.

The estimated 20% cost overrun at Sakhalin Energy Investment Company, the project company of which Shell owns 55%, was widely reported early last month [April], just as the scandal over Shell's misreporting of its global reserves reached new heights.

Sources close to the project - the biggest single integrated oil and gas project ever undertaken, including the construction of Russia's first liquefied natural gas (LNG) plant with an annual capacity of 9.6 million tonnes - suggest that the weak dollar and rising raw materials prices are the main cause of the changing cost profile. But bankers think 20% excessive: "a 10% overrun on a project of this size is unremarkable, but the second 10% needs explaining," said one. And the new Russian government, for whom greater state control over natural resources profits is a strategic aim, was intensely irritated.

Russian deputy economy minister Yuri Isaev expresses "serious concern" about the cost overruns. "We have issues about the constantly rising costs. Obviously the cost profile will impact on our profit oil," he said during the EBRD annual meeting in London, where Sakhalin was a key theme of behind-the-scenes discussions.

News about cost overruns has come at a time when Russian government policy is toughening. "We will not approve any budget without being absolutely clear on all the implications," says Isaev. "Maybe five years ago Russian ministries would have rubber-stamped deals without looking closely enough at them. Now the situation has changed. We need much more information."

A Shell spokeswoman would not comment on specific figures but said that "in a project of this size and complexity there are always unexpected events. The Stage II budget covers an enormous level of activity even beyond the first five years of large scale construction."

Isaev's position reflects the new political consensus in Moscow: that Russia's natural resources were too easily surrendered to private interests in the 1990s, and that now the state must get a greater share, from which, among other things, to fund growth of manufacturing and services.

This outlook is bound up with the reordering of relations between the state and business that began, spectacularly, with the security services' assault on Russia's most succesful native oil company, Yukos. The arrest of Yukos shareholders Mikhail Khodorkovsky and Platon Lebedev was followed by substantial back tax demands to both Yukos and Sibneft, a hefty voluntary arrears payment by Lukoil to cover losses to the state from a now-closed tax avoidance scheme, and closer attention by politicians and regulators in foreign majors' investments.

In this political atmosphere, cost overruns at Sakhalin II - which in themselves present no inherent danger to the project - could provide a useful bargaining tool for those in the Russian government whose key objective is to increase the state's slice of the cake. Russian officials are understood to have made its position on costs clear at a regular meeting of the oversight committee for the Sakhalin project - which comprises Sakhalin Energy, the Sakhalin regional administration and the federal government - in Moscow on 23 April.

The authorities' decision in January this year to withhold licences for oil fields covered by Exxon and Chevron's Sakhalin III project, near Shell's Sakhalin II, highlighted the fact that foreign investors are not immune from the political changes. Industry sources point out that no PSA had been signed for Sakhalin III and the field had long remained undeveloped. But Elena Anankina at Standard & Poors' Moscow office said: "This is an illustration of the fact that political risks - and, specifically, those arising from untransparent regulation, weakness of state institutions and unclear legislation - affect all who do business in Russia."

Paul Collison, oil and gas analyst at Brunswick UBS in Moscow, says: "We are more bullish than ever about Russian oil medium and long term, because of the substantial increase in reserves of all categories. But in the short term, there is a noticeable trend towards greater government assertiveness. TNK-BP, like Sibneft, could be exposed to demands for tax arrears." For project financiers, he says, an indication of trends will be the extent of Gazprom participation in the Kovykta gas project in east Siberia, on which Moscow insists.

Structuring the financing

The Sakhalin II (Phase 2) project financing is now under consideration by a group of multilateral lenders headed by the Japanese Bank for International Cooperation (JBIC) and the European Bank for Reconstruction and Development, and including other development banks, US Ex-Im and other export credit agencies. Sakhalin Energy announced in June last year, when it sent out a project information memorandum to these potential lenders, that about half the then estimated $10 billion cost of Phase 2 is likely to be debt financed.

Sakhalin II is covered by Russia's first production sharing agreement (PSA), signed 10 years ago next month [June] and one of three that is 'grandfathered' (ring-fenced from subsequent legislative changes). The first phase of the project, completed in July 1999, brought into production a 1 million tonne per year oil field, Russia's first offshore production. JBIC, the EBRD and the US Overseas Private Investment Corporation jointly provided a $348 million project finance loan, which is expected to be refinanced by the forthcoming deal to finance Phase 2.

Marathon Oil of the US was one of Sakhalin II's original sponsors, with 37.5%, but sold that stake in 2000 to Shell, now operator and owner of 55%. Mitsui (25%) and Mitsubishi (20%) are the other shareholders. With Marathon's departure the project has no US sponsor, and so OPIC's involvement will be replaced by a small commitment from the US Ex-Im bank. The EBRD, for which Russian project finance is a key area, is in the talks and through its A/B loan structure may involve commercial banks.

JBIC is expected to provide the lion's share of multilateral funding for Sakhalin II, which will primarily serve the Japanese market. The project is vital for Japanese energy strategy, and JBIC's involvement follows its participation in the two most notable LNG project financings of the last decade in the Middle East, Rasgas in Qatar and the Oman LNG project.

Information about how much exposure to the deal may be available to commercial banks is closely guarded. But sources close to the borrowers have indicated that, assuming that debt finance totals $5 billion, up to $2 billion would be needed from commercial lenders and/or a project bond issue, depending on market conditions. There will be also be ECA-covered finance sought from commercial banks. Sakhalin Energy is advised by CSFB and Linklaters; the multilateral lenders by ABN Amro and White & Case.

A project bond, most likely to be issued in the US under Rule 144a, is one of a range of options being studied. A precedent was set by Rasgas, for which Goldman Sachs arranged a $1.2 billion project bond in the Rule 144a market in December 1996, which went alongside a $1.35 billion worth of ECA-backed bank loans. JBIC and Japanese commercial banks played a key role.

Environmental and social impact

Sakhalin's political risk profile adds to the importance of the EBRD and other multilateral institutions for its success - and to the seriousness with which the borrowers are listening to EBRD concerns on environmental and social impact. These were spelled out by EBRD president Jean Lemierre after the bank's annual meeting in London last month. "We are not yet satisfied with the answers we have received and the present situation, and we have said so to the sponsors," he said.

The EBRD has ruled that Sakhalin Energy's environmental impact assessments are 'unfit for purpose' and postponed any decision on the financing until they are revised. Environmental campaigners see this as a window of opportunity to press their concerns, including a threat from offshore construction to the habitat of grey whales, an endangered species.

The efforts of environmentalists, including international groups such as the World Wildlife Fund and local ones including Sakhalin Environment Watch, are centred on two court cases. The first, brought under endangered species legislation by the legal centre Rodnik against the Russian government and natural resources ministry, argues for a series of restrictions, including a ban on offshore pipe-laying and other construction between May and October, the migration and feeding season for grey whales. A hearing of the suit has been listed for 27 May at the Presnensky district court in Moscow.

A second case, demanding that the government release documents relating to the project under information legislation, returned to the court last month after a succesful appeal against a ruling that it could not be heard.

Environmentalists are also concerned about proposal to lay pipelines underground on Sakhalin island, which is an area of high seismic activity, and say the pipelines should be laid on the surface. The planned pipeline route, through spawning areas for endangered species of salmon, is also under challenge.

Dmitry Lisitsyn, chairman of Sakhalin Environment Watch, said that while the company and natural resources ministry have met with campaigners, there has been too little genuine consultation. "The project is smelling more and more odious. Shell is producing massive amounts of documentation, but on the ground nothing is changing. Sakhalin Energy continues to violate a string of international standards. We believe that under these circumstances the EBRD, with its environmental mandate, should not join the financing."

There are two other significant groups of protesters with whom agreement needs to be reached. One is local politicians who are wary about the project's social impact, and vocally demanding extra investment in the island's road system. The main road linking Sakhalin's two largest cities currently goes right through Sakhalin Energy's main site, and last month it was blocked for an hour by protesters led by Aleksandr Svoyakov, mayor of Korsakov, the second-largest city, demanding the repair of roads damaged by heavy vehicles.

Another campaigning constituency are Russian contract firms, which argue that rules laid down in the PSA agreement governing local content are being broken. The PSA agreement stipulates 70%, but Russian parliamentarians and construction companies have alleged it is far lower: last month 15 Russian companies sent a letter to president Vladimir Putin last week claiming it was just 6%. Deputy trade minister Isaev said the Russian government would continue to "push our partners [at Sakhalin Energy] very hard" on the issue of the level of Russian content of construction and other contracts.

Shell's spokeswoman said: "Sakhalin Energy has made changes to the project to meet stakeholder concerns and is trying to do everything possible to provide as much information as possible." She said that Sakhalin Energy "does believe that it is meeting Russian content requirements, which are reviewed on a regular basis."

LNG market

In March Sakhalin Energy announced its fourth sales deal with a big Japanese customer: a 23-year agreement with Toho Gas to supply up to 0.3 million tonnes per year from 2010. The deal took the total volumes sold to 3.1 million tonnes per annum for periods greater than 20 years.

A company spokesman said the Toho Gas agreement "confirms that Russia and Sakhalin Energy are a strategic and competitive supply source for Japan and the Asian Pacific." Nevertheless, the level of contracts signed is low, due to the long-term trend in LNG markets towards spot sales. And that's another challenge for Sakhalin Energy. "The take-up has been slower than we expected," a source close to the project admitted.