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Shell gets black eye with Sakhalin project overruns double earlier estimates Begins new era as single company, but questions persist on its ability to stimulate future growth Allen Baker Petroleum News Contributing Writer
After more than a century with a split corporate structure, the new Royal Dutch Shell PLC began trading as one company July 20. But whether it heralds a shining new era for the huge entity is still in doubt.
Just on the eve of the change, Shell had to admit July 14 that developing its biggest project, the Sakhalin 2 venture, will cost $20 billion — double the company’s earlier estimate. And the company said first deliveries of LNG would be delayed by at least six months, into the summer of 2008.
That announcement came just days after Shell struck a deal with Russia’s Gazprom to trade a 25 percent stake in Sakhalin 2 (Shell keeps 30 percent and the operator’s role) for half of one of the world’s biggest gas deposits — the Zapolyarnoye-Neocomian field in Siberia. It looked like Shell had a new partner with plentiful opportunities, and indeed a rumor soon surfaced that the pair would make a bid for another Russian oil company. But Gazprom may be getting a bit less enthusiastic.
“The need to increase capital spending and the delay in the first LNG shipment from the Sakhalin 2 project will certainly lead to a downward revision of Shell’s assets value (in Sakhalin 2)” said a statement from Alexander Medvedev of Gazprom.
The agreement with Gazprom included provisions for adjustment based on later evaluations of the two interests. Most analysts figured originally that Gazprom would have to sweeten the pot for Shell, but now it looks like Gazprom will be getting the sweetener. Merger-friendly structure? Shell’s new status as a single company could make mergers easier, since Shell shares can now be used in a deal. But Shell management has lost face on several occasions in recent months, and those shares might not be as readily accepted by potential suitors now.
Ownership of the far-flung company was formerly split 60-40 between Royal Dutch Petroleum, based in The Hague, Netherlands, and Shell Transport and Trading Co., with headquarters in London.
But last year’s reserves scandal, in which the company had to adjust its estimates several times, led to the decision to scrap that form and set up a single company. Two classes of Royal Dutch Shell PLC are now trading, but each share represents an equal slice of the company.
The new entity has a market capitalization of $220 billion, putting it among the world’s largest. Shell is now incorporated in London with a single board and management in The Hague.
The move impressed Moody’s Investors Service as a way to improve governance and avoid future pratfalls.
“The unified shareholder structure and a single board, as well as the completion of Royal Dutch Shell’s review of virtually all of its reserves ... have addressed many of the governance and upstream control issues,” Moody’s said July 20. It assigned Shell a high credit rating of Aa1, but said its outlook was negative.
“While the increased costs of Sakhalin 2 have not impaired the long-term viability of the project,” the credit agency said, “delays and overruns on Sakhalin 2 or the other major projects could have implications for Royal Dutch Shell’s reserve replacement and production growth, which will be key to stabilizing its rating outlook.” Dismal reserve replacement Shell’s restatement of its reserves late in 2004 and early this year led to a reserve replacement ratio of around 50 percent for that year, far below the levels of its peers. And production hasn’t been a bright spot either, with liquids flows down 8 percent in the first quarter, compared to a year earlier, and gas flows down 2 percent.
Company executives blamed the cost balloon at Sakhalin 2 on several factors, including rising metal prices, Russian inflation, and a weak U.S. currency. Concerns about disturbing whale migrations led to changes in some pipeline routings that may have boosted costs.
“It is now clear Sakhalin II investment plans were significantly underestimated when they were approved in 2003,” said Malcolm Brinded, head of exploration and production, in a conference call after the announcement.
Despite being well into the construction phase, the new estimates still aren’t firm. According to Ivan Chernikovsky, a Shell spokesman in Moscow, the figures are “still at an early stage and subject to shareholder endorsement.” He stressed that the project was a “work in progress.” The new cost estimate covers the second phase of the project, including development and drilling activity, until 2014. Credibility issues Shell’s chief executive, Jeroen van der Veer, admitted the Sakhalin-2 cost overrun was a blow to the company’s recovering — but not recovered — credibility.
“I fully realize it has an impact on our reputation — certainly for this project, and then of course I’m concerned it will carry over to other things that we do,” Van der Veer told the Financial Times after the announcement. Problems in Canadian oil sands development, in Africa, and elsewhere have led to some doubts among investors about Shell’s ability to manage the big projects that are vital to reserve additions.
Sakhalin 2 still stands to be a success, despite the higher costs. The project, which includes Mitsui and Mitsubishi of Japan as well as Gazprom and Shell, already has long-term sales agreements for about four-fifths of the LNG capacity of the first two trains, which will pump out 9.6 million tons annually.
And there’s enough capacity in the fields to expand that output even further. Ultimate resource recovery is estimated a more than 17 trillion cubic feet of natural gas and a billon barrels of oil.
Material for this story was provided by The Associated Press.
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