"However, the credit impact on Shell will depend on the form and amount of consideration it will receive from Gazprom for a 30% stake, whether Shell will continue to maintain operational control given its technical expertise in large LNG projects and the extent of changes to the hitherto very favourable terms of the respective production sharing agreement it will need to accept as part of the transaction," says Thomas Baumeister, Senior Director in Fitch's Energy team. "It will also hinge on the extent to which Shell will experience significant reductions in its inventory of proved reserves and on whether the Russian authorities will adopt a more accommodating attitude towards Shell, once control has been transferred to Gazprom."
The resolution of the current dispute between Sakhalin II and the Natural Resource Ministry's Environmental Agency, the latter of which has threatened to file a lawsuit for environmental damages for at least USD10 billion, and possibly as much as USD30bn, by March 2007 will also be an important credit factor.
It is understood that Shell's stake in Sakhalin II would decline to 25% from 55% while its two Japanese partners, Mitsui & Co. and Mitsubishi Corp, would both reduce their stakes to 15 % and 10% respectively, with Gazprom acquiring effective control of the venture.
Given the importance Sakhalin II has in Shell's reserve replacement strategy, any significant loss of future production volumes and reserves under a renegotiated production sharing agreement could be detrimental to Shell's efforts to catch up with its peers in respect of reserve replacement and reserve life, an important parameter to evaluate an oil major's long-term growth prospects. Sakhalin II is Shell's fourth largest development project out of nine, both in terms of reserves (1.398 billion barrels of oil equivalent) and net present value (USD4.85bn). When the project is completed, it is expected to have 9.6 million tonnes per year of LNG capacity.
While Shell does not disclose financial and operational details on Sakhalin II, but only on Russia, CIS and the Middle East, a review of Shell's recent operating metrics reveals that this region is key for Shell's future reserve and production growth. The region accounts for the largest part of Shell's upstream capital expenditure and future net cash flows in line with SEC-disclosure rules. Fitch notes that during 2003-2005 about 50% of consolidated organic reserve replacement originated from this project alone and after prospective production start-up in summer 2008, forecast production volume should total some 430mboe/d, including 1.5 billion cubic feet for natural gas, and represents approximately 7% of Shell's 2005 production on an adjusted basis.
As for Gazprom, gaining a stake in the project will further enhance the company's business profile by providing it with an opportunity to participate in an LNG project and to gain much-needed experience in this cutting-edge industry. Additionally, the participation of Gazprom should help ease what has to date been considerable negative political pressure on the project's development.
Fitch also notes that Shell may be more likely to meet a crucial deadline for beginning shipments of LNG from Sakhalin II in 2008 by resolving its regulatory disputes in Russia and reaching an agreement with Gazprom to cede majority control. The reduction of Shell's stake in the Sakhalin II venture may also result in the deconsolidation of the project. This is attractive as Shell, alongside other European integrated majors, only discloses development cost for consolidated developments. This may actually improve Shell's headline finding and development costs in light of the company's likely worsening costs for the Sakhalin II expansion.
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