Journey to Sakhalin: Royal Dutch/Shell in Russia

Questions 1 & 2.The main factor that makes the Sakhalin project attractive for Royal Dutch Shell (RDS) is macroeconomic: the quantity of the estimated reserve of gas and oil around Sakhalin (exhibit 4) combined to Russia’s dominant player position on both markets are likely to provide RDS as a supplier with a strong bargaining power once the reserves can be exploited.

Besides, the overwhelming part of energy in the Russian GDP lets suppose that efforts would be made if, for example, additional infrastructures are needed. The geopolitical situation, to the extent that this project is not located in the Middle-East, could at the first glance be an advantage as well, because the political and social situation of this part of Russia seems to offer much more stability than Middle-East countries.

But actually, no peace agreement has been signed with Japan about Sakhalin and this island may be part of an eventual future conflict between both countries (especially as a counterpart of the disputed Kuril Islands), even if Mitsui’s and Mitsubishi’s participation to this project, which must have been organized with the powerful Ministry of Economy Trade or Industry (METI), minimizes this risk. So, all in all, the geopolitical situation may have been an important factor for RDS to decide to take part to this investment. Another key factor that makes this project attractive especially for RDS is its know-how, not only about the market situation, but also about the non market strategy.

First, RDS has the majority (55%) in the SEIC, which allows it to handle this project following its own ways of doing business, backed by its traditional experience in the energy business. If the project has not been given to Rosatom or any other Russian company, it is because RDS was the only one to have the required experience to first explore offshore gas wells and oil deposits and then tap them. So, in some extent, RDS’ old-age know-how is its competitive advantage in this business. And being aware of that, it must have been a key factor, which has driven RDS to tackle this project.

The threat of rivalry, however, especially Rosatom’s, would give me concern, because we can see that it tried to join the deal even after PSA has been signed and we may always suppose that Rosatom is likely to be backed by Russian Government (which owns 38% of it) and the Duma.

To mitigate this risk, it is to my mind absolutely necessary to pay attention to each part of the PSA, which is part of the nonmarket strategy. And I think the obviousness of the strategy to adopt for this investment, which is not changing the business model of the company nor staying away, but trying to change the institutional context, has also been a key factor.

RDS indeed has tried to implement this nonmarket strategy at each level, so as the two following elements have contributed to make the investment attractive: first, the local population, as well as the local Government, does not appear to be antagonistic to this project. On the contrary, as RDS along with the SEIC has decided to give support to it through many social and environmental programs, this investment might not face local opposition.

Secondly, RDS’ know-how gives it confidence to talk with “middle-level class”, as well as with the Prime Minister. I think therefore that RDS’ experience with global projects makes them think that changing the institutional context is possible, and that must have been decisive when it made its decision to invest in Sakhalin. To sell gas and oil, RDS would also benefit from an advantageous exchange rate trend between ruble and dollar (exhibit 3), to the extent that both markets are in dollar-denominated basis, which might not be a decisive factor but at least an additional one.

However, a few additional factors would give me concern: the historical deficit of FDI in Russia and the legal precedent of BP Amoco, the lack of civil service infrastructure to implement the PSA properly, the Russian oligarchy, which means the dubious links between politicians and businessmen especially in the energy business, the natural milieu (seismic location) and the technical complexity, as well as the political opposition within the Duma.

Regarding the lack of infrastructure, I would have put in the PSA a clause stipulating that the costs of new pipelines, LNG plants and oil export terminal would be shared between the Russian Federation and the company, putting forward that exploring and exploiting those resources would benefit Russia as well. And to the extent that I cannot change Sakhalin’s ground and relief, to minimize those risks, I would have focused all my energy in trying to change the institutional and legal environment to protect my company as much as possible against natural risks and rivalry.

That means that, to my mind, the company must negotiate with both local and central governments, and above all with the Duma to make sure the Russian legislation is not in opposition with the PSA, so that RDS can preserve its competitive advantage (and would not be got ahead by Rosatom or compelled to give additional royalties taken on eventual future RDS’ profit to the Russian government).

Question 3.I think yes, Shell’s managers should proceed with Sakhalin II and invest another $10 billion in Russia, primarily because missing this opportunity would be a “market mistake”: given the estimated reserves and the amounts of money at stake, a Shell’s (Russian) competitor would certainly end up taking this opportunity if Shell does not, especially because Sakhalin is a perfect location to export oil and gas to the emerging markets in Asia. Furthermore, I think Shell has correctly identified all economic, social and political stakeholders of this investment (see questions 1 and 2). It seems to use its nonmarket strategy towards institutional change as a Porter’s sixth force to be defended against future eventual attempts from the Government or competitors to exclude RDS from Sakhalin.

And above all, I guess RDS has the most important nonmarket capability according to David P. Baron: “the knowledge, expertise and skill of managers in addressing nonmarket issues”. Thanks to the company’s background, especially in Africa (Algeria, Libya, Tanzania, South Africa according to Shell’s corporate website) where the legislation can be considered as more unstable than in Russia, I think RDS’ managers can manage this investment as best as possible, by keeping the same market strategy (using its experience to explore and then to tap gas wells and oil deposits at a reasonable price) and by adopting a multidomestic nonmarket strategy, here designed especially to Russia.

Besides, entering the Russian market in Sakhalin would, if the project works well, maybe strengthen RDS competitive advantage of experience regarding the future exploration and exploration in the Arctic Ocean, where so many gas reserves are supposed to be. Finally, this project is said to be “a political statement” (page 11, paragraph 3). This lets us suppose that the interest of the Russian Government is definitely a success of this project to attract other FDI later, which means that RDS can count on the cooperation of it to make the investment successful.

However, I add that, if I had to take this decision now and not five years earlier, I would have paid a particular attention on shale gas and shale oil reserves in Russia’s main gas and oil importer countries: European countries, Asian countries, as well as the United States. If those reserves are estimated so high that some of the traditional main importers can be self-sufficient, I would not have advised RDS to take the risk of such an investment in a country with such an uncertain legislation.