The Sakhalin Oil Boom Part 1: From Poverty to Prospects

The tiny Russian island needs foreign investment -- and Japan needs the oil

Oh for the really good old days, Japanese at that time must have reminisced, recalling the riches so close and yet so inaccessible, under the permafrost-encrusted terrain of Sakhalin Island -- a mere 40 kilometers away across the Soya (La Perouse) Strait. Russian companies discovered oil on the frigid island in the late 19th century, and under the White Russian and later Soviet regimes, Japan obtained concessions for drilling on northern Sakhalin starting in 1919. Sakhalin oil supplied Japan through most of World War II.

The Cold War sealed off Sakhalin's hydrocarbon treasure, as the Russian Far East was transformed into a highly militarized outpost brimming with nuclear subs, air bases and listening posts, its top-secret importance highlighted by the tragic downing of a Korean passenger jet which strayed over the southern coast in '83. But a decade later, when the bankrupt Russian central government was eager to invite foreign consortia to help exploit its bountiful natural resources, Sakhalin energy was back out of the cupboard. Neft ne moloko: Oil isn't milk, it doesn't spoil. Nearly a century after a Mitsubishi-led consortium gained the first rights to extract oil in Sakhalin, the Japanese are again setting their sights on the forbidding but mythically endowed sliver of land to the north.

"If you put everything
together, Sakhalin could rival
some of the Mideast sources"

Investment in Sakh I is expected to reach $12 billion, with $9 billion for Sakh II. Impressive? That's just for starters -- once the bills for infrastructure and support facilities are added up, total investment into this desolate island of less than 1 million residents could spiral up to $100 billion.

"If you put everything together, it could rival some of the Mideast sources," gushes Jeffrey Valkar, director of the American Business Center in Sakhalin. "As far as unproven reserves go, they are found throughout Sakhalin, even up into the Arctic Circle."

Smaller Japanese utilities such as Chubu Electric are in discussions with Shell, says Tsutomu Toichi, managing director of the Institute of Energy Economics in Tokyo. Shell's coup could crowd out Exxon, according to World Gas Intelligence: "If Shell does, indeed, get in first with Sakhalin II LNG, it's unclear that the slow-growth Japanese market would be able to absorb in such a short time frame another increment of the size Exxon is considering."

Superlatives apply when describing the complexity of operating in a remote location and arctic climate, where mid-winter temperatures plunge to minus 35ûC -- a brutal minus 70ûC, if you factor in the windchill -- and ice locks up the island from late fall through spring. Factor in Sakhalin's location astride a seismically active region: The island escaped serious damage during a massive quake in 2000, but was not so lucky in 1995, when a temblor decimated the northern town of Neftegorsk and killed two-thirds of its 3,000 residents. Neftegorsk lies 60 miles west of the Sakhalin II oil drilling platform, which began operations in 1999.

To mitigate the hazards, Exxon, operator of the Sakh I consortium, is installing rigs both on- and offshore. Adam Pearce, finance and administrative manager for Houston-based Parker Drilling, which is building and operating the land rig, calls the enclosed derrick and support equipment "the biggest land rig in the world. This type of horizontal drilling has never been done." To turn the drill bit at an extreme reach of five miles beneath the seabed, pumps and hydraulics run on 9,000 horsepower, more than twice the normal energy requirement for a rig, according to an account in the Houston Chronicle. Exxon had originally planned to "spud the well," or start drilling, by the end of 2002, but has been forced to delay until this summer, Pearce says, after high waves prevented offloading some of the rig components, military landing-style, from ramps on the beach near the Chayvo field. The contractor was forced to sail instead to Korsakov at Sakhalin's southern tip, and rush the last remaining shipment back north by truck.

But fighting forces of nature is not the only challenge for the oil majors, operating in a country which is still getting the hang of concepts such as rule of law. Steve McVeigh reckons it took 600 approvals to get the first phase of Sakh II rolling; "thousands" more for phase two. Exxon and Shell heaved a sigh of relief in April, after the Duma, the lower house of Russia's parliament, decided to abolish production-sharing agreements (PSAs) on Sakhalin, but exempted the first two Sakhalin blocks from the requirement that all projects either be developed under the standard tax regime or be re-tendered. (Under the terms of a PSA, Russia receives neither royalties nor taxes from energy sales until the Western companies are compensated first for the costs of exploration, development and production.)

The oil majors have also been on the defensive after a barrage of criticism from local and foreign environmental groups, who charge Sakhalin's metamorphosis from wilderness to gas pump will decimate valuable salmon fisheries and destroy wildlife, particularly the migration habitat of the endangered Western Pacific gray whale. Environmentalists charge that the oil companies are "cutting corners" in Sakhalin, employing inferior technical standards and leaving the area vulnerable to an Exxon Valdez-grade catastrophe.

"Do you think we want our
island to be covered with
pipelines? What can we do?
We don't have any choice"

The majors say they have gone to great lengths to minimize environmental impact from exploration and drilling, such as funding whale migration research. $2 million has been spent already on research, said Galina Pavlova, director of the Department of Oil and Gas Complex of Sakhalin Region, according to an article in the Alaska Oil & Gas Reporter. Another $5 million is earmarked for whale studies, she said, adding "the issue has been blown way out of proportion."

Still, though she is normally by occupation and temperament an unabashed booster for Sakhalin's transformation into a Pacific oil and gas hub, Pavlova offers a rare and brief moment of candor during an interview in her Yuzhno-Sakalinsk office: "Do you think we want our island to be covered with pipelines?" she says suddenly, abandoning the interpreter to speak in English. "What can we do? We don't have any choice."

Indeed. Yuzhno-Sakalinsk, the dusty, down-at-the-heels capital of Sakhalin, is like many provincial Russian burgs, punctuated at its center by a pigeon-desecrated statue of Lenin. Lenin Square is flanked by cheap hotels and anchored at one end by a railway station, the only link for residents to the northern village of Nogliki, an overnight trip away. An avant-garde monument in dark granite memorializes the victims of the Neftegorsk earthquake. Opposite the rail station is the city government headquarters, adorned with typically heroic, Soviet-era bas-relief pillars of local industry: Fishing. Forestry. Coal. Oil. (Tourism is notably absent from the bas-relief honor roll; in fact, of the nearly 10,000 Japanese who travel to Sakhalin annually, says Kazuo Anzai, president of Tourist Theatre, only about 10 percent go for pleasure, insignificant when measured against the millions of Japanese streaming to other regional destinations such as Seoul or Honolulu.)

Photos and recruitment posters from the '50s, on display at the stately Showa-era Sakhalin Regional Museum, exhort comrades to go east, young man, to a virtual Garden of Eden. Once the Japanese colonists were kicked out of southern Sakhalin (Karafuto, in Japanese) at the end of the war, Russian settlers not only were certain to find work behind a buzzsaw or fishing net, but could depend on an additional stipend for living in the hinterlands, a good eight time zones from Moscow.

But in the wake of perestroika, Sakhalin's citizens fell on hard times. Rationing was reintroduced and power outages -- ironically for a region so endowed with oil and gas -- were frequent. The city's housing stock, dating largely from the '60s, fell into disrepair; lately it is not uncommon to see an altruistic form of graffiti on crumbling buildings, warning passersby to beware of falling concrete. Sakhalin's only easily accessible source of wealth, its fishing industry, has been commandeered by the mafia, who have been fingered for the Molotov cocktail torching of a downtown apartment in April 2002. Vitaly Gamov, 40, who had carved out a reputation as Poacher Enemy number one, died in the attack; his wife Larissa spent months in a Tokyo hospital receiving skin grafts. Even for less high-profile citizens, a trip to the local bakery invites the risk of a mugging. Many Russians avoid going outdoors after dark; Americans and other foreigners rarely leave their chauffer-driven cars, except for a handful of foreigner ghettoes like the SakhCentre business complex and Michinoku Building, the upscale Sapporo and Santa Hotels and the Shell-managed gated community on the outskirts of town, called Zima.

There is no question that foreigners and at least a few Russians will make fortunes in Sakhalin. "Right now, we must depend on federal subsidies in order to pay our civil servants, such as teachers and doctors," says the voluble Vladislav Vladimirovich Rukavets, chairman of the Committee for International, Overseas Economic & Interregional Relations. "But once Sakhalin's offshore deposits are developed, we'll be able to subsidize the central government in Moscow!" Maybe. Since the Russian financial crisis of August '98, downtown Sakhalin is looking a tad sleeker. Residential and commercial space are at a premium, because the oil majors are buying up even dilapidated stock to refurbish and house their ever-swelling ranks. While newbies like Adam Pearce dream of the day when the startlingly franchise-free Sakhalin gets its first McDonald's or Starbucks, local entrepreneurs, particularly the ethnic Korean community, are starting to open smart little cafes and shops. But inflation at the humble local gastronom (grocery store) has hit the pocketbooks of residents in Sakhalin, where the average monthly salary is less than $200 a month, and American officials privately fret that a social disaster is in the making, as energy fortunes widen the divide between haves and have-nots.

"We are not against oil and gas development per se," contends Diana Tarasevitch, lawyer for Sakhalin Environment Watch, a tiny nongovernment organization based in a ramshackle office in Yuzhno that has become a thorn in the side of the oil majors. "But it should be conducted in harmony with our island's social and economic life and ecology."

Right now, the worldwide economic slowdown and competition from rival energy producers such as Indonesia or Malaysia cloud immediate prospects for Sakhalin gas, but around Yuzhno-Sakalinsk, such problems are shrugged off as short-term glitches. Industry players say Sakhalin's natural assets and the Kremlin's desire to show foreign investors it's safe to do business in Russia -- combined with the US's and Asia's quest for alternatives to Arab oil -- make Sakhalin too strategically important not to pay off. @

Photograher Peter Blakely's work can be seen online at www.peterblakely.com