The Sakhalin Oil Boom Part 2: Prejudice versus Profit

Sakhalin's enormous potential could help save energy-strapped Japan. But can Japan deal with the Russians?

A few moments later the rotors begin spinning and we lift off from Chayvo. Outside, sand blows over a cold and uninviting coastline while an earthmover dumps its payload into an awaiting truck. Further in the distance stands the bright blue tower of Exxon's Yastreb oil rig, one of the largest and most powerful oil rigs on the planet.

Eight months ago, none of this was here.

Desolate, ice-bound, tectonically tumultuous, blanketed in red tape and severely lacking in infrastructure, Sakhalin Island, Russia is nevertheless the epicenter of the world's latest dash for oil and gas reserves, with multi-billion dollar projects already underway and others in the works. By some estimates, the Sakhalin shelf is blessed with as much oil and gas as Alaska's North Slope, and could bring in $50 billion or more of investment over the next few decades.

At $12 billion, the Sakhalin I project, run by a consortium of companies led by ExxonMobil, is quite simply the biggest foreign investment in Russian history. (The subsidiary running the project is called Exxon Neftegas Ltd.) The Chayvo site is just the first phase of Exxon's ambitious plan for the island, which includes a natural gas pipeline running south from Sakhalin to Japan.

Sakhalin's sudden prosperity stands
in sharp contrast to Japan's
economic woes

For Japan, Sakhalin Island has never been so close, yet so far. Only 43 kilometers from Hokkaido's northern tip at Wakkanai, Sakhalin's sudden prosperity, though still risky and arguably mismanaged, nevertheless stands in sharp contrast to Japan's continued economic woes.

The abundant oil and gas on the Russian side of La Perouse Strait is like a cruel, geologic joke on the Japanese. Sakhalin has about 600,000 people; Japan roughly 120 million. Yet Japan has a dearth of fossil fuels within its borders and imports between 98 and 99 percent of its oil, mostly from the Middle East. Japan's domestic coal deposits have, for the most part, long since been exhausted, and nuclear power grows increasingly unpopular and problematic. Tokyo Electric Power Co. recently closed 17 nuclear power plants for maintenance, and will be lucky to avoid brownouts this summer (see page 8 for the complete story).

The sting of Sakhalin's boom is that much more potent because of Sakhalin's history as a possession or partial possession of Japan. The Japanese still celebrate the achievements of explorer Mamiya Rinzou, who in 1809 was the first non-indigenous person to identify that Sakhalin was an island, not a peninsula. He also surveyed the geography of the island with remarkable accuracy.

After the Russo-Japanese War of 1904-1905, Japan owned the southern portion of the island below the 50th parallel. Stalin's troops captured it -- or recaptured it, depending on who you ask -- at the end of World War II, together with the Southern Kurils Islands, which to this day Japan claims are illegally occupied by Russia.

During a brief period between 1920 and 1925, Japan owned all of Sakhalin and even had a consortium of companies extracting oil from the northern part of the island, one of which was Mitsubishi Mining. Nowadays, in towns like Otaru and other parts of Hokkaido, it's not hard to find old men who once lived on Sakhalin and who, after a sufficient amount of liquor, start griping about Russia's unlawful takeover of Karafuto, the old Japanese name for Sakhalin.

"Of all the important treaties that Japan and Russia have signed over the last 150 years, Sakhalin has always played a part," says Yoshihisa Kuroda, Japan's consul-general in Yuzhno-Sakhalinsk. It's not a place of trouble per se, continues Kuroda, but he adds, somewhat vaguely: "The history of our relations with Russia shows what Sakhalin is between us."

In other words, the island is a 948-kilometer sticking point. What will become increasingly tricky for Kuroda and other Japanese politicians is the fact that Sakhalin Oblast has jurisdiction over the disputed islands that the Japanese want returned. At the same time, the scramble to get a piece of the pie from Sakhalin's oil boom is under way, and Japanese firms need to be sure not to let conflict over the disputed islands, nor lingering reluctance about doing business with Russians, get in the way of cashing in on the Sakhalin bounty.

At this point, that looks unlikely. A group of 13 Japanese companies, under the name SODECO, holds a 30 percent stake in Exxon's Sakhalin I project, and Mitsui (25 percent) and Mitsubishi (20 percent) are stakeholders in the Sakhalin Energy Consortium operating the Sakhalin II project. These two endeavors are, to date, the largest Japanese investments in Russia.

In May, Sakhalin Energy announced an additional $9 billion infusion in its Sakhalin operations, including contracts to build an oil refinery, liquefied natural gas (LNG) production plant, oil exporting terminal and nearly 800 kilometers of pipeline running down the length of the island. Japanese firms are likely to get a significant portion of these contracts. "The Japanese, as you know, have a lot of expertise, especially with LNG," says Sakhalin Energy spokeswoman Rachel Sheard. Meanwhile, Nippon Steel will soon be arriving to build a pipeline for Exxon to carry oil across the island from the Chayvo drill site to awaiting tankers, which will transport the oil across the Tatar Strait to refineries on the Russian mainland.

Not surprisingly, Japan is also the target market for much of what comes out of the ground in Sakhalin. "It's been a long time since we've had an opening of a major set of fields that are so close to a major market," says David Victor, director of Stanford University's Program on Energy and Sustainable Development. South Korea, China and even the Russian Far East are all prospective customers for the companies drilling in Sakhalin, but wealthy, energy-troubled Japan is clearly the gold-card customer. The recent signing of a $9 billion contract by Tokyo Gas to purchase natural gas from Sakhalin II is what many see as the first of many energy deals to come.

But while the major Japanese firms are shoring up their roles in the Sakhalin boom, small to medium-sized businesses from Japan aren't popping up in Sakhalin like one would expect, considering the island's proximity and the potential for moneymaking in the wake of such massive foreign investments.

"There's a heck of a lot of money there and a lot of people showing up. Go to any major port town in Alaska and the streets have all of these services that are connected to the oil industry. In Sakhalin, that's not there yet, but it will be," says Stanford's Victor. Signs of such tier-two business development are already easy to spot. An Indian restaurateur from Sapporo is about to open the Taj Mahal, Yuzhno-Sakhalinsk's first Indian food restaurant. Another Sapporo-based entrepreneur, originally from New Zealand, is busy making contracts to ship goods to Sakhalin as varied as truck tires, portable toilets and kitchen equipment (see page 41 for the complete story). And a fledgling American company run by a couple of expatriates is importing safety equipment -- like the yellow survival suit safeguarding my limbs on the helicopter to and from Chayvo.

Yet according to consul-general Kuroda, in the past two and a half years not a single new Japanese venture has opened up in the capital of Yuzhno-Sakhalinsk, fewer than 90 Japanese residents live on the island and local representatives from the Hokkaido government seem, well, bored.

The absence of smaller scale Japanese business activity in Sakhalin, and in Yuzhno-Sakhalinsk in particular, could be explained by the fact that the oil boom is in its early stages: As time passes, perhaps word about business potential in Sakhalin will spread among the Japanese and activity will gradually pick up. Perhaps, but that's not the whole story, and again a bit of history helps illustrate the current situation in Sakhalin.

Mistrust between the Japanese and Russians stems back to the 19th century, when the two countries were seeking to acquire new territory in the region -- most notably Sakhalin, but also the Kuril archipelago and even Hokkaido. Broken treaties and wars over the past 150 years have helped solidify feelings of mistrust and dislike. Russian animosity toward the Japanese was exacerbated after the Japanese offensive and subsequent victory in the Russo-Japanese War. Meanwhile, many Japanese perceive Russia's involvement in World War II as a late-in-the-game cheap shot, motivated solely by expansionist aspirations.

Nowadays, relations between the two countries aren't exactly strengthened by accounts of Russian sailors frequenting onsen in Hokkaido port towns and peeving the Japanese with the Russian custom of drinking in the baths and having a boisterous good time. On the other hand, Russia blames Japan for not doing its part to curb smuggling in the region. Russia says it's trying to crack down on fishermen in the Far East who illegally sell an estimated $1.3 billion worth of crab and other marine products annually, but their job is exponentially more difficult because Japanese port officials fail to enforce regulations or simply turn a blind eye to smuggling.

Japanese firms need to be sure
not to let conflict get in the way
of cashing in

If this backdrop of less-than-cuddly relations weren't enough of a deterrent for Japanese business interest in Sakhalin, a recent episode in which the Japanese were burned by their Russian partners irreparably tarnished the image of Sakhalin moneymaking potential in the eyes of Japanese businessmen.

The Santa Resort Hotel in Yuzhno-Sakhalinsk was opened in 1993 as a joint venture between the Japanese company Tairiku Trading Co. Ltd. and the Sakhalin Shipping Co. The partners put up $18 million for the project, but the venture was not profitable until the oil boom began to pick up speed in the late 90s.

In 1998 Sakhalin Shipping Co. went to arbitration court in Russia to recoup losses on the investment and was awarded the hotel and two ships that had also been part of the original joint venture. Sakhalin Shipping thereby seized full control of the venture by re-registering the hotel as an exclusively owned business. That was also about the time the hotel began turning a profit, and the Japanese estimate that it now brings in a profit of $3 million annually. Tairiku has yet to recover a single yen from the endeavor.

"What happened with the Santa Resort Hotel really hurt Russia as far as Japanese business interest is concerned," says Mashihiro Echizen, director of the Hokkaido Government Sakhalin Representative Office in Yuzhno-Sakhalinsk.

This episode grated on the Japanese sense of fair play, reinforced Japanese stereotypes of Russians and magnified the perception of risk about doing business in Russia. For the relatively conservative Japanese, Russia remains uncharted and risky territory.

Whether small to medium-sized businesses will cross over to nearby Sakhalin, find success among the oil bounty bonanza and help close the chasm between the two nations remains to be seen. But as the seasonal ice thaws, life is stirring: In early June, for instance, the Japan Association for Trade with Russia and Central-Eastern Europe sent a high-level trade mission to the region to explore further business opportunities -- focusing on energy. And for giant companies like Mitsui, Nippon Steel and Mitsubishi, the Sakhalin boom is too close, too huge and potentially too profitable to be ignored, irrespective of any misgivings about the Russians. @

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