Russian mega-projects: are the plans realistic?

Continuing on from the post two below this one, I should emphasise that the $2.6 trillion required by Gazprom and Rosneft is only that amount needed to develop Russia’s offshore fields. The onshore developments will need separate funding, as this article in Upstream Online tells us:

Russia’s Gazprom Neft is planning to more than double its oil output by 2020 through a series of buy-ups, the oil arm of gas giant Gazprom said in a strategy document released today.

Gazprom Neft, which produced around 43 million tonnes of oil last year, flat on 2006, has been fighting declining production since its former owner, billionaire Roman Abramovich, sold the company, then called Sibneft, to the gas giant in 2005, a Reuters report said.

I’ll intervene here to say that Abramovich seems to have made a pretty smart move in flogging off a load of declining oilfields for top dollar. He would have had to invest in them himself to keep up production rates, instead he’s just offloaded them onto Gazprom and walked away with the cash. Nice! Anyway, I digress:

Gazprom Neft, which expects Gazprom to hand over the right to develop all of Gazprom’s 11 oilfields within the next two to three years, has said it plans to invest up to $4 billion per year to 2020, or around $50 billion, to boost output.

West Siberia will remain a key region for the company and East Siberia and the northern Nenets region will also be developed.

$4bn per year is one hell of a lot of money for a single company to invest in oil and gas projects, if not much beside the $62bn per year that they say they are going to have to come up with to develop the offshore fields.

To put this in perspective, consider the Sakhalin II project, the largest integrated oil and gas project in the world (by cost), involving Russia’s first offshore platforms and first LNG facility. Put simply, the Sakhalin II project involves the installation and upgrading of an ancient platform they hauled out of some inlet in Canada just to get some sort of production going, followed by the construction and installation of two brand-new modern offshore platforms, an onshore processing facility, two 800km pipelines running in parallel, and a combined LNG plant and oil export terminal. For a more detailed, but still brief overview, go here. Anyway, this project was originally budgetted at $10bn, but the costs have slipped slightly and it’s now looking at coming in at $20bn. The major expenditure on this project has been in the last 4 years during the construction and installation of all these pipelines, facilties, etc., a phase which is due to be complete by the beginning of 2009. So for argument’s sake, and these numbers are rough, let’s take the expenditure as being $16bn over 4 years, which is $4bn per year.

In other words, Gazprom Neft – and this is just the oil arm of Gazprom, not the entire company – thinks it is going to be running projects of the magnitude of the Sakhalin II project from now until 2020, or possibly lots of smaller projects combining to the same value. And this is what is causing me to wonder where these figures are coming from and what they are based on.

Firstly, as the Sakhalin II project has shown, cost and schedule overruns on projects in Russia are serious. There are many reasons why the Sakhalin II project found itself overspent and behind schedule to such a degree, several of which are through the actions of the Russian government. Constantly changing visa laws, dubious customs clearance procedures, Russian content requirements, a restrictive labour code, and selectively applied environmental regulations all combined to add enormous costs to the initial estimates. Some of these obstacles might be removed should a mega-project be run by a state-owned company such as Gazprom or Rosneft, but this is doubtful. Anyone who has worked for a nationalised company in the Middle East will tell you that working on behalf of a government company does not make negotiating the maze of other government departments any easier. It took the government-owned Kuwait Oil Company more than four months to get me a permanent security pass from the state oilfield security police to allow me onto the Burgan oilfield, where I was working daily on a ten month project. The environmental barriers might be pushed aside on a Gazprom project, but I can’t see the customs authorities being any more generous, by which I mean forgoing their unofficial cut, out of solidarity with another state-owned enterprise.

Also important is the fact that the Sakhalin II project overspent and overran partly because of Shell’s failure to manage the project correctly, particularly in their selection of subcontractors and monitoring of progress in the early stages. Shell’s reputation for project management has taken a beating on the Sakhalin II project, and deservedly so in many respects, but it should be understood that the project has been carried out in an incredibly remote and harsh environment with no history of this kind of work being done in the country before. Any company managing this project would have faced the same difficulties Shell has done, and it is very unlikely that any company would have done a much better job. So all things considered, Shell have not made a bad fist of the job. Not too good either, but it’s not a disaster, and in ten years everyone will probably be saying what a great job it was. Production receipts tend to have that effect. Anyway, if Shell as one of the most experienced companies at executing mega-projects in harsh environments struggled more than usual on the Sakhalin II project, how exactly is Gazprom or Rosneft going to fare once they have a go? Neither company has previously undertaken a modern, technically challenging mega-project involving hundreds of subcontractors from dozens of countries, employing thousands upon thousands of people of a bewildering array of nationalities. I’m not sure either has even run a small project with one main foreign subcontractor. I’m not sure if they even have a procurement department which can prepare tender documents in English. I’m not even sure if they have a procurement department. You get my drift. So chances are, whatever calculations and estimations they have made, they are likely to increase significantly over the course of a project, especially if either company falls into the trap of allowing conflicts of interest to go unchallenged, such as the head of contracts and procurement awarding major packages of work to a subcontractor owned by none other than himself. These practices are rife across Russia, and it would be pretty optimistic to assume they won’t occur on oil and gas mega-projects run by nationalised companies.

Secondly, there is the question of who is actually going to carry out these projects, which companies and what people. It is no secret to anyone that there is a serious shortage of skilled people in the worldwide oil and gas industry at the moment, and the high oil price has rejuvinated dozens of expansion, modification, and upgrade projects as well as blown the dust off plenty of planned developments. Workers in an industry like this can afford to be fussy about which projects they join: the Sakhalin projects have lost hundreds of their Malaysian, Indonesian, and Philippino labour force as new projects come up either back in their home countries or in sunnier climes such as Australia. The Sakhalin projects have been competing heavily for skilled resources against the mega-projects in Qatar and elsewhere in the Middle East, usually without much success. For most people, Sakhalin and northern Russia is a place to go and gain some experience and save some money, and once you have a decent skillset, people tend to disappear somewhere more accommodating. Therefore, one of the hardest jobs Gazprom and Rosneft are going to have is attracting and retaining the skilled workers needed to man these projects, and to do that they are going to have to pay probably more than anywhere else. If this manpower premimum hasn’t been considered in the estimations of how much these development projects are going to cost then it should have, because for the next decade and possibly more the Russian projects are going to have to be primarily manned by foreigners.

The giant projects on Sakhalin have produced a good number of Russian workers who have, considering the few years they have been learning, developed astonishingly quickly, and will no doubt find themselves in prominent positions on future projects. But as a proportion of the available working population, which is small to being with given the country’s size and the work to be done, there numbers are way too low. It is a sad fact that in the experience of every company involved in the Sakhalin projects, if you take 10 Russians onto the job, 1 will be brilliant, 1 good, 1 average, and 7 utterly useless. We put several hundred through our training school on the island, of which a grand total of none are still with us. Admittedly we were taking on ex-soldiers and criminals from the labour departments (as we were compelled to do) and hence our recruitment pool was hopelessly poor, but the proportion of ordinary Russian men who fail to make the grade on an oil and gas project either through alcohol consumption, failure to turn up to work, or lack of self-motivation is shockingly high for a country looking to develop rapidly. Which is a shame, because as I said, there is a good core of Russians who within months became as capable and reliable as anybody else, who I know feel a bit let down by a lot of their compatriots. But even Russia cannot take these for granted, because the oil and gas industry is very much global, and if Russians can take a position on a foreign project for more money, chances are they will. So one of the enormous challenges facing Gazprom and Rosneft is how they will staff their projects, especially as they have made it increasingly difficult to bring foreigners to work in Russia, the costs for which will simply be passed on.

The other challenge they will have is to identify which companies will carry out the work, and more importantly, under what terms. As most individuals in the global oil and gas industry are fussy about which projects they can join, as are most companies. The American company Fluor, one of the largest and most experienced oil and gas project management and construction companies in the world, has an order backlog of $30bn. It is in no hurry to bid jobs low just so it can fill its order book and keep its staff employed. Technip in the Middle East a few years ago won so much work it struggled to execute it. Any company working in oil and gas that is struggling for work right now is going to be out of business altogether pretty soon. There is enough work, more than enough, for everybody. So if anybody is going to be bidding work on Russian mega-projects, they will already have seen the lessons of Sakhalin I and II, and be in no hurry to underprice them. The situation in which AgipKCO has found itself on the Kashagan project in Kazakhstan is telling:

Kashagan operator AgipKCO has set back the award of the last big first-stage contract for at least two innovative drilling barges by cancelling a long-standing tender for lump-sum offers and asking for prices based on man hours, writes Vahe Petrossian.

AgipKCO has told the two rival partnerships led by Technip and Keppel Fels, which submitted technical and commercial bids last year, that their prices are too high, a source said.

“They rejected the bids and are considering a reimbursable commercial package,” the source said.

The new requirement is based on estimates of the man hours required to complete the job, which could involve up to six of the cantilevered barges.

This would eliminate all or most of the risk factor priced in by the bidders placing the risk on the client instead. The risk factor is estimated at between one-fifth and one-quarter of the prices quoted so far by the bidders.

The value of the planned contract under a lump-sum arrangement had been estimated at more than $500 million.

Here we had two consortia (a third dropped out earlier) bidding a technically demanding scope which had never been attempted before, in a country where the government changes the laws whenever it feels like it. Unsurprisingly, the contingencies built in were collosal to the point that the operating company, AgipKCO, could not afford to award the job. So AgipKCO has now resorted to accepting reimbursable terms whereby the winning consortium gets paid for manhours and materials expended at agreed rates, instead of a lump sum for completing all works. If the job overruns, the operating company will have to keep paying for the work to continue, an approach which doesn’t give the engineering companies the same incentive to work efficiently. On the Sakhalin II project workscopes, laws, and other circumstances changed so much that Sakahlin Energy reluctantly agreed to accept a change to reimbursable terms for some subcontractors who had fallen way behind and were facing insolvency. Bearing all this in mind, it is certain that any engineering company bidding a mega-project in Russia, especially a ground-beaking Arctic offshore project, will include either an enormous contingency and a raft of conditions in its lump sum bid, or will refuse to accept anything other than reimbursable terms. Such is the uncertainty which faces companies who venture onto Russian oilfields that they will be treading very carefully indeed.

So what does all this mean? Have the Russians taken all these factors into account when coming up with their investment figures, confident that they can pull off without a hitch for 20 years what Shell have struggled with for the past 4? They did put a man into space, after all. Nobody knows, certainly not me. But this what I think. Consider for a moment that these figures of X-billion in developments and investments have been thrown about like confetti for the past few years, but as of yet nothing has really moved forwards, and if anything large steps have been taken backwards from actually preparing the ground for the years ahead. Who can honestly say that massive investment will be easier for the Russians to get in 2008 than it was in 2005? And do the large foreign companies essential for performance of the works have any greater confidence to trust those who will be managing them now than they might have had three years ago? So far, these numbers are all theoretical.
The world is heading for an economic slowdown, and Russia has a new president in charge. So much that was certain is now less so. The Shtokman project has just started, with the main players in place and the first early works subcontracted. All eyes will be on this one, eyes eager to see past the project and into the future of the Russian oil and gas industry. One of the keenest pair will belong to me, who is guessing that these multi-billion dollar figures are been bandied about without due consideration of what they actually entail.


12 thoughts on “Russian mega-projects: are the plans realistic?

  1. Brilliant article, even for someone away from the Oil industry. Very interesting information and analysis. Why don’t you try publishing this article in The Economist, for example? It’s very informative.

  2. Great article – we’re grateful that there are some “keen” eyes on energy investment in Russia.

    I’m also not surprised whatsoever that the Russians are throwing around these investment figures like meaningless confetti … they’ve got a pretty long track record of doing that. It’s similar to the preemptive announcements of MoUs, pipelines, and joint ventures that don’t end up leading anywhere, but serve other purposes in and of themselves. Just ask Claude Mandil at the IEA about Russia’s infrastructure investment – for years he has been scared that Russia is busy creating a future supply crisis for its lack of investment.

    Both Sakhalin and Shtokman are extremely capital intensive projects, and I can’t help but wonder that perhaps when the bureaucrats discover the extend of these investments, that relations might improve with international partners such as Shell and BP. Will they hold a grudge?

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  5. Will they hold a grudge?

    I don’t think they’ll hold a grudge, they’ll go back in for sure, but I think they’ll be a lot wiser as to the extent to which the Russians can be trusted. The likely outcome, as I said in the post, will be the western companies either pricing in enormous contingencies or demanding reimbursable terms. The reason trust is important in business relations is because it lowers costs. Russia has yet to learn this.

  6. Very informative, Tim. I have admit that much of it went over my head, but interesting nevertheless. I second the suggestion to try to publish this (or a variation of it) somewhere else. It deserves a wide audience.

    “The reason trust is important in business relations is because it lowers costs.”

    Right you are! And it applies at all levels, from multinational deals to small business contracts.

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  8. Great article. But don’t you think this is just a continuation of the type of thinking that went on under central planning: you announce some targets and some production plans and everything is magically supposed to fall into place, with the plan fulfilled on time and on budget. In fact Soviet mega projects regularly overran because nobody knew anything about project management, there was no real incentive to finish on time, and no coordination of all the people involved.

    Can’t really see why anything should have changed just because a (relatively) few Russians have had some management training but the show is still run by career politicians (even if not communists these days).

    So what will be the result in 10 years?

  9. My knowledge of Russian history is pretty spotty, so my apologies if the following is in error.

    The Russians were initially very successful with their space program, but it is my understanding that all the praise should go directly to Sergey Korolyov. After he died, the space program took a turn for the worse. Peter the great single-handly brought Russia out of the dark ages and into the enlightenment. After he died, much was reversed. What I am trying to get at I guess, is that Russia can be pretty successful if the right man is in charge. If not, then its pretty much hopeless. I don’t know, maybe thats way too simplistic of an analysis.

    The scary thing about mismangement of oil reserves in Russia is that the whole world gets to take a bite out of the shit sandwich. Oh well, according to this article, there is plenty of un-tapped oil in the US, we just have too many tree huggers in the way to get at it.

  10. I’ve been tracking Russian oil and gas industry on and off for more thne 5 years now. Working as a product manager for the worls biggest plant design software supplier for O&G helps see a lot of examples of how both owner operators – Exxon, Chevron, CP, etc – and EPC’s do business.

    Take the numbers that are being thrown around and multiply them by about times 3. If a Gorgon project off a relatively calm shores of Western Australia is rumored to be made more expensive by about 300 million a month and is likely to grow from official last known 11 billion estimate to 25+, what do you think will be the real costs in Arctic conditions with raging inflation, costs of engineering in Russia going at or above the Houston rates and so on. Or if Exxon fired all local managers and parachuted their own management team at Syncrude to stop continuously bleeding cost overuns – what do you think is going to happen at Sakhalin-II and III and Shtokman? And as well noted Gazprom and Rosneft and others will have to pay premiums to engage first rate PMC and EPC’s like Fluor or Technip or KBR who are facing their own problems with the lack of skilled engineering forces. I was quite tempted myself by references to the GPB50/hr with the overtime in London or AU$130-180/hr in Perth for an experienced instrument designer, how much is the going rate for INtools super-admin at Sakhalin will be?

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