The Sakhalin oil boom Part 1: from poverty to prospects: the tiny Russian island needs foreign investment--and Japan needs the oil.

LONG BEFORE "SHOCK AND awe" became a proprietary brand for pyrotechnics over recalcitrant Arab states, decades even before 9-11, the risks inherent in Japan's near total dependence on Mideast oil were painfully manifest. A chronology of modern Japanese history always pauses for breath during the bad old days of the early 70s, when the OPEC oil embargo not only sent panicked Japanese house wives dashing out to stock up on toilet paper, but permanently etched into the collective subconscious the "oil shocks" which temporarily knocked the legs out of Japan's postwar development miracle.

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 Mitsubishiled consortium gamed 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.

This time, the Japanese aren't going it alone. Sakhalin's regional and central governments have divided the 948-kilometer-long, 26- to 160-kilometer-wide island into six exploration and production blocks, and only the first two are near or at commercial production by two multinational consortia. The Exxon-led Sakhalin I project, in which Japanese firms hold a 30 percent share, aims for first oil in 2005, with natural gas to follow. Sakh I is premised on an extraordinarily large bet--being able to build an undersea gas pipeline down to Japan, an ambitious plan that is by no means a done deal. (While natural gas in other countries is usually transported via pipeline, Japan purchases most of its gas as LNG, gas cooled to liquid and transported in ships.) Sakhalin II, led by Shell and with 45 percent Japanese ownership, including Mitsubishi, is further along. It began producing a trickle of oil in December 2001, but needs to earn its keep off the inure plentiful natural gas deposits under its production block. In mid-May, the Sakh II consortium finally secured initial agreements with Tokyo gas and Tokyo Electric Power (Tepco) to supply each of the major utilities with about one million tons of LNG per year over long term contracts, a "major breakthrough," according to Sakhalin Energy. Construction is set to proceed on the world's biggest LNG plant at Prigorodyne by 2006.

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 35[degrees]C--a brutal minus 70[degrees]C, 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 an 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, front 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 role 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. 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.

RELATED ARTICLE: Sakhalin's environmental quandaries.

How to protect the environment while plundering the land. By David Wolman

WITH EVERYONE AND THEIR cousin racing to Sakhalin to build off rigs, pipelines and roads in what was once untouched wilderness, environmental protection has become a major concern in this corner of the north Pacific. The Sakhalin oil and gas fields are close to some of the most active faults on the planet, and the Japanese maritime protection forces in nearby Hokkaido have already begun running drills in case of an oil spill.

In September 2002, the Wall Street Journal ran a cover story comparing oil companies' environmental practices in Sakhalin with their practices in Alaska, stating examples in which foreign firms working in Russia were not doing everything they could or should when it came to protecting endangered Pacific gray whales, properly disposing of a drilling byproduct known as drilling muds or conserving fragile salmon habitats. Exxon and Sakhalin Energy thought it was a hatchet job.

"The claim that we're doing things here that we don't do in Alaska is simply not true," says Sakhalin Energy's spokesman Julian Barnes. Pointing to a USAID-commissioned report that refutes the claims of environmental groups, Barnes and Sakhalin Energy vehemently deny claims made in the Journal article.

Corporations today spend millions of dollars on social and environmental impact studies. Though critics say these expenditures are all about PR and liability protection, companies are nevertheless held to much higher standards than they were in the past. In the 70s, when the Trans-Aalaskan Pipeline was being built, environmental Law was still a budding area of litigation. Sakhalin Energy and Exxon are not stupid; the scope of these projects, let alone the very names of these companies, means they must contribute to environmental protection. They also know that nongovernmental organizations (NGOs) are scrutinizing their every move.

Assessing the possible effects of Sakhalin off development on endangered Pacific gray whales is difficult. The relevant scientific research is sparse and what is available seems to verify claims on either side, depending who you ask. What is clear is that there are only an estimated 100 of these whales left in the world, and that fact alone puts environmentalists in a panic and oil companies on the defensive, even before anyone bothers to examine data about whale migration and eating patterns.

And then, plaguing the environmentalists, there are always opinions from locals like 28-year-old Dimitry Bulgakov: "Ninety-five percent of people here say: 'Whales? What whales?!'" he says incredulously, waving his hand to the side. "People want a job."

Environmentalists also accuse Sakhalin Energy of dragging its feet for years over its continued dumping of drilling muds and cuttings. In an October 2002 meeting with members of Sakhalin Environment Watch and Oakland, California-based Pacific Environment, the company pledged to re-inject 100 percent of this material "where technically feasible," which is the preferred, though more expensive method of disposal.

"We are still arguing with them over the term 'technically feasible,'" says Pacific Environment's David Gordon, "since the company refuses to give us an idea of how much this actually is."

Although whales and drilling muds are probably not central to me everyday concerns of Sakhalin residents, the welfare of salmon is different. Fishing is Sakhalin's second largest industry, incorporating more than a dozen salmon hatcheries, and the island has some of the most abundant salmon runs in the world. Yet when it comes to protecting salmon, the sincerity of Sakhalin Energy's effort is suspect. Both Sakhalin Energy and Exxon plan to dredge below rivers for pipeline construction during the winter, which minimizes damage to fish because the salmon are out of town. This is a decent gesture, but that may be all it is.

Exxon plans to build a pipeline across the narrow island to a port where it will ship oil to mainland Russia, crossing a handful of rivers in the process. Sakhalin Energy's plans, however, call for a pipeline down most of the length of the island, crossing 1,103 streams and rivers. In its own report, Sakhalin Energy identified 63 of these 1,103 rivers as "sensitive salmon spawning rivers." This figure was determined by a Sakhalin-funded ecological survey, and for the sake of argument, let's say it's accurate. The question is: how to protect those sensitive rivers?

"The generally preferable method is bridge crossings," says David Martin of the Wild Salmon Center in Portland, Oregon. "No impact on the stream and easy to detect leaks. For really wide and shallow floodplains, it might make sense to use horizontal directional drilling (HDD)."

Out of the 63 rivers it has identified as sensitive, Sakhalin Energy will not cross any of them with bridges. And of the 63, the company has chosen only eight to cross with (HDD). Why only eight of 63? Barnes says that within this group of 63, some rivers are more important than others. This may not be wrong, but it sounds pretty weak considering the 63 were already selected out of 1,103 as the most sensitive. Barnes adds that building HDD in remote settings means bringing in heavy machinery, which in turn has other damaging effects on the natural environment. "So you see, it's about tradeoffs." Trade-offs indeed, but still: A baseball player with a .127 average is not a good hitter.

Exxon has its own environmental challenges, but this is a company that knows all too well what damage to the environment can do for business. On the surface at least, Exxon appears willing to pay what's necessary to minimize ecological impact, not to mention liability, specifically with regard to shipping oil across ice-bound waters to mainland Russia. (Sakhalin Energy's pipeline to the south will allow the company to ship out of a port that isn't frozen over in winter. Exxon must go through the ice.)

To study the feasibility of shipping in such conditions, Exxon outfitted a tanker with sensors and clipboard-toting scientists and sent it out to break through the ice and collect data on impact to the tanker's hull, thickness of sea ice and the optimal speed for tanker travel. In a public relations video about the tests, a bow-mounted camera shows the front of the tanker cruising through ice-covered waters, with flakes of ice crumbling on impact as if they were giant tortilla chips.

When asked whether tests from one ship during one winter were sufficient to ensure safe passage, Exxon Sakhalin project vice president, Larry Smith, does not shy away: "I'm the guy it comes down on if we screw up." Data from the tests, explains Smith, will be used in the design and construction of five, custom-made tankers, with reinforced double hulls, added thickness at the bow and other beefy features. Furthermore, Exxon will be sending two ice-breakers to accompany each tanker on their journeys to and from Sakhalin. Adequate measures to prevent disaster?

"All people in Sakhalin worry that oil and gas development will hurt nature," says Sakhalin native Natalya Gorbunova, who just recently got a job with Exxon. "But I believe these companies will work honestly and properly. I hope so, and I believe so." We hope so too, Natalya.

DAVID WOLMAN (The Sakhalin Oil Boom, Part 2, page 34) is a Sapporo-based journalist whose writing has been featured in Forbes, New Scientist, Business.2.0, MIT Technology Review and the San Jose Mercury News. He is a Boston native and a San Francisco transplant who graduated from Middlebury College and holds a degree in journalism from Stanford University. He is living in Hokkaido for one year on a Fulbright Fellowship. In 1997-98, he lived in Aichi Prefecture, working for international manufacturer OSG Corp.

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

LUCILLE CRAFT (The Sakhalin Oil Boom, Part 1, page 28) is a Tokyo-based producer and reporter for "The Nightly Business Report" on PBS TV. Her writing on Japanese and Asian business, politics, society and culture has appeared in the Asian Wall Street Journal, the Washington Post and other publications, and she can be heard on National Public Radio and Public Radio International. She is the founder of the Kuril Island Network (www.kurilnature .org), a Nature conservation group.