Is Russia's Hostility Exposing Royal Dutch Shell?

Most energy investors probably know that the Western oil major with the greatest exposure to Russia is BP (NYSE: BP  ) . The British oil giant owns a 19.75% stake in Kremlin-controlled Rosneft and relies on Russia for nearly a third of its total oil production and more than a third of its reserves.

But many of BP's Big Oil peers also have varying degrees of exposure to Russia, including Royal Dutch Shell (NYSE: RDS-A  ) . Let's look at Shell's operations in Russia and whether investors should be concerned by its exposure.

Photo Credit: Wikimedia Commons.

Shell's biggest venture in Russia
Shell's primary exposure to Russia is via its 27.5% ownership interest in the Sakhalin-2 project, one of the world's largest integrated oil and gas export operations and Russia's only offshore gas project, which Shell operates alongside Russian state-owned energy giant Gazprom and two Japanese companies, Mitsui and Mitsubishi.

The project, which currently accounts for roughly 5% of the world's liquefied natural gas, or LNG, market, is capable of producing 10 million tons of LNG and 47 million barrels of oil per year, enough to meet nearly 9.5% of Japan's gas demand and 6% of South Korea's -- its two main customers. Of the nine operating LNG liquefaction plants that Shell owns interests in, Sakhalin LNG is among the largest, behind only Malaysia LNG, Nigeria LNG, and the Australia North West Shelf LNG plant.  

Interestingly, despite escalating tensions between Russian and Ukraine , Shell actually said last month it plans to expand the Sakhalin-2 project's LNG capacity by 50% to take advantage of growing gas demand from nearby Asian markets. It even has Russian President Vladimir Putin on its side. At a meeting in April at Putin's residence near Moscow, the Russian leader pledged his support for the project's expansion to Shell CEO Ben van Beurden.

Shell's other projects in Russia
Shell also owns a 100% interest in three major Russian exploration and production licenses: the Barun-Yustinsky block in Kalmykia, the Arkatoitsky and Lenzitsky blocks in the Yamalo Nenets Autonomous District, and the North-Vorkutinsky area in the Komi Republic.

In addition, the Anglo-Dutch oil major maintains a 50% interest in western Siberia's Salym fields, as part of a 50/50 joint venture with Russia's OAO Gazprom Neft. Production from these fields in 2013 totaled roughly 145,000 barrels of oil equivalent per day, or BOE/d, of which 72,500 BOE/d was net to Shell.

After three years of evaluation and appraisal activity, Shell and Gazprom began drilling their first horizontal appraisal well in Upper Salym earlier this year. Over the next few years, they plan to drill four additional horizontal appraisal wells in the Salym fields, the results of which will determine whether they proceed with large-scale development.

Is Shell's exposure to Russia cause for concern?
As you can see, Shell clearly has significant exposure to Russia. The worst-case scenario for the company, as well as for BP and other companies operating in the nation, would be if the U.S. and European Union sanctioned Russia's energy sector. Such economic penalties would make it problematic for Shell to maintain relations with Gazprom and for BP to continue working with Rosneft.

Indeed, the U.S. is preparing broader sanctions intended to hurt the Russian economy, including a potential ban on exporting oil and gas technology for new projects operated by Russian state-owned companies. The objective is to hurt state-controlled companies like Rosneft and Gazprom, while ensuring that Russian energy exports don't fall off a cliff and wreak havoc on global energy markets.

As I understand it, such a sanction, if imposed, would not impact Shell's existing projects. However, it would affect new projects and expansion plans, including perhaps the proposed expansion of Sakhalin-2. It could also hamper Shell's 50/50 joint venture with Gazprom in western Siberia's Salym fields since further development of this zone would probably require additional imports of hydraulic fracturing equipment.

All told, while there's a good chance that many of these risks are already priced in, I remain cautious about Shell's exposure to Russia. While I believe the oil major is slowly but surely improving, I'd recommend waiting until more details emerge about additional economic sanctions and how exactly they might impact Shell's Russian investments before initiating or exiting a position in the company.

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Arjun Sreekumar

Arjun is a value-oriented investor focusing primarily on the oil and gas sector, with an emphasis on E&Ps and integrated majors. He also occasionally writes about the US housing market and China’s economy.

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