After the disintegration of the Union of Soviet Socialist Republic (USSR) and creation of an sovereign Russia in 1991, thus ending the Cold War, Russians and other former USSR republics began to consider opening their borders to freer trade, and also introduce some free-market economy initiatives. It was and is still perceived that the failure of state-run economy itself was the reason. During the early 80s the economy of Russia ceased to grow, making the government gradually deviate from communist ways of governing the economy. However this caused the USSR to break away.
The reason why Russia had encouraged foreign investment on its soil is the potential for growth. Russia wishes to extract its natural resources for domestic use and export, which can help it sustain growth. Just upon creating, a number of free market reforms were introduced to improve the economy. Among those reforms, especially those that encourage foreign investment, Production Sharing Agreement was introduced in 1994 which was signed with the Sakhalin II project consortium. Sakhalin Sakhalin is an island located in the far east of Russia, close to Japan.
It is now known for its oil and gas reserves. There have been two projects that include Sakhalin I and Sakhalin II. The area has grown in importance to Russia because it is has one of the unexploited oil reserves in the world. Sakhalin remained unexploited because USSR has other oil reserves in their central republics. It is estimated that the island and its surrounding have oil reserves amounting to 1. 8 billion tons of oil and gas reserves of about 2 billion cubic meters of natural gas. Such large amount of untapped resources have make Sakhalin an attraction for foreign oil companies.
Sakhalin inhabitants have seen a general improvement is their life styles since the oil generation brought economic boom to their island. The inhabitants, who are traditional in outlook are becoming more modern, and now prefer to move to the central Russia, which is more developed. The Consortium The consortium consisted of Shell, Mitsui and Mitsubishi, which are multinational corporations, of which Shell had 55% of the shares. Royal Dutch Shell is a company which is jointly owned by the Dutch and Britain. Its core business is in oil and gas.
It have make diversifications into many other areas of non-renewable and renewable energy generations. So it can be more appropriately defined to be in the energy sector. It was the majority shareholder of the project, which reflects the project core product. The remaining two minority shareholder, the Mitsui (25%) and Mitsubishi (20%) are corporations based in Japan and are conglomerates. Energy is not their core business. They have created small companies for some market share in the energy sector. Thus they exist in the Sakhalin II, sharing the revenues and reducing investment risk for Shell.
Their exclusion from the project may not be of much concern to them because they have businesses in other products. However, for Shell, the exclusion will be a severe blow for Shell. This is because the Sakhalin II project is considered by investors and media alike as an image building project. The Shell was planning to make further investments in the energy sector in the phase II of the project, which could have broken several records which are the largest investment of Shell itself, the largest foreign investment in Russian history and also creation of worlds largest integrated oil and gas project.
Such strides would have provided great potential for Shells growth. Exclusion means that Shell will lose their reputation by having to leave a project. The fourth partner emerged in the Sakhalin II project consortium is Gazprom which is Russia state owned energy corporation. It entered the consortium when it bought shares from all the three companies reducing them to exactly half of what it had been. Thus Gazprom became the majority share holder with 50% and one more share, giving it a majority position in the share.
Gazproms entry into the consortium is rather controversial. It is known that the Russian government forced Shell to sell their shares. This caused a blow to the image of Shell. The circumstances under which Gazproms takeover took place also controversial. The Sakhalin Energy Investment Company is the operating company of which the shares are owned by the consortium. The creation of such a company is a legal requirement that is usually done two or more company want to do a joint venture. This arrangement helps the companies to organize their resources under a common company.
For the Russian government, it helped ensure liquidity of the shareholdings, which means that any part of it can be traded with any company, and it is this feature that helped the Russian government make Gazprom a major shareholder. Production Sharing Agreement The consortium made explorations in the Sakhalin Island, and also succeeded in making export revenues. Soon, the Sakhalin II wan being considered as a most important project for Shell. The only challenge that Shell or the Russians faced for in bringing Shell was the Production Sharing Agreement.
This agreement is a commercial contract which allows the member of the consortium to share the profits from the project. This agreement had many legal problems because it has many clauses which are not supported by other Russian Laws such as that of taxation. This has created a controversy which had been an obstacle to Shells presence right from the beginning. Production Sharing Agreement is supported by Russian Law but for non- Multinational corporations, which are state run companies in Russias case, there is a different law. This create another issue of multi-nationals presence throughout the world; circumvention of local law.
To encourage multinationals to remain in the country, new laws are created which are often are not available to local companies. (Abdelal, 2006) Production Sharing Agreement is designed to over-ride any local law. For example, in the energy sector of Russia the petroleum taxation for foreign oil companies is lesser than a local company. So, for example, they may stipulate a certain taxation rates on the profits of the foreign oil company that is party to the agreement, which is different from that of the general fiscal regime in the country as a whole.
Production Sharing Agreement gives too much powers to the multinational corporations. First these contract cannot be changed without any mutual agreement. If the government want to change any clause, for example, place limits on productions or increase tax rate, it is not possible unless the multinational corporation agrees. If it implements any change without the multinational accepting, then the multinational has the right to bring international arbitrators to resolve the issue. Production Sharing Agreements remain in force for the full duration of the contract.
The duration is usually a long period of time. This is favorable for the multinational because it gets the security for making any large capital investment. If would be quite risky for any foreign corporation to make a large investment without assurances. These assurances are not new to any country attracting foreign investment. However it also benefits the country because there is a limited time given to the multinationals to make explorations. If the explorations does not yield any reserves, then the multinational company cannot reclaim more than their original investment.
Once the exploration succeeds, the company first covers it costs until what is left is the profit oil. As stated by the name of the agreement, the productions profit is shared between the state oil company and the foreign oil company according to an agreed ratio which is usually 40 percent allocated to the foreign oil company. In any case, the investment made by the multinational is usually a risked investment. Recently there has been an issue with such agreement as being ineffective. The Russian Natural Resources Ministry believes that the projects should be reviewed.
The ministry reported that the production-sharing agreements are ineffective and are damaging Russias national interests. If the agreements are taken for review and revision, this can potentially discourage the foreign investment in the future. (Buckley, 2006) Perhaps acting on national interests, the Russian government felt compelled to take over the Sakhalin II project. The project has a good estimate of profit oil which have been realized to be of a strategic importance to the Russia.
There were other issues which may have compelled the Russian government to take such a step which can potentially discourage foreign investment. Environmental Issues One issue that may have compelled the government to change the clauses of the agreement are environmental issues. The construction process has caused harm to the environment. The environmental issues is an important issue that weakened Shells position in Russian energy sector because it lost the financial support of the European Bank for Reconstruction and Development, a major financer of the project.
There are numerous environmental violation that took place. The construction of oil tankers bay needed extraction of undersea mud and disposal on a site farther away in the sea. This had a damaging impact on marine life and ecosystem, which produces fish for local populations consumption. The island is seismic in nature, however there are no safeguard against any major earthquake. The pipelines are not made up of an appropriate material and are vulnerable to breakdown in case of any such natural calamity. This can cause oil spill and thus are a risk to the environment.
Also during the construction of some pipelines, it was found that large amount of earth was left in the open alongside the pipelines which caused the temporary revocation of the construction licenses and the contruction process had to be stopped. Such hindrances in the construction process increases the overall cost of construction and also endangers the environment. The consortium had to pay US $ 110,000 in advance to the Russian Federation for all the potential damage that can be caused to fish off-shore in the Sea of Japan, although there has not been any oil spill till date.
There have been reconstruction of some pipelines and also the re-routing of pipelines to prevent any potential damage in the future. Lessons from Shell in Sakhalin It has been found that since the publication of the case, Shell came under pressure from the environmental issues as well as the economic opportunities for Russia that compelled Gazprom to take over half of the Sakhalin II. With Shell under pressure, it became increasingly possible for Russia to come under a mutual agreement with Shell to change some clauses of the Production Sharing Agreement.
Thus the intent of Russia was not to deal with the environmental issue but rather to gain control of the world gas industry as the project produces over 8 % of worlds gas and that too in the most transportable form, LPG. The goal might be to create a cartel in the future that can control the gas prices in the future. (Miriam, 2008) One lesson learnt is that in today globalizing world, multinational corporations face challenging situations where they have to know the interests of the country they are operating in.
No matter what assurances have been made, it is important to consider the changing underlying economic interests behind such assurances. As we see in the case, the apparent reason for assurances made by Russia was to exploit its resources, however as it realized the economic potential of such vast reserves, they looked for an appropriate time to start the takeover program. The other lessons learnt is the multinationals should look at the social interests of the country where they have their operations. Environmental issues as we have seen in the Shells case were alarming social issues that went unheeded in the beginning.
It is a habit of multinationals not to look after the social issues. Their motive is to exploit the market and maximize their profits in the process. In the type of industry which Shell belongs to is rather short term. After exploiting non-renewable resource until these have been exhausted, there will be no reason to stay in the country. Thus is this industry where short term interests exist, multinationals do not wish to make social investments. Another lesson that has been learnt is the approach to issues. As we have seen, Shell did not have a proactive approach let alone an interactive approach.
We have seen that Shell took corrective steps towards environment only if it was prompted by the Russian government and international environmental activists. Moreover, such steps seemed to be taken in haste, without much thought to the fact that such steps are also causing pollution. Such an approach is a reactive approach and it is now being discouraged in business circles. If an interactive approach had been taken, the conditions would have been much better, showing the world that the corporation is socially responsible and knows the interests of the countries where they operate.
Russian Conditions for Foreign Direct Investment If we are to rely on the case study, we can infer that Russia has been making attempts to place itself as a destination for Foreign Direct Investment in the early 90s. That time was much different from what it is today. That time, Russians believed that free market economies can produce better results. For that reason they introduced new regulations that encourage investment by multinational corporations. However today, the government is once again centralizing its control of economy. This can change the way the Russian economy is managed.
Such a step, which is unexpected and has not been favored by the multinationals, has stemmed from the local pressures. The public opposition of programs that favor the multinationals has increased. However, this has come at a time, when several opportunities are being realized. By coincidence or by intention, as we see in the case, the step was taken when the economic opportunities were on the maximum. It has been found that although Russia has become a favoured destination for FDI, other large developing countries are becoming more popular in the recent years.
WTO and multinationals are urging the Russians to right against corruption, red-tapes and bureaucracy, which are known causes why foreign investment does not enter Russia. Thus it has been realized that most investors enter Russia because of its largely untapped resources and markets. This has meant that investors still give low mark on Russias promotional efforts. (The School of Russian and Asian Studies, 2006) Due to the reluctance of Russia to open up as investors expect it to, has caused China and India become more favored destinations for FDI, although their growth in FDI is not as high.
This is because these countries have already been allowing FDI much more openly even before Russia did. China opened up in1979 while India did in 1991. However in the current global financial crisis, it has been found that FDI will fall in all these economies. So is difficult to predict which economy will get least affected by this crisis. It can be said that Russia may be least affected because its economy which is not as open as India or China, can prevent the shocks from reaching their economy. This goes with those who believe that there is a firewall that protects some Asian economies.
References Abdelal, Rawi (2006) Journey to Sakhalin: Royal Dutch/Shell in Russia, Harvard Business School Publishing Buckley, Neil, Thomas Catan, Carola Hoyos and Arkady Osrovsky, (2006) Russia Calls for Review of Two Foreign Oil Projects: Sakhalin Island, The Financial Times. 26 May 2006 p. 6. Miriam Elder (2008-12-2007). Russia look to control worlds gas prices, Telegraph. Retrieved on 27 December 2008 The School of Russian and Asian Studies (2006)RUSSIA: INVESTMENT DESTINATION II, Retrieved Decemer 28, 2008, from RUSSIA: INVESTMENT DESTINATION II, http://www. sras. org/news2. phtml? m=648