Nicholas Watson in Prague -

Investors didn't dump Royal Dutch/Shell's stock after news the company was giving away more than half its share in one of the world's biggest oil and gas projects to state-owned Gazprom, showing how few people, in the markets at least, were surprised that the one-sided contract for this project would be renegotiated to Russia's advantage.

By Tuesday's close - some 24 hours since reports began dribbling out that Shell had caved in to Kremlin pressure and offered to cede control of its $22bn Sakhalin-2 project to Russia gas behemoth - the oil firm's share price was down just 1%.

"With all due respect, the markets are a great deal more intelligent than certain parts of the press," says Eric Kraus, managing director of the Nikitsky Russia/CIS Opportunities hedge fund.

While Shell insisted Tuesday it has not yet agreed to surrender control in the project and talks were still ongoing, Gazprom said it's looking to buy a stake of about 50%, which would see Shell's stake fall to 25% from the current 55%. Mitsui and Mitsubishi would see their stakes fall to about 10% each.

However, Shell will continue to run the show as it is the one with the necessary technical expertise to complete the second stage of the project in the extreme climatic conditions on Sakhalin Island in Russia's Far East.

The Western operators will receive cash for the stakes they give up, though Shell said Tuesday that no numbers have been agreed yet.

The Financial Times reported that Gazprom might pay $4bn for a 50% stake in the project, a valuation that Aton Capital said would be reasonable given the project's near-completion status, contract terms and growth potential.

This is a far cry from the possible $9bn that MDM Bank says the stake could be worth if there weren't environmental fines hanging over the project, which Oleg Mitvol, the deputy head of the state's environmental watchdog agency Rosprirodnadzor, said Tuesday could actually end up being as much as $30bn. Legal action on these violations, the agency said, will begin from March 2007.

Valuations have also been hurt by massive cost overruns. Shell had actually already agreed a preliminary deal with Gazprom back in September to swap a 25% stake in Sakhalin-2 for 50% in the development of the Neocomian layers of Gazprom's Zapolyarnoye gas field. That deal fell apart when Shell revealed, somewhat belatedly, that the expected capital expenditure for Sakhalin-2 would be some $20bn rather than the originally predicted $12bn.

This massive cost overrun is symptomatic of everything wrong with the Sakhalin-2 production sharing agreement, or PSA, that was drawn up by Shell and the Russian government in the early 1990s.

Stench of corruption

PSAs are the normal means by which by oil companies undertake high-risk exploration projects in developing countries, where political and economic risks are high.

However, as Russia no longer considers itself to be either an "emerging market" nor economically risky given the huge piles of cash sitting in the state's vaults, it has phased out the use of PSAs, leaving Sakhalin-2 as one of just three PSA projects in the Russian oil and gas sector.

The Sakhalin-2 PSA was always going to be a target for an increasingly assertive Russia. However, the terms of this PSA were especially humiliating for the government.

The cost overrun rubbed the Kremlin's nose in the fact that this PSA unlike the other two contracts had no cap on costs and the Russian state wouldn't receive any profits from the oil produced whatsoever until after all the costs were recovered and the operator received a 17.5% internal rate of return.

Another aspect of the deal that irked the Russians was the lack of any time limit on the PSA. Unlike most PSAs, which run for 20 years, Sakhalin-2 was set for an initial 25 years, but the deal was renewable at the sole discretion of the operator.

Finally, though Sakhalin is a geographically challenging area to operate in, there was no exploration risk for the Shell consortium as the Soviets had already carried out extensive initial exploration and mapped the fields.

While the Sakhalin-2 PSA was certainly irritating to the Kremlin, the project itself is also extremely important for Russia. Sakhalin-2 has total recoverable reserves of 4.9bn barrels of oil equivalent and current oil output of 22,000 barrels per day. The project’s most prized asset is its liquefied natural gas facilities, which will allow the production and export of up to 9.6m tonnes of liquid natural gas (LNG) annually

"Sakhalin-2 sits on the Pacific coast and on an artery that feeds China, Japan, South Korea, the rest of Asia and the US – very strategic markets for Russia," says Axel Busch, an analyst with Energy Intelligence Group.

While in some respects Sakhalin-2 is a special case, it does fit into a wider pattern of the state reasserting control over the country's natural resources, which inevitably raises the question of how far the Kremlin will go in this process.

Resource nationalism

Analysts say that the Sakhalin-1 project operated by Exxon Mobil is almost certainly at risk, though unlike the Sakhalin-2 project it does already have a Russian state partner in the form of Rosneft, which owns a 20% stake. Even so, there is a feeling that Rosneft's role in this project will grow.

"One way or another, the Russian state will have a majority stake in all of the three PSAs," says Kraus.

Outside of the PSAs is BP's Russian venture TNK-BP. The UK firm took a 50% stake in this venture for $6.75bn in 2003 in a deal that would be unthinkable in today's climate. There is growing speculation that TNK-BP's Russian partners will sell out to a state company and BP will be forced into accepting a junior role in this venture, though the company denies this.

In the mining sector, shares of Peter Hambro Mining took another hit Tuesday, closing down 17%, on further worries about the fate of its mining licenses. The shares have been under pressure since November 30 when the same person who is hounding Shell over its environmental violations at Sakhalin-2, Oleg Mitvol, asked the Federal Natural Resources Agency to revoke five mining licenses of Peter Hambro Mining.

However, while it is now accepted the Russian government is gradually reasserting control over its raw materials and any further substantial resource developments will require at the very least a Russian company, if not an actual state company, as the dominant partner, the markets clearly see it going little further than that.

Still, in the midst of all this environmental brouhaha, investors seem blissfully unconcerned. If you were only watching the stock market you might be forgiven for thinking the Kremlin had just given Shell an extra 25% of the Sakhalin-2 project. Russia's leading index the RTS rose through the 1,800 mark for the first time ever earlier this month and analysts are expecting a further rally until the end of the year. And the spread on 10-year Russian government bonds has narrowed to just 60 basis points over US Treasuries.

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