TOP INTERVIEWS Interview with Mr. STEPHEN H. MCVEIGH CEO of Sakhalin Energy Investment Company LTD. Yuzhno-Sakhalinsk, July 22nd, 2002 During Phase 1 of the Sakhalin-2 project you forecast reserves of about 400 million barrels of crude oil. What are some of your most recent production achievements and investments so far? Phase 1 went into production in 1999 with the construction of the Molikpaq platform and the Vityaz complex in the Astokh field. This was the first offshore oil production in Russia. Over the first 3 years we have produced approximately 30 million barrels of oil. We produce during the 6 summer months of the year, because in the summer the sea is ice free and allows our tankers to travel into and out of the complex. In 2001, we achieved a record production of over 15 million barrels in 6 months. Currently, in 2002 we expect production to be lower than last year - about 10 million barrels - which is associated with the natural pressure decrease of the Astokh reservoir. However, we are installing a pressure maintenance system to inject water into the reservoir, and as we inject water in the reservoir and retain pressure, oil production will almost immediately increase. This is an investment of about $275 million including new wells which should be completed by end of 2003. Once this process is implemented, production will have risen to about 18 million barrels during the 2005 6-month season. If all goes well at the Shareholder meeting at the end of this year and your shareholders take a Final Investment Decision, what is the expected progress and timeline of "Phase 2" for construction of the $8.5 billion LNG and oil export project? It is a very ambitious project in terms of its scope and extent. We are a fully integrated company and this is a fully integrated oil and gas development project, which is a unique characteristic of this venture by our shareholders Shell, Mitsui and Mitsubishi. "Phase 2" is an ambitious project in light of the fact that Sakhalin is a relatively undeveloped oil and gas province; oil and gas reserves offshore Sakhalin were discovered in the 70s, but the Soviet Union did not have the technology or funding to develop them. Finally, in the 1990s the Sakhalin 2 PSA [Product Sharing Agreement] was negotiated and ultimately signed in 1993, resulting in the formation of Sakhalin Energy in 1994. Planning has been extensive, and in the past three years "Phase 2" started to crystallize in terms of selection of concepts. The first question we needed to answer was "What is the most beneficial way of producing and taking gas reserves to the market?". Our shareholders chose LNG [Liquid Natural Gas] for several reasons: It was the quickest way to get to the market, it represented the most economical plan, and it allowed serving customers in multiple markets such as Japan, Korea, China and Taiwan. We are examining various opportunities and believe that access to multiple markets will improve our flexibility and reduce our dependence on any particular market. "Phase 2" poses four major challenges:     1. The construction of infrastructure;     2. The commercial marketing of the oil and gas;     3. Finding financing sources to obtain construction loans;     4. The approvals which involves receiving clearance and permission within the Russian system. We have considered our development options, costed our alternatives, made our final selections and now all the front-end engineering has been completed. We are in the process of going through a combination of engineering and construction work tenders which can then allow us to start with various phases of the project. We hope to be in a position to award these major contracts by the end of this year. If we are on schedule for hardware development, this will set the ground for year-round oil production starting in late 2005 or early 2006. We expect the first cargo of LNG to go out in November 2006. What has been your strategy to establish your presence in Chinese, Japanese, Korean and Taiwanese markets? During the past four years we have exported cargoes of crude oil to Japan, Korea, China and the USA and this has established us as a reliable supplier of energy to these four countries. We believe there is significant demand for LNG in Asian Pacific markets. Japan has been our primary focus due to its proximity to Sakhalin - we are only two days away from Tokyo by tanker - and the fact that we have two major Japanese shareholders, Mitsui and Mitsubishi, who own 45% of the company. Our marketing progress in Japan is slower than expected, partly due to the fact that the country is only starting to lift itself out of an economic downturn. Meanwhile, Japan is also trying to deregulate its natural gas and electricity markets, yet they do not know exactly how to do it, which has caused considerable uncertainty for the utility companies. This has also stalled their ability to make future commitments, so we hope that the situation will soon be clarified and the Japanese economy will start to grow. Korea is another significant market where there is clearly a demand for LNG in the future. In 2010 Korea will have about 8 million tons of open demand for LNG, and they currently do not have supply contracts to meet this increase in demand. Yet the situation is similar to the Japanese since the energy sector is in the process of being restructured as well. The Korean government has not allowed KoGas [the Korean Gas Corporation], the major national gas company to go out and contract for new demand and the government is currently deciding whether to split the company into several different entities, or to keep it together. This has caused uncertainty for KoGas. However, the fact that KoGas remains specifically interested in winter LNG supplies, during which season of the year our LNG production will be a maximum, makes us natural partners in the LNG business. In regards to China, we were delighted to be invited to participate in the tender for the Guangdong project. However, we did not make the short list of bidders due to the distance from Sakhalin to the Southern areas of China and the resulting higher on shipping costs. However, the market has changed since then, we have adjusted our estimates, and we are working on other projects. We were also ready to submit a bid for Taiwan last fall, but when the tragic events of September 11th occurred, Taiwan chose to cancel their tender exercise. Nevertheless, we expect to offer competitive LNG supply proposals to Taiwan in the near future. Governor Farkhutdinov said that "the export of liquefied gas is the most realistic option", since Japan has developed infrastructure for its importation. If this is the case, why is Exxon planning to build a pipeline to Japan? Are you not competing directly against each other for the same markets? Yes, we are competing. It is my opinion that Exxon has a different situation for field developments. Their major resource is the Chaivo field; a gas cap field with a large oil rim and significant oil reserves. With that kind of reservoir, it is better to produce significant quantities of oil before producing large quantities of gas, because you will waste the energy that the gas provides in the reservoir and reduce ultimate recovery. Therefore, it makes sense for them to start with oil projects, whereas we have decided to pursue an integrated oil and gas development simultaneously. Secondly, some of their investors are interested in the longer term construction of a gas pipeline to Japan. Perhaps someday there will be a pipeline from Sakhalin to Japan. We may even be interested in being involved in this in the future, since we will have reserve capacity in our gas pipeline to the LNG plant on the south end of the island. But in reality, it is going to take a long time to complete technical and environmental feasibility studies and develop the economics of such a project. Look at the Japanese market today - it is not a growing market and in order to build a long-distance pipeline to supply one single market, you have to have a large incremental demand that you will supply, yet this does not exist today. Perhaps this project will be feasible in 10 to 15 years, but not today. Therefore, we plan to supply incremental demand. Japan already has LNG terminals so we are simply a natural choice for them thanks to proximity shipping. Our shipping costs will be lower than any other LNG producer. Therefore, we are able to offer very attractive terms based upon low shipping cost and the overall scale of the project. I also understand that you are in discussion with a wide range of potential lenders for the financing of phase two. What is the progress on this? We have been in discussions with large banking institutions like the Japanese Bank for International Cooperation (JBIC), and we expect them to be our largest financier for the project. They are still involved in Phase 1 financing and we expect them to be heavily involved in Phase 2. The primary reasons for their strong willingness to participate is that our project is in the strategic interest of Japan in terms of a further diversification of energy supply, as well as the fact that we have 45% Japanese ownership. We have also been targeting the European Bank for Reconstruction and Development (EBRD), which is involved in Phase 1. The US Export-Import Bank is also a possible lender, given that there will be a significant US content to supply equipment and materials to this project. Likewise we foresee potential lenders from Korea, since they will be most probably an important partner for the construction of our offshore platforms. You first arrived to Sakhalin in October 2000, and moved here in January 2001. What are some of the valuable lessons you have learned in the two years that you have been coming here? Planning is everything. We are working in a location where it takes very careful planning and patience. You cannot expect to get the turnaround that you would expect from an established oil-producing province, and you have to be aware of the weather fluctuations when working in the northern areas of the island. Getting things shipped to the island is difficult in the winter time and because of customs procedures, but it all can be done with good planning and with consideration of all those factors. What has been your best experience here in Sakhalin? My best experience here is the opportunity to work on a huge trailblazing project with an amazing amount of diversity, especially since it is my first international assignment. Shell has contributed a wealth of experience in project management, engineering and design for the execution area, while Mitsubishi and Mitsui bring commercial expertise in the area of building relationships in Asia. We are learning how to sell the project and adapt to the diversity we have among our shareholders and stakeholders. We have the Russian government as partners in the project and their desire is to ensure that the benefits to Russia are considerable in terms of the creation of wealth and the development of Russian staff. Korean companies are also very interested in participating in our project. The common denominator is business, but the approach is multicultural. This has been one of the best experiences for me - learning how to find the common denominator for all the different cultures involved in the Sakhalin Energy project. Note: WINNE cannot be held responsible for the content of unedited transcriptions.