Annual Overview Sakhalin Energy The New Energy Source for the Asia Pacific

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1 Sakhalin Energy The New Energy Source for the Asia Pacific Sakhalin Energy The New Energy Source for the Asia Pacific Annual Overview

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3 Sakhalin Energy The New Energy Source for the Asia Pacific Annual Overview

4 Letter of Introduction from CEO It seems that every year, when we reflect on the past year s developments, we conclude that it was challenging. As it happens, 2006 seems to have been one of the most challenging and pivotal years so far. The Sakhalin II Project, which started in 1996, marked its first decade milestone last year. It is therefore an appropriate time to take stock of the journey that we have travelled together. We have come a long way in building the world s largest integrated oil and gas project on Sakhalin. We were the first in Russia to begin an offshore field development and to commit our gas to LNG exports. Oil produced by this Project was also instrumental in allowing Russia to break into the fast growing markets of the Asia Pacific region. We owe this success to our employees and shareholders and of course to the entire team of excellent designers, engineers, managers and workers. The Russian Federation authorities and the Sakhalin Oblast Administration also played a role that cannot be too strongly emphasised. Despite the harsh weather that delayed the beginning of Phase 1 operations in 2006, we were able to achieve over 11.5 million barrels of oil produced with excellent flaring performance. The installation of the Lunskoye platform topsides was undeniably the most impressive event of the year and also a key milestone on a critical path toward first LNG. In another, no less challenging, operation, two giant new modules were installed on the Molikpaq platform. This also was done with impeccable accuracy. These modules will play an integral role in enabling yearround production of oil. The installation of all the offshore pipelines, apart from some tie-ins, was completed in All of the planned Horizontal Directional Drilling river crossings are complete and over 95% of the onshore pipelines had been welded by the end of Construction of the LNG plant also continued apace in 2006, with the LNG tanks and all marine works, including the installation of the LNG jetty, now complete. Out in Aniva Bay, the Tanker Loading Unit, which will be used to load tankers with crude oil bound for international markets, was also successfully installed and powered up. Sakhalin Energy The New Energy Source for the Asia Pacific

5 We have an extensive work programme to deliver in 2007, including installation of the Piltun-Astokhskoye-B topsides, year-round production for Molikpaq and LNG commissioning The Onshore Processing Facility also progressed. Construction works are progressing well and in January 2007 the plant commenced supplying power to the Lunskoye platform. With more agreements with LNG buyers in 2006, we are happy to report that we have contracted to customers practically the entire LNG capacity for Trains 1 and 2 on a long-term basis. An ever greater role in the Project has been played by domestic suppliers and contractors, Russian specialists and Sakhalin communities. By the end of 2006, the total value of contracts signed with Russian vendors and suppliers exceeded US$8.2 billion. This includes significant new awards to local contractors, who have demonstrated their ability to meet international standards in developing the oil and gas industry on the Island. More than 740 Russian staff, including 439 locals, were hired in 2006 as we built up our capacity. We are confident that a largescale project such as this one should ultimately improve the quality of life for local communities. With this in mind, we continued to develop the Island s infrastructure, building and fitting out social welfare facilities and providing support to the indigenous people, healthcare and education systems. We have moved on from everyday social issues to long-term goals for the socio-economic development of the Island. We also remain committed to protecting the environment on the Island. In 2006 we involved independent environmental experts to further mitigate potential risks to the Western Gray Whale population. We are taking unprecedented actions not to disturb the nesting Steller s sea eagles on the Island, have embarked on a programme to research Sakhalin taimen and a river restoration project that will increase salmon spawning areas. When the Project was criticised by Russian regulators, we took this as a challenge to improve our environmental performance, find new solutions and strengthen controls and management of our contractors. All this was incorporated into our new Environmental Action Plan, which is now being implemented to ensure a higher level of protection for the sensitive environment of Sakhalin Island. Looking ahead, we have an extensive work programme to deliver in 2007 including installation of the Piltun- Astokhskoye-B topsides, yearround production for Molikpaq and LNG commissioning. An important factor in the Project s progress is the agreement with the Russian Party on the Amended Development Budget, reached in December The entry of Gazprom, the world s largest gas producer and exporter, as a leading shareholder will also be of great value to the Project. And one more thing. You really shouldn t be surprised if you read in our next Annual Report that 2007 was the greatest year of all in the Project s history. We have a close-knit team of professionals which is determined to reach new heights of success. Sincerely, Ian Craig, CEO Sakhalin Energy Investment Company Ltd. Annual Overview 3

6 Contents MILESTONES IN OUR PROJECT, OUR COMPANY 12 Sakhalin Energy and Sakhalin II Project 14 Shareholders 15 Production Sharing Agreement 16 Benefits for Russia 17 Resource Base 19 Phase 1 and Phase : Key Milestones of the Decade 21 Key 2007 Milestones 23 INNOVATIONS. CONSTRUCTION 24 Project Map 26 The Innovator 27 Offshore Platforms 28 LNG Plant 30 Oil Export Terminal 32 Onshore Processing Facility 33 Onshore Pipelines 34 River Crossings 35 Offshore Pipelines 37 Ensuring Seismic Safety 38 Infrastructure Projects and Logistics 39 PRODUCTION. COMMERCE 40 Oil Production 42 Oil Marketing 43 4 Annual Overview

7 LNG Marketing 44 Hydrocarbons Transportation 45 ECONOMICS. FINANCE 46 General Business Principles 48 Financing and Project Costs 49 Economic Efficiency 50 Taxes and Payments 51 RUSSIAN CONTENT 52 Russian Content Development Strategy 54 New Contracts 56 How to Become a Contractor 57 MANAGEMENT. PERSONNEL 58 Management System 60 Supervisory Board 61 Committee of Executive Directors 62 In Dialog with the Society 63 Personnel Development 64 ENVIRONMENT. SAFETY 66 Safety and Environment: Integrated Approach 68 Labour Safety 69 Environmental Protection 70 Emergency Response 72 Rare Species 74 SOCIAL RESPONSIBILITY 76 Annual Overview 5

8 Sakhalin Energy The New Energy Source for the Asia Pacific Milestones Milestones in 2006

9 On 26 June 2006, Sakhalin Energy successfully completed the installation of the Lun-A topsides on the Concrete Gravity Base Substructure in the Sea of Okhotsk Oil Production In December 2006 Sakhalin Energy successfully completed the eighth production season at the Vityaz Complex. Production season 2006 at the Molikpaq Platform resulted in million barrels of oil produced. A total of 19 cargoes of Vityaz crude were delivered during the season to existing markets in Japan, Korea, Thailand and the USA. The Phase 1 cumulative oil production since 1999 amounted to 85 million barrels, or approximately 11.5 million tonnes. (For more detail see Production and Commercial) Construction of Major Oil and Gas Infrastructure In 2006, considerable progress was achieved in the construction of the Phase 2 oil and gas infrastructure. The most significant milestones include the installation of Russia s first offshore gas platform at the Lunskoye gas field, the installation of two Molikpaq tie-in modules, the completion of the offshore pipeline construction (achieved ahead of schedule) and finalisation of the LNG jetty construction. On 26 June 2006, Sakhalin Energy successfully completed the installation of the Lun-A topsides on the Concrete Gravity Base Substructure in the Sea of Okhotsk in the north-eastern segment of the Sakhalin shelf. Lun-A will be the key source of gas supply to Russia s first LNG plant under construction in Prigorodnoye. Sakhalin Energy completed the installation of the Molikpaq tie-in modules on 19 July The two modules, each the size of a 10-storey block, were successfully lifted into position using Castoro 8, a mobile crane barge. In addition, a new multi-milliondollar crane assembled locally in Kholmsk was also installed successfully on the platform. These modules will allow yearround production from the platform when the pipeline system is complete. With the installation of the last trestle and the LNG loading platform of the LNG jetty reaching out 800 metres into Aniva Bay, Sakhalin Energy completed the LNG jetty construction on 23 August The completion of the LNG jetty represents a major event for the Project, as the jetty will be used to load LNG onto specialised tankers for delivery to customers. The LNG jetty is capable of handling LNG tankers ranging from 18,000 m3 to 145,000 m3. On 30 August 2006, Sakhalin Energy completed the Sakhalin II offshore pipelines ahead of schedule. The completion of the offshore pipeline construction ahead of schedule allowed the early demobilisation of vessels engaged in the construction works, which significantly reduced total noise impact. Success in LNG Marketing New LNG sale and purchase agreements were added to the LNG long-term contract portfolio in This has contributed to Sakhalin s development as a new strategic source of natural gas for Japan and has confirmed the Asia Pacific region as a major new market for Russian energy. By the end of 2006, practically all the LNG to be produced at Trains 1 and 2 of the LNG plant was Annual Overview 7

10 maintenance of three offshore platforms and onshore oil and gas pipelines was awarded to a joint venture between the Sakhalin company SakhalinMorNeftemontazh (SMNM) and the American VECO. Sakhalin Energy awarded a US$85 million contract to a consortium of several Sakhalin construction companies for the construction of five Pipeline Maintenance Depots along the 800 km onshore oil and gas pipeline route. sold, which allows the Company the pride of reporting that the Trains 1 and 2 LNG marketing campaign is complete. The first contract, for the provision of maintenance services for the first Russian LNG plant, oil export terminal and onshore processing facility, was awarded to SakhlinNefteGasService (SNGS). The Russian contractor will be paid around US$100 million for its services. The second contract, again worth some US$100 million, for The contract for design, fabrication, procurement and commissioning of the Russian turbine generators and substation for Booster Station 2 was awarded to ZAO Iskra Energetika (Perm). The contract value is RUR 500 million, or approximately US$19 million. A 5-year contract was signed with Primorskoye Shipping Company for the provision of charters of two oil tankers, Sakhalin Island and Governor Farkhutdinov. The tankers built in 2004, each with deadweight of 108,000 tonnes, will be used to ship the crude oil produced at the Sakhalin II facilities. In addition, Russian shipbuilding companies were awarded four contracts to build new ships for the Sakhalin II Project. Two harbour tugs and two mooring tugs will be built by, respectively, Admiralty Shipyard in St. Petersburg and Zvezda Plant in the Russian Far East. These orders are executed within the 15-year contract for the charter of six new ships, which Sakhalin Energy, the Sakhalin II operator, has awarded to SvitzerWijsmuller Sakhalin. (For more detail see Russian Content) 8 Annual Overview

11 A 5-year contract was signed with Primorskoye Shipping Company for the provision of charters of two oil tankers, Sakhalin Island and Governor Farkhutdinov Infrastructure Development A formal ceremony was held on 13 October 2006 to put into operation the upgraded section ( km) of the Yuzhno-Nogliki road in Makarov District. Sakhalin Energy provided US$24 million financing for the design and construction of this upgrade. This is one of many examples of implementing logistics and infrastructure development projects in Sakhalin, including asphalt coating of 8 kilometres of roads in Yelniki, Onor, Zonalnoye, Krasnaya Tym, Ado- Tymovo and Argi-Pagi villages, provided together with Sakhavtodor in SKS, the main telecommunications contractor of Sakhalin Energy, built 480 km out of 823 km of fibre optic cable required for interconnection of all production facilities. (For more detail see Innovation. Construction) Investment Increase The Sakhalin II Shareholders Royal Dutch Shell, Mitsui and Mitsubishi and the RF Ministry of Industry and Energy as the Government body vested with PSA supervision authority reached on 21 December 2006 an agreement about the Sakhalin II amended budget and cost recovery. The Amendment to the Development Budget for Sakhalin II Phase 2 is to be submitted to the Supervisory Board for approval. The Production Sharing Agreement for the Sakhalin II Project will continue. The parties have agreed to jointly resolve all outstanding issues. The shareholders now look forward to implementing the project in line with the current schedule, including obtaining all necessary permits and approvals granted in accordance with applicable Russian legislation and the PSA. (For more detail see Project Economics and Finance) Gazprom to become a Leading Shareholder The signing of the 21 December 2006 protocol to bring Gazprom into the Sakhalin Energy Investment Company Ltd. as a leading shareholder was a landmark event. Agreement has been reached for the current Sakhalin Energy shareholders Royal Dutch Shell, Mitsui and Mitsubishi to give up half of their respective shareholdings for Gazprom to acquire a 50% stake plus one share in Sakhalin Energy for a total cash purchase price of US$7.45 billion. The current Sakhalin Energy shareholders will each dilute their stakes by 50% to accommodate this transaction, with a proportionate share of the purchase price. Shell will retain a 27.5% stake, with Mitsui and Mitsubishi holding 12.5% and 10% stakes, respectively. Sakhalin Energy will remain the operator of the Sakhalin II project. Gazprom will play a leading role as majority shareholder while Shell will continue to significantly Annual Overview 9

12 contribute to Sakhalin Energy management and remain as Technical Advisor. The key focus for Sakhalin Energy is to complete the project on schedule, allowing LNG to be delivered to existing customers in Japan, Korea and the North American West Coast. All existing LNG sales contracts will remain in force and will be honoured. After the protocol signing ceremony the Sakhalin Energy shareholders met with President Vladimir Putin in the Kremlin. The Russian leader welcomed the agreement with Gazprom and assured the shareholders that the Russian Government would give full support to the Sakhalin II Project. The leaders of the parties in the negotiating process expressed their full satisfaction with its outcome. Jeroen van der Veer, Chief Executive, Shell: We welcome Gazprom s entry as a project partner and a leading shareholder. The greatest news is that we have stabilised the situation with the project and all the partners can now work together to get Sakhalin II up and running. This agreement is an important step forward, and positions Sakhalin II for further growth opportunities. I think all the parties have won from the deal the Russian Federation, LNG buyers in Japan, Korea and other Asia Pacific markets and, of course, the project investors. I hope that we, the shareholders, will find further growth opportunities for the LNG project after the first phase is complete. Shoei Utsuda, President and CEO, Mitsui: We believe that Gazprom's entry in the project is one of the most significant milestones in the Sakhalin II project. We, Mitsui, are confident that Gazprom s entry, coupled with the project s cooperation with the Russian Government and the Sakhalin Oblast, will not only give more strength to the project, but will also contribute to further development of Russia-Japan relations. 10 Annual Overview

13 Sakhalin Energy will remain the operator of the Sakhalin II project Sakhalin has extensive hydrocarbon development opportunities that are still unused and we believe that this cooperation will encourage further growth of hydrocarbon developments in Sakhalin. Given Sakhalin's proximity to Japan, we intend to scale up our activities in Sakhalin with a view to increasing energy security for Japan and its people. Yorihiko Kojima, President and CEO, Mitsubishi: We are very glad that all issues have been resolved and we would like to welcome Gazprom s entry as a new partner. We trust that the unity and strength of four shareholders will enable Sakhalin Energy to become not only a strong player in the LNG market, but also a highly valued supplier of crude oil to Asia Pacific markets. In this connection we see new opportunities for development in our joint work with the partners. We are also happy that the shareholders have finally succeeded in reaching mutual understanding and agreement with the Ministry of Industry and Energy on the outstanding issues connected with the project. We are assured that this agreement will add strength and solid performance to our project, which will prove and strengthen our commitment to deliver the project in particular, our preparedness and commitment to supply LNG to our buyers in Japan and other Asia Pacific markets. We are focused on delivering LNG to our buyers on schedule. Alexey Miller, Chairman of the Management Committee, Gazprom Gazprom has negotiated its entry into Sakhalin II and joint LNG business with Shell for two years. The Japanese shareholders from the very beginning supported the idea of Gazprom joining the project. Gazprom becomes the majority shareholder and will jointly work with other shareholders to launch the Sakhalin II Project as soon as possible. We are consistent in implementing our strategy of increasing Gazprom s role in the LNG market. Joining in an LNG production and export project is another step in that direction. Annual Overview 11

14 Sakhalin Energy The New Energy Source for the Asia Pacific Our Project. Our Company

15 Sakhalin Energy and the Sakhalin II Project 14 Shareholders 15 Production Sharing Agreement 16 Benefits for Russia 17 Resource Base 19 Phase 1 and Phase : Key Milestones of the Decade 21 Sakhalin II Project: 2007 Major Milestones 23 Annual Overview 13

16 Sakhalin Energy and the Sakhalin II Project O ff the north-east coast of the Sakhalin Island in the Russian Far East, Sakhalin Energy is delivering a groundbreaking oil and gas project the Sakhalin II Project. This project involves crude oil, natural gas and LNG production and export. The Sakhalin II Project will contribute to the oil and gas infrastructure development of the entire Sakhalin Island and neighbouring regions. The Project based on the Production Sharing Agreement that was signed in June 1994 involves the construction of offshore platforms to produce oil and gas, a system of oil and gas pipelines, an LNG plant and export facilities for oil and LNG. Some of these facilities are operating; most of the others are well advanced on the way to commissioning. The Russian Party to the PSA represented by the Russian Government and the Administration of Sakhalin Oblast supervises the project implementation and development. The significance of this unprecedented integrated oil and gas project is mainly determined by the contemporary trends in the world energy markets. For example, the IEA estimates that the average annual growth of world crude energy supply will be around 1.6%. The fastest average growth, around 2% per annum, will be in the demand for cleaner fossil fuels such as natural gas. Russia, as one of the world s biggest energy producers and holders of energy resources, will be pivotal to achieving this growth. President Putin outlined the target for Russia to become a world energy leader. This will require ambitious large-scale developments of the country s reserves. The more exhausted the hydrocarbon reserves become onshore, the more interest will be shifted to offshore reserves. It is going to be a massive learning curve for the world oil and gas community to deliver commercially viable projects in sensitive frontier environments. And that learning curve is underway in Sakhalin, a world-class oil and gas province, with estimated resources of some 45 billion barrels of oil equivalent, comparable to the undeveloped reserves of the North Sea. The Sakhalin II Project, accounting for only about 10% of these resource volumes, is the largest infrastructure project in Russia and the largest integrated oil and gas export project in the world. Because of lack of basic infrastructure, Sakhalin II can be referred to as a project being built from scratch in a harsh subarctic environment. As of end 2006, Phase 2 construction work was about 80% complete and the entire volume of LNG production was contracted. Sakhalin II is creating infrastructure that on completion of the project would be available for use by other potential offshore Sakhalin oil and gas developments. The successful implementation of Sakhalin II will help forward other longterm projects involving large oil and gas supplies from the Russian Far East to world markets. Russia has supplied gas to Western Europe for many decades and has acquired a reputation as a reliable supplier. The prospects of repeating this success in the Asia Pacific markets and gaining profit from Sakhalin II are a great encouragement for all parties involved in the project implementation. Sakhalin II enjoys strong support of the Russian Party at the federal and local levels. The Russian Party and Sakhalin Energy are working together to deliver the project. The head office of Sakhalin Energy is in Yuzhno- Sakhalinsk, Russia. The company also has offices in Moscow and The Hague (The Netherlands). In 2006, Sakhalin II Project teams worked in London (UK), Yokohama (Japan) and on Geoje Island (Republic of Korea). 14 Annual Overview

17 The head office of Sakhalin Energy is in Yuzhno-Sakhalinsk, Russia. The company also has offices in Moscow and The Hague (The Netherlands). In 2006, Sakhalin II Project teams worked in London (UK), Yokohama (Japan) and on the Geoje Island (Republic of Korea) Shareholders A t the end of 2006, Sakhalin Energy shareholders were Shell Sakhalin Holdings B.V. ( Shell ), Mitsui Sakhalin Holding B.V. ( Mitsui ) and Diamond Gas Sakhalin ( Mitsubishi ). The stakes they held in Sakhalin Energy were 55%, 25% and 20, respectively. On 21 December 2006, the Shareholders agreed that Russia s leading energy company, Gazprom, would join the Project as a shareholder. Once the transaction is closed, Gazprom will hold a 50% stake plus one share, Shell will retain 27.5%, Mitsui and Mitsubishi 12.5% and 10%, respectively. Shareholding Structure of Sakhalin Energy in 2006 Sakhalin Energy was established in April 1994 by the MMM Consortium (Marathon, McDermott and Mitsui), which was later joined by Shell and Mitsubishi to form the ММММS Consortium. Sakhalin Energy was established as a result of the Consortium winning the international tender launched in May 1991 by the Russian Government and Sakhalin Administration for a feasibility study to develop the Piltun-Astokhskoye and Lunskoye fields. Shell is a major player in the world energy market, with 35 million barrels of oil equivalent daily production. It is operating in 140 countries and is a major investor in the Russian economy. The company is a world leader in LNG production, having implemented five LNG projects in Australia, Brunei, Oman, Malaysia and Nigeria. Mitsui is one of the leading trading companies in the world. Mitsui is involved in projects that annually supply 18.6 million tonnes of LNG to Japan and plays a significant role in the energy-related projects implemented in the CIS area. Mitsubishi is a leader in the world trading business, the core of the largest finance business group in Japan and one of the largest in the world. It is currently responsible for over 50% of total LNG imports to Japan and is involved in eight LNG projects developing the reserves of six countries, with 38 million tonnes of total contracted LNG supplies. Gazprom is the world s largest gas company, with a % stake owned by the Russian Government, and the world largest holder of natural gas reserves. Gazprom accounts for around 20% of world gas production and for around 90% of gas production in Russia. Gazprom supplies gas to 32 countries. The Russian Government has appointed Gazprom as the Coordinator of the Programme for Establishment of a Unified Gas Production, Transportation and Supply System in Eastern Siberia and the Far East, with a View to Possible Export of Gas to the Markets of China and the Rest of the Asia-Pacific (Eastern Programme). Shareholding Structure of Sakhalin Energy after the Transaction with Gazprom Annual Overview 15

18 Production Sharing Agreement T he Sakhalin II Project is being carried out on the basis of a Production Sharing Agreement (PSA) signed on 22 June The parties to the PSA are the Russian Federation and Sakhalin Energy. This is the first ever PSA in Russia. In 1996, the Company was granted licences to develop the Piltun-Astokhskoye and Lunskoye licence areas under the Sakhalin II PSA. Subject to the provisions of the PSA, the Sakhalin II Project should be implemented in accordance with laws, regulations, decrees and other governmental acts applicable in the territory of the Russian Federation, officially enacted, and publicly available, and standards generally accepted in the international oil and gas industry. According to the PSA, the Russian Federation retains its title to the oil and gas fields, while Sakhalin Energy invests all necessary finance for the development and pays bonuses to the Russian Federation once significant Project milestones have been achieved. Throughout the whole life of the Project, Sakhalin Energy will pay the Russian Federation 6% of all oil and gas produced in royalties. All proceeds from the sale of hydrocarbons, less royalties, are allocated to the Company in compensation for the capital investment in the Project, until full cost recovery is achieved. The remaining part of all revenues after cost recovery is allocated between the Russian Federation and Sakhalin Energy in the manner prescribed in the PSA. On top of that, as was reported by Mr. Dementiev, Deputy Minister of Energy and Industry of the Russian Federation, in his speech delivered at the State Duma (lower chamber of the Russian parliament), on November 21, 2006, the Russian Federation receives a 32% profit tax on the revenues of the Sakhalin II PSA operator Sakhalin Energy. What is a PSA? A Production Sharing Agreement (PSA) is a contract between the investor and the state, which enables large-size, long-term and risky investments to be made by investors. The purpose of a PSA is to secure a set of terms and conditions applicable to the development of the resource, by replacing the regular tax and licence treatment with contractual provisions remaining in force throughout the life of the project. The first PSA in history was signed in August 1966 in Indonesia. Since then, PSAs have become a common practice all over the world. They have been used in 64 countries, including all oilproducing post-soviet states, from Uzbekistan to Ukraine. There have been hundreds of such agreements. Each PSA is aligned to an individual project and its specific conditions. The only thing that remains invariable is the basic principles, which include the state s title to the fields, stability of the PSA terms and conditions, and priority allocations for the investor s cost recovery (as a result of which the tax burden is minimal at the start of the project and becomes heavier as the project develops). In lieu of a part of the tax payments, the state and the investor share the profit production in an agreed proportion, which helps to address two problems, the first being the long-term forecast of the tax burden, and the second being the customised tax treatment. Contrary to common belief, the PSA is not a preferential tax treatment, but rather a different form of settlement between the investor and the state. Depending on the terms of each individual agreement, the Project development phase and market trend, the state s incomes may prove to be higher than those resulting from the regular tax treatment. Furthermore, by finetuning the project s economics it is possible to achieve a significant extension of the Project s life in comparison to the regular tax treatment. As a consequence, the overall incomes from a PSA project may be higher than those yielded by the regular tax treatment. Another important feature of PSA projects is the complete transparency of their economics. The State approves the budgets and has an opportunity to supervise the investor s production costs. This would have been impossible with a regular licence. Finally, due to the contractual relationship between the parties, they both feel mutual responsibility to follow the established rules of the game. 16 Annual Overview

19 The project has boosted the growth of investment and business activities Benefits for Russia T he benefits for the Russian Federation from the Sakhalin II Project are manifold and significant. The Sakhalin II Project delivers benefits not only to Russia nationally, but also to Sakhalin Island itself and even to some of its neighbours. Thousands of Russian households began to live better and obtained new positive opportunities. In the geopolitical and international cooperation aspects, and in terms of strengthening economic and energy security, Russia is interested in building up the oil and gas complex in its eastern regions. Sakhalin II triggered the process of Russia opening up the new fast-growing oil and gas markets in Asia Pacific and North America. The world-largest integrated oil and gas project has brought to Russia the unique offshore experience and state-of-the-art technologies. The large-scale development of Russian offshore fields is only being prepared, but we are convinced that the experience gained from our project and our technological solutions will be in high demand, as will be many Russian specialists with experience of Sakhalin II. Also, a modern oil and gas infrastructure has been built in Sakhalin from scratch, so that future energy developments in the Okhotsk Sea will be less expensive and less challenging. The project has boosted the growth of investment and business activities, with a positive effect not only for Sakhalin Oblast, which is now the most economically dynamic of all Annual Overview 17

20 districts of the Russian Far East, but also for Russia in general. Russian companies were awarded over US$8.2 billion of total contracts in This has triggered larger and more advanced industries, potential access to non-russian markets, new jobs, higher salaries, growing retail trade, better social programmes and higher tax payments, or what is usually referred to as a multiplier effect. At a forward oil price of US$34 per bbl the project will generate US$50 billion for the Russian Federation over 40 years in the form of direct payments and the Russian share of profit production. This estimate takes into account the consequences of the revised project costs. At the same time, this is a conservative estimate in terms of the world oil price scenario. Obviously, the higher the oil price, the greater the financial benefit to the Russian Federation. Thus, at the average oil price of US$50 per bbl the payments to the Russian Federation will surge to around US$80 billion. Obviously, the source of revenues for both the Company and the Russian Federation are the sales of hydrocarbons. By the end of 2006, the revenues to the Russian Government from the Sakhalin II Phase 1 development exceeded US$550 million in bonus payments, royalties and taxes. As part of the figure, US$100 million was contributed to the Sakhalin Development Fund, which is managed by the Sakhalin Administration. This money has helped to address the old problems with the energy/heat/water supply to households in Sakhalin. The Sakhalin Development Fund also helps support health and social facilities, as well as local manufacturers in food, woodworking, farming, coal, energy and transport industries. Sakhalin Energy also spends over US$400 million on the upgrades of roads and bridges, sea-ports and airports, telecommunications and other infrastructure projects. Phase 2 employed in 2006 over 20,000 people, the majority of whom (70%) are Russian citizens. Unemployment on the Island has dropped to the all-time low of 1.5%. In the operations phase, Sakhalin Energy and its contractors will create about 2400 permanent jobs. The Sakhalin II development opens up new prospects for local businesses in Sakhalin, resulting in increased demand for local services in design, environmental consulting, office refurbishment, transportation, catering and many other areas. And last, but not least, the project is becoming a propellant of the economic growth, creating a foundation for the development of other related businesses and contributing to the general upgrading of economic and living standards in Sakhalin. 18 Annual Overview

21 Availability of such gas resource volumes will enable Sakhalin Energy to supply 9.6 million tonnes of LNG per annum for at least 25 years Resource Base T he Sakhalin II Project involves the development of two offshore fields: Piltun- Astokhskoye (containing mostly oil with some free gas and cap gas) and Lunskoye (containing mostly gas with some condensate and considered among the largest in the world). The Piltun- Astokhskoye field is kilometres offshore in an area of sea metres deep. The Lunskoye field is kilometres offshore in waters metres deep. Both fields were discovered in the 1980s by Sakhalinmorneftegaz. The fields are approximately 15 km offshore northeast Sakhalin, in the waters of the Sea of Okhotsk, covered with ice for 6 months a year. As at the date of the Production Sharing Agreement, the total original in-place resource volumes of the Piltun- Astokhskoye and Lunskoye fields on the balance sheet of the Russian Federation were approximately 435 million tonnes of oil and condensate and 490 billion cubic metres of gas. Since then, the Company has completed exploration as required by the PSA. In addition, 3D seismic surveys have been carried out using state-of-the-art technologies, and two new appraisal wells were drilled, which allowed pre-development work and detailed studies of the deep horizons. The 3D seismic and appraisal drilling by Sakhalin Energy resulted in significant incremental hydrocarbon resource volumes. In particular, in 2001 Sakhalin Energy declared the increase of the Lunskoye resource volumes by 40%, from 384 billion cubic metres (13 trillion cubic feet) to 531 billion cubic metres (18 trillion cubic feet). The State Reserves Committee of the RF Ministry of Natural Resources approved the revised gas resource volumes of the project. The world-class resource volumes of the Lunskoye field are the largest of the Sakhalin proven resource volumes. The total in place hydrocarbon resource volumes in both fields are about 594 million tonnes (4.5 billion barrels) of oil and condensate and more than 700 billion cubic metres (24 trillion cubic feet) of natural gas. The recoverable resource volumes of the Sakhalin II fields are estimated at around 653 billion cubic metres (22.4 trillion cubic feet) of gas and 183 million tonnes (1.4 billion barrels) of oil and condensate. Availability of such gas resource volumes will enable Sakhalin Energy to supply 9.6 million tonnes of LNG per annum for at least 25 years. Over 7 years since the beginning of the development of the Astokh Feature of the Piltun-Astokhskoye field, the Company has produced 11.5 million tonnes of oil, and the recoverable oil resource volumes have increased by more than 30 million tonnes, which means that the Company has achieved an actually triple replenishment of the cumulative production from the incremental resource volumes. Sakhalin II Hydrocarbon resource volumes (1 January 2006) Names of Fields Crude oil (В+С 1 +С 2 ), million tonnes Dissolved gas (В+С 1 +С 2 ), billion cubic metres Free gas and cap gas (С 1 +С 2 ), bil-lion cubic metres Condensate (С 1 +С 2 ), million tonnes In place Recoverable In place Recoverable In place Recoverable In place Piltun-Astokhskoye Lunskoye Total RF Government Annual Report on PSAs, Moscow, 2006 Annual Overview 19

22 Phase 1 and Phase 2 T o accelerate the commencement of the Sakhalin II development, Sakhalin Energy proposed a phased approach to the project implementation. The Work Programme for Phase 1, which was launched in 1996, selected the development of the Astokh feature as the starting point and included plans to continue research studies and to launch commercial oil production with a view to increasing the oil recovery factor in the future. Phase 2 started in 2001 as a fullfield integrated development of the Piltun-Astokhskoye and Lunskoye licence areas, including the construction of a new infrastructure for hydrocarbon production and oil and LNG transportation. Phase 1 The implementation of Phase 1 began with large-scale prospecting and exploration activities in the Piltun- Astokhskoye field, including seismic surveys and the drilling of prospecting and exploration wells between 1986 and The PА-А (Molikpaq) platform, which began to produce oil in July 1999, was installed in the Sakhalin shelf in Today, the PА-А platform is the heart of the Vityaz Production Complex, which also includes the doublehull Okha Floating Storage and Offloading (FSO) vessel, a Single Anchor Leg Mooring (SALM) and a sub-sea pipeline. The Vityaz operations include drilling, production and offloading of oil and the associated support and exploration activities. Oil production occurs only during a 6-month period when ice cover is not prohibitive to navigation and SALM operation. During the ice period, from approximately December to May, the FSO is disconnected from the SALM and leaves the Okhotsk Sea. As the PA-A platform has no oil storage facilities, oil production is suspended till the end of the ice period. To increase oil recovery by maintaining reservoir pressure, water flooding was implemented from the PA-A platform (Phase 1). The successful implementation of Phase 1 using the PА-А platform made it possible to obtain important field and operation data, including environmental monitoring data, which has been used to optimise the next Phases of the Sakhalin II implementation. Phase 2 In 2001, Sakhalin Energy presented the Integrated Plan of Development of Piltun- Astokhskoye and Lunskoye Licence Areas (POD), which was approved by the Supervisory Board, the steering body of the Project. On 15 May 2003, the Company announced the Development Date for Lunskoye Field, which marked the formal launching of Phase 2 of the Sakhalin II Project. Full-field development of the Sakhalin II Project involves the construction of two new offshore platforms, onshore pipelines to carry oil and gas to the south of the Island, an Onshore Processing Facility (OPF), a liquefied natural gas (LNG) plant and offloading terminals for crude oil and LNG. The LNG plant, consisting of two trains capable of producing the total of 9.6 million tonnes of LNG per annum will be the first LNG facility in Russia. Phase 2 of the Project also includes the tie-in of the PА-А (Molikpaq) platform to the field pipeline system of the Piltun- Astokhskoye field, in order to ensure year-round hydrocarbon production, which is expected in late Phase 2 construction work is now (as at the end of 2006) about 80% complete, and the entire volume of LNG production has been contracted. 20 Annual Overview

23 : Major Milestones over the Past Decade I n June 2006 Sakhalin Energy held its first decennary of the Sakhalin II Project, which started the very same day 10 years before. In this interval of time the Project added many bright pages to its track record 1996 Sakhalin Energy announced a Commencement Date under the Sakhalin II Production Sharing Agreement the official start of the Project The Government of the Russian Federation approved the plan of development of the Astokh feature (Phase I) of the Piltun- Astokhskoye field. Carried out 3D seismic on the Licence Areas over an area of 1330 square kilometres. Sakhalin Energy started financing the project for studying of grey whale population distribution and behaviour near the Vityaz production complex offshore Sakhalin Sakhalin Energy concluded a US$10 million contract for the development of project technical specifications for the LNG plant construction. Contracts for the offshore and onshore facilities design awarded, including mainline pipelines required for the full-scale development of the Piltun-Astokhskoye and Lunskoye fields. Shell concluded an asset swap with Marathon and assumed the major shareholder role in the Project Natural gas geological resource volumes increment by 40% was obtained at the Lunskoye field. Integrated Plan of Development of the Piltun- Astokhskoye and Lunskoye fields approved The Molikpaq ice-class drilling and production platform was installed offshore. PA-16 prospecting hole of 3200 m target depth was drilled at the Piltun-Astokhskoye field at a depth of 2480 m. A commercial oil flow was obtained The offshore Vityaz oil and gas producing complex started producing oil under Sakhalin II Project. The first crude cargo produced offshore Sakhalin was exported. Annual Overview 21

24 2002 Sakhalin Energy prepared and submitted for the state expert reviews the TEOC of Integrated Development under the Phase 2 Project The official launch of the implementation of the Sakhalin II Phase 2 Project. The Shareholders took the Final Investment Decision. The Lunskoye field Development Date officially announced. Sakhalin Energy announced the start of tenders for the main contracts under the Sakhalin II Phase 2 Project. First LNG sale contracts with Japan utility companies negotiated. Positive conclusions of the state expert reviews obtained Commencement of the onshore oil and gas pipeline system construction one of the biggest in the world. Sale and purchase agreement signed to supply LNG to the Western Coast of Northern America Russia s first gravity-base structures (GBSs) for the offshore platforms in the Lunskoye and Piltun fields successfully installed The Lunskoye-A topsides installation on the base structure successfully completed in a recordbreaking operation offshore Sakhalin Island. Lunskoye-A is the first gas-producing offshore platform in Russia. It will become the main source of gas production for the LNG plant at Prigorodnoye. New modules successfully installed on the Molikpaq platform. All offshore pipelaying completed ahead of schedule. First Russia s LNG jetty completed. A protocol to bring Gazprom into the Sakhalin II Project as a leading shareholder signed. 22 Annual Overview

25 Sakhalin II Project: 2007 Major Milestones I n 2007 documents will be signed to bring Gazprom on board as a leading shareholder of Sakhalin Energy. This expected event will give new stimuli for the development of our Project and strengthen the Company s position in the LNG and oil market place in Asia Pacific. A wide-scale work programme for 2007 has been outlined, the completion of which will allow us to report major new achievements for the Sakhalin II Project, such as: Lun-A platform well drilling, Installation of PA-B platform topsides, Operational readiness of the offshore and onshore pipeline, Commencement of year-round oil production at the Molikpaq, Arrival of the first LNG carrier Start of testing and commissioning activities at the LNG plant. It is beyond any doubt that the implementation of this project will contribute significantly to improving the global energy market. Energy consumers in Japan, the Republic of [South] Korea, and North America will certainly notice these improvements. This project will certainly also benefit Russians living in the region and the Russian government. Vladimir Putin, President of Russia. (21 December 2006) Annual Overview 23

26 Sakhalin Energy The New Energy Source for the Asia Pacific Innovations. Construction

27 Project Map 26 The Innovator 27 Offshore Platforms 28 LNG Plant 30 Oil Export Terminal 32 Onshore Processing Facility 33 Onshore Pipelines 34 River Crossings 35 Offshore Pipelines 37 Ensuring Seismic Safety 38 Infrastructure Projects and Logistics 39 Annual Overview 25

28 Sakhalin II Project 26 Annual Overview

29 Sakhalin II brings innovation to the Russian Federation in terms of new technologies such as LNG and offshore production of hydrocarbons The Innovator I t is safe to say that the Sakhalin II Phase 2 is a megaproject by any standard. This is a truly mammoth groundbreaking development in a frontier environment, requiring the simultaneous execution of several major multi-million dollar complex engineering projects. Sakhalin II brings innovation to the Russian Federation in terms of new technologies (LNG, offshore production, seismic protection) and in terms of new management techniques (simultaneous execution of several large scale subprojects, transparency in activities and decision making). The Project is an integrated oil and gas development in an extremely harsh frontier environment, which creates additional challenges to the design and construction teams. For example, the pipeline on its way from the north to the south of the Island crosses more than 1000 rivers and streams. A largescale monitoring programme was carried out for over three years. The resulting data were used to develop a River Crossing Strategy covering an extensive set of actions aimed at minimising any potential environmental impact. The seismic activity on Sakhalin Island is a further example of the challenges facing the Project. The offshore platforms are designed to withstand the kind of earthquake strength level that is expected on average around every 200 years without yielding or failure of equipment, and to survive a rare intensity earthquake, expected on average every 3000 years, without any serious damage. A seismic safety factor has also been built into the design of the LNG plant and the pipelines. Proven techniques and technologies, as well as extensive experience of the company shareholders, are used in an innovative manner to ensure safe and effective operations. By the end of 2006, the Phase 2 construction was about 80% complete. The most significant milestones of the past year include the installation of Russia s first offshore gas platform, Lunskoye-A (Lun-A), the transportation and installation of giant new modules for the Molikpaq platform in a one-of-a-kind operation, and completion of the laying of the offshore pipeline. By developing unique engineering solutions, we are helping forward their broad utilisation by other potential developments. Annual Overview 27

30 Offshore Platforms he Sakhalin II Project T provides for the development of the Piltun- Astokhskoye and Lunskoye oil and gas fields using three fixed offshore ice-class platforms: PA-A (Molikpaq), PA-B and Lun-A (Lunskoye-A). In the course of construction in July 2006 two modules were successfully installed on the Molikpaq platform. These complex modules, each the size of a 10-storey apartment block, will be used to hook up the platform to the pipeline system being constructed, which will enable year-round oil and gas production. The modules were installed using a heavy lift crane barge. In addition, a new multimillion-dollar crane assembled locally in Kholmsk was also installed on one of the modules. The modules were constructed by Gulf Piping Company in Abu Dhabi and delivered to Sakhalin by a 160-m self-propelled barge, Enterprise. The 11,000 km voyage to the installation site offshore Sakhalin took more than a month. Construction of the two modules, one for oil and one for gas, took 14 months. The modules, designed by ABB and constructed by Gulf Piping Company, can withstand the harsh winter climate offshore Sakhalin with temperatures as low as minus 40 degrees Centigrade. The commissioning of the modules is planned for summer Installation of Lunskoye-A, the first offshore gas platform in Russia, was a major 2006 milestone for the Sakhalin II Project. PA-A platform The platform consists of a concrete gravity base substructure (CGBS) and topsides. The Lunskoye-A substructure was installed offshore Sakhalin in The PA-A platform (Molikpaq), installed at the operations site in 1998, is the first offshore production platform in the Russian Federation. PA-A is a converted drilling rig first used in Arctic waters offshore Canada. A steel spacer manufactured by Amur Shipyard was fitted to the bottom of the Molikpaq so it could be used in the deeper waters and severe ice conditions of the Sea of Okhotsk. Molikpaq is located 16 km offshore north-east Sakhalin. The platform is 120 m wide and weighs 37,523 tons. Molikpaq is the key facility of the Vityaz production complex, which also includes Single Anchor Leg Mooring and Okha Floating Storage and Offloading Unit. Phase 1 of the Project has been producing oil since 7 July 1999 on seasonal basis. Lun-A platform Lun-A (Lunskoye-A), installed 15 km offshore north-east Sakhalin at a depth of 15 km, is a drilling and production platform with the minimum necessary of process equipment. The platform is designed for year-round operation in ice conditions, low temperatures, wind, wave and seismic loads. The main part of the gas to be used at the LNG plant will be produced at this platform. The platform production capacity is more than 50 million cubic metres of gas per day and some 50,000 barrels of condensate per day (8000 cubic metres per day) The Lunskoye CGBS was the first huge facility built in the port of Vostochnoye in the Primorsky Krai. It has a total dry weight of 103,000 tonnes. The 28 Annual Overview

31 Lunskoye-A platform is almost as high as the building of the Moscow State University on the Vorobyovy Hills and approximately as high as one of the Seven Wonders of the World, the Lighthouse of Alexandria base is 105 metres by 88 metres. The overall height of the structure is 69.5 m. The Lunskoye-A topsides were manufactured in May 2006 by Samsung Heavy Industries at their yard at Geoje in South Korea. The topsides are a fully integrated deck with all the necessary drilling and production equipment, an accommodation module for the operating personnel and life support equipment. The topsides have 27 drilling slots designed for drilling of directional wells, which will ensure full-scale development of the Lunskoye field. The platform design incorporates unique engineering solutions to meet the combined challenges of artic, wave and seismic design and ensure fail-proof operation. For the first time in international practice, friction pendulum bearings are used on an offshore platform to allow the platform to withstand earthquake loads. They will help the platform sustain heavy earthquakes. On the other hand, in calm environments they can serve to reduce wave and ice loads onto the topsides and the equipment. The Lunskoye-A topsides were successfully installed on the CGBS in May 2006: the heavy 21,800 tonne topsides were slowly and gradually lowered onto the CGBS by ballasting the barge build specially for this operation. The silent elegance of the docking and mating of these two structures was a new world record for offshore operations of this type. Drilling of wells from Lunskoye-A will commence in Sakhalin Energy will operate the platform with a zero discharge of drilling wastes into the sea. The PA-B platform topsides are under construction at the Samsung Heavy Industries construction yard on Geoje Island in Korea. As at late 2006, the fabrication is mechanically complete. As soon as the ice thaws, the 28,000 tonne topsides will start the journey to Sakhalin and will be installed in the summer of The drilling complex should ensure the drilling of directed wells through a subsea PA-B platform substructure shaft. At the Piltun- Astokhskoye field, it is planned to drill wells with large inclination angles and deviations, horizontal wells, and wells to be stopped in several horizons. The horizontal deviation of wells will reach 6 km. To increase oil recovery, a module capable of daily injecting about 20,000 m3 of water to the formation will be installed at the platform. All produced water will be injected back to the formation, and treated seawater will be also injected if additional volumes are required. The construction of injection wells is similar to that of oil wells. The PA-B (Piltun-Astokhskoye-B) platform at the Piltun- Astokhskoye field is an integrated oil and gas production platform with drilling equipment that will produce oil and associated gas in the Piltun area. The platform will be operating some 12 km offshore north-east Sakhalin at a depth of 32 metres. Similar to Lun-A, the PA-B platform is equipped with friction pendulum bearings to protect the platform from earthquake loads, and to reduce wave and ice loads onto the topsides and the equipment. The concrete gravity base substructure with four legs was built in the port of Vostochny in the Russian Far East and installed in August Production capacity: Oil: some 70,000 barrels/day (11,130 m3/day) Associated gas: 100 million standard cubic feet/day (2.8 million m3/day) The Lunskoye-A platform is almost as high as the building of the Moscow State University on the Vorobyovy Hills and approximately as high as one of the Seven Wonders of the World, the Lighthouse of Alexandria. In terms of weight the Lunskoye-A platform topsides can compete with three Eiffel towers. A barge as large as two football fields was required to carry these topsides. Transportation of the even heavier PA-B topsides will require a new gigantic barge. Annual Overview 29

32 LNG Plant LNG Plant The Liquefied Natural Gas Plant (LNG Plant) is being built near Prigorodnoye on the south coast of Sakhalin (Aniva Bay). The total area of the LNG Plant is 490 hectares. It is designed to process and liquefy natural gas. It is the first LNG plant in Russia. The LNG Plant has two process trains to purify, process and liquefy natural gas. Should there be in the future a requirement to expand the plant with a third train, the premises are large enough to accommodate additional facilities. The combined capacity of the two trains will be 13.8 bcm of feed gas per annum (approximately 1510 million standard cubic feet of feed gas per day). The Plant is designed to produce 9.6 million tonnes of LNG per annum (4.8 million tonnes of LNG per year produced by each of the process trains). The LNG Plant process trains will utilise the Shell Double Mixed Refrigerant process for gas liquefaction, which will allow them to take advantage of the natural specifics of Sakhalin s cold climate and to use energy effectively in the LNG process. Liquefied gas will be stored in two LNG storage tanks of 100,000 cubic metres net capacity each and from there shipped by LNG tankers. All LNG Plant buildings and their substructures are designed to withstand earthquakes. The facility has special units for safe disposal of LNG tanker boil-off gas. By the end of 2006, the overall progress in engineering, procurement and construction work scope at the LNG site was over 90%. Commissioning activities started on the project in The Central Control Room and the Main Administration were handed over to the operations team. Construction activities within the main production area have been completed. Start-up and commissioning of the emergency diesel generator, instrument air compressors, boilers and fire water pumps was successfully finalised. Installation of all process equipment in both LNG trains was completed by the year end. The total weight of the installed equipment is over 25,000 tonnes. In 2006, both LNG storage tanks were successfully hydrotested. The density of water is about twice that of LNG which means 30 Annual Overview

33 The International Energy Agency predicts a dramatic increase of the LNG share in natural gas interregional trade. Russia leads the world in natural gas reserves and gas production, but so far it has not produced LNG. The Sakhalin LNG plant will be Russia s first step in utilisation of this advanced technology Contractors The LNG Plant construction contract was awarded to CTSD, set up by Chiyoda Corporation and Toyo Engineering from Japan, and Russian NIPIGasPererabotka (NIPIGaz) and Khimenergo consortium. Khimenergo consists of Transstroi Engineering Corporation, IKEM and Angarsk Building Company. that the greatest load imposed during the lifetime of the tanks occurs during the hydrotest. Another important milestone of 2006 was the completion of all LNG jetty installation activities. The LNG jetty is capable of handing LNG tankers ranging from 18,000 cubic metres to 145,000 cubic metres. Once the plant is operational, loading of LNG tankers from the jetty is expected to take between six and sixteen hours, depending on the size of the vessel. As construction work intensified, approximately 10,000 people were employed on site during the peak periods of More than 50 percent of those working on the site were Russian nationals and almost 1500 were employed from the local district of Korsakov. Opening Daruma s Eye Daruma is a traditional Japanese spherical tumbler toy personifying Bodhidharma, a godling of good fortune. When you make a wish, you paint a black pupil in one of its eyes, and when your wish comes true you are supposed to fill in the other eye of the Daruma toy. The official ceremony of signing some of the LNG and OET facilities ready for commissioning certificate was also accompanied by the Daruma Eye Opening ritual executed by Japanese representatives of CTSD, the EPC contractor. The Project participants and guests will see this memorable ceremony more than once since the completion of all LNG/OET facilities is close. Visitors In 2006, LNG/OET construction team hosted more than 150 various visits and more than 2000 people had a chance to see the construction of the 1st LNG plant being built in Russia with their own eyes. Key visitors in 2006 included Russian Deputy Prime Minister Mr. Medvedev, the RF President s Envoy in the Far East Region Mr. Iskhakov, Minister of Foreign Affairs Mr. Lavrov, representatives of various Embassies including British, Australian, Japanese and Dutch. Annual Overview 31

34 Oil Export Terminal The OET is located 500 metres east of the LNG plant at the same site in Aniva Bay. The OET will be used to store oil in two oil storage tanks with geodesic curvature-type domes and floating internal roofs. The tanks have total net operating capacity of 1.2 million barrels (190,000 m3). This is approximately equal to six days throughput for the onshore pipeline. To prevent soil contamination, oil leak detection systems will be installed in the tank pads. Crude oil will be exported via a subsea pipeline to the Tanker Loading Unit (TLU) located approximately five kilometres offshore in Aniva Bay. Crude oil will be offloaded at the rate of about 50,000 barrels per hour (8000 cubic metres/hr). The TLU will be equipped with a pressure equalising system to protect the TLU against overpressure and oil spills in case of an abrupt offloading system shutdown. Work on this project is nearing completion. In 2006 crude oil pumps were installed. An onshore pipe rack and a pipeline from the tanks to the TLU were installed and tested. Installation of the TLU was completed. Four lightning towers around the oil tanks were installed to provide protection against lightning as required by Russian legislation. The towers are 60 metres high (crude oil tanks are 18 metres high). 32 Annual Overview

35 Onshore Processing Facility Onshore Processing Facility The Onshore Processing Facility (OPF) is located near the northeastern coast of Sakhalin, 7 km inland from the Lun-A platform pipeline landfall. The OPF is designed to treat the Lunskoye Field gas and condensate prior to their piping to the Oil Export Terminal and LNG Plant at Prigorodnoye, in the south of Sakhalin. The OPF will also receive oil and gas from the Piltun-Astokhskoye Field offshore platforms to prepare them for further pipeline transportation to Prigorodnoye. The OPF includes a 100 MW power plant capable to supply power required by the OPF and the Lun-A platform. When operated at full design capacity, the OPF will be able to process 1800 million standard cubic feet of gas (51 million cubic metres) and approximately 60,000 barrels of condensate/oil (9500 cubic metres) daily. All of 2007 will represent the very complex phase of completing construction and getting the systems flushed and ready for startup at the end of the year. Transition from a construction site to a live plant and from a project organisation to a long term operating organisation requires a lot of attention, and the OPF will see its highest manning over its lifetime while it is undergoing this change in OPF facilities The Onshore Processing Facility includes: inlet vessels three phase separation units; condensate stabilisation unit; condensate storage tanks; gas dehydration and dew point control; flash gas compression. The OPF also includes a wastewater treatment plant. Booster Station # 1 (BS #1) is located on the OPF premises and includes compressor stations to service the gas and oil export pipelines. BS #1 compresses the Lunskoye Field gas, as well as the Piltun-Astokhskoye Field gas for its further pipeline transportation. The pumps boost pressure of the stabilised condensate and oil stream to deliver them by main pipelines to the Oil Export Terminal (OET). Annual Overview 33

36 Onshore Pipelines subcontractors and ten Russian subcontractors are engaged in support operations. The onshore pipeline deploys the major proportion of the entire Russian pipeline laying capacity. The pipelines installation is done by pipeline spreads which include both personnel and machinery required to complete all phases of pipeline construction, from pipeline layout at the initial phase to land reinstatement at the close of activities. T he onshore oil and gas pipelines will run from the Piltun-Astokhskoye Field in the north of Sakhalin via the Onshore Processing Facility (OPF) near the Lunskoye Field to Prigorodnoye, in the south of the Island. The total length of each pipeline will be over 800 km. The oil and gas pipelines will share a single pipeline corridor. The pipelines are each installed in a separate trench (backfilled by a minimum m layer of soil over the pipe). The external surface of the line pipe has an external three-layer polyethylene to protect them against external corrosion. At fault-crossing sites, special pipe-laying techniques are used to ensure their safety in case of seismic activity. Operation of both main pipelines will be controlled by a state-ofthe-art pipeline leakage detection system. In 2006, the Onshore Pipeline Project advanced significantly. The delivery of pipes for the pipeline system was completed. Total length of the pipes delivered to Sakhalin exceeded 300 km of offshore and some 1600 km of onshore pipelines, weighing more than 500,000 tonnes km of line pipe were welded out of the total length of 1600 km. Oil and gas pipelines were installed across some of the most difficult areas of Sakhalin. The engineering, procurement and construction contractor for this project is Starstroi. Nine big Russian companies are involved in the project as construction Booster Station #2 In 2006, the Right of Way underwent two significant environmental protective exercises. One of them was a programme to install temporary soil erosion control measures such as silt fences, slope breakers, silt traps, river protection devices, etc. The other one was a winterisation programme in preparation for spring thaw (to protect the exposed ROW areas which may be vulnerable to erosion during spring thaw). In particular, the winterisation programme included heli-seeding of over 200 km of the pipeline Right of Way. Booster Station#2 (BS#2) is tied into the onshore trunk pipelines near Gastello approximately half way between the Onshore Processing Facility and Oil Export Terminal. It includes main line oil pumps, gas compressors and auxiliary equipment, including the nitrogen oxides inhibition system. There is also a flare system to release gas in case of emergency from the gas compression system as well as fuel gas. BS#2 will be also used as a pipeline emergency response centre. In 2006, Sakhalin Energy awarded the BS #2 Front End Engineering and Design, as well as Engineering, Procurement and Construction contracts. Construction of site roads, piling and foundations all commenced during Q4. Purchase orders for most long lead items were also placed during Q4. 34 Annual Overview

37 All the rivers classed as most sensitive for salmon spawning are crossed during winter River Crossings Т he onshore pipelines cross over 1000 watercourses. These include small channels and streams, but some of them are spawning rivers of high commercial importance. The pipeline route also crosses several watercourses which may be inhabited by Red Data Book fish species. Sakhalin Energy is committed to no net loss of salmon habitats. The Company undertakes all measures to reduce the impact of the pipeline crossings construction and operation to insignificant and short-term. All the rivers classed as most sensitive for salmon spawning will be crossed during winter. Wherever possible and permitted, river crossings will be constructed using a dry-cut method. This uses a flume pipe, through which the river flows temporarily whilst the trench is being prepared, ensuring that sedimentation from construction activities is minimised. Where the use of a flume pipe is not possible, wetcut methods will be applied, with strict control over water management to ensure minimal impact on the rivers. Out of 179 rivers, eight are crossed by Horizontal Directional Drilling (HDD) and one by the augur bore method. Sakhalin Energy s enhanced approach to the crossing of the remaining 170 sensitive watercourses is documented in the Company s Construction of the Naiba River crossing in the Dolinsk District turned out to be a formidable challenge for DrillTechRus, Sakhalin Energy s HDD contractor. It was one of the longest HDD river crossings (about 1.15 km), where the 48-inch pipe had to be laid deep beneath the river bed. The Naiba River is no more than 50 metres wide at the crossing site, but the contractor drilling crew had to drill a well bore over 1 km long to comply with environmental requirements. For the HDD method, a slant rig was installed on one of the river banks at an angle of 60. A small diameter borehole was first drilled under the river bed to the other bank and subsequently reamed out to the 64-inch diameter by increasingly larger augers to hold the 48-inch line pipe. Immediately after the borehole reaming, a pre-welded 1150 m long section of pipe was pulled through for tie-in. The pipeline section weighed about 730 tonnes, but the line pulling force was reduced to 80 tonnes due to rollers and special buoyancy control methods. The pipeline pull-in activity lasted 12 hours altogether. Annual Overview 35

38 River Crossing Strategy (public document) and among other things stipulates the crossing of these sensitive rivers under lowflow conditions and largely during the winter period (December April), which timing constraint is imposed over and above the Sakhrybvod timing conditions. In 2006, the last of the Horizontal Directional Drilling (HDD) river crossings was completed. Each drilling operation took several months. Sakhalin Energy put in place a focused winter river crossing campaign for winter December 2005 April 2006 using specified working methods, dedicated work crews and supervision. Information gained from this successful campaign is taken into account during the winter season for crossing the remaining sensitive rivers (a total of 23 oil pipeline crossings and 35 gas pipeline crossings of sensitive rivers and 30 crossings of tributaries). Also, at the end of the winter season 2005/2006, approval was obtained from Rosselkhoznadzor to cross a number of small rivers (up to 4.5 m wide) with flume pipes and this method will be applied wherever necessary to minimise environmental impact. Sakhalin Energy prefers not to construct any above ground river crossings for the pipelines for security reasons. In terms of environmental impact during construction, elevated crossings have a lesser impact than open trenching and more impact than HDD. With regard to the rivers on Sakhalin, however, due to extensive flood plains, possibility of liquefaction and potential scouring, this type of crossing would require significant foundation construction to support the pipelines. This type of crossing also carries additional maintenance requirements over and above the routine maintenance for buried pipelines. The exposure to the extreme air temperatures would lead to the requirement for insulation, which in itself adds to the maintenance requirements as this can lead to enhanced corrosion probabilities. Compared to open trenching, the construction of elevated crossings requires additional time and hence a longer period of impact. Regardless of the crossing method to be used, silt fencing will be installed along both banks of the stream and along the limit of ROW for a minimum distance of 20 metres to minimise the effects of wash out of excavated spoil. After that, clearing and grubbing, and installation of required equipment will be completed. 36 Annual Overview

39 The overall length of the Sakhalin II oil and gas pipelines exceeds the distance between Moscow and Berlin, which spans two time zones The pipeline system weighs as much as 1300 Tsar Cannons would weigh, and the Tsar Cannon is recorded in the Guinness Book of Records as the world s heaviest howitzer Offshore Pipelines he offshore pipelines systems T includes oil and gas pipelines designed to transport production from PA-A and PA-B to the shore, multiphase pipelines from the Lun-A platform to the shore, a MEG (monoethyleneglycol) feed line from the Onshore Processing Facility (OPF) to the Lunskoye Field platform, and an oil export pipeline in the south of the Island. The offshore pipeline engineering, procurement and construction contract was awarded to Saipem, a worldwide leader in offshore pipelaying. A dredging and backfilling subcontract was awarded to Jan de Noel. The delivery of the pipes for the offshore pipelines was completed in early Total length of pipes delivered to Sakhalin exceeded 300 km. In August 2006 Sakhalin Energy completed the Sakhalin II offshore pipeline construction ahead of schedule. The 2006 summer season work scope included dredging and installation of four pipelines (total length over 230 km): these were the oil and gas pipelines from the Chaivo Bay shore to the future PA-B platform and similar pipeline from the Chaivo Bay landfall to the existing Molikpaq (PA-A) platform. When constructing the pipeline, the Company used heavy-duty pipes with a thick coating of concrete, ensuring high reliability in any conditions. To eliminate the potential risk of pipeline damage caused by icepack ploughing, deeper trenching was used in the sea areas less than 30 metres deep. These challenging and largescale operations completed in the severe conditions of the Sea of Okhotsk have no impact on the Western Grey Whales. This is proved by the results of a widescale acoustics monitoring of construction noise. The monitoring was carried out by the Company during the 2006 construction season. Monitoring activities were also undertaken by independent environmental organisations. The monitoring proved that the noise impact was in compliance with the officially established noise standards. The early completion of the offshore pipelines installations allowed the support vessels to depart from the operations area ahead of schedule, which dramatically reduced the overall noise impact. The installation of the offshore pipelines was followed by diving operations for the final tie-in of the pipelines and offshore platforms. Upon completion of this stage, the pipeline will be hydrotested. Annual Overview 37

40 Ensuring Seismic Safety T he exploration of oil and gas in seismic frontier regions is a further example of the challenge and complexity of delivering and operating Sakhalin II Phase 2. Seismic activity in Sakhalin is on a par with the Persian Gulf. Therefore, the ability to maintain safe operations in the event of a major earthquake has been embedded in both the design and construction of the project s hydrocarbon infrastructure. In general, Sakhalin Energy has minimised potential impact by rerouting where possible the pipelines away from areas prone to both landslides and seismic hazards. The offshore platforms are designed to withstand the kind of strength-level earthquake that is expected on average around every 200 years without yielding or failure of equipment, and to survive a rare intensity earthquake, expected on average every 3000 years, with only limited damage. This is made possible through the pioneering deployment of a cradle system (friction pendulum bearings) never before used on an offshore platform. More commonly used in major infrastructure such as highways, bridges and airports, the cradle system reduces the horizontal loads on the platform topsides in extreme conditions by helping to isolate the topsides from the most damaging earthquake ground motions. Sakhalin Energy has designed and is building the LNG plant in line with global LNG safety standards to survive, without yielding or failure of equipment, the kind of earthquake expected at the site once in 500 years, and to survive, with only limited damage, a rare-intensity earthquake expected once in 10,000 years. Even in the case of such extreme events, the plant has been designed to prevent major loss of containment. The onshore pipelines cross faults at a number of locations. At these locations, a combination of thicker-walled pipe and special trenching is employed to minimise the deformation imparted to the pipeline by a potential fault rupture. The offshore pipelines do not cross any active faults. On Sakhalin, landslide risk is mostly confined to a particularly mountainous 120 km section of the pipeline route. The total cumulative length of landslides was identified to be in the order of 20 km, accounting for 2.5 per cent of the total length of the right of way. In addition to rerouting, Sakhalin Energy has adhered to industry best practice to mitigate the risk from landslides to the pipelines. Sakhalin Energy is currently producing a seismic monitoring plan that will cover a significant length of the Island and includes all of the pipelines and all the other major project assets. Data will be collected at Sakhalin Energy s seismic monitoring stations during any earthquake and will be recorded in digital format and be available for processing immediately after the earthquake event. To ensure emergency response capability, the processed data will be transmitted to the pipeline control centre for use in operations decision-making. Seismic data from Sakhalin Energy can also be made available to emergency response agencies and various scientific institutes. For the first time in the world, seismic isolation devices are installed on the Sakhalin II offshore platforms to protect them against seismic loads. The pipe is installed in a trapezoidal trench containing special backfill (either made up of selected sand or lightweight expanded clay) to allow the pipe to move more freely. If minor to moderate fault displacement occurs, all movement will take place within the special backfill. In the unlikely event of greater displacements the pipe is designed to be able to rise out of the trench. The design for the oil and gas pipelines also includes approximately 105 automated block valves, including block valves on either side of fault zones. 38 Annual Overview

41 A major milestone for 2006 roadworks was the commissioning of the Makarov road Infrastructure Projects and Logistics Marine Operations In 2006, three Platform Supply Vessels (PSV), designed to serve the offshore platforms, arrived to Sakhalin. The PSVs were built in Romania and outfitted in Norway. The new support vessels do not require icebreaker assistance and their dynamic positioning systems allow them to stay put at a specified position next to the offshore platform. Icebreaker class support vessels are the first in the line of special purpose vessels which are being built by the JV set up by the Primorsk Shipping Corporation and Swire Pacific Offshore for the purpose of the Sakhalin II marine operations in the Sea of Okhotsk. Kholmsk Port In 2006, Sakhalin Energy awarded the contract for provision of 1537 various containers to Sakhalinremflot. Some of the containers were completed in the Sakhalinremflot yard in Kholmsk. The contract with Sakhalin Shelf Services for the provision of warehousing and personnel in the Sakhalin Western Sea Port was extended for a further 4-year period until Aviation The remaining three contract helicopters were equipped with Health and Usage-Monitoring System (HUMS); modifications completed by the end of October. The Lun-A helideck received its certification and approval from the Federal Aviation Authorities on time and on schedule to allow helicopter operations to commence in An additional five helidecks on the various barges and rigs required for the summer offshore operations were certified during the year, also without any problems or delays. Telecoms The main telecom contractor SKS has installed 480 km of fibreoptic cable (FOC) on the Pipeline Right of Way out of a total of 823 km required to connect all the Project facilities into a single system. Installation of the new fibreoptic cable across the whole of the Island will allow the management and control of the Project facilities as well as improving the level of telecoms services provided to the Sakhalin public. Among other things in 2006, key achievements were the mechanical completion, commissioning and handover of the OPF to Lunskoye FOC link. This also enabled the platform to be connected into the network, which is now fully operational, carrying all voice, data and process control networks. Telecoms systems installation and commissioning was completed successfully on the Lunskoye platform and 90% complete at the OPF by the end of Roads and Bridges A major milestone for 2006 roadworks was the commissioning of the Makarov road (about 10 km). The general contractor is SU-4/FSC Joint Venture. In 2006 Sakhalin Energy in conjunction with Sakhavtodor completed asphalting works in the communities of Yelniki, Onor, Zonalnoye, Krasnaya Tym, Ado- Tymovo and Argi-Pagy, a total length of about 8 km. In 2006 Sakhalin Energy and Sakhavtodor were awarded the contract for replacement of 13 temporary bridges to the permanent ones to OOO Vostokdorstroi. The company has started the works and it is planned to complete them in Road repairs are going on in Korsakov. JV SU-4/FSC started the upgrades of the Korsakov Novikovo section of the road. In 2006 a new bridge across the Korsakovka river was constructed under the contract between Sakhalin Energy and Korsakov administration. Hospital Upgrades In 2006 Sakhalin Energy commissioned upgrades in the Kholmsk District hospital. New equipment was supplied including surgical tables, ventilators (both surgical and cardiac), ICU beds, and others. The repairs work was done by the local (Kholmsk) construction company OOO Remstroiservice. Annual Overview 39

42 Sakhalin Energy The New Energy Source for the Asia Pacific Production. Commerce

43 Oil Production 42 Oil Marketing 43 LNG Marketing 44 Hydrocarbons Transportation 45 Annual Overview 41

44 Oil Production I n December 2006 Sakhalin Energy successfully completed the eighth production season at the Vityaz Complex, which has been producing Russia s first offshore oil since The cumulative oil production for the 2006 season which started in mid-june was million barrels of light Vityaz crude. The eighth production season had a late start-up, caused by the ice invasion in early June and by very challenging construction activities associated with installation of tie-in modules on the Molikpaq producing platform. These gigantic modules will be used to tie-in the offshore platform to the export pipeline system. Nevertheless, the Company managed to produce as much crude as in 2004, which was only 4% less than in In view of the above, the 2006 production season can be considered successful. The cumulative Sakhalin II oil production since the project commencement is almost 85 million barrels. The Vityaz Production Complex consists of the Molikpaq offshore platform, Single Anchor Leg Mooring (SALM) and the Floating and Storage Offloading Unit Okha. During production season the Okha tanker is moored to the SALM and receives produced crude for further offloading into shuttle tankers. In winter, when production on the Vityaz Complex is shut down, the Okha tanker is used as a regular crude carrier and the SALM is lowered to the sea floor. Due to the harsh climatic conditions of the Okhotsk Sea, oil is currently produced only during the six months of the year in the ice-free period. The changeover to year-round production from Russia s first offshore Molikpaq platform is Vityaz Crude Properties planned to take place in the end of From then on produced oil will be transported via the 800 km long main pipeline to the Oil Export Terminal which is being constructed in Aniva Bay in the south of Sakhalin where the sea is free of ice the year round. Density (g/cm3) API 33.6 Pour point ( C) <-45 Kinematic viscosity (at 20 C, cst) 3.85 Sulphur (wt%) 0.24 Solubleness (m3/m3*mpa) 6.11 Gas/Oil (m3/ton) 138 Molikpaq Production Profile 42 Annual Overview

45 The Sakhalin II Project opened up new prospects for Russian oil on the Asia Pacific and USA markets Oil Marketing I n 2006, the Company marketed mln. bbl of Vityaz crude and achieved a record result with a weighted average crude oil sales price for the year. The success of the Crude Oil marketing team strategy was highlighted by the record number of customers that participated in the Company tenders and sales negotiations, confirming the continuing increase in interest in Vityaz crude in the Asia Pacific crude oil market. Vityaz Crude Sales Geography and History ( ) All produced crude oil is exported and in 2006 a total of 19 cargoes of Vityaz crude were delivered during the season to existing markets in Japan, Korea, Thailand and the USA. In addition to these countries, Vityaz crude was exported in previous years to China, Taiwan and the Philippines. The Sakhalin II Project opened up new prospects for Russian oil on the Asia Pacific and USA markets. About 85 million barrels of crude oil have been exported to these markets since the beginning of oil production on the Molikpaq in A primary buyer of Vityaz crude in 2006 was Japan, which imported about 70% of produced oil. It should be noted that Japan has been the largest consumer of the Vityaz oil since Vityaz Crude Sales Pattern Annual Overview 43

46 LNG Marketing In 2006 Sakhalin Energy managed to execute and prepare for signing several additional LNG (liquefied natural gas) sales agreements. As a result, the Company was able to conclude to date various LNG sales contracts and has sold 98% of the LNG plant capacity on a long-term basis. The remaining 2% will be used for operational flexibility. It has in effect successfully completed the LNG marketing of the first two trains. That was accomplished well in advance before the LNG Plant completion and Sakhalin II commercial gas production. In 2006 Sakhalin Energy executed two new LNG sales agreements with Japanese buyers Hiroshima Gas and Tohoku Electric. In addition, the Company finalised Heads of Agreement for LNG sales with Chubu Electric and reached an agreement in principle on the execution of a similar document with Osaka Gas. Under the Tohoku Gas Electric contract, Sakhalin Energy undertakes to supply annually 0.42 million tons of LNG over a period of 20 years. The Sales and Purchase Agreement (SPA) provides for the supply to Hiroshima Gas Co. Ltd. of 0.21 million tonnes of liquefied natural gas (LNG) per annum for 20 years. This deal is the first one involving use of a small LNG carrier, and indicates the flexibility that can be offered at the Sakhalin Energy LNG plant marine loading facilities. Under the Chubu Electric and Osaka Gas HOAs, the buyers will receive annually 0.5 million tonnes and 0.2 million tonnes of Sakhalin LNG for 15 and 20 years respectively. In view of the latest agreements, the Sakhalin II overall long-term LNG commitments have reached 9.4 million tonnes per annum whilst the total capacity of the future LNG plant will be 9.6 million tonnes of LNG per year. Approximately two thirds of the Sakhalin LNG plant capacity will be supplied to Japan to nine buyers located all over the country. This figure proves that Sakhalin Island is becoming a new strategic source of natural gas supply to Japan. The remaining LNG will be supplied to Korea and West Coast of North America. Sakhalin gas will be delivered to the receiving terminal Costa Azul in Baja California, Mexico, where some of it will be used to satisfy the growing Mexico s demand, while the rest will be exported to the USA. Alongside with drafting the LNG HoAs and SPAs, Sakhalin Energy negotiated with customers mitigation of the LNG shortfall during the initial phase, which will occur due to the Project schedule slippage. Sakhalin Energy is resolved to develop an optimum action plan to mitigate the effect of the project schedule changes. In addition, with the execution of an original trilateral swap deal, Sakhalin Energy secured purchase of the first LNG cargo to commission the LNG facilities, which will allow it to meet the Project schedule. The first LNG cargo is planned to be offloaded from the plant at Prigorodnoye in the south of Sakhalin in Annual Overview

47 Marketing of LNG of the first two trains is successfully completed Hydrocarbons Transportation n 2006, one of Sakhalin I Energy s priorities was the development of marine transportation system to ensure the smooth delivery of LNG to customers. In September 2006 the Company signed an agreement with Primorskoye Shipping Company ( PRISCO ) for the provision of two oil tanker charters for five years. The floating charter price will be tied to the market environment, making this contract attractive for both parties. The 108,000 DWT tankers will be used to ship the crude oil produced at the Sakhalin II facilities. These tankers were built in 2004 to state-of-the-art standards in Croatia. Both iceclass tankers were designed to operate in low-temperature environments and natural conditions prevailing offshore Sakhalin, which are especially harsh from January to March. In line with the Sakhalin Energy s environment protection policy, both ships are constructed as double-hull. PRISCO has installed a bowloading system suitable for loading oil from the year-round Tanker Loading Unit, which is already installed and is being commissioned in Aniva Bay. PRISCO has been providing tankers for crude shipping to Sakhalin Energy since Construction of the three LNG ships chartered by Sakhalin Energy on a long-term basis is progressing as planned. The new LNG ships being built at shipyards in Japan have been ordered by two Russian-Japanese consortia, with which Sakhalin Energy signed long-term chartering agreements earlier. Sovkomflot and PRISCO are Russian parties to these consortia. As a symbolic commencement of construction, first steel was cut in January 2006 for a new LNG tanker constructed in Nagasaki (Japan) by a consortium including Sovkomflot. Each of the ships can transport 145 thousand cubic metres of LNG. The two Russian companies will play a key role in ownership of the ships and provision of Russian crews. In 2006, the two Russian companies already started training their crews in LNG transportation. Russian ship-owners are gaining valuable experience that will become useful for implementation of other LNG projects in Russia, in particular, Russian arctic shelf development. Annual Overview 45

48 Sakhalin Energy The New Energy Source for the Asia Pacific Economics. Finance

49 General Business Principles 48 Financing and Project Costs 49 Economic Efficiency 50 Taxes and Payments 51 Annual Overview 47

50 General Business Principles Sustainable development We are committed to contributing to sustainable development. This requires balancing short- and long-term interests, and integrating economic, environmental and social considerations into business decision-making. Economics Long-term profitability is essential to achieving business goals and ensuring continuous growth of the Company. It is a measure both of efficiency and of the value that customers place on Sakhalin Energy s products and services. It is essential to the allocation of the corporate resources necessary to support the investment into development and production of future energy sources that meet customer s demands. Criteria for investment decisions take into account sustainable development considerations (commercial, social and environmental) and an appraisal of investment security. Competition Sakhalin Energy supports free enterprise. It seeks to compete fairly and ethically and within the framework of applicable competition laws; it will not prevent others from competing freely with the Company. Business Integrity Sakhalin Energy insists on honesty, integrity and fairness in all aspects of their business and expects the same in its relationships with all those with whom they do business. The direct or indirect offer, payment, soliciting and acceptance of bribes in any form are absolutely unacceptable practices. Any payments aimed at streamlining formalities are also considered bribes and should not be effected. All business transactions on behalf of Sakhalin Energy must be reflected accurately and fairly in the accounts of the company in accordance with established procedures and will be subject to audit and disclosure. Political Activities Sakhalin Energy acts in a socially responsible manner within the laws of the Russian Federation and the other countries in which it does business in pursuit of its legitimate commercial objectives. Sakhalin Energy does not make payments to political parties, organisations or their representatives or take any part in party politics. Safety and the Environment Consistent with its commitment to contribute to sustainable development, Sakhalin Energy has a systematic approach to health, safety and environmental management in order to achieve continuous performance improvement. Local Communities Sakhalin Energy endeavours to be a good neighbour in local communities and continuously develops ways to improve, directly or indirectly, the welfare of the communities in which it does business. The Company pays considerable attention to the social impacts of its business activity, cooperates with other parties for the benefit of the communities and seeks to mitigate any impacts resulting from its activities. Communication Sakhalin Energy recognises the importance of ongoing communication with the stakeholders. The Company undertakes to report on results of its business and provide full relevant information about its activities to legitimately interested parties, subject to any overriding considerations of business confidentiality. Compliance with Law Sakhalin Energy undertakes to comply with all applicable laws and regulations of the country it operates in. Observance of Our Principles The main general values of Sakhalin Energy integrity, openness and respect for people underlie all Company s activities and serve as a basis for the general business principles. For many years the general business principles have been providing the foundation for the Company s business and adherence to these principles is the key component of our future success. 48 Annual Overview

51 Financing and Project Costs S akhalin II is Russia s first large-scale multi-source financed project. Phase 1 of the Project was for the most part financed by Sakhalin Energy shareholders, with additional financing in the amount of US$116 million provided by three lenders: European Bank for Reconstruction and Development (EBRD), Overseas Private Investment Corporation (OPIC) and Japan Bank for International Cooperation (JBIC). Currently, Phase 2 financing is accomplished by Company shareholders, including reinvestment of proceeds from sale of crude. Decisions on further financing will be made by shareholders after the official entry of Gazprom into the Project. According to the updated cost estimate formally presented by Sakhalin Energy to the Russian Party in the fall of 2005, the full cost of Phase 2 implementation was estimated at some US$20 billion. In December 2006, Sakhalin II shareholders and the RF Ministry of Industry and Energy, as the body authorised by the RF government to supervise PSA implementation, reached an agreement on Sakhalin II updated development budget and cost recovery. The Sakhalin II Phase 2 updated cost estimate is to be reviewed and approved by the Supervisory Board in The reasons for the cost increase cost inflation. The industry has seen many projects around the world impacted by material cost increases as a result of the inflated market. The impact on Sakhalin II has been exacerbated by the long project duration and the fact that much of the original design and costing dates from some years ago. Cost has further been impacted by Russian inflation and strengthening of the Rouble. In addition to rising energy prices and inflation in Russia, both recommendations from Russian technical expert bodies and changes to detailed design have impacted cost. For example, following additional seismic analysis, changes were required in the technical specifications of our offshore facilities, requiring additional steel for strengthening the concrete-based gravity structures. Also, Russian whale scientists identified the need to better mitigate the impact of the project on the endangered Western Grey Whale population. Following a review of the recommendations, the Company decided to reroute the offshore pipelines at a considerable cost. Furthermore, when the development was sanctioned, over-aggressive targets in terms of cost and schedule were set. They did not fully reflect the uncertainties and challenges of this frontier province, which have led to a lengthening of the construction schedule, and some design adjustments as a result of detailed engineering, or through improved technical or scientific understanding, in some cases as a result of the recommendations of Russian expert bodies. Nevertheless, the project remains economically sound for the shareholders and beneficial for Russian Federation (see Economic Efficiency). High oil prices have resulted in an increased demand for oilfield services and commodities (e.g. steel) and has led to substantial Annual Overview 49

52 Economic Efficiency uite naturally, the updated Q Sakhalin II Phase 2 cost estimate (approximately US$20 billion) caused concern over commercial impact of this disclosure on Sakhalin Energy and its shareholders as well as on the state as a party to production sharing under the PSA. In conformity with the recommendations of the Project s Supervisory Board and decisions of the Supervisory Board s Working Group the economic efficiency of Sakhalin II Phase 2 was thoroughly analysed to allow for cost increases caused by objective reasons related to market, environmental and production factors. This work was carried out with the participation of the Company specialists, experts of the leading Russian and international consulting firms, representatives of the Russian Ministry of Energy and Industry, Ministry of Finance, Ministry of Economic Development and Trade, and the Sakhalin Oblast Administration. Analysis results clearly demonstrate the commercial viability of the continuing implementation of the Sakhalin II Project. The Project remains economically attractive for the Russian Federation. Assuming an oil forward price of US$50 per barrel, the Russian take will amount to US$80 billion. Once the project has reached cost recovery (estimated to be in 2014), the yearly benefit to Russia in royalties, profit hydrocarbons and taxes rises to around US$2 billion per year. The mechanism in the PSA that gives a higher share of the profit hydrocarbons to the RP at higher returns assures that in case of beneficial impacts on the project in the future (higher sales revenues, additional volumes ) the RP will benefit to a larger extent. Under the structure of the PSA, the most part of the overall loss in value is borne by the Company. It is also important to note that even with Project costs up to US$20 billion, Sakhalin II Phase 2 unit costs are comparable with those of other similar oil and gas projects already implemented or still in progress. At the same time, the increase in Project costs provides a motivation for Sakhalin Energy to contain the growth of expenditures and to proactively seek saving opportunities. 50 Annual Overview

53 In total, from the start of the Sakhalin II development to the end of 2006 Russia has received some US$552 million from the Project Taxes and Payments he pivot of the special PSA T treatment is not a benefit to any of the parties of the Agreement, but the stability and opportunity to redistribute the tax burden in time (it grows as the production volume increases, the cost recovery approaches and the rate of return goes up). Once the revenues from the Project have achieved a certain level, the Russian Federation s share may reach up to 70%. In addition, Sakhalin Energy pays tax on all of its profit gains. In 2006, Sakhalin Energy paid taxes and fees to the Federal and regional budgets in the amount of US$91.8 million. In addition to royalty, the profit tax, individual income tax and mandatory payments to social funds, as well as a number of other tax payments and changes, the Company pays a number of special payments envisaged in the PSA, including bonuses, compensations for past exploration expenses and contributions to the Sakhalin Development Fund. Structure of Sakhalin Energy s payments and Taxes ( ) In total, from the start of the Project to the end of 2006 Russia has received some US$552 million. This amount includes the Commencement Date Bonus (US$50 million), past exploration expenses (US$80 million) and Sakhalin Development Fund contributions (US$100 million). When the Project reaches the production plateau (in the end of the current decade), Russia will be getting approximately US$300 million every year in royalties alone. Annual Overview 51

54 Sakhalin Energy The New Energy Source for the Asia Pacific Russian Content

55 Russian Content Development Strategy 54 New Contracts 56 How to Become a Contractor 57 Annual Overview 53

56 Russian Content Development Strategy Nine elements of the Russian Content Development Strategy Contracting and Procurement activity plan for ; Russian Content Opportunity Identification Process; Sakhalin Island Business Development; Russian Vendor Development Programme; Russian Content Communication Plan; Strengthening of the Russian Content Development Department; Increased involvement of the Joint Committee; Revised Tender evaluation procedure; Russian Content Responsibility and Compliance with Russian Content Plan. STRATEGY ussian content is an R important criteria to measure the overall success of Sakhalin II; it remains to be one of additional benefits which the Project brings to Sakhalin Region and the Russian Federation. In 2006, Sakhalin Energy continued implementation of the Sakhalin II Russian Content Development Strategy approved in May The main concept of the strategy is the long-term planning of future requirements in terms of Contracting and Procurement, and the timely identification of potential for involvement of Russian resources and companies, as well as rendering assistance to Sakhalin and Russian enterprises seeking contracts under Sakhalin II. The objective of the strategy is to use Sakhalin industry potential to the full, and maximise payments for goods and services provided, thus increasing contribution to Sakhalin economic development. Based on the approved Russian Content Development Strategy, a five-year contracting and procurement plan was developed ( ), and measures were taken to identify Russian content opportunities. Overall cost and amount of new contracts awarded in 2006 and contract variations approved in 2006 Total Including Russian vendors Russian vendors share % New contracts Cost, million USD 1, , % Quantity 2,766 1,962 71% Contract variations Cost, million USD 2, % Quantity 1,118 8,535 48% Overall awarded value Cost, million USD 3, , % 54 Annual Overview

57 In 2006, 83% of new contracts value was awarded to Russian industry In 2006 the Company commenced with preparation of a structured Russian Vendor Development Programme to provide targeted assistance in removing shortcomings of selected Sakhalin and mainland Russia based vendors. MAJOR ACHIEVEMENTS n 2006, Sakhalin Energy I continued successful fulfilment of one of its key obligations under Sakhalin II efficient involvement of Russian industry and manpower (Russian content). The value of new contracts awarded to Russian vendors in 2006 made up 83% of the overall value of new contracts. Taking into account 2006 contract variations, the value of contracts awarded to Russian companies added up to US$ million or 57% of the overall value of contracts in Both figures indicate that involvement of Russian industry in project work has improved in comparison with prior periods. As of the close of 2006, Russian content in the Project measured in man-hours of service provided and volume of material and equipment delivered exceeded 70%. From 1996 to 2006, Russian companies and manpower worked over 159 million man hours, which makes up approximately 78% of overall labour costs under the Project, and Russian materials and equipment exceeded 8.9 million tons or made up 91% of the overall volume of materials and equipment supplied. The Company appreciates the importance of Russian content measured in value terms. From the time when Phase 1 construction commenced (1996), Russian contractors and subcontractors had been awarded contracts for US$8.2 billion or 46% of the overall cost of awarded contracts and contract variations. JOINT COMMITTEE T he Joint Committee is an effective information channel between Sakhalin Energy, the Russian Party and Russian industry. Successful performance in the area of Russian content development was achieved by joint efforts of all JC participants. The Joint Committee includes two representatives of the Company, two representatives of the Federal Government and two representatives of the Sakhalin Oblast Administration. The Joint Committee: The main objective of the Joint Committee is provision of maximum involvement of Russian industry in Sakhalin II. The established procedures and mechanisms of this body help the Russian Party better understand the Company s procurement and facility maintenance processes as well as the Project requirements and to educe new opportunities for the Russian industry. At the same time, the Joint Committee helps the Company take into account the changes in the business practices in the Russian Federation. In 2006, the Joint Committee and other Russian Party representatives attended 4 (four) Special Tender Board meetings. Based on the results of those meetings, two (2) very large Sakhalin II onshore and offshore facilities maintenance and repair contracts were awarded to Russian contractors. provides consultancy to Russian and foreign companies on how to better introduce their companies to be involved in Sakhalin II; makes a list of goods and services that can be provided by Russian contractors and subcontractors, as well as a list of potential Russian contractors, including manufacturers of equipment and service providers; provides Sakhalin Energy with recommendations on wording of the tender conditions; assists in arranging inspections at factories of potential Russian contractors; arranges workshops for potential contractors for the purpose of explaining the PSA requirements, as well as to discuss problematic issues; identifies activities where establishment of joint ventures can be efficient; renders assistance in establishing joint ventures. Annual Overview 55

58 New Contracts Contracts for maintenance services for production assets In 2006, two joint ventures were awarded two long-term contracts for maintenance of Sakhalin II Project production assets with the total value of about US$200 million. The first contract for the provision of maintenance services for the first Russia s liquefied natural gas (LNG) plant, oil export terminal and onshore processing facility was awarded to SakhalinNefteGasService (SNGS). SakhalinNefteGasService is a Sakhalin enterprise consolidating the international experience of its partners (Fluor Daniels and Dietsmann) and the experience of a local contractor, Dalelektromontazh. The second contract for maintenance of three offshore platforms and onshore oil and gas pipelines was awarded to the joint venture of the Sakhalin company SakhalinMorNefteMontazh (SMNM) and the American VECO. Award of two major contracts for high-tech industrial equipment for Booster Station 2 The EPC contract worth 500 million roubles (approximately US$19 million) for the Booster Station #2 power generation and substation package was awarded to ZAO Iskra-Energetika, a Russian manufacturing company based in the city of Perm. Also, Sakhalin Energy awarded an EPC contract worth 230 million roubles (approximately US$8.7 million) for supply of two gas turbine-driven crude oil booster pump packages to OAO Aviadvigatel, one of the largest enterprises in the Perm Engine- Manufacturing Complex. These pump units will be installed as part of Sakhalin II Booster Station #2. Major contracts with Sakhalin enterprises Sakhalin Energy awarded a contract for the construction of five Pipeline Maintenance Depots along the onshore pipeline route to a consortium of several Sakhalin construction companies: Sfera, Transstroy Sakhalin and Joint Venture SU-4/FSK. The contract value is US$85 million. This is the largest contract under Sakhalin II awarded to Sakhalin companies for the works on development of Sakhalin shelf. Another major contract was awarded to ZAO Transstroi- Sakhalin. The scope of work under this contract includes construction work to be done in the coastal area adjacent to the Material Offloading Facility at Prigorodnoye. The contract worth US$35 million for the lease of shipping containers, provision of storage services, as well as container and sling certification and maintenance services was awarded to Sakhalinremflot, a local company based in the city of Kholmsk. A US$30 million contract for construction of thirteen (13) capital bridges across the Yuzhno-Nogliki-Okha motorway to replace temporary bridges was awarded to Vostokdorstroi. Other major contracts were awarded to JV SU-4 and FSK for road maintenance and upgrading. A US$140 million contract was awarded to Sakhtransbunker for diesel fuel supply for the Sakhalin II Project needs; another US$18 million contract was awarded to Sakhalin-Shelf-Service for fuel transportation in the north of Sakhalin Oblast. Vyksa Metallurgic Plant Vyksa Metallurgic Plant (VMP) representing the United Metallurgic Company (OMK) has successfully completed the manufacture of 399 conductor pipes (4224 metres long and weighing 3000 tonnes) that will be used as elements of the well design at the Lunskoye and Piltun production platforms. Such conductor pipe was the first of its kind ever manufactured in Russia. Having acquired this experience, Vyksa Metallurgic Plant was the first Russian company and became the fifth company in the world to produce to such high technological standards. Booster Station #2 Construction The construction contract for Booster Station #2 was awarded to Eaststroi company. 56 Annual Overview

59 The contract for the construction of five Pipeline Maintenance Depots awarded to a consortium of Sakhalin construction companies (Sfera, Transstroy Sakhalin and SU-4/FSK) is the largest contract awarded to Sakhalin construction companies Utilisation of Russian shipbuilding companies and shipowners Four new vessels are being built at the Russian shipbuilding yards as part of Sakhalin II. The order is being executed within the framework of marine services contract between Sakhalin Energy and SvitzerWijsmuller Sakhalin. Under the contract terms, all vessels will sail under the Russian flag and have Russian crews on board during the whole 15-year charter period. In 2006, the St. Petersburg Admiralty Shipyard started construction of the harbour tugs. Zvezda Plant in the Russian Far Eastern Nakhodka is building the mooring tugs. The tugs will have oil spill response and fire-fighting equipment installed. Russian plants apply advanced technology to build these vessels because their technical specifications need to meet the highest international standards. In 2006, the Russian British Joint Venture company, Prisco Swire Offshore, constructed three modern icebreaker class supply vessels for provision of year-round supply services for three offshore oil and gas production platforms of the Sakhalin II Project. The charter of Pacific Enterprise, Pacific Endeavour and Pacific Endurance will continue for 15 years. A five-year contract was signed with Primorskoye Shipping Company for the provision of two oil tanker (Sakhalin Island and Governor Farkhutdinov) charters. Safe air transportation for Sakhalin II Project In 2006, Aviashelf company finished work on the installation of the monitoring system and diagnostics (OMSD) onboard four Mi-8MTV1 helicopters. The system on board the helicopters, performing flights for the Sakhalin II Project, was installed at a request of Sakhalin Energy. How to Become a Contractor S akhalin Energy awards most contracts for materials and services on a competitive basis. The bidding process has the following stages: Making a list of potential bidders This list is based on the Company s database containing information on all registered or qualified vendors. Contractors registration To register as a potential vendor, it is necessary to fill in a vendor registration questionnaire found at the Sakhalin Energy website ( or send a fax to +7 (4242) Pre-qualification At this stage potential vendors included in the long list are prequalified for the purpose of identifying those with the capability to carry out work or provide materials in accordance with the Company s standards. Distribution of invitations to bid The Company s contracting department sends invitations to bid to the vendors included in the list. From now on, they are called applicants or bidders. Information clarification A bidder can request from the Company any additional information on the bidding process. The bidders questions and the Company s answers are placed in a tender bulletin to be sent to all the bidders. Bid submission By a fixed date, all bidders submit their bids. Bid evaluation On the basis of the bid evaluation the Company makes its decision as to the bid that can be considered the optimal one. Price is an important aspect. However, contracts are not necessarily always awarded to bidders who offered the best price. Other key aspects that are taken into account are quality of service, compliance with high HSE standards, as well as a schedule of work. Contract award Once all bidding stages are completed, the Company awards a contract. Annual Overview 57

60 Sakhalin Energy The New Energy Source for the Asia Pacific Management. Personnel

61 Management System 60 Supervisory Board 61 Committee of Executive Directors 62 In Dialogue with the Society 63 Personnel Development 64 Annual Overview 59

62 Management System akhalin Energy management S system has been formed under the influence of two major factors. On the one hand, the Project is being implemented under a PSA, which assumes the active participation of the Government in the supervision of the Project, making strategic decisions and approving them. On the other hand, Sakhalin II is the world s largest integrated oil and gas project, whose production units have very complex interrelations which requires synchronisation of all processes under one project while providing an adequate autonomy to functions in their core activities. Sakhalin s natural/climatic environment and shelf conditions make synchronisation even more important, because many operations can be carried out only during certain seasons: a delay of several weeks or days can result in one year lost. The highest executive body that makes the most important strategic decisions is the Supervisory Board, with equal membership from the Shareholders and the Company on the one hand, and the Russian Federation (the RF Government and the Sakhalin Oblast Administration) on the other. The Supervisory Board members from the Russian Federation are appointed by a decree of the RF Government. Sakhalin II Governance Structure in the PSA context Russian Party). The Board of Directors holds responsibility for communication with the Shareholders and general management of the Company. The Committee of Executive Directors provides implementation of decisions made by the Board of Directors and the Shareholders meeting, and holds responsibility for a day-to-day and operational management of the Company. Sakhalin Energy Corporate Governance Model The Company s functional departments and directorates, chaired by senior managers of the Company, exercise control over the management of various activities and the efficiency of integration of them. As of today, there are eight functions: Project, Operations, Technical, Commercial, Finance, Human Resources, Legal and External Affairs. Sakhalin Energy is operating under a three-tier model of management. Key decisions are made by the Shareholders (the most important ones are submitted for discussion of the 60 Annual Overview

63 The Supervisory Board held five meetings in 2006 that addressed various strategic issues of Sakhalin II development Supervisory Board he Supervisory Board is T Sakhalin II s highest executive entity and consists of six members nominated by Sakhalin Energy (Sakhalin II Operator and Investor) and its shareholders, and six members nominated by the RF Government and the Sakhalin Oblast Administration. Duties of the Supervisory Board. The Supervisory Board shall have the following responsibilities: review and approval of the Development Plans and Development Budgets and review and approval of any material amendment to the aforesaid documents; review and approval of Annual Work Programmes and Budgets and review and approval of any material amendment to the aforesaid documents; review and approval of any LNG Sales Agreement or other agreement for the long-term sale of natural gas, and of any material amendment thereto; review and approval of the Procurement Procedures; review and approval of the Plans for Employment and Training of Russian Nationals; review of Annual Reports; approval of the appointment of an Operator, financial service provider, marketing service provider or technical service provider that is not an Affiliate of the Company; review of the principal Financing Documents. The Supervisory Board has two Co-chairmen: one from the Russian Party and one from the Company. The Cochairmen chair the Supervisory Board meetings on an alternating basis. The Supervisory Board shall meet at least four times every year. Decisions of the Supervisory Board shall be adopted by majority vote of all members of the Supervisory Board. In 2006, five meetings of the Supervisory Board were held that addressed various strategic issues of Sakhalin II development, including the following: approval of the base Work Programme & Budget; discussion of updated reservoir management plans for Lunskoye and Piltun licence area; discussion of the status of the Amendment to Development Budget approval; Heads of agreements negotiated with LNG customers; reports on the measures taken to address the RF Accounting Chamber and Rosprirodnadzor audits findings; plan for establishment of the port and border checkpoint at Prigorodnoye and offshore operations. Annual Overview 61

64 Committee of Executive Directors As of 31 December, 2006 Steering Group members are heads of the Company s departments Chief Executive Officer Ian Craig Technical Director Jaap Huijskes Head of Corporate Affairs Igor Ignatiev Deputy Chief Executive Officer/Sakhalin II Project Director David Greer Commercial Director Ate Visser HR General Manager Mark Wojcik Production Director Tim Hake Finance Director Kerst Troost General Counsel / Corporate Secretary Guus Klusener 62 Annual Overview

65 Engagement with community-based organisations and non-governmental organisations (local, national and international) has significantly increased with the development of the Phase 2 Project In Dialogue with the Society T he Company believes that regular communication and constructive interaction with the public and key stakeholders, as well as broad promotion of Sakhalin II in mass media, are important for Sakhalin II s successful implementation. For more than ten years, the Company has been building up its strategy for conducting information campaigns and consultations with the public via communication with Sakhalin communities and other stakeholders. The strategy was shaped using the information received from the public. According to advanced international practices, during implementation of large oil and gas projects community liaison officers (CLO) are necessarily involved. The aforesaid officers form the Company s eyes and ears, they are always ready to help the local administration and people find answers to numerous questions associated with the Project s implementation. Involvement of CLOs is important at all Project stages. However, it is especially important during facility construction when a large-scale mobilisation is taking place, enormous amounts of work are carried out and the potential impact on the population is highest. The Company s CLO team was formed in early 2003 and by the end of 2006 it included eleven specialists working in the Company and six specialists working in contractors organisations. Besides there are specialists responsible for social performance in contractors and subcontractors organisations. In the communities, impacted by the Project, meetings with the public, interviews with experts and public opinion surveys are conducted on the regular basis. The Company arranged a free hotline to receive Sakhalin community enquiries and complaints. On a regular basis, the Company interfaces with representatives of indigenous peoples of North- Eastern Sakhalin. On 25 May 2006, a tripartite agreement was signed for cooperation between the Sakhalin Oblast Administration, Sakhalin Energy and representatives of indigenous peoples. Val reindeer herders are the only group of indigenous people that is directly affected by the Project construction. To mitigate impacts on this group and jointly fix the most acceptable timeline for construction, it was decided to hold regular meetings with the reindeer herders. Engagement with communitybased organisations and nongovernmental organisations (local, national and international) has increased with the development of the Phase 2 Project. Sakhalin Energy has held many face-to-face meetings on Sakhalin Island, in Japan (Hokkaido Island and Tokyo), and with representatives of NGOs in a number of locations including the UK, the Netherlands and the United States. This increase in meetings and the type of meetings has come about in response to feedback received by Sakhalin Energy from stakeholders. Meetings with NGOs NGOs 2002 (from IV Quarter 2002) Local (including formal organisations of indigenous peoples ) Regional National Japanese Other international Annual Overview 63

66 Personnel Development akhalin Energy feels certain: S the core value of all business processes is in people, and it is people who form the main resources of the Company. The Company developed and implemented seven basic principles of personnel development, which help form an employee-friendly environment. The backbone of the approach is in honesty, integrity and respect towards people. Sakhalin Energy strives to bring the best international experience of its shareholders to the Company s everyday work. To achieve this, the Company offers various programmes for personnel recruitment and development as well as for the education and training of youth. A structured approach allows the Company to evaluate its needs in experts at a given time, determine their development pattern and ensure their career growth. Being a multinational company, Sakhalin Energy tries to treat each and every employee as a personality. Employees differ in many ways: age, professional background, education, nationality, religion, personal and career expectations. The key target of the Company with regard to personnel is to nurture an understanding of personality and respect towards it, as well as to establish an environment that is comfortable for each individual, whilst remaining part of the Company s atmosphere and its corporate culture. A few years ago the Company s management set a goal, from which multiple personnel recruitment and development programmes were drawn up. This goal implies both potential appointment of Russian employees to key management positions in the Company and scaling down expatriate personnel in favour of Russian nationals. Personnel Recruitment In 2006 Sakhalin Energy was actively involved in personnel recruitment. Throughout the year the Company employed 740 people to staff both administrative positions and positions at the facilities. A total of 439 of those employed are Sakhalin residents, 15 were relocated from the Far East, and the remaining 286 came from other regions of Russia. Training and Professional Development Sakhalin Energy implemented a compulsory programme for the annual appraisal of personnel, which stimulates the employees to develop a corporate approach towards identification of their professional targets and objectives and appraisal of their performance. Results of the appraisal serve as the basis for individual development plans, in which employees build their career prospects, thus guiding their further development and improvement potential. In 2006 the personnel development programme provided training for 819 Russian and 399 expatriate employees of the Company. Personnel development may be divided as follows: recruitment of personnel; training and professional development of personnel; training of personnel for work at the Company s new facilities; internship for students; educational grants. 64 Annual Overview

67 In 2006 the personnel development programme provided training for 819 Russian and 399 expatriate employees of the Company Apart from training and workshops, the Company has developed an on the job training programme, which includes coaching and mentoring. This means that more experienced employees share their knowledge and skills with younger experts on the job. As of today, formal mentors are assigned to 45 Russian employees. To ensure Russianisation, the Company implemented a programme for the development of talents which is targeted, though not limited to, substitution of expatriate personnel with Russian personnel. In 2006, Sakhalin Energy welcomed 23 Russian experts at management positions of various levels. Forty eight persons were promoted within the Company to managerial positions occupied by foreign personnel. Training of Personnel for Work at the Company s New Facilities Today, Sakhalin Energy manages its own education centre, where the Company trains technical experts using its own resources. All the trainees are Sakhalin residents. The experts required by the Company, need to be technically trained in an engineering school or college. The training centre provides education for vessel electricians, builders and mechanics, as well as for some specialists with higher education. The professional training programme guarantees a well-paid and interesting job. Upon completion of intensive six months language course, trainees undertake thorough technical training, the aim of which is to qualify the trainees for various trades. As the course is completed, they may choose a job at one of the Company s facilities: offshore platforms, LNG Plant, Onshore Production Facility (OPF) or pipelines. In 2006, 125 trainees participated in the programme, and 39 of those trained earlier moved on to work. Internship for Students Sakhalin Energy provides senior students of Russian institutes and universities with an opportunity to take internship in a major oil and gas producing company, acquire knowledge of Western business methods, as well as to conduct research, as required by their courses. Internship in the Company is organised in winter and in summer. One of the objectives of the programme is to discover young talent who have the potential to become successful candidates for the positions in the Company. The internship programme was launched in In 2006, 27 students participated in it. Educational Grants Sakhalin Energy contributes to the professional growth of the talented young residents of Sakhalin Island, providing them with access to educational centres, both on the Island and on the mainland. Upon completion of the programme, the participants can be employed by the Company. The programme was launched in In 2006, thanks to the Company s support, nine young programme participants were enrolled in Russian universities. Throughout the three years, the programme has helped 42 boys and girls become students. Annual Overview 65

68 Sakhalin Energy The New Energy Source for the Asia Pacific Environment. Safety

69 Health, Safety and Environment: Integrated Approach 68 Labour Safety 69 Environmental Protection 70 Emergency Response 72 Rare Species 74 Annual Overview 67

70 Health, Safety and Environment: Integrated Approach Management of health, safety and environmental protection (HSE), protection of the population and preservation of the environment that supports the basic functions of life is an integral part of the Company s management system for the completion of the Project. t all Project stages the A Company seeks to minimise the negative impact caused by its activities on health, safety, the environment and the social sphere, and to maximise the benefits contributed by its activities to the population of Sakhalin Island and any other parties whose interests might be affected by the Project. Sakhalin Energy HSE Management Components The Company has developed and implemented an integrated HSE Management System. This System describes management levers, used by the Company to handle risks, which the Company came across in the field of health, safety and environmental protection. Sakhalin Energy s HSE Management System ensures systematic management of hazards and their impact on health, safety and environment. The Management System describes a structured process for the disclosure, assessment, control and elimination of risk factors. The emphasis is placed on those activities which might result in a potential impact on the population and the environment. Once identified, procedures for continuous improvement of the Company s HSE indicators are envisaged. Sakhalin Energy s HSE Management System has been implemented in all works and projects performed by the Company, and is applicable throughout the activities of Sakhalin Energy personnel. 68 Annual Overview

71 In 2006 the Company managed to bring down the number of road accidents registered in the course of three consecutive years Labour Safety akhalin Energy accords S special priority to safety at work. In 2006 the Company managed to reduce the number of incidents and accidents at all facilities. However, unfortunately, four contractors employees died while working on the Project. To prevent fatalities in future, the Company launched the Safety Rangers project. The Company organised a workshop for 100 senior managers. During the workshop emphasis was placed on rigorous observance of safety rules by all the Company s employees. All the managers committed to perform at least the minimum of checks and to observe international golden rules and the Company s in-house regulations. A road safety project and a project for safety during hoisting operations were launched, and safety training for managers was organised in line with the plan. Close attention to compliance of hoisting operations with safety rules resulted in the avoidance of any serious incidents in The Company managed to reduce a specific number of occupational diseases down to 4.5 occurrences per 1 million man-hours versus 4.8 occurrences in Traumas of bone and muscular tissues were the most frequent, which can be explained by the large number of manual works at the Project construction sites. information campaigns are launched on a regular basis. Compliance of employees with professional suitability with regard to medical requirements is controlled duly at construction sites; reasons requiring medical intervention are eliminated at once. Throughout 2006 the Company kept investing funds into road safety programmes and managed to bring down the number of road accidents registered in the course of three consecutive years. The Company kept supporting Sakhalin Road Safety Partnership (SRSP), whose members worked on the implementation of five projects aimed at reduction of fatality and accident rates in Sakhalin Oblast. These projects include an educational programme, the identification of especially dangerous road sections, Road Victims Remembrance Day, the second phase of a seatbelt campaign, and medical treatment at preadmission. The latter two projects were financed fully by Sakhalin Energy, whereas the others were coordinated by the Company. It is worth mentioning that it was Sakhalin Energy who initiated the establishment of the partnership, which allowed the unification of road safety efforts of the state authorities, business and the public of the Sakhalin Oblast. SRSP, established 2004, is the first association of that kind in Russia. Health, safety and environmental protection training courses are provided for a large number of newcomers, mainly those employed in production, commissioning and start-up. All the Company s units have introduced HSE competence processes, which involve a significant number of senior managers, HSE experts and employees in senior positions. All the basic tasks associated with improvement of HSE indicators in 2006 were successfully accomplished. Those tasks incorporated health, safety and environmental protection issues. Shell performed an audit of health issues, which proved its approach to health management to be structured and efficient. Healthcare Annual Overview 69

72 Environmental Protection onstruction of Phase 2 С facilities is ongoing in an extremely challenging environment. Sakhalin Energy, being committed to minimising all harmful environmental impacts from construction works, has undertaken a whole range of actions to ensure that the unique natural environment of Sakhalin Island is preserved to the maximum extent. However, those actions proved not to be completely sufficient: in 2006 the environmental authorities demanded that Sakhalin Energy should pay more attention to the Project s environment safety. In the second half of 2006 RosPrirodNadzor held a number of inspections to check the environmental compliance of Phase 2 construction, especially the onshore pipelines. To eliminate the problems identified by RosPrirodNadzor inspections, on 8 November 2006 Sakhalin Energy submitted a draft Environmental Action Plan (EAP) to the Ministry of Natural Resources. The proposed Plan contains short-term, mid-term and longterm actions in respect of all onshore facilities and some of the offshore facilities of the Company, with the main focus on the onshore pipeline construction. The implementation of the Plan had already commenced in November. In parallel, work continued to update and elaborate the Plan following the recommendations by RosPrirodNadzor. In total, since the RosPrirodNadzor inspections in Dolinsk (July 2006) and Makarov (August 2006) districts, Sakhalin Energy has completed a large range of work to eliminate the problems identified by the inspections. Most of the actions proposed in the Corrective Action Plan, developed by the Company and put into practice in August November 2006, have been completed, as had been prescribed by the corresponding Citation of RosPrirodNadzor issued in September The Company strengthened control and management over all contractors involved in onshore pipeline construction. A clear-cut system setting personnel responsibility for environmental compliance has been introduced on Company sites. To provide information from construction sites to the integrated steering group in charge of onshore pipeline construction, special reporting forms are used. Actions in the EAP provide a platform to ensure that the onshore pipeline construction project is successfully delivered whilst maintaining high environmental standards and remaining in full compliance with RF legislation. Stringent compliance with environmental requirements will be achieved by way of strengthened control over the construction techniques and the contractors quality of work on the Company s sites. The most important areas of environment performance within the EAP are river crossings, erosion control and reinstatement, as well as management of spoil, which are the subject of the Company s internal control. Specially developed control and management systems in these areas were introduced in May and August 2006, especially in erosion control and spoil management. In the winters of and several groups of 70 Annual Overview

73 Sakhalin Energy have dug up about 28,000 objects of cultural heritage independent observers were engaged to ensure compliance during river crossing construction. They informed us of every noncompliance with the winter river crossings strategy. Information received from independent observers helped the Company eliminate the non-compliances and prevent their occurrence in subsequent river crossings. One of the most significant environmental challenges we will continue to face is erosion control and permanent reinstatement at our facilities. This summer saw us undertake a huge effort to ensure erosion controls were installed and maintained at particularly sensitive areas near our onshore pipelines, such as steep slopes leading down to rivers and riverbanks. We undertook hand seeding, aerial seeding and hydroseeding at these sensitive locations to prevent run-off of soil into salmon spawning rivers. Although we will continue to install and maintain erosion controls at our facilities, we anticipate that this will continue to pose a challenge in The Company s EAP was rated highly by Head of the Ministry of Industry and Energy, Viktor Khristenko. He said that he is committed to close out all those problems that occurred due to justified criticism from environmental regulators, but also to prevent such situations from happening in future. I am extremely pleased that Russia s environment agencies and our investors have agreed on the procedure to address the identified problems In principle, the issue may be considered closed, and the approaches to problem resolutions agreed on, President Putin noted during a meeting with Sakhalin Energy shareholders in the Kremlin on 21 December A further challenge the Company has faced this year has been spoil management. The Makarov mountains present the most difficult terrain along the onshore pipeline route, with their low but steep mountains and deeply incised steep-sided river valleys and landslides. As a result of this a large volume of spoil is generated during construction, whilst there are limited areas where excess spoil can be stored. The total quantity of spoil that will be generated is estimated to be in the order of 3 million m3. Sakhalin Energy will continue to address the issue of spoil management and any associated environmental impacts. The Company successfully completed another season of archaeological fieldwork, and the excavation work undertaken on Sakhalin II Project s pipelines was heralded by the local media as delivering us into an archaeological golden age. Sakhalin Energy have dug up about 28,000 objects of cultural heritage many of which are thousands of years old. These objects will be kept in Sakhalin s local museum. We are aware that despite our many ongoing efforts in 2006, our environmental performance still has overall room for improvement. We do, however, recognise that we have significantly improved our performance since Annual Overview 71

74 Emergency Response mergency management E aimed at emergency prevention is an integral part of the Company s HSE policy. Sakhalin Energy has been involved in planning for emergency prevention and response since The response plan is reviewed and updated on a regular basis. Potential emergencies provided for by the plan are oil spills, fires, airplane, ship and vehicle accidents, criminal activities and acts of sabotage. Special resources are allocated and a detailed action plan is developed to deal with hazardous risks and emergencies, in particular oil spills. Oil spill response Oil spill prevention and response (OSR) is very important for Sakhalin Energy. The Company addresses this complicated problem through an integral approach. Being the largest integrated oil and gas project worldwide, Sakhalin Energy recognises that the additional infrastructure associated with Phase 2 of the project, together with year-round production, carries with it a greater degree of complexity for oil spill response planning. Therefore, the company has reviewed equipment needs, type and availability, requirements for additional trained personnel, river as well as coastal and marine oil spill recovery procedures, and its response during ice conditions. Sakhalin Energy has also increased coordination with various external bodies including the Russian Federation Ministry of Emergency Situations and the Ministry of Transport, the Japanese Marine Disaster Prevention Centre, and international response organisations. During 2006, Sakhalin Energy purchased six mobile response units, ten rapid response trailers, one vessel-based kit and two port packs. Procurement of additional oil spill response equipment to support Phase 2 operations will continue into Sakhalin Energy continues to conduct research in oil and ice behaviour and response technology for a variety of conditions. In 2006, studies of algae in oil and ice, winter modelling, oil and ice response, and in situ burning and dispersant effectiveness with Vityaz crude got under way. The company is also participating in joint industry studies concerning oil and ice response, oil dispersants and herding agents. Ensuring seismic safety Sakhalin Island is located in an area of high seismicity. The possibility of Since the commencement of oil production in 1999, the total volume of hydrocarbons spilt as a result of emergencies at Sakhalin Energy production facilities amounted to some 350 litres. When compared to the total oil production of some 85 million barrels, this figure translates into about 1 litre for each 39 million litres of oil produced, which makes Sakhalin Energy one of the best oil production operators worldwide. a large magnitude earthquake during the Project s lifetime presents challenges in technical design and construction for all aspects of the Project. As a precaution, Sakhalin Energy has followed the most stringent Russian and international design codes to ensure that in the event of an earthquake, the structural integrity of its facilities will remain intact and, when necessary, operations can be safely shut down. The Company has minimised the potential impact of these factors by diverting the pipeline route to avoid seismic and landslide hazardous areas wherever possible. Sakhalin II offshore platforms are designed to withstand loads from earthquakes with a recurrence interval of 200 years without damage or equipment failure and those from very rare earthquakes with a recurrence interval of 3000 years without significant damage. The onshore pipeline route crosses several seismic faults. To minimise pipeline deformation due to possible earth movement in seismic fault areas, the Company uses a combination of increased pipe wall thickness and special pipe-laying techniques. Furthermore, as part of the oil and gas pipeline construction project, some 105 automatic block valve stations will be installed, including ones preceding and following each seismic fault. Offshore pipelines do not cross seismic faults. The results of seismic risk microzoning conducted to refine seismic conditions at the LNG site show that even in the event of a rare intensity earthquake with 72 Annual Overview

75 Since the start of oil production in 1999, the total volume of hydrocarbons spilt at Sakhalin Energy facilities amounted to some 350 litres. This makes Sakhalin Energy one of the best oil production operators worldwide recurrence interval of 10,000 years, the structural integrity will remain intact and there will be no major loss of containment at the plant. Sakhalin Energy is currently producing a seismic monitoring plan that will cover a significant length of the Island and include all of the pipelines and all the other major project assets. Data will be collected at Sakhalin Energy s seismic monitoring stations during any earthquake and will be recorded in digital format and be available for processing immediately after the earthquake event. To ensure emergency response capability, the processed data will be transmitted to the pipeline control centre for use in operations decision-making. Seismic data from Sakhalin Energy can also be made available to emergency response agencies and various scientific institutes. Landslide protection On Sakhalin, landslide risk is mostly confined to a particularly mountainous 120 km section of the pipeline route. The total Key elements of emergency response plan potential emergency analysis; establishment of an organisational structure that may be mobilised in a timely fashion in the event of emergency; availability of the necessary facilities (for example, oil spill response equipment), purchased and stored in a state ready for employment, and in some cases in stand-by state; establishment of a communication system for emergency response control centres; personnel education and training, conducting special training exercises; liaison with Russian governmental structures and relevant private organisations. cumulative length of landslides was originally identified to be in the order of 20 km, accounting for 2.5% of the total length of the right of way. Sakhalin Energy pays special attention to the issue of protection from landslides, which present a hazard affecting pipeline integrity and project safety. The major mitigation measure Sakhalin Energy has applied for landslide areas is to reroute to avoid them, but where rerouting is not practicable other design methods include complete removal of the landslide, stabilising the landslide or installing the pipelines below the landslide slip plane. In 2006, on instruction from Sakhalin Energy, an additional audit of design decisions was carried out by internationally recognised foreign experts. Sakhalin Energy suspended work at the 7-km pipeline section to ensure that proper construction practices were used. In view of the fact that a relatively small section of the ROW is exposed to landslides, no delay or schedule disruption is envisaged. Annual Overview 73

76 Rare Species Steller s sea eagle The study of Steller s sea eagle habitat and population size in north-east Sakhalin conducted by Russian specialists and financed by Sakhalin Energy is worthy of special note. Based on this study, in the beginning of construction for each work area special mitigation measures were developed and successfully implemented for this rare species. The eagles are officially classified as a vulnerable breed, and they re on the Sakhalin Island s Red Data Book. Therefore, the Company was advised to carry out the survey of the eagle population. Results of the survey showed that only about 7% of the 500 nesting sites on the Island were likely to be located on or near the pipeline right of way. The area where eagles are most likely to be exposed to Project activities is located in the vicinity of the Onshore Processing Facility (OPF), in the north-east part of the Island, near Lunskoye bay. Steller s sea eagle are nesting on Sakhalin, so Sakhalin Energy identified pipeline sections located close to the nesting grounds and, wherever possible, rerouted the pipeline or took measures to mitigate the impact if rerouting was not an option. Since 2003 Sakhalin Energy has been working with Dr Vladimir Masterov, an eagle expert from Moscow University. Dr Vladimir Masterov conducted studies of the nesting sites impacted by pipeline construction. If, in his opinion, the construction is too close to nesting sites, then a protective zone is established around the nests or other measures are taken, such as suspension of all activities from mid-march to mid-september (if nesting birds have been sighted in the area) or traffic limitations in the area inhabited by Steller s sea eagle. Sakhalin taimen The Company initiated a project aimed at preservation of the Sakhalin taimen population (a member of salmon family). The Sakhalin taimen is a Red Data Book fish species and protected under Russian law. Not a great deal of information exists on the ecology of the Sakhalin taimen and in recognition of this Sakhalin Energy is committed to continue the taimen research project. The project will focus on research of ecological requirements and study of species biology and distribution and will involve Russian, Japanese and other international specialists, including NGOs. Western Grey Whales Every summer a small Western Grey Whale population feed off the north-east coast of Sakhalin Island, near the Piltun-Astokhskoye field. These endangered species have chosen this water area for their summer-autumn feeding. This neighbourhood bounds Sakhalin Energy to take enhanced environmental protection measures in its offshore activities. At the time of implementation of the Sakhalin II project, only a few grey whales have been observed in the immediate vicinity of the Molikpaq platform. Until now, independent studies have not revealed any evidence supporting negative impact of the Company s activities on Western Grey Whales or other marine mammals inhabiting the area around the Vityaz production complex. Nonetheless, the development programme of Sakhalin Energy is formed with an allowance for the fact that some common production activities may have a negative impact on grey whales. Recognising such potential negative impact, Sakhalin Energy together with Exxon Neftegaz Ltd. has been financing (since 1996) programmes of studying and monitoring of grey whales. The Company has used the data from these studies to draw up and implement a plan for protection of the Western Grey Whale population. This plan has been designed to provide all reasonable measures, reducing negative impact on the endangered population of these sea mammals. 74 Annual Overview

77 Sakhalin Energy considers preservation of biodiversity on Sakhalin island that potentially may be impacted in the course of Sakhalin II implementation as one of its most important tasks Until recently no plan to protect the habitat for whales or pinnipeds has existed anywhere in the world. The first ever plan of this kind has been drawn up by the initiative of Sakhalin Energy. Sakhalin Energy is continuing to develop the Sakhalin Salmon Protection Programme. This programme was launched in October 2006 as a collaborative initiative that will be focused on promoting sustainable use of salmon and the ecosystems on which they depend. The programme is also aimed at the establishment of organisational resources to support environment protection and sustainable economic development. Sakhalin Energy undertook to minimise all potential impact on the whale population. In particular, pipelines in Piltun Bay were rerouted away from the Western Grey Whale feeding grounds. An acoustic monitoring programme was successfully implemented during the installation of the Lunskoye topsides. Noise from vessels during this year s construction season was shown to be below the thresholds proposed by international scientists. Recognising the importance of a reasonably justified approach to environmental issues, the Company continued cooperation with the International Union for Conservation of Nature and Natural Resources (IUCN) and proposed to establish a specialist group to provide consulting that would enable the Company to adopt optimal solutions during construction and operation of offshore facilities that do not impact grey whales. In November 2006, the first meeting of Western Grey Whale Advisory Panel was held, convened by the IUCN at Sakhalin Energy s request. The experts are drawing up recommendations for improvements in offshore construction, operation and research, with the aim of creating a balance between whale conservation and oil and gas developments. The Western Grey Whale, one of the largest mammals on the planet, is an endangered species: this whale was considered to be extinct in the north-eastern Pacific until 1972, when several individuals were sighted near Sakhalin Island. Currently, the north-eastern Pacific population is believed to number 123 adults. Annual Overview 75

78 Sakhalin Energy The New Energy Source for the Asia Pacific Social Responsibility

79 The Company s Sustainable Development Policy establishes that Sakhalin Energy makes its own contribution to satisfy the needs of the population of Sakhalin Island today and in the future maintains the balance between economic development, environmental protection and social responsibility. Annual Overview 77

80 Social Responsibility or the past decade Sakhalin F Energy exerted every effort to become a good neighbour to the people of Sakhalin. The Company actively participates in the resolution of local problems, providing a whole package of social investments. According to the PSA, the Company donated US$100 million to the Sakhalin Development Fund, managed by the Sakhalin Oblast Administration. The Fund supported the development of the Sakhalin infrastructure, energy sector and social provision, i.e. healthcare, education, etc. Donations to social projects exceeding US$26 million were made from the provisions of the Company s contractors. Throughout its activities the Company allocated US$400 million on modernisation of Sakhalin infrastructure (roads, bridges, railways and healthcare facilities). The Company invested around US$24 million in this project. We resolved to invest US$10 million into modernisation of Korsakov infrastructure. We established a donation and sponsorship fund, which is replenished annually by our shareholders. These costs are not included in the costs submitted for recovery. In 2006 the budget of the Donation and Sponsorship Fund was US$500,000. Sakhalin Indigenous People May 2006, Sakhalin Oblast Administration, Sakhalin Indigenous Minority Council and Sakhalin Energy signed a trilateral agreement for cooperation, laying the foundation for the Sakhalin Indigenous Minorities Development Plan (SIMDP). To finance its implementation, Sakhalin Energy will allocate Nivkhi, Nanai, Uilta, and Evenki represent four principal groups of the indigenous population of the Sakhalin Island. Despite histories of arrival on Sakhalin being unique for each of the minority, they are all seen as indigenous population of the Sakhalin North. Today, there are 3500 of them on the Island. Obviously, they are not nomadic, but many of them depend on nature, as they farm deer, hunt, go fishing and gather wild herbs. US$1.5 million in the next five years. It is a unique commitment. 45% of the funds is intended for support of traditional activities (raindeer breeding and fishing), another 45% will go to the social development programmes and the remaining 10% will go to the fund of the minor grants, managed by representatives of the indigenous minorities. The annual budget of the Social Development Programme within the SIMDP is US$130,000. Financial resources will be invested in healthcare, education, culture and training. A programme for support of traditional economic activities was developed to aid some employment issues of indigenous minorities and to support their economic development. Another reason was the concern about the impact on the environment and natural resources. The Programme budget is US$140,000 a year. In 2006, nine bids were studied. The proposed projects concerned gathering and reprocessing of wild herbs, fish processing, and the establishment of production of garments and knitwear with traditional embroidery patterns. All submitted bids were reviewed, four business projects and two self-sufficiency projects from three regions of Sakhalin have been approved for financing. Compensation Payments Sakhalin Energy is implementing a Resettlement Action Plan, which envisages support to people that had to resettle to new locations due to construction works and/or compensation payments for crop loss, incurred by construction of the LNG Plant and onshore pipelines. 78 Annual Overview

81 Throughout its activities the Company allocated US$400 million on modernisation of Sakhalin infrastructure such as roads, bridges, railways and healthcare facilities By the end of 2006, compensation in the total amount of US$3.6 million was paid to 111 land users (including 51 unregistered users). In 90% of cases the impact is of temporary nature. Providing compensation payments to the unregistered land users, the Company establishes new standards of social responsibility in the Russian Federation. Grievance Process Sakhalin Energy continuously works to prevent public grievances through mitigation and public awareness enhancement measures, to help foresee potential issues and address them in advance before they became grievances. When grievances do occur, they are addressed and resolved within the Company s grievance procedure. In 2006, Sakhalin Energy undertook proactive efforts to raise public awareness about the Company s grievance procedure. These efforts outreached to both local communities and contractors involved in the Project. Accepted and registered in 2006 were 151 grievances, against 40 in The likely reasons for this growth were the following: (i) raising of public awareness about the Company s grievance procedure, and (ii) peak level of project construction activities, which unavoidably multiplies all kinds of issues. Most of these grievances were addressed locally by Community Liaison Officers through engagement of relevant contractors and facilitation of communication with local authorities and complainants. The Social Performance Team continuously monitors the grievance process to detect and track potential manifestations of the systematic nature of a particular issue, to work out an integrated response approach to the issues revealed. Unexploded Ordnance One of the most serious problems on Sakhalin, endangering lives of people and animals, is unexploded World War II ordnance. Since 2002 Sakhalin Energy has been financing removal of unexploded ordnance from the territories impacted by the project. In line with Russian legislation, the removal is performed by servicemen. Like warfare agents, unexploded ordnance are either destroyed in situ or removed. The remains of the deceased soldiers of WWII are exhumed. Remains of Soviet soldiers were reburied with military honours; remains of Japanese soldiers were cremated in line with ritual, the ash transported to Japan. The Company finances and supports groups which assist servicemen in the removal of unexploded ordnance. The main task of the groups is to study information on unexploded ordnance, military materials and equipment, obtained from the civilians. As of end 2006 over 5000 items of unexploded ordnance have been disarmed, more than litres of chemical substances have been removed. The World of Equal Opportunities Throughout its activities Sakhalin Energy has been supporting projects related to assistance for disabled people. One of the recent instances is the Nadezhda Art Centre for handicapped people in Poronaisk, which provides an appropriate environment for the social activities of the handicapped through arts and crafts. Today, the Company is implementing the World of Equal Opportunities project, a major US$100,000 programme for the handicapped. The main aim is to contribute to development of the facilities of rehabilitation centres and social integration of the handicapped. Sakhalin Energy also supported an arts festival for the handicapped. Healthcare In 2006 the Company kept supporting medical institutions of Sakhalin Island. Thus the surgery centre of the Central Regional Hospital was commissioned in Nogliki. Modern medical equipment was installed in the surgery centre. Sakhalin Energy participated in the financing of the purchase. In the same year, Nogliki Regional Hospital received a new ambulance vehicle. Sakhalin Energy provided another five fully equipped ambulance cars to the hospitals of Korsakov, Kholmsk, Dolinsk, Poronaisk and Yuzhno- Sakhalinsk. These vehicles ensure immediate emergency medical treatment. In Korsakov, Sakhalin Energy is constructing an outpatient clinic. The Company allocated more than US$4 million to the project. Annual Overview 79

82 Sports Support Eleven winning teams of various Sakhalin regions participated in the finals of a tournament for children s amateur hockey teams, Sports against Juvenile Delinquency All teams which qualified for the final received hockey gear kits from Sakhalin Energy, the tournament General Partner. The Company also provided catering, insurance and accommodation for the young sportsmen. As Vladislav Frolov, from Oblast Administration, puts it: this is one of the most colossal children s projects in Russia. In summer 2006, two new sports facilities were opened with the participation of Sakhalin Energy: a hockey and skating pitch in Aniva and a futsal pitch with artificial grass and stands with a capacity of 150 seats in Makarov. University Students and Schoolchildren Winners of the contest between students for the development of the best sustainable development project were awarded with laptops by Sakhalin Energy. Students proposed an unconventional project for heating the Tymovsk area with solar energy. Another project was launched by Sakhalin Energy in For two months the Company s experts lectured on the Sakhalin II Project and various aspects of its implementation, focusing mainly on subjects intended for future oilmen. The pilot project was concluded with a workshop, called Sakhalin in 10 Years. Development Scenarios. Tymovsk orphanage has its own computer class now. New computers, equipped with training software and games, were donated by Sakhalin Energy and Startsroi, the Company s general contractor for pipelines. Several initiatives of the Company are intended to cultivate safety skills among pupils. Thanks to the partnership programme of Sakhalin Energy, the Oblast institute for extension courses for teachers, EMERCOM and Piligrim, Boomerang and Rodnik NGOs, classrooms for the study of basic safety rules were equipped in a number of schools in Sakhalin Oblast. Video and audio equipment, stands, modern text and reference books, compasses, medical wallets, anti-gas and fire protection equipment were supplied to the classrooms. All the classes are equipped with devices for crisis therapy in emergency situations. Our Children Draw Safety, a vivid desk calendar designed with children s drawings, ensures the safety rules will not be neglected. This list of examples is far from the full list of actions initiated by Sakhalin Energy as part of its programme for safety. In 2006 Sakhalin State University created a Sustainable Development Chair. The basic targets of the Chair are to develop a Sustainable Development Programme for Sakhalin Oblast and conduct related scientific research to implement the Programme. The sustainable development concept is based on the simple idea of improvement of living standards for both the living and future generations. Apart from the initiative on organisation of the Chair, Sakhalin Energy committed to invest US$40,000 in its development within five years. Changing Priorities Sakhalin II Project is gradually transiting from construction to operation, which surely implies significant changes of priorities in social sphere. As soon as construction is completed, a number of challenges, varying between the negative impact of transport activities and impact on land resources and lifestyle pattern, will no longer be urgent. Advantages, associated with the construction stage (employment and local contracting), will also be decreasing. The Company s key objective in the social sphere is to manage the shift of priorities efficiently. At the initial stage, as the impact of construction was especially apparent, and the need for infrastructure especially crucial, the Company had to invest funds, intended for sustainable development, into short-term infrastructure projects. Step by step, Sakhalin Energy Social Team started to launch long-term strategies and facilitate augmentation of the potential of local organisations on Sakhalin Island. The Company initiated the establishment of a number of partnerships, which can be distinguished by an external party participating in decision making and thus augmenting its potential. This approach will bear fruit in the next several years. As the Company transits to operation, it will be using sustainable development tools to support the long-term social and economic development of Sakhalin Island. The Company also studies the opportunity for local long-term support of social initiatives and economic growth. In the next year the Company will cooperate with interested parties on Sakhalin Island to develop a plan for the future and determine its role in the process, one that is acceptable both to other companies and to the authorities. 80 Annual Overview