Sakhalin Energy2 Sakhalin Energy 2004 ANNUAL REVIEW 3 Message from the CEO 2004 was another...

Sakhalin Island (Head Offi ce)Sakhalin Energy Investment Company Ltd35, Dzerzhinskogo StrYuzhno-Sakhalinsk, 693020, Russia

Moscow branchSakhalin Energy Investment Company LtdNovinsky boulevard, 31 Moscow, 123242, Russia

Rijswijk branchSakhalin Energy Investment CompanyVisseringlaan 25, P.O. Box 602280 AB Rijswijk, The Netherlands

www.sakhalinenergy.com

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2 0 0 4 A N N U A L R E V I E W

Sakhalin EnergyThe New Energy Source for The Asia Pacifi c

Sakhalin EnergyThe New Energy Source for The Asia Pacifi c

Completed CGBS at sunset.

2 0 0 4 A N N U A L R E V I E W 1

2 Message from the CEO

4 The Sakhalin II Development – An Overview

8 The Sakhalin II Development - 2004 Progress

9 Celebrating Six Years of Production

10 Infrastructure Projects and Logistics

15 Offshore Platforms: Concrete gravity Based Structures (CGBS) and Topsides

16 Onshore Processing Facility (OPF)

19 Onshore and Offshore Pipeline Projects

20 LNG Plant and Oil Export Terminal (OET)

22 The Markets

24 Meeting the challenge

25 Russian Content

26 Employment Opportunities for Sakhalin Island Residents

29 Indigenous People

30 Social Investment - Korsakov

32 Pipeline River Crossings

35 Western Gray Whales

36 Oil Spill Response

39 Waste Management

40 Health, Safety, Environment, Security (HSES) and Social Activity in 2004

con t e n t s

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2 Sakhalin Energy 2 0 0 4 A N N U A L R E V I E W 3

Message from the CEO2004 was another remarkable year for Sakhalin Energy. It was a year in which the Sakhalin II development achieved yet more “fi rsts” for Russia thanks to Phase 1 crude sales and Liquefi ed Natural Gas (LNG) marketing. We also made good progress on our Phase 2 Project. Overall progress on this groundbreaking project – which includes design, procurement and construction – was almost 50% complete at the end of 2004.

Refl ecting on some of the highlights in 2004, Sakhalin Energy commenced its sixth crude oil production season earlier than usual and produced a total of 11.7 million barrels, a 14% increase in comparison with 2003. In November 2004, we delivered the fi rst shipment of Russian Far East crude direct to Japan’s Tohoku Electric Power Company, representing the fi rst sale of Vityaz crude directly to a power company. We also expanded our existing customer base with the fi rst shipments to Thailand.

In October we achieved a major breakthrough when we signed an historic agreement that will see Sakhalin Energy deliver Russian gas to the extremely competitive North American market. This landmark deal represents the fi rst sale of Russian natural gas to North America and strengthens Russia’s position as a global supplier of natural gas.

Other LNG sales developments in 2004 include the signing of a binding Heads of Agreement with Toho Gas and the execution of fully termed Sales and Purchase Agreements with both Kyushu Electric and Tokyo Electric. By the end of 2004, we had sold over 50% of the capacity of our two LNG trains and with a number of commercial opportunities in Japan, Korea and China we aim to substantially complete selling the remaining capacity in 2005.

In March 2005 we decided to reroute the offshore pipeline routes linking the two production platforms in the Piltun-Astokskoye fi eld off Sakhalin Island to the shore. We selected the most southern route as this alternative allows us to fi nd a balance between meeting regional energy needs, contributing to Russian’s economic development and protecting the endangered western gray whale.

Major project construction milestones were achieved in 2004. The successful completion of the main concrete works of the Lunskoye platform - the fi rst concrete gravity based structure to be built in Russia - is a magnifi cent achievement, and a tribute to the many Russian companies and workers who have played a key role in this success. We also made considerable progress on infrastructure upgrades, including extensive road and bridge works, as well as upgrades to Nogliki airport, which opened for daylight operation in October 2004.

Whilst the Company achieved some signifi cant safety milestones in 2004 and early 2005 thanks to the efforts made by both Sakhalin Energy employees and our contractors, our overall safety performance still needs improvement. It is with deep regret that we recorded six fatalities associated with our operations in 2004, four of which involved road traffi c accidents. Recognising that safety is one of our biggest challenges, we have launched a road safety campaign that involves both Company employees and our contractors. The three-year campaign will focus on training, education and road safety awareness in an effort to reduce road traffi c accidents.

As we journey into 2005 the Company looks forward to building upon the production successes of Phase 1 and the overall progress of the Phase 2 Project in a safe, effi cient and environmentally responsible way. I hope that you will fi nd this report a useful and informative review of Sakhalin Energy’s activities during 2004.

Ian Craig

Chief Executive Offi cer

1 Construction of the Sakhalin II Onshore Pipline networks.

2 Molikpaq platform.

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The Sakhalin II development is an oil and gas exploration and production project undertaken by Sakhalin Energy, a Shell-led operating company, in partnership with Mitsui and Mitsubishi, for the Sakhalin II Production Sharing Agreement (PSA). Sakhalin Energy was formed in 1994 to develop the Piltun Astokhskoye (PA) oil fi eld and the Lunskoye gas fi eld in the Sea of Okhotsk, offshore Sakhalin Island in the Russian Far East.

Sakhalin II operates under the fi rst PSA signed in Russia and when we produced our fi rst crude oil in 1999 it represented Russia’s fi rst offshore oil production.

The multi-billion dollar Sakhalin II development represents the largest single foreign direct investment project in Russia. Phase 1 of the project has been successfully producing oil from the Vityaz complex since July 1999, and during that time, over 60 million barrels of oil have been produced and exported.

Phase 1 of the development focused on oil development and went into seasonal production during the summer period in 1999 at the Vityaz Production Complex. The sea around the Vityaz Production Complex is covered with ice for approximately six months of each year and, as such, production from Phase 1 is currently limited to the ice-free period – about 180 days.

The Phase 2 Project focuses on extending the existing Phase 1 development to enable export of condensate and crude oil year round from the Sakhalin II oil and gas assets. Phase 2 also includes the construction of Russia’s fi rst LNG plant, which will have an annual capacity of 9.6 million tonnes (mtpa). In addition to the construction and installation of two new offshore platforms, a system of offshore pipelines will be constructed to bring the oil and gas onshore from the platforms. The hydrocarbons will then be sent to an Onshore Processing Facility (OPF), where the gas and condensate will be separated and further processed in order for it to be transported via two 800 kilometre onshore pipelines – one each for oil and gas. These pipelines lead to an Oil Export Terminal (OET) and LNG plant at Prigorodnoye on Aniva Bay in the south of the Island, where the sea remains largely ice-free all year round.

The Sakhalin II Development – An Overview

1 LNG construction site.

2 Completed LUN-A CGBS.


Piltun Astokhskoye Platform - A (PA-A)/Molikpaq The Sakhalin II Phase 1 Project involves the development and production of oil hydrocarbons on the Astokh feature of the Piltun Astokhskoye fi eld. The Molikpaq forms the central feature of the Vityaz Production Complex, which also consists of a Single Anchor Leg Mooring (SALM) buoy and the Okha Floating Storage and Offl oading (FSO) vessel. Oil produced in the ice-free summer season from the Vityaz Production Complex is transported by sub-sea pipeline to the SALM and FSO where it is transferred to shuttle tankers for sale to customers.

During the Phase 2 Project, the Molikpaq platform will be connected to the new pipeline infrastructure to enableyear-round production.

Piltun Astokhskoye Platform - B (PA-B)PA-B will be a manned integrated oil and gas platform with drilling facilities. Its oil production capacity will be 70,000 barrels per day (11,000 cubic metres per day) and it will export 2.6 million standard cubic metres (92 million standard cubic feet) of associated gas per day. The drilling, processing and production platform will extract oil and associated gas from the Piltun reservoir. The platform will be located approximately 12 kilometres off the northeastern coast of Sakhalin in a water depth of 32 metres.

Lunskoye Platform (LUN-A)The LUN-A Platform will have drilling facilities, accommodation and minimum processing facilities. It will have the capacity to produce 51 million cubic meters of gas per day (1,800 million standard cubic feet per day), and approximately 50,000 barrels of condensate per day (8,000 cubic meters per day). It will be located 15 kilometres off the northeastern coast of Sakhalin Island in a water depth of 48 metres. Separation, including gas treatment of LUN-A’s oil/condensate will be undertaken onshore at the OPF, which will also supply power to the platform via submarine cable. This platform will produce the majority of the gas for the LNG Plant in Prigorodnoye.

PipelinesThe pipelines, one oil and one gas, will transport hydrocarbons from the three platforms via the OPF, to the LNG Plant and OET. The offshore pipelines running from PA-A to shore will each cover a distance of approximately 46km while the offshore pipelines running from PA-B to shore will each travel a distance of approximately 72km. Once onshore, the oil and gas pipelines will be co-mingled respectively and will each cover a distance of approximately 800 kilometres, and will share a standard 43 metres width right of way (ROW). The total length of onshore pipelines to be installed is some 1,670 kilometres.

Onshore Processing Facility (OPF)The OPF is located in the northeast of Sakhalin Island, inland from the landfall of the Lunskoye Platform gas pipeline.

The primary function of the OPF is the processing of gas and condensate received from the Lunskoye fi eld prior to transportation to the LNG plant and Oil Export Terminal (OET). The OPF will also receive oil and gas streams from the two platforms on the PA fi eld for onward transportation by pipeline to the OET.

The OPF will include a 100 Mega Watt power plant, which will generate power for the OPF itself as well as the LUN-A Platform. At full capacity, the plant will be capable of processing 51 million cubic meters per day (1,800 million standard cubic feet), and about 10,000 cubic meters of condensate/oil per day (65,000 barrels).

The condensate will be integrated with oil production from the PA fi eld, and transported by pipeline via the OPF. The combined condensate and oil will then be sent through the main onshore oil line to the OET using booster pumps at the OPF with a capacity to pump up to 195,000 bbl/d.

Infrastructure Projects and Logistics (IPL)Sakhalin Energy has upgraded a signifi cant amount of Sakhalin Island’s infrastructure to support the Phase 2 Project construction activities. These are collectively referred to as the Infrastructure Upgrade Project (IUP). In total these works will involve approximately $US 350 million worth of improvements to Sakhalin Island’s infrastructure. At the end of 2004, the Company had already spent $US 225 million on upgrades to the island’s roads, railways, bridges, hospitals, waste disposal sites, Kholmsk Fishing Port and the Nogliki Airport.

LNG Plant and Oil Export Terminal (OET)The LNG processing plant and OET are being built on a 490 hectare site at Prigorodnoye on Aniva Bay, approximately 15 kilometres east of Korsakov. The LNG Plant is intended for the reception, treatment, processing and liquefaction of gas from the Lunskoye fi eld and associated gas from the PA fi eld. It includes storage and loading facilities and is the fi rst LNG plant to be built in Russia.

The LNG plant will consist of two gas liquefaction process trains, which will use a dual mixed refrigerant process particularly suited to Sakhalin’s cold climate. Both trains will have an annual capacity of 4.8 million tonnes each. The LNG plant will also include two 100,000 cubic metre storage tanks and a jetty, with two loading arms and a vapour return arm, that will extend offshore some 800 metres.

The OET will be located 500 metres east of the LNG plant. Crude oil will be exported via a sub-sea pipeline to a tanker loading unit located approximately fi ve kilometres offshore. The OET will support the storage and export of 170,000 barrels per day of crude oil, along with 5,000 barrels per day of condensate from the LNG facility. The OET will comprise of two fl oating roof oil storage tanks with export pumps and associated facilities.

The LNG plant and OET will be self suffi cient having their own integrated facilities including power, water, fi re fi ghting, waste water treatment services and oil spill response capability.

1 Sakhalin Island and the Sakhalin II Project.

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P H A S E 1 Celebrating Six Years of Production2004 was the sixth year of production for the Complex and cumulative oil production for the season was 11.7 million barrels. In total, Phase 1 has now produced and exported more than 60 million barrels to markets in Asia and beyond. In June 2005, it is anticipated that the hundredth cargo of Sakhalin Vityaz crude oil will be loaded at the Vityaz Terminal.

Oil production levels have fallen during recent production seasons due to natural pressure reduction in the reservoir. The Pressure Maintenance Project (PMP) designed to boost production, started operations in March 2004. The PMP facilities are designed to treat seawater and inject it into the reservoir thus raising reservoir pressure and increasing annual oil production levels and ultimate recovery from the reservoir. Construction and commissioning work was completed on the surface facilities in the fi rst quarter of 2004. Following drilling of the fi rst water injection well, injection of water into the reservoir commenced in March 2004. Three additional water injection wells were subsequently drilled and by the end of April 2005 up to 90,000 barrels per of day were being injected into the reservoir through these four wells.

Molikpaq Tie in Project (MTI) In early 2005, work began offshore on the Molikpaq platform and at fabrication yards onshore for the construction of new modules for the MTI project. This project which forms part of the Phase 2 project, will enable year round oil and gas production and export from the Molikpaq by connecting it to the new pipeline infrastructure which will deliver gas and oil to the LNG plant and OET being built at Prigorodnoye in the south of the Island.

The Sakhalin II Development - 2004 Progress


2 PMP module lifted onto Molipaq platform.

3 Hose reel on FSO (Okha).


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P H A S E 2Infrastructure Projects and Logistics Hospitals:In 2005, Sakhalin Energy will begin upgrades on hospitals in Nogliki and Poronaysk, as well as on the region’s main hospital in Yuzhno-Sakhalinsk at a total cost of $US 7.2 million. These upgrades will include construction works, the provision of medical equipment (in excess of $US 3 million), training in emergency care and the provision of operation and maintenance funding. The list of the medical equipment to be provided includes X-ray machines, blood banks, digital ultrasonic scanners, artifi cial kidney machines and more. In addition to this, Sakhalin Energy will also provide fully equipped ambulances to six district hospitals – Nogliki, Poronaysk, Kholmsk, Korsakov, Argi-Pagi (Tymovsk) and Yuzhno-Sakhalinsk.

The upgrades will allow for the provision of safe, unimpeded emergency healthcare services for local residents and communities as well as Sakhalin Energy employees, contractors and subcontractors.

Roads and Bridges:Road and bridge infrastructure upgrades commenced in late 2002 when Sakhalin Energy and the Sakhalin Oblast Administration agreed on a programme of road and infrastructure construction works. Work under this programme is expected to continue until the end of 2007.

By the end of 2004, Sakhalin Energy had already reconstructed more than 15 kilometres of roads and 175 culverts. The Company has also constructed more than 60 kilometres of gutters, 13 temporary bridges and 18 permanent bridges. Work to date has been completed in cooperation with Sakhalin Road Department (Sakhavtodor), and involved local Island contractors Vostokdorstroy, Tymovsk Road Construction Department and Sakhalin Construction and Investment Company.

Agreements have also been executed with seven of the Island’s Municipalities (Korsakov, Kholmsk, Dolinsk, Makarov, Poronaysk, Nogliki and Yuzhno-Sakhalinsk) for road and bridge upgrades and asphalting of roads in townships that are experiencing increased traffi c fl ow as a result of the Phase 2 construction period. The cost of this work is approximately $US 14.5 million.

Kholmsk Port:In 2003-2004 Sakhalin Energy upgraded Kholmsk Fishing Port to permit the receipt of Phase 2 construction materials, including line pipe and cargo for the OPF. In 2004, the port serviced 45 vessels and unloaded more than 114 thousand tonnes of pipe. Ancillary works at the port, including offi ce upgrades, were also undertaken. At the end of 2004, Sakhalin Energy’s contractor, 3-S, employed approximately 100 local people full-time in the port. In addition, three Sakhalin freight companies were working permanently in the Port managing the onward transfer of cargo.

In 2005, warehousing requirements at the port will be reviewed to ensure they meet the longer-term onshore and offshore supply requirements of the Project. Sakhalin Energy will also investigate the establishment of an economical development zone to encourage local service providers to supply the Company during the operational stage of the Project (supply of construction consumables, fi lters, oil and other materials) from 2007 onwards.

Nogliki Airport:In October 2004, following extensive upgrades, the Nogliki Airport was opened for daylight operation. The upgrade work at the airport was completed in conjunction with Exxon Neftegas Limited, the Sakhalin I PSA project operator. In 2005, work will focus on the installation of health monitoring systems in all aircraft and the modifi cation of offshore helicopters to international standards.

1 IUP road upgrade.

2 IUP bridge upgrade.

3 IUP road repair.

4 IUP bridge upgrade.

5 Nogliki Airport.

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Unexploded Ordnance:Sakhalin Energy funds the work for clearance of the Company’s construction sites and pipeline right of way; this includes the demolition or removal of unexploded ordnance (UXO) (carried out by Russian military sappers), demolition or removal of military chemicals and the disinterment and reburial of war dead (Russian and Japanese). All work is done in conjunction with the Military Commissariat and districts administration and follows Russian Federation legislation. By the end of 2004 more than 3,500 live UXO had been demolished and 29,750 litres of chemicals had been removed. The search for war dead discovered 41 Russian soldiers – who have been reburied with full military honours - and 33 Japanese soldiers – who have been cremated according to the Shinto Rites.

In addition, Sakhalin Energy is working with military support teams who are responsible for responding to civilian callouts on military UXO, materials and equipment. Sakhalin Energy’s support for these works started in 2002, during the past few years the Island’s capacity to deal with UXO and military chemicals has strengthened. These works are reducing the threat to both human and animal life, and ensuring increased safety.

Telecommunications Project:In order to complete the Phase 2 Project, a number of telecommunications works are being carried out by Sakhalin Energy, including the installation of an 850 kilometre fi bre optic cable network that will connect all of the Company’s facilities for safety and operational purposes. The installation of this cable will also allow the public telecommunications operator on Sakhalin Island, Dalsvyaz, to provide modern telecommunications in towns and villages along the route of the new cable, thus providing a long-term benefi t to these communities. Installation of the 850 kilometre fi bre optic cable will commence in 2005.

Kholmsk:Following the grounding of Cristoforo Colombo off the port of Kholmsk, Sakhalin Energy, as a responsible oil and gas operator and long-term citizen is carrying out a number of goodwill projects in this town. These projects have been agreed with the Kholmsk District Administration, and include the deployment of oil spill response equipment for use in the town, Primorsky Boulevard beautifi cation, replacement of a local kindergarten roof, fi rst aid equipment and furniture for children’s clinic, and provision of an emergency medical centre at the hospital. All of these initiatives are currently being implemented and are scheduled for completion by the end of 2005.

Please refer to page 36 for details on Sakhalin Energy’s Oil Spill Response (OSR) plan.

1 The start of beautifi cation work at Kholmsk boulevard.

2 Fibre optic cable ready to dispatched from St. Petersburg factory.

3 David Greer, Deputy CEO and Phase 2 Project director (right), Ivan Malakhov, Governor of the Sakhalin Region (centre), Anatoly Gusto, Mayor of the Kholmsk District (left), and Irina Stepuk, Chief Medic of the clinic, attend the opening of the Kholmsk Children’s Health Clinic. The renovation of the Clinic premises was fi nanced by the Administration of the Sakhalin Region while Sakhalin Energy purchased all the medical equipment and furniture.

4 Conduit (for fi ber optic cable) installed on Askasai river crossing.

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Offshore Platforms: Concrete gravity Based Structures (CGBS) and TopsidesConcrete gravity Based Structures (CGBS)Norwegian GBS specialist Aker Kvaerner Technology AS and Finnish Company Quattro Gemini OY are undertaking the engineering and construction of the PA-B and LUN-A CGBS. Both of the CGBS have been built in the Russian Far East at a purpose built dry dock in Vostochny Port, near Vladivostok.

The two CGBS are amongst the biggest structures ever built in Russia and the varied geometry of their legs puts them amongst the most complex concrete slip forming jobs ever undertaken. The design specifi cally takes into account the winter sea-ice conditions and seismic nature of the area in which they will be located. They are the fi rst structures of their type to be built in Russian and a workforce of some 2,000 were involved in their construction.

The construction of the two CGBS has a high percentage of Russian involvement – in total over 85% Russian content - and has provided an opportunity for local industry to gain extensive experience in the construction of such structures through the transfer of knowledge and technology. It has also created signifi cant business opportunities for Russian companies who are providing materials and other services to the construction site.

Construction of these substructures commenced in March 2004 when the fi rst concrete was poured. In November Sakhalin Energy reached a signifi cant milestone with the completion of the main concrete works on the CGBS for the Lunskoye platform. The Lunskoye concrete substructure consists of a base slab and four cylindrical legs that support the topsides of the new offshore platform. It has a total weight of 103,000 tonnes. The base is 105 metres by 88 metres and 13.5 metres high. The diameter of each leg measures more than 20 metres and they are some 56 metres high. Total height of the entire structure is 69.5 metres.

The main concrete slip forming works were also completed on the CGBS for the new PA-B platform at the beginning of 2005, which was followed by completion of fabrication and installation of all the required mechanical equipment of the Lunskoye and Piltun-B substructures.

In summer of 2005 the two structures will be fl oated out of the dock, towed to their locations on the Lunskoye and Piltun feature of the PA fi elds, and then carefully ballasted to place them gently on the seabed.

TopsidesSimultaneously, at the Samsung Heavy Industries construction yard on Geoje Island in Korea, the LUN-A and PA-B platform topsides are under construction. First cutting of steel for the LUN-A topsides was undertaken in July 2003 and in January 2004 for PA-B topsides.

By the end of 2004, progress on the 22,000 tonne Lunskoye topsides reached 65%. All living quarters had been lifted into position on the main deck and all the main deck blocks had been erected - leaving only the drilling module, fl are boom and helideck to be installed. Fabrication of piping was over 65% complete and tenders for a subcontractor for the offshore installation activities was also underway.

Fabrication on the 28,000 tonne PA-B topsides started in February 2004 and is making good progress, with the lower deck now erected on site. Erection of the upper deck is planned for March 2005 and overall progress at the end of 2004 was over 35%.

Installation of the topsides onto the CGBS will be undertaken offshore Sakhalin. In order to ensure a successful installation of both topsides, a second installation barge is now being built in a Chinese yard.

1 Completed CGBS in dry dock.

2 Topsides construction.

3 LUN-A CGBS at sunset.

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Onshore Processing Facility (OPF) By the end of 2004 overall design and procurement progress was more than 85 % complete and the majority of bulk purchase orders had been placed. Completion of detailed design is planned for June 2005.

Construction work continued in 2004 with piling, casting of foundations, construction of concrete and steel buildings, piperacks and off-site prefabrication of piping spools. Piling was completed by mid 2004 when in excess of 5000 piles had been drilled and cast.

A signifi cant success for the Phase 2 Project in 2004 was the beach landing campaign at the OPF site in July and August 2004. This included the successful delivery of three barge loads of heavy and large equipment items - such as gas turbines, compressors and heat exchangers, which due to their size and weight could not be transported over land.

Overall construction at the OPF was approximately 40% complete by the end of 2004, and multi-discipline construction, including electrical and instrumentation works will continue through 2005, in anticipation of phased commissioning commencing in 2006.

The OPF is planned to commence delivery of fi rst power to the LUN-A Platform in 2006, initially using diesel fuel for the gas turbines. It is expected to receive fi rst gas and fi rst year-round oil from the PA fi eld when the Molikpaq tie-in works are completed and commissioned.

1 OPF heat exchangers. Pipe rack in background.

2 OPF heat exchangers at sunset.

3 Work continues throughout the winter months at the OPF site.

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Onshore and Offshore Pipeline Projects2004 was a year of intense activity on the Sakhalin II Phase 2 pipelines, with the start of construction both onshore and offshore, manufacture and delivery of a large amount of line pipe and substantial progress on supporting engineering, design and approval activities.

Russian pipe and steel manufacturers are participating in the delivery of line pipe. By the end of 2004 ZAO United Metallurgical Company had completed successful delivery of 42,500 tonnes (330 kilometres) of line pipe worth a total of some $US 35 million from its Vyksa Steel Works pipe mill - with the major Russian steel manufacturer, Severstal, supplying the steel plate. This order is part of a joint venture with the Japanese company, Mitsui & Co., Ltd. Other suppliers involved are a joint venture between Russian company OOO Transpromresurs and Metal 1 (whose major shareholder is Mitsubishi Corporation of Japan), and ILVA from Italy. OOO Transpromresurs in partnership with Metal 1 has constructed a new high technology pipe coating plant in Vostochny for coating the majority of line pipe. This commenced fi rst production in the early 2004. Work continued throughout 2004 and is expected to complete pipe coating sometime in the third quarter of 2005. This coating plant, which cost approximately $US 15 million to construct, will carry out pipe coating work worth some $US 30 million for the Sakhalin II Phase 2 Project.

Total investment for supply of all onshore and offshore line pipe exceeds $US 400 million, and involves some 515,000 tonnes of steel. Cumulative coated line pipe supply for onshore use reached 275,000 tonnes (1200 kilometres) at the end of 2004, of which more than 1000 kilometres is already stored on Sakhalin. Delivery of offshore line pipe (32,000 tonnes, 170 kilometres to date) to Kuantan, Malaysia, also began during 2004. It is being transferred to the offshore pipelines engineering, procurement (excluding line pipe) and construction contractor, Saipem.

During 2004 offshore pipelines dredging and installation activities in the Lunskoye fi eld and in Aniva Bay were completed as planned. This followed completion of relevant detailed design, weld procedure qualifi cations and civil works at Aniva Bay and Lunskoye landfalls.

For 2005 a full season of construction work is planned for the offshore pipelines, to largely complete the pipeline and cable systems in the Lunskoye fi eld and in Aniva Bay. Work will comprise dredging, pipeline installation and pre-commissioning. The offshore pipeline spreads will also carry out a variety of work in support of the CGBS installation. Providing conditions are favourable, the pipeline connectors for the PA-A platform will be completed.

The engineering, procurement and construction contract for the onshore pipeline system is being executed by Starstroi. In 2004 engineering substantially progressed and construction work commenced following a ‘fi rst weld’ ceremony for the onshore pipelines in January 2004. By the end of 2004, mainline welding of 312 kilometres of pipe had been completed, and a further 1000 kilometres is planned for completion in 2005. Nearly all engineering and construction work has been subcontracted to Russian companies.

Onshore pipelines construction is progressing rapidly, and work is being carried out in the fi eld by major Russian pipeline construction subcontractors. In total there are approximately 5,000 staff now onsite, operating from main construction camps in Val, Nogliki Onor, Tumanovo, Sokol and several secondary camps along the pipeline Right-Of-Way (ROW). In 2005 engineering activities will be largely completed and procurement of pipeline valves, shelters, pig traps and a variety of supporting equipment fi nalised.

In addition, winter river crossing construction has started with 39 oil pipeline and 11 gas pipeline crossings completed in the 2004/2005 winter - the remaining crossings are planned to be installed in the 2005/2006 winter. . Detailed crossing design for some 21 seismic faults and 30 kilometres of the pipeline route which passes through landslide areas in the Makarov mountains is ongoing, with completion of planned design in 2005 and subsequent construction in 2006.

At particularly sensitive locations onshore, such as seismic faults, roads and railways and in the vicinity of settlements, the thickness of the pipeline wall will be increased, and numerous block valves will be installed along the length of the pipeline to optimise the control of the transportation of hydrocarbons. The pipeline systems will also be equipped with a highly sensitive leak detection system, and will operate under a comprehensive maintenance programme.

1 Inspection of 48-inch pipe.

2 Work continues throughout winter months.

3 Local Community Liaison Offi cer views pipeline progress.

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Liquifi ed Natural Gas (LNG) Plant and Oil Export Terminal (OET)In 2004 work on the LNG/OET project shifted from the design and procurement centre in the offi ces of Chiyoda Corporation in Japan to the construction site at Prigrodnoye. By the end of 2004, the main contractor, CTSD, had awarded all of the major subcontracts for construction of the permanent facilities to contractors from Russia, Japan, Korea, USA, UK, Ireland, Turkey.

The early works programme - site preparation, site bypass road and the Material Offl oading Facility (MOF) - commenced in August 2003 and has been successfully completed. Construction of a 6000-man accommodation camp also commenced at the same time, and is now complete with fi nal accommodation and recreational units within the camp fi nished by the end of March 2005. The early works programme paved the way for the permanent engineering, procurement and construction works that took place in the spring and summer of 2004. In April 2004, the concrete batching plant which produces concrete from locally provided raw materials was opened by HRH Prince Andrew, The Duke of York. April 2004 also marked the start of construction of the major equipment and piperack foundations within the OET, utilities area and process train 1.

Structural work commenced on the two 100,000 cubic-metre LNG storage tanks in September 2004, and the 37-metre high steel vapour barrier now dominates the skyline at Prigrodnoye. In the spring of 2005, the concrete walls of the giant outer tank will start to appear, and the roof that is currently being built inside the tank will be raised by air pressure to the top of the tank.

On another area of the site TOA Corporation has created a crushed stone ring foundation for the 100,000 cubic metre oil export tanks. Following this, Russian contractor, Koksokhimmontazh, has made excellent progress in erecting the tanks. By October 2005, it is expected that the tank shells will be complete and ready for pressure testing.

In April 2004 the Sakhalin Energy construction offi ce on site was offi cially opened, allowing staff to be permanently located at the worksite. The permanent buildings, including substations and the operations and administration buildings are all progressing well, ensuring that follow-on contractors will be able to work in relative comfort during the winter of 2005.

In October 2004, subcontractors Daewoo and Gama commenced steel erection across the entire site to bring a signifi cant change to the LNG site’s skyline. Steel piperacks create the backbone for the entire plant, and in the second half of 2005 the pipe racks will start to be fi lled with process piping from half inch to 72 inches in diametre.

2004 also marked the opening of the main pipe fabrication facilities in which pipe will be cut and welded to fi nal confi guration for installation in the LNG/OET plants. More than 80 kilometres of both carbon steel and stainless steel pipe will be welded here. Teams of welders from a number of different countries will be engaged to complete the fabrication work.

Numerous material deliveries have been made direct to the site and offl oaded at the MOF since the start of 2005. Planning is in process for the single heaviest lift to be carried out on site - a 600 tonne pressure vessel to be lifted into place in the main process area.

Throughout the year, work underground will continue with piping and the 1000 kilometres of electrical and instrument cable that will be installed throughout the plant.

1 Construction work at the LNG site.

2 LNG train 1 under construction. LNG tank construction in background.

3 Workers at the LNG construction site.

4 OET tanks under construction. LNG site in background.

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LNG Sales2004 was an impressive year for Sakhalin Energy for our LNG and oil marketing activities. The Company strengthened its presence in the Asia-Pacifi c market place by confi rming existing commitments and expanding the customer base for both LNG and crude oil sales.

In May 2004 Sakhalin Energy signed a binding Heads of Agreement (HOA) with Toho Gas and executed fully termed Sales and Purchase Agreements (SPAs) with Kyushu Electric and Tokyo Electric. Japan remains Sakhalin Energy’s core market with foundation customers continuing to expand their offtake commitments, and negotiations are ongoing with other key Japanese buyers.

In October 2004 Sakhalin Energy concluded an SPA to supply 37 million tonnes of LNG over a 20-year period, to Shell Eastern Trading Ltd. for the North American natural gas market. This pioneering deal represents the fi rst sales of Russian natural gas to North America and marks the beginning of Sakhalin Island as a strategic new source of natural gas for both Mexico and the US West Coast markets. LNG from Sakhalin Energy will be supplied to the new Energía Costa Azul LNG receiving terminal that will be constructed in Baja California, Mexico

Natural gas from the new terminal will be used to satisfy Mexico’s growing energy needs, with excess natural gas exported from the Mexican terminal to California in the US where, as in Mexico, there is an increasing requirement for new natural gas supply sources. The agreement calls for a plateau supply of 1.6 million tonnes per annum, with signifi cantly higher volumes of LNG deliveries during the fi rst three years.

Vityaz Crude Oil SalesSakhalin Energy continues to see a healthy appetite for Vityaz crude within Asia-Pacifi c as buyers seek to diversify energy sources away from the Middle East. Not only did Sakhalin Energy achieve record premiums for its crude oil sales over the Oman oil market price – which is a similar type of oil and is used as a benchmark price for Vityaz crude - the Company also expanded its customer base with its fi rst ever sales to Thailand, in addition to continuing deliveries to Japan, Korea, China, USA and the Philippines.

Moreover, Sakhalin Energy achieved another milestone with the fi rst sale to Tohoku Electric. This is the fi rst time Vityaz crude has been delivered direct to a power generation company – all previous sales have been to refi neries. Overall in 2004 Japan increased its dominant position as the Company’s primary crude customer by purchasing 76% of total production with four new customers.

Sakhalin Energy continues its preparations towards year-round oil exports from Prigorodnoye. At peak production, Sakhalin Energy will produce around 180,000 barrels of oil and condensate per day. Combined with the future production from the Sakhalin I Project, Sakhalin will be exporting almost 420,000 barrels of oil per day, which is a substantial fi gure for Asia. Overall Sakhalin crude production will be larger than oil exports from Vietnam (350,000 barrels of oil per day), Malaysia (400,000 barrels of oil per day) and close to that of Indonesia (500,000 barrels of oil per day).

LNG ShippingIn 2004 Sakhalin Energy geared up its shipping capacity to facilitate the delivery of LNG supplies as called for under some of the sales contracts. Following a detailed tender process for the long-term charter of LNG ships, Sakhalin Energy awarded deals for three new-build 147,200 cubic metre Moss-type LNG carriers in November 2004. Two ships will be chartered from a consortium of Sovcomfl ot and Nippon Yusen Kabushiki Kaisha (NYK), and one ship to the consortium of Primorsk Shipping , Mitsui OSK lines, K Line. The two ships to be chartered from by Sovcomfl ot and NYK will be constructed by Mitsubishi Heavy Industries. The third carrier to be chartered from Primorsk/Mitsui/K Line will be built at Mitsui Engineering & Shipbuilding.

These deals represent Russia’s fi rst entry into the LNG shipping business. The Japanese-Russian partnership combine Japanese experience of 20 years of accident-free LNG shipping with unique Russian skills in ice navigation and experience of Russian ports. These landmark deals demonstrates the benefi ts of the Sakhalin II Project to Russia through opening up new areas of industry and the introduction of new technologies.

Latest Update – 2005 Gas SalesSakhalin Energy achieved another major marketing breakthrough in February 2005 winning a tender to supply 1.5 million tonnes per annum (mtpa), plus a possible option of a further 0.5 mtpa, of LNG to Korea Gas Corporation (KOGAS). The Heads of Agreement (HoA) with KOGAS represents the fi rst major strategic energy deal between Korea and Russia.

In addition in the fi rst week of June 2005 Sakhalin Energy signed three more long term (20+ years) LNG supply deals with Japanese utilities - a HoA with Hiroshima Gas, for 0.21 mtpa, a HoA with Tohoku Electric for 0.42 mtpa and an SPA with Toho Gas for 0.5 mtpa.

These 2005 gas sales bring the total commitments for LNG from the Sakhalin II Project to up to 8.0 mtpa for period of 20 years or more.

The Markets

1 Energy use in South Korea.

2 Ian Craig, Sakhalin Energy CEO (right), Ivan Malakhov, Governor of the Sakhalin Region (left) and Ann Pickard, Executive Vice President Shell Gas and Power (centre), celebrate as a pioneering LNG supply deal is signed with Shell for North American Markets.

3 Celebrations at LNG shipping ceremony.

4 Okha FSO (part of Vityaz complex).

5 Tokyo Electric SPA signing.

6 Kyushu Electric SPA signing.

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Russian ContentRussian Content remains a key element of the benefi ts that the Sakhalin II development will bring to Russia throughout the life of the Project. The involvement of Russian industry in both the construction and operational phases will play an important role in the overall success of the Project.

The Sakhalin II Production Sharing Agreement (PSA) defi nes russian content in terms of manhours and the volume of materials and supplies, recognising the diffi culty Russian industry would have in providing unique processes and equipment required during the construction phase. In line with this approach the PSA also states that Sakhalin Energy must use its best efforts to achieve a 70 percent target for Russian Content over the life of the Project.

The Company and its partners in the Federal and Regional Government are working together, through the auspices of the Joint Committee, to promote the use of Russian industry. This committee seeks to identify Russian businesses and industry that can undertake contracts for the Sakhalin II Project. The committee is also advised of all contract awards and checks that the Procurement Procedures used by Sakhalin Energy have been applied in a fair, transparent and consistent manner.

The work of the committee has played a key role in promoting the involvement of Russian companies in the Sakhalin II Project. Since construction activities commenced – initially on Phase 1 and now on Phase 2 – between 1996 and the end of 2004 Russian contractors and subcontractors have won thousands of contracts worth up to a total of $US 4.2 billion.

The fi gures also show that not only is the PSA target of 70% already being achieved, but is being exceeded. 63 million Russian labour man-hours had been expended on the Project by the end of 2004 - 73% of total - and material and equipment supply had exceeded 3 million tonnes, some 86% of the total.

Russian Content Performance in 2004 has been the Company’s highest to date. In order to ensure this performance is continued in the coming years - particularly into the operations phase of the Project, the Company is in the process of developing its Russian Content Development Policy and Strategy. This will create a renewed focus within the Company of looking to the future and of developing Russian Content opportunities. The Joint Committee will continue to play a pivotal role in the Company’ Russian Content Development activities, particularly in working with the Company to review the forthcoming 2005 –2010 Contracting and Procurement Activity Plan, in order to identify Russian Content Development opportunities.

The Company will continue to work with other oil and gas operators and engage the major oil and gas service companies on the island to collectively identify resource sharing/synergy opportunities required by the Sakhalin oil and gas industry. The development and retention of Russian skilled tradesmen/workforce will also be a key focus area.

Sakhalin Energy believes that with the continued support of the Russian Party and the Joint Committee it is on track to meet the Russian Content requirements of the PSA and possibly even exceed them.

1 CGBS construction site.

2 Line pipe coating plant in Vostochny.

2 Russian Supervisor inspects pipe welding.

Meeting the challenge

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Employment Opportunities for Sakhalin Island ResidentsAs part of Sakhalin Energy’s commitment to provide jobs for the local population, the Company launched an apprenticeship scheme in October 2003. The scheme focuses on providing training for Russian men and women from Sakhalin Island who have a keen interest in working as technical professionals in production operations and maintenance for Sakhalin Energy. The apprentices will be the future operations and maintenance technicians for the Sakhalin II onshore and offshore facilities.

The scheme is a structured course combining theoretical study and on-the-job training for people with little or no knowledge of operations and maintenance. The fi rst period of study involves English language training, followed by technical and as well as safety training in the classroom and workshop in Russia as well as overseas. Following this, up to two years will be spent with on-the-job-training, depending on the apprentice’s ability and his or her chosen discipline.

The training programme ensures that each apprentice becomes a specialist in one of four fi elds – either operations, mechanical, electrical or instrumentation, whilst receiving a solid grounding in all disciplines.

Sakhalin Energy hopes to recruit and train in excess of 270 Sakhalin residents in its apprenticeship scheme between 2003 and 2018. The fi rst group of 11 apprentices was recruited in October 2003, and in November 2004 they attended a six-week training course in China. As part of the overseas training course, which was conducted entirely in English, the apprentices completed a number of tasks in a workshop setting and had the opportunity to develop their technical skills and their awareness regarding Health, Safety and Environment issues. At the end of the six weeks, the apprentices were independently assessed against internationally recognised standards and were rated as exceptionally high.

By January 2005 the fi rst four apprentices had successfully completed their English language and technical training and had commenced their competence based on-the-job training.

In 2004 a further fi ve groups were recruited – in total more than 60 apprentices. Three of these groups started their English-language training programme in early 2005 in preparation for the technical training to follow.

Sakhalin Energy’s Recruitment scope reaches far beyond the apprentice programme and is following international best practice: all applicants get screened against a standard competency framework, starting with initial handling of incoming CV’s, followed by selection based on structured interviews and other validated tools. To meet the signifi cant staffi ng challenge in the coming years, the Human Resources recruitment function of Sakhalin Energy has been signifi cantly staffed up. To ensure that Sakhalin Energy generates the large numbers of applications by experienced Russian nationals that are required, the Company has extended its Attraction scope to the Russian Far East and beyond. For details on available opportunities, interested parties can check the Sakhalin Energy internet site (www.sakhalinenergy.com).

1 On-site training at the OPF site.

2 On-site training at the OPF site.

3 Apprentices – classroom training.

4 Apprentices – English language training.

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Indigenous PeopleSakhalin Energy has a history of engaging, supporting and working with local communities and the indigenous groups of Sakhalin Island. In 1992 SEIC initiated a programme of consultation for indigenous people (IP). For the Phase 2 project, this programme has been expanded to meet the requirements of the Russian legislation, as well as the spirit and intent of the World Bank Group Operational Directives (OD 4.20 and OD 4.30).

As part of its IP programme the Company’s ongoing monitoring and consultation activities include:

• Communication with herders relating to construction schedules and pipeline routes;

• Indigenous people socio-economic surveys;

• Assessment and discussion of potential and perceived Project-related impacts on indigenous people communities, their natural resource base, livelihood activities and settlements;

• Assessment and discussion of proposed and already implemented mitigation measures;

• Regular consideration and consultation with stakeholders on indigenous people issues;

• Determination if supplemental assistance is needed;

• Identifi cation of community needs and discussion of potential programmes/ projects to be supported.

In 1994 the Company started to conduct public meetings with Nivkh, Evenk, Orok and Nanai people to build closer relations with the different groups and organisations representing the interests of indigenous people.

Since then the Company has supported indigenous people through a wide range of social initiatives and projects including education programmes, the preservation of traditional culture and community development, culture and sports promotion and fi nancial support of IP conferences, congresses and other events.

In 2004 the Company started active stakeholder engagement with reindeer herders. Sakhalin Energy, in partnership with the Nogliki District Administration initiated quarterly workshops with reindeer herders to inform them of the Project schedule and discuss their concerns related to the Sakhalin II Project.

At the end of 2004 and in early 2005 the Sakhalin indigenous peoples made demands that all of the oil and gas operators on the Island carry out an ethnological expertiza to determine the cumulative impacts to their traditional way of life and subsequently defi ne levels of compensation owed to them.

An agreement signed in January 2005 between the Sakhalin Oblast Administration, some representatives of the indigenous people and oil and gas companies proposes the development of effective coordination between the Oblast programme, “Economic and Social Development of the Indigenous People of Sakhalin in 2005-2008” and other activities and social assistance programmes being implemented by the companies aimed at supporting the indigenous minority peoples of the north of Sakhalin Oblast.

In March 2005, more than 70 delegates of indigenous people came to Yuzhno from all Sakhalin districts to elect an IP Council and coordinate their views on the main priorities for the socio-economic development of indigenous population of the island. Sakhalin Energy has welcomed this Council’s election and has encouraged them to work with all oil and gas operators and the Sakhalin Oblast Administration to address these needs. The Company has also committed to the development of an IP Development Plan during 2005 with the full participation of the indigenous peoples of Sakhalin Island.

1 Regular SEIC workshop with reindeer herders.

2 David Greer, Deputy CEO and Phase 2 Project Director, at the IP agreement signing in January 2005.

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Social Investment - KorsakovSakhalin Energy is committed to maximise the benefi ts of the Project to communities impacted by our activities and works hard to mitigate potential negative impacts. The town of Korsakov which lies on the northern edge of Aniva Bay in the far south of Sakhalin Island is an example of a community effected by the Sakhalin II Project. It is located 42 km south of Yuzhno-Sakhalinsk, the administrative centre of Sakhalin Island, and 15 km west of the Sakhalin II LNG site. Korsakov is the district administrative centre of the Korsakov District, and is the third largest community on Sakhalin Island with a population of 39,300 (circa census of October, 2002).

In developing the LNG and oil export facilities there are a number of negative impacts from the construction activity that the Company works hard to address and minimise their impact. Increased vehicle transport in the town and associated safety risks have been addressed through a focused safety campaign with the authorities, citizens and schools. Potential social impacts such as health impacts from dust and noise, or the impact of an increased workforce for the site construction are all monitored and mitigated where possible.

However, the construction of the Sakhalin II LNG and oil export facilities has also brought various benefi ts to the district of Korsakov.

Increased employment, business opportunities and tax incomeThe construction and operation of the Sakhalin II LNG facilities have and will continue to create employment opportunities for Sakhalin Island residents, particularly those from Korsakov. To date, in the construction phase, the main LNG contractor (CTSD) has employed, directly or indirectly, 57 Sakhalin companies as subcontractors. By March 2005, CTSD and its subcontractors employed over 1,000 Korsakov residents on the LNG project, making up 25% of the current LNG workforce.

During the start-up and operational phase of the facilities, it is anticipated that a number of local support services will be required, including security services, catering and administration services (camp cleaning, snow cleaning, grass cutting, etc), which will lead to the creation of new business opportunities for the community.

The increased level of local business activity also brings an increase in tax income from Project execution (contractors, subcontractors) to the local Korsakov budget. In co-operation with the relevant Russian Authorities, Sakhalin Energy and our main contractor CTSD are using their best efforts to ensure that all LNG contractors and sub-contractors register locally and pay local taxes.

Infrastructure improvementsProjects to improve infrastructure within Korsakov have also been and will continue to be undertaken by Sakhalin Energy. These include a culvert upgrade over Chkalovka and Ulitovka rivers, over 5km of road upgrades and repairs and the upgrade of the Korsakov landfi ll site. Also, navigation polygons, which were not operational prior to the new construction, were moved from the LNG site to Aniva – improving navigation safety for Korsakov Port.

In addition to undertaking ongoing repairs of Korsakov roads utilised by project vehicles, Sakhalin Energy has signed an agreement with the Sakhalin Oblast Administration for the concrete asphalt surfacing of the road between Korsakov and Kvartsitovy Konus, including the LNG bypass section. This work will be completed in 2007.

Sakhalin Energy has also signed a contract with the Korsakov Administration for the re-construction of the Korsakov Park as compensation for loss of beach access due to the construction of the LNG/OET facilities.

Sakhalin Energy is committed to open and transparent dialogue with residents and the District Administration of Korsakov on any matters related to the implementation of the Sakhalin II project. In addition to holding regular meetings with the District authorities, in 2004, the company began quarterly community engagement sessions in Korsakov. Local residents are also able to obtain information and express any concerns that they may have in the community liaison offi ce that is located in the city centre.

1 Dust suppression truck on the Korsakov – Prigorodnoye Road.

2 Construction camp at the LNG site.

3 Financial support given to fi sh farm reconstruction in Ozersky.

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Pipeline River CrossingsSakhalin Energy is constructing pipelines to carry oil and gas from the offshore hydrocarbon fi elds northeast of Sakhalin Island to the south of the Island as part of the Phase II Project. The pipelines will cross more than 1000 watercourses. These mostly comprise small brooks and streams, but also include rivers with economically signifi cant salmon fi sheries and a small number of rivers that possibly contain Red Book fi sh species. Sakhalin Energy recognises the importance of these watercourses to the ecology and local economy of the Island - particularly in terms of the salmon fi sheries - and is committed to ensuring that the impact of river crossings during construction and operation of the pipelines will have only a minor short-term effect on the environment.

Sakhalin Energy has spent more than fi ve years undertaking surveys to collect environmental baseline data collection along the onshore pipeline route to assess the potential impact of pipeline crossings on the environment, in particular on salmon streams. The research has been undertaken together with Sakhalin Scientifi c Research Institute for Fisheries Management and Oceanography (SakhNIRO), the Sakhalin State University and Russian environmental survey company Averina.

The research has enabled Sakhalin Energy to design river crossing methods, which determine how and when a river is crossed based on its sensitivity. River crossing timing and construction methods are approved by the relevant Russian Federation regulatory agencies, including local fi sh inspectorates, the regional fi shery regulatory agency, Sakhrybvod, and the Federal level agency, Tsuren.

During construction, trenching methods employed to cross a river can produce a short-term and localised increase in water turbidity, or suspended silt particles in the river. Although temporary in nature, this could potentially have an effect on fi sh and salmon spawning grounds. This potential effect is minimised by avoiding salmon spawning grounds wherever possible, reducing construction durations, adjusting the timing of the crossings to non-critical periods, construction in low fl ow situations and, in a few cases, drilling under the river. The silting effect is expected to be no worse than that experienced naturally by rivers each year during the spring thaw or from heavy rain.

Construction of pipeline crossings on rivers identifi ed as important to salmon spawning and those which may contain Red Book species will be carried out during the winter months. This is typically from December to April when many of the rivers and riverbanks are frozen. This minimises silt generation and transport during construction and after spring thaw. This winter period is also outside the salmon spawning season when there are no salmon present, thereby limiting physical disturbance to the river and virtually eliminating the impact of construction activities on these fi sh.

By the end of 2004, 17 fi sh sensitive streams had been crossed with one pipeline, with no measureable, permanent negative impact to the environment.

Seven of the most sensitive larger rivers are planned to be crossed with the use of Horizontal Directional Drilling (HDD) technologies. Here pipelines will be drilled and installed underneath the river, without disturbing the river. This method is not suitable for all rivers and geographical conditions because of the need for a suitable subsurface geological profi le. This method also requires the use of special drilling muds, which is not recommended for use in highly permeable soils where there is potential for release into to the environment. The fi rst two HDDs were executed by a specialist contractor on the Vazi and Nabil Rivers in the north of the Island in early 2005.

Sakhalin Energy has developed an awareness programme that focuses on compliance with construction procedures and erosion control for river crossings. River crossings with the highest sensitivity will have dedicated drawings, work execution plans, inspection and test plans. They will be executed only in the presence of environmental inspectors, who will verify compliance with environmental procedures during construction. The environmental inspectors have the authority to stop the work if they consider that procedures or regulations are being breached, or if the environmental impact is not acceptable.

In addition to stringent Company, Russian and international standards that are being applied to river crossings, Russian regulatory requirements also include a system of fi sh damage assessment and monetary compensation. This compensation is paid whether or not there is any actual damage and represents some of the most stringent regulation of its type anywhere in the world. The damage the onshore pipelines and other Sakhalin II Project facilities may potentially cause to fi sh has been calculated according to Russian legislation. This has resulted in a sum of approximately $US 11 million in compensation. This is being paid into a government fund and used to improve the fi shing industry on the island. Part of these funds will be used to establish two new fi sh hatcheries.

1 Winter river view.

2 Preparation for winter river crossing.

3 Winter river view.

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Western Gray Whales The northeast coast of Sakhalin Island is rich with marine life and is a summer feeding area for the critically endangered western gray whale (WGW). Two known feeding grounds for the WGW have been identifi ed off the northeast coast of Sakhalin, a near-shore one in the Piltun Bay area, and an offshore feeding ground further south adjacent to Chayvo Bay. The two feeding grounds have a total area of 1570 square kilometres.

In a clear demonstration of it’s commitment to ensure that its activities will have no adverse impact on the WGW, the Company halted its offshore pipeline construction activities in the PA fi eld for two seasons to allow for additional studies after the Company’s own research suggested that acoustic impacts on the whales might be greater than anticipated.

During 2004 Sakhalin Energy evaluated three possible pipeline route options for the PA fi eld – the existing identifi ed route and two alternatives. Additionally, the Company carried out offshore and onshore environmental and engineering surveys of the three route alternatives, and completed another season of extensive WGW surveys. The body of information collected from past surveys combined with the 2004 work helped Sakhalin Energy assess the potential impacts and establish effective mitigation measures to ensure that the WGW is not adversely impacted by the Company’s planned offshore activities in the PA fi eld. Sakhalin Energy collated and assessed all of these results in the “Comparative Environmental Analysis of the Piltun-Astokh Field Pipeline Route Options” (CEA) report. One of the conclusions of the CEA was that with varying levels of mitigation, all three route options would be technically viable.

However, in parallel with it own study and research activities on the WGW, Sakhalin Energy took the bold step of asking IUCN – the World Conservation Union to convene an Independent Scientifi c Review Panel (ISRP) to review the effectiveness of it proposed mitigation measures to minimise the impact of its operations on the WGW and associated biodiversity in the context of the Sakhalin II Project.

The ISRP report was published in mid-February 2005. Taking into account the advice contained withon the report and based on the conclusions of the CEA Sakhalin Energy announced its decision to reroute its offshore pipelines in March. The pipelines - linking the PA-A and PA-B platforms off Sakhalin Island to shore – will be moved 20 kilometres south of the original location, away from the key feeding area of the WGW. Sakhalin Energy is currently seeking approval from Russian government agencies for this change.

This decision is in line with the ISRP’s Report which called for a conservative risk management approach. The selected pipeline route is the most precautionary alternative that maximises the distance between the Company’s activities and the whales.

The ISRP Report identifi ed further measures to minimise the impacts on the whales and Sakhalin Energy has already included many of these measures in revised mitigation plans for its offshore activities. As a follow-up to the Panel’s report, IUCN has invited members of the ISRP to review these plans for mitigating risks to the whales associated with the development.

Protection of the environment and species like the WGW form part of Sakhalin Energy’s overall commitment to sustainable development. Sakhalin Energy is determined to ensure that the Phase 2 Project can be developed in line with international environmental standards and the Company’s commitment to mitigate potential impacts as far as is practicable - not just to the WGW, but to the Island as a whole.

1 Sakhalin Energy Western Gray Whale acoustic research.

2 Western Gray Whales offshore Sakhalin Island.

3 Sunset near Piltun Bay.

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Oil Spill Response (OSR)Sakhalin Energy takes the issue of oil spills seriously and has implemented a number of measures to ensure that the likelihood of spills is minimised and any potential consequences are reduced. Our primary goal is prevention of oil spills. This is achieved through the robust design of production, export and transport facilities, it is also achieved by ensuring sound maintenance and operating procedures – in both regards Sakhalin Energy is committed to the implementation of high international standards and best practices.

Sakhalin Energy has a comprehensive Oil Spill Response (OSR) plan, which has been approved by the Russian authorities, for operations under Phase 1 of the Sakhalin II development that involves the Molikpaq offshore platform and tanker loading facilities. The Company maintains an effi cient and effective OSR organisation and has access to its own regional resources. The OSR facilities for our existing production operations have a 24-hour response capability from the OSR base that is maintained in Nogliki. The OSR vessel, Irbis, is maintained on standby in the Piltun-Astokhskoye fi eld 24 hours a day throughout the ice-free production season.

The OSR organisation has a clear and tested chain of command, with clearly identifi ed roles and responsibilities. A thorough training programme, tested regularly, ensures that response teams have the right skills, and all potential team members are familiar with OSR procedures.

During the last two years, less than one litre of oil has been spilt from the Phase 1 offshore operations – a spill record that puts Sakhalin Energy amongst the top performers in the world.

The high standards set for Phase 1 OSR will be maintained for the Phase 2 facilities. OSR plans for the Company’s Phase 2 facilities are under preparation and will be completed, agreed with the Russian authorities and put in place before these facilities commence production. Sakhalin Energy will deploy permanent OSR equipment and resources at each asset, and at strategic locations along the onshore pipeline route. Helicopter drop off points will be identifi ed along the coast and the pipeline route for the air-transportation of OSR equipment and teams to ensure that a rapid response can be achieved in the unlikely event of a spill.

Field surveys were undertaken in the summer of 2004 and these will be continued in 2005. These are aimed at identifying sensitive areas, developing site-specifi c response strategies and logistical information. Ground surveys will be supported by aerial surveys. Data obtained will be added to the Sakhalin Energy Geographical Information Systems-based sensitivity maps and database. These already cover the coastal and lagoon areas adjacent to the Phase 1 facilities along the northeast Sakhalin coast.

In 2004 Sakhalin Energy also reviewed equipment specifi cations, with particular regard to Sakhalin Energy’s light oil and to prevailing weather and sea conditions in Sakhalin. In addition, Sakhalin Energy will ensure that equipment is suitable for third party spills that may occur on or around Sakhalin Island. In this respect, Sakhalin Energy is committed to supporting Russian Federation and Oblast agencies in third party spills, and will respond to any incident if registered under the ‘Unifi ed Command” arrangements.

Sakhalin Energy will continue to promote and be involved in regional OSR workshops and training courses, and to foster regional OSR cooperation.

Cristoforo Colombo On September 8 the dredger Cristoforo Colombo was blown aground at Kholmsk by the strong winds and waves caused by the typhoon ‘Songda’ when its engines failed. At the time of the accident the vessel, which was not owned or directly contracted to Sakhalin Energy, was at rest anchored several kilometres off Kholmsk Commercial Port awaiting remobilisation to the Lunskoye area.

Sakhalin Energy has no production operations at Kholmsk. The Company and its contractors use this port in the same way any other industry may use a port for normal shipping activities. Any ship in the vicinity of Kholmsk, such as a ferry, fi shing boat or merchant ship, could have suffered the same fate under such severe weather conditions. Under such circumstances, there is no requirement for Sakhalin Energy to have an oil spill contingency plan or equipment for the port.

Sakhalin Energy however, reacted immediately and was requested to manage the ongoing response under the “Unifi ed Command” system. The Company established its own emergency response team and mobilised its own oil spill contractor’s command group and response team within one hour. Clean up of effected areas was essentially completed by September 12, with certain areas of the Primorsky Boulevard reopened to the public that day. The entire clean up was completed in about two weeks.

1 OSR exercise – boom deployment.

2 Cristoforo Colombo in Kholmsk.

3 OSR training.

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Waste ManagementSakhalin Energy has developed a responsible waste management strategy. Central to this strategy is an integrated approach to the management of waste. This places emphasis on the minimisation, re-use and recycling of waste wherever practicable, and the safe treatment and disposal of remaining materials. This approach is not only in accordance with international best practice, but also complies fully with Russian Federation regulations.

The largest volume of waste to be generated in Phase 2 will be during the construction period (2002-2008). Sakhalin Energy’s approach to waste management involves waste being disposed of as close to source as possible. This means that each project facility has full duty of care for the waste.

To support this strategy, Sakhalin Energy has developed a system that will track waste generation, classifi cation, transport, storage, treatment and disposal. As a commitment to the management of waste as close to source as possible, each project facility will have a specifi c waste management plan for the construction and operational phases of the Project.

In 2004, under a cooperative agreement signed with the Sakhalin Oblast Administration, Sakhalin Energy conducted upgrades to three existing municipal waste landfi lls in Korsakov, Nogliki and Smirnykh. The landfi ll upgrade project provides for technical solutions in line with international best practice. These landfi ll facilities will be used for the disposal of the Company’s non-hazardous wastes during the construction of Phase 2, as well as for the disposal of municipal waste originating from local communities. Upgrade of the Nogliki landfi ll has been conducted in partnership with Exxon Neftegaz Limited.

In addition to the upgrades at existing waste management facilities, Sakhalin Energy is developing an oily waste bio-treatment project and comprehensive waste minimisation plan to allow for minimisation and recycling of hazardous wastes. Sakhalin Energy will also assist the Sakhalin Oblast Administration in the development of the local waste recycling industry.

In this way, Sakhalin Energy is pursuing a co-operative approach with local authorities to improve waste management on the island, which will be of signifi cant benefi t to local communities and the environment.

1 Korsakov waste site.

2 Waste monitoring at the OPF site.

3 Korsakov waste site.

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2004 was a year in which Sakhalin Energy Investment Company (SEIC) put in place many of the structures, systems, techniques and training to manage HSES and Social issues in the Sakhalin II project. It was also a year in which the company achieved many, but not all of the targets it set.

Looking back over 2004, it is clear that safety, environmental compliance and social responsibility will be the main areas of focus in 2005. SEIC has expanded its HSES and social programmes to match the increased scale of the main construction operations, and can look forward to signifi cant improvements in HSES and social performance in the coming years.

SEIC planned for 2004 knowing that it was going to be a challenging year from the perspective of health, safety, environment and security (HSES). With the Phase 2 major construction projects due to reach peak working levels, and over 16,000 staff and contractors expected to work more than 46 million man hours, the nature of the company’s activities would expand and change signifi cantly during the year.

To adapt to these changes, a detailed plan was formulated to manage the HSES aspects of SEIC’s construction and operations activities throughout the year. The HSES plan contained a range of targets and milestones designed to monitor performance and provide continuous improvement to the SEIC HSES framework.

While not all of the specifi c targets in the plan were reached, signifi cant structural progress was achieved, and SEIC is looking forward to further improvements in HSES during 2005.

HealthThe benchmark for health in 2004 was to achieve a target of having less than 8.5 occupational illness cases per million man hours worked. There were in total 262 cases of occupational illness, 74 of which resulted in absences from work. This represents 5.6 cases per million man hours worked. Occupational Illness case reporting by contractors has signifi cantly improved during 2004, although under reporting in some projects areas was observed.

To improve the standard of health amongst staff and contract workers, the HSES Plan called for a number of programmes to be run throughout the year. In accordance with the plan SEIC:

• started to upgrade the emergency response capabilities in regional and district hospitals and built helipads at the major construction sites to speed medical evacuations

• jointly organised with the Sakhalin Oblast Administration, a high-level workshop on ‘State, Business and Community leaders response to STI/HIV/AIDS and other diseases of a social character’. The workshop resulted in a joint action plan that later was confi rmed by an offi cial resolution issued by the Vice Governor responsible for Social and Health Affairs

• conducted the fi rst health risk assessment programme of the onshore projects, bringing in expert industrial hygienists to train managers and staff in each area

• upgraded the sanitation, water supply, catering and medical clinics at contractor sites in response to a government sanitary audit, resolving 95% of the issues raised within four months

• ran a series of fi rst-aid training courses and health awareness workshops, and made a $10,000 donation to the Sakhalin Regional HIV/AIDS centre

• further improved the compliance of fi tness-to-work tests for all local SEIC staff, conducted a number of health incident investigations (food poisoning and non-accidental death cases) and conducted a series of audits of contractor staff health certifi cates

• continued to promote health awareness among employees through a series of educational programmes on topics such as tobacco, alcohol and stress management.

As a result of these initiatives, the company is confi dent that in 2005 the health objectives will once again be achieved.

Hea l th , Safe ty, Env i ronmen t , Secur i t y (HSES) and Soc ia l Ac t i v i t y in 2004

1 OPF construction site.

2 Working at heights – LNG site.

3 OPF construction site.

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SafetyDue to their scale, complexity and geographic spread, the Phase 2 construction projects carried a higher safety risk than ongoing Phase 1 operations, so safety was made a major area of focus in the 2004 plan. Despite this emphasis on safety, regrettably six fatalities related to SEIC and contractor activities occurred: four due to road traffi c accidents, one from a fall after operational procedures were not followed and the other following a fi ght in a contractor construction camp.

The main safety issue identifi ed in the HSES Plan was road safety, with the target of less than 3.20 road traffi c incidents per million kilometres driven. By the end of 2004, there had been 181 motor traffi c accidents involving company and contractor vehicles, representing 3.56 incidents per million kilometres, and 11% over target. This under performance was recognised early in the year, and a signifi cant effort put in to developing road safety through the second half of the year. In August, a formal Road Safety Steering Committee was formed and charged with developing and implementing a comprehensive road safety programme.

The ‘Think, Drive, Survive’ programme was launched to over 17,000 people in December 2004, and will be conducted both within the company and among the community until at least 2008. SEIC also developed a working relationship with the Global Road Safety Partnership – an initiative of the World Bank aiming to promote road safety issues worldwide. In early 2005 the “Sakhalin Road Safety Partnership” was formed on Sakhalin Island with the assistance of the Global Road Safety Partnership.

Other aspects of the 2004 safety programme included:

• a comprehensive safety review by Shell Group experts of all Phase 2 projects. As a result of this review, improvements to lifting safety and the auditing of contractor methods are being implemented.

• integrating each project’s emergency response plan into a centralised approach and successfully conducting two major emergency fi eld exercises

• designing and implementing a new incident reporting and investigation system.

SEIC understands the critical importance of safety to the well-being of workers and the local community, and is confi dent that the efforts made this year to improve safety across the company will result in further measurable improvements in 2005.

1 OPF road safety initiative.

2 Korsakov Road Safety Day.

3 SEIC staff participate in Korsakov Road Safety Day.

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EnvironmentTo meet the requirements of relevant Russian Federation and international environmental legislation, SEIC enforced environmental protection measures and created improvements using a variety of environmental controls and activities. Highlights of SEIC’s environmental activities included:

• the 8th successive year of research and monitoring carried out on the western gray whale

• the production of a comprehensive environmental analysis of three possible Piltun pipeline route options

• the 7th successive year of ecological monitoring carried out around the Molikpaq production platform

• the 2nd year of a three year monitoring and research programme carried out on the Steller’s Sea Eagle

• industrial control activities including compliance monitoring to evaluate and ensure requirements of environmental permits and licences met

• completing the fi rst stage of development of a comprehensive company-wide integrated environmental monitoring project for the operational phase

• fi nalising the solid waste management plan and upgrading three landfi lls

• ecological survey and monitoring of onshore and offshore habitats

• oil spill prevention, preparedness and response planning.

SEIC is committed to conducting its operations in compliance with all applicable Russian Federation environmental regulations, and in addition has its own stringent internal standards. SEIC and its contractors routinely monitor their performance to ensure that their activities meet the requirements of the permits and licences that have been issued for their construction activities and operations.

Two environmental milestones were achieved in 2004 at the Molikpaq platform. The producing operation underwent two surveillance audits in 2004 and maintained the ISO14001 certifi cation of its Environmental Management System that it achieved in 2003. The platform also met SEIC’s fl aring target in 2004. Total hydrocarbons fl ared in 2004 were 12.7 million standard cubic feet per day, below the internal SEIC target of 13 million standard cubic feet per day.

SEIC also met its targets for oil spills from Molikpaq, with not a single spill over the HSE Plan defi ned size of 50 litres and indeed no recordable spills during operations, despite producing more than 11 million barrels of oil.

In September, SEIC’s emergency response team was fi rst on the scene for the successful cleanup of combined fuel oil and diesel near Kholmsk port when a contractor-owned dredger was blown aground during a typhoon.

1 Piltun Bay.

2 March in Sakhalin.

3 Sea birds.

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SecurityThe security priorities defi ned in the 2004 HSES Plan were to ensure staff and families had a safe and secure environment, protect SEIC assets from theft and damage, review and improve security measures across the whole operation and investigate incidents in conjunction with the Russian authorities.

Two security reviews were conducted in 2004. The fi rst was an assessment of the security threats on Sakhalin and in the Russian far east which was requested by the lenders. The second was a standard security review conducted by the security team. These reviews involved site visits to the main onshore and offshore assets, and to a number of pipeline construction sites and associated camps.

With the exception of a fatal knife attack in one of the contractor construction camps arising from alcohol related violence, these reviews found that there were no major security issues in 2004. The very regrettable fi ght incident was thoroughly analysed and several improvement activities undertaken. However, most of the security incidents reported were, as would be expected on such a project, theft of equipment from company sites and employee accommodations, verbal and physical threats to employees and other street related crime.

A further success in the year was SEIC achieving compliance with the International Ship and Port Security (ISPS) Code, which came into effect in July with Russia as one of the signatories.

SocialSakhalin Energy strives to achieve excellence in social performance, both in the way that the Company and its contractors work and engage with local communities, and in the broader sense of having a positive impact on society, through Project benefi ts and social investment initiatives.

Sakhalin Energy has worked hard to ensure that its social management processes meets international best practice and seeks to be a leader in this area. The Company is committed to a broad range of ongoing public consultations and social assessments during construction and has already devoted substantial resources to support this effort.

In 2004, Sakhalin Energy continued to conduct social impact monitoring and extensive public consultation programmes in the communities directly and indirectly affected by the Sakhalin II Project. Under these programmes, more than 50 communities were visited in April, June, November and December 2004, to update them on the Sakhalin II Project and to obtain feedback from them.

Most of this consultation work was performed by Sakhalin Energy’s Community Liaison Offi cers (CLOs). Their key responsibilities include meetings with local stakeholders and residents, distribution of information on Project status and addressing community concerns and grievances in line with the company’s grievance procedure. In addition, the CLOs provide information on job opportunities with the Sakhalin II Project. By the end of 2004 more than 1000 local residents had been provided with Project-related information and 1300 residents had been consulted on job opportunities within the Project. Assistance was also given on resumé development.

In addition to the Company’s on-going CLO activity, Sakhalin Energy is also involved in supporting the people of Sakhalin through partnerships and sponsorships. In 2004, Sakhalin Energy donated $400,000 to support projects that contribute to the environmental, economic and social development of the Island.

1 SEIC donation of sewing machines to Nysh school.

2 SEIC English language training partnership project.

3 SEIC school road safety presentation.

48 Sakhalin Energy

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