A N N U A L R E V I E W

05

Sakhalin EnergyThe New Energy Source for The Asia Pacific

Sakhalin Energy Investment Company Limited (Sakhalin Energy) was formed in 1994 to develop the Sakhalin II Project under a Production Sharing Agreement (PSA) executed with the Russian Federation and the Sakhalin Oblast Administration (collectively the “Russian Party”).

Our organisation is a unique partnership, which draws upon global oil and LNG (liquefied natural gas) expertise and experience. Our shareholders are Shell Sakhalin Holdings B.V. (Shell), which has a 55 percent share in the Project, Mitsui Sakhalin Holdings B.V. (Mitsui) with a 25 percent share and Diamond Gas Sakhalin, a Mitsubishi company, with a 20 percent share.

Shell is a global leader in developing LNG projects, having had experience of developing seven such projects around the world. Both Mitsui and Mitsubishi are leading Japanese trading houses. Mitsui is currently participating in ventures that are supplying 18.6 million tonnes of LNG to Japan annually, and is active in energy related development throughout the CIS countries (Commonwealth of Independent States). Mitsubishi now handles more than 50 percent of LNG imported to Japan through eight projects in six countries, whose total annual contract volume reaches 38 million tonnes of LNG.

Sakhalin Energy’s corporate headquarters are in Yuzhno-Sakhalinsk, Russia. It has a representative office in Moscow and a wholly owned LNG marketing services subsidiary in the Netherlands. Currently there are also project teams working in more than five countries around the world.

S A K H A L I N E N E R G Y – W H O W E A R E

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MESSAGE FROM THE CHIEF EXECUTIVE OFFICER 2

THE YEAR AT A GLANCE 4

PHASE 1 6

Celebrating Seven Years of Production 7

PHASE 2 8

Offshore Platforms: Concrete Gravity Base Structures (CGBS) and Topsides 9

Onshore Processing Facility (OPF) 11

Onshore and Offshore Pipeline Projects 13

Liquefied Natural Gas (LNG) Plant and Oil Export Terminal (OET) 14

Infrastructure Projects and Logistics 16

THE MARKETS 18

MEETING THE CHALLENGE 20

Russian Content 20

Community Dialogue 22

Pipeline River Crossings 26

Western Gray Whales 29

Oil Spill Response 31

Dredging in Aniva Bay 32

Seismic and Geohazards 34

HEALTH, SAFETY, ENVIRONMENT, SECURITY IN 2005 36

SOCIAL 40

DATA 2004 – 2005 42

2005 IN A GLANCE IN PHOTOS 43

C O N T E N T S

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2005 was a year of real contrasts for us. We achieved good progress on several fronts and completed many milestones yet we also faced the challenges associated with the Phase 2 development’s revised cost and schedule.

In July 2005, we announced a revised cost estimate for Phase 2 of the order of $20 billion for the full project to 2014. We also announced that the first LNG deliveries to customers would not be until summer 2008. These cost and schedule revisions were, and still remain, our best estimate but we continue to pursue aggressively cost and schedule improvements within the bounds of safety and environmental commitments.

Cost and schedule revisions not withstanding, 2005 was a year of remarkable achievements for this very challenging frontier project. The demand for crude remained strong, and a major milestone was achieved in summer 2005 when

the 100th oil cargo was loaded from the Vityaz production complex. This memorable achievement is a great tribute to the Phase 1 team, including the shipping and marketing support groups, who have been

safely and successfully producing and exporting Vityaz Crude for the past seven years.

On the LNG front, customers continued to demonstrate confidence in Sakhalin II LNG supplies. Excellent progress was made and three new contracts were signed for an additional 3.3 million tonnes per annum. As a result of these agreements we have now pre-sold over 75 percent of our LNG capacity under long-term contracts and, with increased LNG demand in the Asia Pacific, we have confidence that we will be able to pre-sell the remainder.

By the end of 2005, construction was more than 60 percent complete on the Phase 2 Project with significant milestones achieved at the LNG plant, at the onshore processing facility, on pipeline construction and, most notably, offshore, where we successfully installed Russia’s first concrete gravity based structures.

We are proud of the level of Russian involvement throughout our activities, and of how Russian industry has risen to the challenges of the Sakhalin II development. The construction of the Phase 2 facilities, and indeed their future, will continue to require the extensive utilisation of Russian industry, labour and materials. We plan to build upon our work with the Oblast and local businesses to further develop the capability of Russian companies.

M E S S A G E F R O M T H E C H I E F E X E C U T I V E O F F I C E R

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We will also step up our efforts to train Russian nationals in the specialist skills required by this industry to help the local community continue to make the most of the opportunities presented by such developments.

Ensuring safety at work is the top priority of Sakhalin Energy. I deeply regret that five people lost their lives in work related activities in 2005. Improving our safety performance therefore remains a key commitment as we move into 2006.

Internally, we will continue to run aggressive safety campaigns to instil an ever-vigilant safety culture amongst our employees and contractor staff, particularly at supervisor level. Externally, we remain focused on improving road safety and we look forward to continuing to work closely with the Sakhalin Road Safety Partnership. As part of this partnership, I am pleased to report the launch of the Sakhalin Island Seatbelt Campaign supported by Sakhalin Energy and implemented by the GIBDD (local traffic police) in November 2005.

In December 2005, Sakhalin Energy welcomed the European Bank for Reconstruction and Development’s (EBRD) announcement that the Sakhalin II Phase 2 Project’s approach to environmental and social issues management was fit for the purpose of consultation.

This announcement followed a very thorough assessment by EBRD and provided an independent endorsement of the rigorous standards and commitments adopted by the company.

Moving into 2006, we look forward to continuing to benefit from the independent perspective provided by our potential lenders. We also welcome the opportunity to continue discussions with stakeholders, both during the 120-day period of public disclosure and consultation initiated by the EBRD, and in the months and years beyond.

We are engaged in an exciting venture to provide vital oil and gas infrastructure on Sakhalin Island, to support its development as a leading energy source in the region and broaden the diversity of supply to our customers. We are committed to deliver this Project in a manner that we, our shareholders, the people of Sakhalin and the Russian Nation can be justly proud of.

Ian Craig

Chief Executive Officer

Left: the LUN-A CGBS being installed at the Lunskoye field.

Below (from left to right): the LNG/OET construction site; the Molikpaq platform surrounded by ice;

Environmental Officer checking erosion protection at Pilenga river crossing spread 1C, September

2005; the launch of the Sakhalin Energy Seat Belt Campaign, November 2005.

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An overview of the Project, financial, social and environmental activities in 2005.

LOSS OF LIFESadly five of our contractors’staff lost their lives at work during 2005.

IMPROVING SAFETYSakhalin Energy initiated the formation of the Sakhalin Road Safety Partnership (SRSP), to develop and implement projects which aim to reduce deaths and injuries from road traffic accidents on Sakhalin.

PROJECT COST AND SCHEDULE UPDATEFollowing a detailed review, Sakhalin Energy announced that the Sakhalin II Phase 2 Project costs are anticipated to be in the order of $20 billion to 2014 and that the first Liquefied Natural Gas (LNG) deliveries to customers are now scheduled for summer 2008 and year-round oil production is planned for late 2007.

ORGANISATIONAL CHANGESIn defining the optimum Company structure, the number of executive members on the Board of Directors was expanded and a transition plan was established to set out the key organisational changes required as the Company moves into Phase 2 operations.

PHASE 1 MILESTONESIn June 2005, the 100th oil cargo was loaded from the Vityaz production complex and production exceeded the target for the year.

PHASE 2 CONSTRUCTION PROGRESSBy end 2005, the Project was more than 60 percent complete on construction. In addition to the tow out and installation of the LUN-A and PA-B Concrete Gravity Based Structures, the offshore pipeline route was finalised and almost 1000 kilometres of onshore pipelines were welded. The Tanker Loading Unit Piled Substructure was installed in Aniva Bay and good progress was made at the Onshore Processing Facility, the Liquefied Natural Gas Plant, the topsides facilities in Korea and the Molikpaq Tie-In modules in Abu Dhabi.

T H E Y E A R A T A G L A N C E

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LNG SALESApproximately 75 percent of the capacity of our two LNG trains has been presold, including an agreement to sell the first Russian gas to KOGAS in Korea.

RUSSIAN CONTENTRussian companies received about $1 billion worth of new contracts for project-related work in 2005, which constitutes 87percent of the total amount of all new contracts awarded in 2005.

In 2005 Sakhalin Energy employed 267 Russian specialists. In 2005, Phase 2 employed approximately 17,000 people, the majority of whom (70 percent) are Russians.

ENVIRONMENTAL PERFORMANCEIn March 2005, based on the reports of the independent scientific review panel of the World Conservation Union (IUCN), Sakhalin Energy made a decision to reroute offshore pipelines to help protect the endangered Western Gray whale.

Sakhalin Energy made a commitment to support the establishment of a long-term Western Gray Whale Advisory Panel (WGWAP).

Sakhalin Energy signed an agreement with the Sakhalin Oblast and other partners in the oil and gas industry to integrate our efforts and resources to respond to emergencies associated with the production, offloading and transportation of hydrocarbons.

An enhanced 2005/2006 Winter River Crossing Strategy was introduced which included independent observers on all sensitive river crossings. Observers’ reports are publicly available on the Company website.

Gas flaring from the Phase 1 Vityaz complex was reduced by 65 percent. Vityaz continued to maintain its exemplary spill record in 2005, spilling only 3.082 litres of oil. Less than one tenth of a litre was spilled from the Molikpaq in 2005.

The European Bank for Reconstruction and Development (EBRD), a prospective lender, considering part financing the Sakhalin II Phase 2 Project, announced that the Sakhalin II Phase 2 Project’s approach to environmental and social issues management is fit for the purpose of consultation.

S R S P

Left: the PA-B CGBS installed at the Piltun-Astokhskoye field.

Below (from left to right): Tanker Loading Unit (Piled Substructure) in Aniva Bay, November, 2005;

Spread 1C, independent monitors checking quality of water after winter river crossing at Slavka river,

January 2006; Sakhalin Road Safety Partnership implemented by Sakhalin Energy together with

the Local Traffic Police and the Church; Western Grey Whales acoustic research work.

Left: Sakhalin Road Safety Partnership logo.

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P H A S E 1

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CELEBRATING SEVEN YEARS OF PRODUCTION2005 was an excellent production year for the Vityaz production complex. Despite a late production start due to sea ice, the oil production for the season was 12.1 million barrels of crude, exceeding the production target for the year. This was due to excellent reservoir and plant performance. 2005 was the seventh year of production for the Vityaz production complex and cumulative production from the field now exceeds 70 million barrels.

On 30 June 2005, the Sakhalin Energy Phase 1 team reached a major milestone with the loading of the 100th oil cargo from the Complex. The cargo of approximately 680,000 barrels was loaded onto an export tanker for delivery to Japan. This production milestone was passed whilst maintaining the highest safety and environmental standards – the Vityaz complex has an oil spill record second to none for this type of operation. This milestone is a great tribute to the effort and professionalism of the operations, shipping and marketing teams.

The Pressure Maintenance Project (PMP), which started operations in March 2004, has proved successful in maintaining and raising oil production levels. The PMP facilities are designed to treat seawater and inject it into the reservoir thus raising reservoir pressure and ultimate oil recovery. Drilling of the water injection wells continued throughout the first half of 2005 on the Molikpaq platform while all the drilling cuttings and used oil-based drilling mud was re-injected into a dedicated cuttings-re-injection well. Following completion of the fourth and final water injection well in April 2005 (thus completing the PMP project and enabling effective pressure support of the Astokh reservoir), water injection rates were ramped up to 110,000 barrels of water per day by mid-year, raising cumulative oil production levels to 12.1 million barrels of crude oil in 2005 as compared to 11.7 million barrels in 2004.

In keeping with the Company’s principle of minimising the Project’s impact on the environment, gas flaring on the Complex in 2005 was reduced by 65 percent due to improvements in availability and reliability of gas re-injection compression.

Construction work on the Molikpaq Tie-In (MTI) project continued throughout 2005. This project will enable year-round oil and gas production and export from the Molikpaq. Heavy lifts were carried out in mid 2005 to install support frames for the two modules, which will be installed in mid 2006. The modules are currently being constructed in Abu Dhabi. The pipeline risers were also installed from the Molikpaq topsides to the seabed.

Left: the Molikpaq platform.

Below (left to right): the Molikpaq platf�

Left: the Vityaz production complex.

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P H A S E 2

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OFFSHORE PLATFORMS: CONCRETE GRAVITY BASE STRUCTURES (CGBS) AND TOPSIDESConcrete Gravity Base Structures (CGBS)2005 marked the successful completion of one of the biggest challenges in implementing the Phase 2 scope - the successful construction, tow-out and installation of the LUN-A and PA-B CGBS. The two CGBSs will act as the base for the topsides facilities that will be installed atop these impressive structures to form the LUN-A and PA-B platforms. Together with the existing Molikpaq platform these two new platforms will lie at the very heart of the Sakhalin II Project, providing the oil and gas for the Project’s downstream facilities.

Following completion of the main concrete works on the CGBS at the end of 2004 by Norwegian GBS specialist Aker Kvaerner Technology AS and Finnish Company Quattro Gemini OY, mechanical fit out was undertaken in early 2005 to allow both structures to be completed and floated out of the Vostochny dry dock from the Russian mainland to their respective fields.

In a near perfect operation, the LUN-A CGBS was towed out of Vostochny Port on 14 June 2005 and after final checks, started the 1765 kilometre journey to the Lunskoye Field. After the successful tow it was ballasted down on the sea floor on 4 July 2005.

A few weeks later in a repeat of the process described above, the PA-B CGBS commenced its journey from Vostochny Port to Piltun – Astokhskoye field and on the 1 August 2005, the structure was placed within 0.7 metres of target and within 0.1 degree of target orientation on the seabed.

These two significant project milestones were not just a great achievement for Sakhalin Energy, they were also a great victory for Russian industry. Russian manhours used during the construction add up to almost 6 million – and account for more than 80 percent of the overall labour used to build the LUN-A and PA-B CGBS. Russian subcontractors carried out work at all stages of construction. In addition 97 percent of the total volume of materials used to build both CGBS were purchased in Russia.

TopsidesThe LUN-A and PA-B platform topsides are under construction at the Samsung Heavy Industries construction yard on Geoje Island in Korea. By the end of 2005, progress on the 22,000 tonne Lunskoye topsides reached 94.5 percent. All steelwork had been erected and nearly all of the pipework had been installed and tested. All electrical installation and testing had been completed and pre-commissioning and commissioning works were in progress.

Fabrication on the 28,500 tonne PA-B topsides started in February 2004 and by the end of 2005 the decks, drilling module, derrick and accommodation had been erected. The helideck and flare boom were installed in November 2005 and 90 percent of the pipe-spools had been completed, with hydro testing approaching 30 percent complete. Pre-commissioning is planned to commence in February 2006.

Left: welding works on the topsides construction, at the Samsung Heavy Industries shipyard, South Korea.

Below (left to right): the LUN-A CGBS under tow-out from the construction site in Nakhodka, Russian Far East; the LUN-A Topsides under construction at the Samsung

He�

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P H A S E 2

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ONSHORE PROCESSING FACILITY (OPF) Overall design and procurement progress on the OPF was virtually complete by the end of 2005. Construction work continued with the construction of concrete and steel buildings, tanks, pipe racks, installation of major equipment items, installation of pre-fabricated piping spools, pulling and terminating of electrical and instrumentation cable, and miscellaneous civil works including fencing and lighting.

A significant milestone for the OPF in September 2005, after a similar exercise in 2004, was the second beach landing campaign, which culminated in the successful delivery of heavy and large equipment to the site (including pressure vessels and stand-by generators), which due to their size and weight, could not be transported over land.

Overall construction at the OPF was approximately 80 percent complete by the end of 2005. Multi-discipline construction, including electrical and instrumentation works will continue through 2006.

During 2005 the OPF commissioning team and the first operations staff moved to the OPF site, in the Nogliki district of the Island.

Left: the OPF construction site at night, September 2005.

Below (left to right): construction work at the OPF construction site, August 2005; aerial view of the OPF

construction site, July 2005; work continues at the OPF construction site even in harsh conditions,

December 2005.

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P H A S E 2

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ONSHORE AND OFFSHORE PIPELINE PROJECTSGeneralThe year 2005 was again one of intense activity on the Sakhalin II Phase 2 onshore and offshore pipelines, as demonstrated by the 23 million man-hours dedicated to this part of the project and some 40 million kilometres driven by pipeline project vehicles on Sakhalin Island. During 2005 significant construction progress was achieved onshore and offshore, supported by the timely manufacture and delivery of large quantities of line pipe and substantial completion of supporting engineering, design and approval activities.

In 2005 a decision was reached on re-routing the offshore pipelines between the Piltun platforms and the shore to minimise impact on the Western Gray whales, with a resulting re-route of the associated northern onshore pipelines. Local and federal approvals were successfully obtained against a tight schedule to permit onshore construction in the Chaivo area during the 2005/2006 winter season, which avoided impact on protected bird species, and also offshore construction during the 2006 ice-free summer season.

Line pipeLine pipe supply was largely completed at the end of 2005. The joint venture between Russian company OOO Transpromresurs and Metal One from Japan completed their line pipe coating in the specially built pipe coating plant in Vostochny during 2005, as planned. Total supply for onshore and offshore line pipe involves some 530,000 tonnes of steel. At the end of 2005 some 480,000 tonnes of onshore line pipe (1650 kilometres) and some 46,500 tonnes of offshore line pipe (275 kilometres) had been manufactured. In total, approximately 1500 kilometres of onshore line pipe was on Sakhalin, either installed or stored, by year-end.

Offshore PipelinesThe engineering, procurement and construction contract for the offshore pipeline system is being carried out by Saipem, with dredging and backfilling subcontracted to Jan de Nul. During 2005 dredging, surveying, installation and backfilling activities were completed for the offshore pipelines and cables in the Lunskoye field and in Aniva Bay. In addition the two PA-A riser sections were installed during 2005 and many small scopes of work were carried out on behalf of the offshore platforms team.

Onshore PipelinesThe engineering, procurement and construction contract for the onshore pipeline system is being executed by Starstroi, with nearly all engineering and construction work subcontracted to Russian companies. In 2005 core design and engineering were substantially completed, and procurement progressed, with first units delivered to Sakhalin. Construction progressed and a total of 1021 kilometres of mainline welding completed (out of a scope of 1575 kilometres).

Good progress was made on the design and engineering for seismic fault crossings along the pipeline route, and for landslide crossings in the Makarov Mountains.

The 2005/2006 winter river crossing programme made an excellent start with good quality execution confirmed by independent observers. From 1 December 2005 an intensive programme of winter river crossings started at environmentally sensitive rivers, supported by a River Crossings Strategy that was declared fit for purpose of consultation, by one of the Project’s prospective lenders, the European Bank for Reconstruction and Development (EBRD) in December 2005. Some 125 individual pipeline river crossings had been completed by end 2005, including those done in the prior winter season, out of a total of 388 (across 179 rivers). The total number of water courses to be crossed by the pipeline along the 800 kms length of right of way (ROW) is approximately 1100.

Left: the pipeline route, aerial view, July 2005.

Below (left to right): preparation for a winter river crossing, December 2005; offshore pipe-laying: Welders on-board the Semac vessel, July 2005;

48 inch gas �

seabed, July 2005; offshore pipe-laying: welded pipe is lowered to the seabed in the Lunskoye area, July 2005.

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LIQUEFIED NATURAL GAS (LNG) PLANT AND OIL EXPORT TERMINAL (OET) By the end of 2005, overall project progress at the LNG site was 82 percent complete, ending the year slightly ahead of schedule.

As construction work intensified, 7000 people were employed on site during the peak periods of 2005 and over 5000 were living in the construction camp. Almost 60 percent of those working on the site were Russian nationals and over 1000 were employed from the local town of Korsakov.

Operations at the Material Offloading Facility (MOF) started in early 2005, facilitating numerous plant and equipment deliveries direct to the site.

On 26 May 2005, the largest onshore lift at the site occurred when the 600 tonne sulfinol absorber was brought to the Island by the vessel ‘Happy Ranger’. It was offloaded via the MOF then transported to its location on site and installed on LNG train one. After a five-hour installation process, the sulfinol absorber now stands at an impressive 50 metres in height and six metres in diameter.

Dredging activities in Aniva Bay for the LNG jetty turning circle and caisson sockets were successfully completed in December 2005.

Construction progressed well at the LNG site particularly over the summer months. At the LNG jetty, a total of 14 out of 25 caissons, as well as two out of the 10 jetty trestles were installed. Construction of the piperack/track foundations within the OET, utilities area and LNG train one were essentially complete by year-end. Over 10,000 tonnes of structural steel were erected on LNG trains one and two in 2005. Key equipment on both LNG processing trains was installed: including sulfinol absorbers and air fin coolers. Equipment such as the main cryogenic heat exchangers, and pre-mixed refrigerant compressors were installed on LNG train one, while installation of the static equipment commenced on train two with the installation of the sulfinol columns and the compressor suction drums.

During the spring and summer, the roofs of both LNG tanks were raised using air pressure and then welded into position. The roofs weighed 640 tonnes each and the operation to raise them, to the top of the LNG tanks in which they had been constructed, took approximately two hours.

P H A S E 2

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This was the first time that this operation had ever been performed in Russia. The first of the inner tank plates was welded in July, and by the end of 2005 the eighth ring was being welded in the first tank and fifth ring in the second tank. Concreting of the outside walls of the LNG tanks was completed.

In mid October, a milestone 100,000 cubic metres of concrete was supplied from the TOA Corporation batching plant on site. This concrete was used primarily for the foundations for both trains and other parts of the production area, plus the bases of the OET tanks. The crude oil tanks, constructed by Koksokhimmontazh, a Russian Company, were nearing mechanical completion by the end of 2005 and hydrotesting - which involved filling the tanks with water to check for leaks, structural integrity and the stability of the foundations – had been successfully completed.

Marking yet another milestone achievement in the Phase 2 Project in 2005, the Piled Substructure (PSS) for the Tanker Loading Unit (TLU) was successfully installed in Aniva Bay, 4.5 kilometres offshore from the OET.

In 2005, the Sakhalin LNG construction site opened its doors to visitors keen to see Russia’s first LNG plant. From January to November 2005, the site hosted over 120 visits and more than 1800 people.

OPERATIONS READINESS The Operations Readiness and Assurance team continued efforts aimed at a flawless start-up and operation of all future assets. Key activities included building and populating document maps for assets and supporting functional organisations, development of operating and maintenance philosophies, manuals and procedures; development of the organisational establishment design, recruitment and training of operating personnel.

The first groups of Sakhalin Energy apprentices began familiarisation with the newly constructed assets.

Operability checks of new assets have been done and design changes were initiated where necessary. Operations support contract strategies were also developed in 2005.

Left: Hot section of the second LNG train.

Below (left to right): the LNG construction site, panoramic view; the LNG construction site,

HSE Officer, on top of process Train 1, September 2005; the LNG construction site, general view

towards flare knockout drums and LNG tank.

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INFRASTRUCTURE PROJECTS AND LOGISTICS HospitalsIn 2005 Sakhalin Energy commissioned upgrades in three hospitals – the Nogliki Polyclinic, the Poronaisk District Hospital and the Oblast Hospital in Yuzhno-Sakhalinsk to allow for the provision of unimpeded and improved emergency healthcare services.

Six new, fully equipped ambulances were also provided to district hospitals by Sakhalin Energy in 2005 – Nogliki, Poronaisk, Kholmsk, Korsakov, Dolinsk and the Oblast Hospital in Yuzhno-Sakhalinsk.

Together these health projects provided significant improvement in the conditions for medical staff and patients alike, and have improved the quality of medical care for the residents of Sakhalin.

Roads and BridgesIn 2005 Sakhalin Energy in conjunction with Sakhavtodor asphalted about 12 kilometres of roads in the communities of Tikhaya, Grebenskaya, Tumanovo, Leonidovo, Matrosovo, Palevo and Novoye. Local construction companies Pereval and Temp-Sakhalin Vostokdorstroi carried out this work. Extensive

repairs to road sections were done in the Makarov, Smirnykh, Tymovsk, and Poronaisk districts, and Sakhalin Energy together with Exxon Neftegaz Limited financed asphalt works in Val.

Under the Addendum to the Protocol of Mutual Obligations signed by Sakhalin Energy and the Oblast Administration in July 2005, Sakhalin Energy also asphalted the Makarov road and reconstructed the Lesnaya bridge (Porechye). The cost of the Lesnaya bridge construction will be shared with the Oblast Administration.

Road repair works were also undertaken in Korsakov, including asphalt repairs of the main streets and storm-drain system.

LandfillsThree upgraded landfills, fitted with a twin layer of geomembrane to prevent contamination of subsurface waters, began operations in Korsakov, Smirnykh and Nogliki in 2005. These landfills are accepting waste from each of the respective communities, as well as Sakhalin Energy’s contractors and subcontractors. As part of the upgrade works at these landfills, Sakhalin Energy has committed to supporting the expenses of the landfill operators for the next three years until these companies become mature enough to run by themselves.

P H A S E 2

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Kholmsk PortIn 2005 Sakhalin Energy continued to make further upgrades to the Sakhalin Western Sea Port in Kholmsk to permit the receipt of Phase 2 construction materials, including line pipe, equipment and cargo. By year-end, 144 pipeline vessels had delivered 360,767 tonnes of project oil and gas linepipes, as well as 842 train wagons.

The 2000 square metres warehouse was additionally fitted with motorized racking and small parts storage systems, and refurbished to include new concrete flooring, painting and installation of a heating and ventilation system. Repairs to the Sadovnicki warehouse were completed to allow storage of surplus materials. In addition to the upgrades, a 1600 square metres warehouse was constructed to accommodate a chemical mixing plant. The warehouse upgrade project included the hire of local people as storekeepers and security personnel.

Sakhalin Energy and Exxon Neftegaz Limited started sharing the port in 1 July 2005.

AviationIn 2005 the operational certification for a Russian designed and developed helicopter system of mechanical Health and Usage-Monitoring (HUMS) was received. HUMS, which will be installed in each of the helicopters used by Sakhalin Energy, represents the first time such a system has been used operationally within Russian aviation. The HUMS diagnostic system has the ability to identify potential defects, present early warning of possible failures and provide information to reduce flight vibration levels, all of which will improve the safety of flights and contribute to overall, long-term, maintenance cost savings.

Marine OperationsIn May 2005 Sakhalin Energy awarded the contract for port operations in Prigorodnoye to OOO Svitzer Sakhalin Company. Sakhalin Energy will charter four new-built ice-class harbour tugs and two new-built line boats. The first two tugs and one line boat will be delivered at the end of 2006 while the second two tugs and a line boat will be delivered at the end of 2007. The tugs and the line boats will be operated and maintained by Russian-only crews for 15 years.

To serve the offshore platforms, three platform supply vessel (PSV) hulls are being built in Romania. The first PSV was towed out on 27 September 2005 from Romania to Norway where she is being fitted out.

The PSVs are 91.5 metres long, 19 metres wide with deadweight of 3250 tonnes. They are being constructed for PRISCO-SWIRE who will operate them.

Unexploded OrdnanceSakhalin Energy funds the work for clearance of the Company’s construction sites. This work includes the destruction or removal of unexploded ordnance (UXO), demolition or removal of military chemicals and the disinterment and reburial of war dead (Russian and Japanese).

All work follows Russian Federation legislation and is done in conjunction with the Military Commissariat and respective districts’ administration. By the end of 2005 more than 4500 live UXO had been safely de-commissioned and 29,750 litres of chemicals had been removed. The search for war dead discovered 41 Russian soldiers - who were buried with full military honours - and 33 Japanese soldiers - who were cremated with appropriate ceremony, and their ashes returned to Japan.

Telecommunications ProjectTo connect all of the Company’s facilities for safety and operational purposes, the main telecom contractor, SK-S Telcom, began installation of the 850 kilometre fibre optic cable in 2005. They have also supplied two emergency response vehicles, which will be the first line of response deployed to incidents that occur along the 800 kilometre onshore pipeline route.

Left: Sakhalin Energy contracting company Aviashelf provides helicopter services for the Company.

Below (left �

presented to district hospitals; helicopter, equipped with HUMS diagnostic system.

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LNG SalesThe secured LNG sales commitments at the end of 2005 continued to highlight the diverse customer demand for Sakhalin LNG, with long-term sales contracts secured with customers in Japan, Korea and North America.

By the end of 2005 LNG sales commitments accounted for over 75 percent of the 9.6 million tonnes per annum LNG capacity which will be produced by the two Sakhalin Energy LNG trains, and negotiations are ongoing to sell the remaining volume with other buyers.

Key deals were secured during the summer of 2005 with Japan remaining as Sakhalin Energy’s core market. On 30 May 2005 Sakhalin Energy signed a Heads of Agreement (HOA) for the long-term sales and purchase of up to 0.2mtpa of LNG for 20 years to Hiroshima Gas Company. The deal with Hiroshima Gas is the fifth agreement signed with a utility company in Japan. This deal represents the first involving the use of a small LNG vessel, and indicates the flexibility that can be offered at the Sakhalin LNG plant marine loading facilities.

In June 2005, Sakhalin Energy signed a binding HOA with Tohoku Electric to supply 0.4 mtpa of LNG commencing in 2010 for a period of 20 years, and signed a Sales and Purchase Agreement (SPA) for 0.5 million mtpa of LNG to supply to Toho Gas Co Ltd, also in June, for 24 years from 2009. This was the fourth full SPA to be signed between Sakhalin Energy and a major utility company in Japan, and follows an earlier HOA that was signed in March 2004 for 0.3 mtpa. As part of the full SPA, Toho Gas has also decided to take an additional 0.2 mtpa.

After winning a tender in February 2005, Sakhalin Energy completed negotiations and on 15 July 2005 signed a SPA with Korea Gas Corporation (KOGAS) for supply of 1.5 million tonnes per annum from 2008 for a period of 20 years. This SPA was KOGAS’ first long-term commitment in seven and a half years.

Significant progress at end-2005 was made towards additional sales in Japan and North America which are expected to be signed off during 2006.

T H E M A R K E T S

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These deals demonstrate strong customer confidence in Sakhalin LNG supplies, and enhance the strategic role that the Sakhalin II Project continues to play in Japan and the wider Asia Pacific region.

Vityaz Crude Oil Sales Sakhalin Energy’s seventh crude oil production season started on 10 June 2005. On 30 June 2005 Sakhalin Energy reached a major milestone with the loading of the 100th oil cargo from the Vityaz production complex.

Japanese buyers remain the prime customers of Vityaz Crude, taking the majority of production. In 2005, following a good outcome of a trial cargo in 2004, Sakhalin Energy began regular supplies of Vityaz Crude to Japanese power generation companies.

The Company continues to focus on broadening its customer base. From the start of production in 1999, tankers have transported Sakhalin Vityaz crude oil to customers in Japan, Korea, China, the USA (including Alaska and Hawaii), Taiwan, Thailand and the Philippines.

Shipping PerformanceTo deliver LNG from the Sakhalin II LNG plant to customers, Sakhalin Energy awarded contracts to two Japanese-Russian shipbuilding consortia for the long-term charter of three new-build LNG ships in 2004, each capable of carrying 145,000 cubic metres of LNG. For JSC Sovcomflot and the Primorsk Shipping Company (PRISCO) this represents the first ever Russian involvement in LNG shipping, and both Russian companies will play a key role in the ownership and manning of these ships with Russian officers and crew.

Preparation for the construction of these three long-term charters progressed well in 2005. For the first two LNG ships to be built in the Mitsubishi Heavy Industries shipyard in Nagasaki, Japan, over half of the 400 design plans have been completed and approved. All major design issues have been resolved and the construction of cargo tanks begun. The plan approval process for the third LNG ship, to be built in the Mitsui Engineering & Shipbuilding shipyard in Chiba, Japan, also began.

On the crude shipping side, the export tanker “Primorye” provided reliable delivery to customers in the North Asian market, whilst balancing high utilisation to minimise freight costs and consistent service from the Vityaz complex.

Left: agreement Signing Ceremony with KOGAS in Moscow, 15 June 2005.

Below (left to right): Hiroshima Gas Signing Ceremony, 30 May 2005; KOGAS signing ceremony,

15 June 2005; Hiroshima Gas Signing Ceremony, 30 May 2005.

S A K H A L I N E N E R G Y T A N K E R

Above: Sakhalin Energy LNG tanker.

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RUSSIAN CONTENT The use of Russian industrial and human resources, referred to by Sakhalin Energy as ‘Russian Content’, is a key commitment of the Sakhalin II development. It is an important measure of the Project’s overall success, and remains a major benefit that the Sakhalin II development can bring to Sakhalin Island, and the Russian Federation, throughout the life of the Project.

In the Sakhalin II Production Sharing Agreement (PSA), Sakhalin Energy undertook the commitment to achieve a level of 70 percent Russian Content (including labour, materials, equipment and contract services) over the life of the entire Sakhalin II Project, subject to Russian enterprises meeting the price, quality and delivery timing requirements of the Project. We currently exceed the 70 percent Russian Content requirement in terms of man-hours of services and volumes of materials and equipment. Since 1996, over 100 million Russian man-hours of services were expended, representing some 72 percent of the total, and material and equipment supply exceeded 6.2 million tonnes, some 89 percent of the total by the end of 2005.

We also recognise the importance of maximising Russian Content performance in terms of value. Since construction activities commenced in 1996 on Phase 1, Russian contractors and subcontractors have won thousands of contracts worth up to a total of $6.1 billion.

To ensure sustained Russian Content development throughout the life of the Project, we developed, and began implementation of, a new strategy in the second half of 2005 which focuses on proactive, longer-term planning of contracting and procurement activities and early identification of opportunities for Russian Content development. In line with this new strategy, Sakhalin Energy prepared a five year Contracting and Procurement Activity Plan, identifying opportunities for using Russian industry, Russian vendor development and Sakhalin business development. The implementation of these programmes is planned to start in 2006.

In 2005, Sakhalin Energy continued to cooperate actively with the Russian Federation Government and Sakhalin Oblast Administration, to develop Russian Content through the auspices of the Joint Committee.

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The objective of this committee is to identify Russian businesses and industry that are capable of undertaking contracts for the Sakhalin II Project. The committee is also advised of all contract awards and ensures that the procurement procedures used by Sakhalin Energy have been applied in a fair, transparent and consistent manner.

In another effort to help stimulate local enterprise, we organised a visit in October 2005 by several Sakhalin businessmen to Aberdeen, Scotland, where the presence of foreign oil and gas industry has transformed the local area and business. The purpose of this trip was to demonstrate the range of supply and service infrastructure requirements associated with oil and gas development, and so highlight some of the associated business opportunities for local enterprise in Russia.

Apprenticeship ProgrammeAs part of Sakhalin Energy’s commitment to provide jobs for the local population, Sakhalin Energy 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 main focus of the apprenticeship programme is to meet the needs and requirements of all Sakhalin II operational areas providing asset specific training where possible. The programme provides maintenance and operations personnel with the required skills and knowledge, instils both Sakhalin Energy’s HSE policy and the required HSE components of the Russian Federation legislation, and promotes a spirit of both self development and development as a team member of Sakhalin Energy. The apprentices will go on to be fully employed by Sakhalin Energy at the end of the four-year apprenticeship period.

By the end of 2005, 11 trainees had successfully completed the training programme and an additional 80 persons were still involved in training.

The apprenticeship scheme is now delivering some very talented future employees. The Company plans to train some 200 technicians via this scheme. This solid professional foundation will provide an excellent starting point for future career development for many young Sakhaliners.

Left: the Onor construction camp, built by Russian sub-contracting companies.

Below (left to right): construction works at the CGBS construction site, Nakhodka, Russian Far East;

the pipe laying construction works, spread 2; the CGBS construction site in Nakhodka,

Russian Far East; LUN-A CGBS sailing away from port Vostochniy, Russian Far East.

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COMMUNITY DIALOGUE The Challenge of Engagement Sakhalin Energy considers regular engagement with the public and key stakeholders, as well as the public disclosure of relevant Project information, to be important for the successful development of the Sakhalin II Project.

The Company’s strategy for public consultation and the disclosure of information complies with the legal requirements of the Russian Federation for public consultation, as well as the International Finance Corporation (IFC) on the preparation of a Public Consultation and Disclosure Plan (PCDP).

Shaped by feedback, public consultation has evolved over the past 10 years during our work with Sakhalin communities and other interested parties. This will continue throughout the life of the Project.

Community Liaison Officers (CLOs) In order to build and maintain a basic understanding and good relationship with Sakhalin communities, and to provide a link between the community, our company and our contractors, Sakhalin Energy has established a network of Community Liaison Officers (CLOs).

Currently, during construction, this network of CLOs is working within the communities closest to where construction is going on.

In 2005, the CLOs continued to carry out regular community meetings with the public. Consultations with local communities directly and indirectly affected by the Sakhalin II Project were held in 13 settlements. The meetings gave more than 500 of the Island’s citizens an opportunity to ask questions and raise concerns with Sakhalin Energy, as well as receive a Project update containing news about Project benefits to the community, social initiatives, sustainable development projects, employment opportunities and local business development.

Public opinion surveys were conducted in 2005 to gain information for more effective stakeholder involvement with the communities. Surveys were conducted with almost 2500 residents from Korsakov and Ozersk, Nogliki, including Val and Nysh, Tymovsk, Kholmsk and Yuzhno-Sakhalinsk. The results of these surveys will help Sakhalin Energy to better understand, and address, the communities’ concerns.

The CLOs also conducted regular social impact monitoring in 2005 and provided information on the Project to more than 1500 people.

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In addition, they helped people with their curriculum vitaes, and responded to more than 1000 inquiries from residents seeking information on job opportunities within the Project.

Grievance ProcedureShould grievances emerge, Sakhalin Energy, is committed to addressing these in an appropriate manner in accordance with Russian Federation Law, international best practice and the Company’s internal Grievance Procedure.

The Grievance Procedure has been published widely with advice to the community on how it can lodge a complaint relating to Sakhalin II Project activities. This also applies to individuals who have been part of an involuntary resettlement programme to make way for the Project construction.

In 2005, the CLOs addressed more than 30 community grievances, of which 24 have been resolved and the balance are all in various stages of resolution. The majority of the problems involved traffic use and road damage issues, and employment and payment related grievances.

Korsakov The town of Korsakov lies on the northern edge of Aniva Bay in the far south of the Island, 15 kilometres west of the construction site of the Sakhalin II LNG plant.

Sakhalin Energy recognises that the proximity of our building work has both positive and negative impacts on the Korsakov community.

As far as possible, the Company works hard to minimise any negative impacts from our construction activity, and in addition to the regular community meetings and an ‘open door’ policy at the Korsakov CLO office, the Company supported special engagement initiatives in 2005 to address specific concerns.

One such concern, raised by some members of the community, was the potential impact to Aniva Bay caused by dredging and disposal work, related to the construction of the LNG Plant’s Material Offloading Facility and Jetty. To create transparency on our dredging activities in Aniva Bay, in November 2005 we took representatives from the local fishing industry and some marine environmentalists on a boat trip to the dredging and disposal area, to help them to understand our activities better. This visit helped reassure them that working together during the construction and operations phase was achievable.

The construction of the Sakhalin II LNG and oil export facilities also brings benefits to the district of Korsakov, including increased employment, business opportunities, tax income, and many infrastructure improvements.

Left: representatives of Sakhalin Energy and local fishing community on a boat trip to the

dredging area at Aniva Bay.

Below (left to right): Korsakov residents fishing at Aniva Bay; sunny day at Prigorodnoye, people

swimming in Aniva Bay; big catch in Aniva!

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INDIGENOUS PEOPLE

Sakhalin Energy has been implementing a support and consultation programme with Sakhalin’s Indigenous Peoples since 1994, which has developed to meet the requirements of World Bank Operational Directive 4.10, and the spirit and intent of World Bank Operational Directive 4.20 on Indigenous Peoples.

Up until early 2005 Sakhalin Energy had maintained a regular and effective dialogue with representatives of the Indigenous Peoples who were identified as being directly affected by the Company’s activities.

In January 2005 the Indigenous Peoples of Sakhalin held a protest aimed at the oil companies operating on Sakhalin Island. The protesters requested that the oil and gas operators conduct an ethnological expert review and establish a separate Indigenous Peoples’ development fund, which could be used towards the restoration of their traditional livelihoods, such as fishing and reindeer herding.

Sakhalin Energy made a conscious decision to step up our involvement to ensure that we were speaking to representatives of all Indigenous Peoples on the Island (around 3500 people in total) rather than just those who had been identified as being directly affected by our activities. This approach has been viewed favourably by the Indigenous People of Sakhalin.

Sakhalin Energy also took significant steps to respond to the Indigenous Peoples’ requests by inviting a World Bank expert on Indigenous Peoples’ issues to the Island in April, to support the development of a Sakhalin Indigenous Minorities Development Plan (SIMDP) - one in a series of such plans to be designed and implemented over the life of the Sakhalin II Project.

In addition to the World Bank expert, the Indigenous Peoples’ Council (set up in March 2005 to represent all Indigenous groups on the Island and their views), officials from the local government and the Sakhalin Oblast are also working with Sakhalin Energy in the development of the SIMDP. This three-way cooperation extends to the setting up of a SIMDP Working Group and two additional committees, one on social development programmes and another one on sustainable resource use, to ensure that the SIMDP meets World Bank standards.

Since April, through ongoing cooperation and constructive dialogue between Sakhalin Energy and the Indigenous Peoples’ Council on perceived impacts, mitigation measures and the direction of development activities, a draft of the SIMDP has been produced.

In the last week of 2005, both Sakhalin Energy and the Indigenous Peoples’ Council signed a non-binding Memorandum of Understanding that confirms the intention of both parties to complete the SIMDP by second quarter 2006. The five-year budget of the first SIMDP is $1.5 million.

Left: “Preservation and Development of Traditional Crafts” Workshop organised by Sakhalin Energy for Sakhalin Island Indigenous People, December 2005.

Belo� raditional Crafts” Workshop organised by Sakhalin

Energy for Sakhalin Island indigenous peop�

representatives and Indigenous People; Indigenous People traditional crafts.

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PIPELINE RIVER CROSSINGSThe onshore pipelines will cross more than 1000 watercourses. These mostly comprise small brooks and streams, but also include rivers with economically significant salmon fisheries and a small number of rivers that possibly contain Red Book (Sakhalin endangered) fish species. Sakhalin Energy recognises the importance of these watercourses to the ecology and local economy of the Island - particularly in terms of the salmon fisheries - 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 five years undertaking surveys to collect environmental baseline data 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 Scientific 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 apply assessments to each river or stream, to determine how and when a river is best crossed to minimise the ecological and soil impact. River crossing timing and construction methods for each river and stream is approved by the relevant Russian Federation regulatory agencies, including local fish inspectorates, the regional fishery regulatory agency, Sakhrybvod, and the Federal level agency, Tsuren. The river crossing strategy has also been reviewed by experts from potential lenders to the Project, and was approved as fit for purpose of consultation at the end of 2005.

During construction, trenching methods employed to cross a river can produce a short-term and localised increase in water turbidity (suspended silt particles), in the river. Although temporary in nature, this could potentially have an effect on fish 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, for example in the winter when the river is frozen, executing construction in low flow situations and, in a few cases, horizontally drilling under the river.

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Construction of pipeline crossings on rivers identified 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, thereby limiting physical disturbance to the river and virtually eliminating the impact of construction activities on these fish. Environmental monitoring is conducted to measure the actual impact. This monitoring includes suspended solids and turbidity readings during construction, as well as longer-term fish monitoring. In addition, teams of external and independent observers attend all the winter crossing pipeline installations. Their role is to assess if the construction of the crossings is done in compliance with the declared standards. Their reports are published on the Sakhalin Energy public website.

By the end of 2005, a total of 727 oil pipeline crossings, (of which 81 are on sensitive rivers) and 265 gas pipeline crossings (of which 44 are on sensitive rivers), were constructed.

It is planned to cross six of the most sensitive, larger rivers and the Chaivo lagoon with the use of Horizontal Directional Drilling (HDD), with the river Tym crossed twice. Pipelines will be drilled and installed underneath the river, without disturbing it. This method is not suitable for all rivers or ground conditions because of the sub-river bed geology. In 2005, the HDDs for the Val, Vazi and Nabil rivers were completed and work for the Tym (second crossing) and Firsovka rivers was almost finished.

In addition to stringent Company, Russian and international standards that are being applied to river crossings, Russian regulatory requirements also include a system of fish damage assessment and monetary compensation. This compensation is paid whether or not there is any actual damage and represents some of the most stringent regulations of their type anywhere in the world. The damage the onshore pipelines and other Sakhalin II Project facilities may cause to fish, has been calculated by Tsuren (the Central Department of Fishery Expertise and Development of Fishery Regulation, of the Russian Ministry of Agriculture), according to Russian legislation. This has resulted in an agreement of a sum of $11 million in compensation. This was paid into a special government fund and will be used to improve the fishing industry on the Island. Part of these funds will be used to establish two new fish hatcheries.

Left: completed winter river crossing.

Below (left to right): independent monitors checking quality of water after winter river crossing;

preparation works for a winter river crossing; snowy winter north Sakhalin.

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WESTERN GRAY WHALES Sakhalin Island’s North East coast is rich with marine life and is a summer feeding area for the critically endangered Western Gray whale. (WGW). Sakhalin Energy identified two WGW feeding grounds off the Northeast coast of Sakhalin; a near-shore one in the Piltun Bay area, and an offshore feeding ground further South adjacent to Chaivo Bay. These two feeding grounds have a total area of about 1570 square kilometres.

As an independent step, Sakhalin Energy asked the World Conservation Union (IUCN) to convene an independent scientific review panel (ISRP) to evaluate the science underlying the assessment of potential impacts on the whale and the effectiveness of the Company’s planned mitigation measures. The ISRP’s Report called for a conservative risk management approach. To reflect this, in March 2005 Sakhalin Energy decided to reroute offshore pipelines in its oil and gas development in the Russian Far East to help protect the Western Gray whale.

The pipelines - linking two production platforms in the Piltun-Astokhskoye field off Sakhalin Island to the shore - will be moved 20 kilometres south of the original location, away from the key feeding area of the critically endangered whales.

In 2005, we focused our efforts on minimising any potential impact on the WGW population from the installation of the concrete gravity base structure (CGBS) at the PA-B location. To meet this challenge, a sophisticated acoustic model was developed to predict the noise footprint in the feeding area, and to assess the impact on the WGW from the PA-B CGBS installation. To validate and verify the model predictions, the Pacific Oceanographic Institute of the Far Eastern Branch of the Russian Academy of Science conducted acoustic measurements of underwater noise produced by the LUN-A CGBS installation, an operation similar to the installation of PA-B but which took place a month earlier. The results of the tests were evaluated and we generated additional recommendations that further improved the noise reduction of the CGBS installation at PA-B.

Sakhalin Energy’s overall performance in minimising potential impacts on the WGW was also thoroughly monitored during the offshore construction season in 2005 by behavioural, distribution and abundance survey teams based onshore, on a vessel and in the air.

To minimise vessel collision risk to whales, Sakhalin Energy developed and implemented a set of measures that included the establishment of protection zones, navigational corridors, speed limits and the presence of patrolling Marine Mammal Observers (MMO) on vessels. These MMOs kept a continuous watch on the marine mammals to ensure compliance with the Company’s commitment to marine mammal protection.

As a follow up to the independent review process led by the IUCN that started in 2004, Sakhalin Energy set up a round of consultations with independent scientists to discuss and propose improvements to our monitoring and mitigation strategy. Based on these discussions, we adopted a revised real-time monitoring and mitigation strategy that was successfully implemented. No discernable impacts were observed on whale abundance, distribution and behaviour.

In September 2005, the Company’s representatives met independent scientists in Vancouver, Canada, to discuss the Company’s WGW conservation efforts. A decision was made to form the Western Gray Whale Advisory Panel (WGWAP) to create a framework for coordination and cooperation to assist the conservation and eventual recovery of the WGW population. Sakhalin Energy committed to provide all support necessary for WGWAP to be a fully functioning advisory body and to cooperate on WGW conservation.

Protection of the environment and endangered species like the WGW forms part of our overall commitment to sustainable development. We are determined to ensure that the Sakhalin II Project can be developed in line with international environmental standards, and the Company is committed to reducing potential impacts as far as is practical - not just to the WGW, but to the Island as a whole.

Left: Western Gray whales offshore Sakhalin Island.

Below (left to right): Sakhalin Energy researching Western Gray whales; Akademik Oparin research vessel – Western Gray whales acoustic studies; special equipment is put on the sea

bed to gather acoustic data on the Western Gray whales; Western Gray whales visual monitoring; Western Gray whales acoustic researchers collecting data from the sea bed.

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OIL SPILL RESPONSE Sakhalin Energy takes the issue of oil spills very 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 the prevention of oil spills. This is achieved through the robust design of production, export and transport facilities, and by ensuring sound maintenance and operating procedures.

Sakhalin Energy has a comprehensive Oil Spills Response (OSR) plan for operations under Phase 1, which has been approved by the Russian authorities. This covers the Molikpaq offshore platform and tanker loading facilities in the northeast of the Island. During the last two years, less than four litres of oil have been spilt from the Phase 1 offshore operations – a spill record that puts Sakhalin Energy amongst the top performers in the world.

As part of the Phase 2 development, Sakhalin Energy will start to operate all-year offshore oil and gas production, and our OSR plan must therefore contain appropriate measures to provide oil spill response both in the open sea and also in ice conditions. OSR plans for the Company’s Phase 2 facilities are under preparation and will be completed and approved by Russian authorities and put in place before these facilities commence production. Sakhalin Energy will deploy OSR equipment and resources at each asset, and at strategic locations along the onshore pipeline route. Helicopter drop-off points will be identified 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 will continue into 2006. These are aimed at identifying sensitive areas, developing site-specific response strategies and logistical information. Ground surveys in 2005 were supported by video aerial surveys and linked to Global Positioning Systems. The obtained

data is being added to the Sakhalin Energy Geographical Information Systems (GIS) database, and is used to prepare maps identifying environmentally sensitive areas. Maps have already been completed for the coastal and lagoon areas adjacent to the Phase 1 facilities along the northeast Sakhalin coast.

In 2004 and 2005 Sakhalin Energy reviewed OSR equipment specifications, and inspected Russian and overseas equipment to determine its quality and suitability for Sakhalin Energy’s light oil, and for the prevailing weather and sea conditions in Sakhalin. Sakhalin Energy will ensure that equipment is also 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.

In October 2005, Sakhalin Energy signed an agreement with the Sakhalin Oblast and other partners in the oil and gas industry to integrate our efforts and resources, to prevent and respond to emergencies associated with the production, offloading and transportation of hydrocarbons.

Through the signing of this agreement all signatories committed to working cooperatively to prevent emergencies, and to respond to emergencies, using available resources, technologies, personnel, scientific and administrative capabilities.

Sakhalin Energy has promoted, and will continue to promote, regional OSR cooperation and the development of response capabilities through workshops and training courses.

Left: aerial video surveys of the sensitive areas of Sakhalin Island for Oil Spill Response data.

Below (left to right): Sakhalin Energy signing agreem�

of the Oil Spill Response equipment.

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DREDGING IN ANIVA BAY The development of the LNG and OET in the south of Sakhalin Island involved the construction of two offshore structures in Aniva Bay, the Marine Offloading Facility (MOF) and the LNG Jetty. Construction of both facilities included the dredging and disposal of approximately 1.45 million cubic metres of seabed to allow for the safe berthing of cargo vessels and LNG vessels.

Although the dredging and disposal sites account for only 0.02 percent of the Aniva Bay area, Sakhalin Energy recognised that dredging and disposal operations could potentially impact the Aniva Bay marine environment, mainly through the increase in suspended solids in the water, and it introduced a number of mitigation measures to ensure that disturbance to the rich biodiversity, ecological processes and commercial resources of Aniva Bay was as low as possible.

Prior to construction, several environmental baseline surveys were carried out around Aniva from 1998 to 2001. These studies provided the basis for the identification of environmental sensitivities and environmental impacts associated with the Project. We also set up a programme in 2003 to monitor the environmental impacts before and after the dredging and disposal operations.

By the end of 2005, a total of 35 environmental monitoring reports had been generated. Studies were undertaken by the Russian scientific organizations, Sakhalin Research Institute of Fisheries and Oceanography (SakhNIRO) and the Sakhalin Hydro Meteorological Agency (Sakhhydromet).

One of the main challenges for dredging in the Aniva Bay area is the tight window imposed by environmental considerations. In 2005, as in previous years, dredging operations were discontinued during the ecologically sensitive period from May until the end of August, when salmon spawning and other important ecological processes take place. The challenge was increased by navigational restrictions during winter.

All dredging and disposal operations were targeted for completion in 2005. An early start on the dredging work in March 2005, after the Korsakov Port Master lifted ice season restrictions for vessels, guaranteed sufficient progress before the summer, to allow the planned installation of 16 elements of the LNG jetty: 14 caissons and two trestle sections.

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Dredging work was successfully completed in November 2005, and installation of the remaining LNG jetty units is expected in the summer of 2006. Dredged materials have been re-deposited in a specially chosen site. Disposal of all dredged materials in the demarcated area is guaranteed through the use of global positioning system equipment on the dredging barges. All dredging work strictly adhered to the planned dredging volumes to limit the environmental impact to Aniva Bay. Post-dredging surveys of the disposal site carried out by Pacific Engineering Co. corroborated that the total dredging volumes were well within the permitted levels.

Further sound environmental practices included the implementation of a zero discharge policy for all the working vessels, through the collection of all the waste, sewage and oily effluents by special transport, and bringing it for treatment to approved onshore facilities. Preparation was also made for potential oil spills through procedures, equipment, external support, training, drills and emergency exercises involving the marine contractor, Sakhalin Energy and the Russian Ministry of Emergencies.

In 2005, we organised visits to the dredging and disposal area together with representatives of local fishing companies with an interest in Aniva Bay. The visits allowed them to understand better our activities, and assured them that working together during the construction and operations phase was possible. At the end of 2005, the results of the environmental monitoring programme established that the increase of suspended solids caused by dredging and disposal were nearly three times less than originally predicated and some sea bottom organisms were still living in the immediate vicinity of the disposal site boundary when a total loss was expected here. However, the diversity of organisms decreased temporarily in line with predictions.

Nevertheless, in terms of the environmental impacts caused by dredging and disposal, scientific research and experience shows that the environment will reinstate naturally over a period of approximately three years, by which time even the most sensitive organisms on the sea bottom will have recovered. Our focus during future years will be in following up this recovery process.

Among other findings, it was observed that the salmon migration and spawning were not affected and continued throughout the three years of the work. The number of fish registered in 2005 exceeded comparable results from the baseline monitoring carried out prior to the start of construction in 2003, by two and six times, in the Mereya river and Goluboi stream, respectively. Reasons for this can be attributed to natural variation: 2005 was an exceptional year for fish numbers, and this shows there was no negative impact from the LNG plant construction. The Mereya river is immediately adjacent to the LNG site, and the Goluboi stream actually passes through the construction area.

Trawl and diving surveys carried out at fixed stations dedicated to determine the status of nine commercial invertebrates (shellfish) such as Japanese scallop, sea cucumber and Red King crab, showed that the presence of these species and their biomass did not differ throughout the monitoring period from 2003 to 2005.

Russian experts from the company Ecoterra Ltd conducted a peer review in October 2005 and based on the existing environmental reports they confirmed that there was no evidence suggesting negative changes in the chemical and biological quality of the waters in Aniva Bay. As such, the Russian government issued permits to allow completion of our 2005 dredging activities over the last months of 2005. The European Bank of Reconstruction and Development (EBRD), an important potential lender to the Project, also approved our activities as fit for purpose of consultation in December 2005.

Left: fishing vessel in Aniva Bay.

Below (from left to right): dredging in Aniva Bay; t�

fishing in Aniva Bay.

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SEISMIC AND GEOHAZARDSSakhalin Island is located in an area of high seismicity (risk of earthquakes). The possibility of a large magnitude earthquake during the Project’s lifetime presented challenges in technical design and construction for all aspects of the Project. Although it is possible to predict earthquakes, it is not an exact science. 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 shutdown.

LNG PlantA risk analysis was undertaken to establish the earthquake intensity that the plant should be designed to withstand. This analysis included a review of all recorded earthquakes in the Sakhalin region, which was used to develop a seismic hazard-zoning map to which earthquake magnitudes and occurrence rates were assigned. In addition to this general model, we studied the Prigorodnoye area to identify local faults.

In the event of an earthquake that may be expected to occur once in 500 years at the site, the LNG Plant has been designed to continue production safely.

In the event of a rare high intensity earthquake, predicted to occur only once every 10,000 years, the LNG Plant has been designed to prevent major loss of any LNG and ensure the structural integrity of critical elements such as the emergency shutdown valves and the plant control room for safe shutdown.

Offshore PlatformsThe Lun-A and PA-B platforms lie in proximity to active fault lines, making them susceptible to earthquakes caused by the displacement of these faults.

The Lun-A and PA-B platforms have been designed to withstand earthquakes with a return period of 200 years (relatively low intensity) without any local yielding or failure of equipment, and to survive with limited damage a rare earthquake with a return period of 3000 years (relatively high intensity). Both LUN-A and PA-B can survive earthquakes that are more severe than the maximum credible earthquake magnitude in the area.

The seismic design of the Lun-A and PA-B platforms has involved seismic hazard evaluations carried out jointly by the Russian Institute of Marine Geology and Geophysics (IMGG), and the US earthquake consultants, ABS Consulting.

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The structural platform solutions for both Lun-A and PA-B are in principle identical and comprise a four-legged concrete gravity base structure (CGBS) supporting an integrated deck, with a proprietary seismic isolation system known as Friction Pendulum Bearings (FPBs) interposed between the topsides and CGBS. In late October 2005, the FPBs were assembled and tested in San Francisco where they had been constructed. The bearings, which act as a seismic isolator, are placed just below the topside structure at the top of the concrete shafts, thus isolating the platform topsides should there be any seismic motion. Following the successful completion of testing and assembly, the eight sets of bearings have been shipped to South Korea for installation onto the platforms.

PipelinesRevised offshore pipeline routes at Piltun required that additional studies be carried out and we can report that no hazards, such as recent active seismic faulting at the seabed, were found and the new routes match the safety of the original routes from the geohazards perspective.

The onshore pipelines have been designed to withstand both the seismic activity of the region and winter soil freezing. At fault crossings, the pipeline will be covered to a depth of one metre, enclosed in polystyrene board insulation and the pipeline thickness will be increased.

In 2005, we conducted additional surveys and field inspections, and local re-routing has now brought the number of locations where the pipelines cross active seismic faults down to 19. Detailed design of these remaining crossings, which cannot be avoided, is progressing at the design subcontractor’s offices in Italy.

In the Makarov region where the onshore pipelines cross the most mountainous terrain along the route, the tree clearance on the right of way has allowed more detailed mapping of the slope instability hazards. This mapping has given us the necessary information to reroute pipelines or increase pipeline burial depths to avoid any seismic hazards. Our design and construction philosophy through the Makarov region was the subject of a peer review by an eminent consultant-engineering geologist and his recommendations have been accepted and implemented.

In addition we were this year subject to a “due diligence” review of our handling of seismicity and other geohazards by a geologist appointed by the Lenders to the Project, and were declared fit for purpose of consultation. On the basis of this and other discussions with the Lenders we have made commitments on how we will complete the design and construction of the pipelines in geohazardous areas to the highest standards for the long-term safety of the pipelines.

S E I S M I C D I A G R A M

Above: Friction Pendulum Bearings for the LUN-A and PA-B platforms.

Left: the LNG construction site, general view towards flare knockout drums.

Below (from left to right): the pipe laying construction works; the LNG construction site, cryogenic

heat-exchangers; the pipe laying construction works, view through the 48” pipe.

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H E A L T H , S A F E T Y , E N V I R O N M E N T , S E C U R I T Y

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Sakhalin Energy planned for 2005 knowing that it was going to be a challenging year from the HSES perspective. To adapt to these challenges, a plan was developed to guide the HSES aspects of construction and operations throughout the year. The HSES plan contained a range of targets designed to monitor performance and provide continuous improvement.

Two major targets were achieved: firstly, Sakhalin Energy did not suffer a road accident fatality in 2005 and secondly, the European Bank for Reconstruction and Development (EBRD) declared publicly in December that the Sakhalin II Project HSES framework and documentation was fit for the purpose of consultation. The documents describing this have been released publicly.

HealthThe benchmark for health in 2005 was to achieve a target of having less than 8.5 occupational illness cases per million man-hours worked. There were, in total, 315 cases of occupational illness (six of which resulted in absences from work) representing 4.8 cases per million man-hours worked. These were largely muscular/skeletal injuries associated with the high level of manual work on the Project construction sites. 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 Sakhalin Energy progressed with the implementation of ‘Minimum Health Management Standards’, and additional screening programmes for those identified as ‘at risk groups’ by HSES. Sakhalin Energy reached its targets in these areas for 2005.

A review of the company and contractors’ Alcohol and Drug (A&D) standard was conducted in 2005. 15 contractor companies contributed to the review, which included the roll out and implementation of a major awareness campaign.

In addition there was further progress on the joint Company and community HIV/AIDS awareness and prevention programme, which included training of volunteers, increasing student awareness and supporting ‘at risk’ groups by teaching them about preventative behaviours.

To ensure good quality emergency response facilities were available locally, the Company completed upgrades to Yuzhno’s regional hospital and the district hospitals in Nogliki and Poronaisk.

SafetySafety continued as a major focus area in 2005, but very sadly there were five fatalities on the Project, related to Sakhalin Energy and contractor activities. Three of these were the result of falls from height, one resulted from a falling steel door that trapped the victim, and one resulted from alcohol abuse.

The main safety issues identified in the HSES plan were road safety and lifting operations.

The “Think. Drive. SURVIVE!” Road Safety programme was launched in December 2004 and continued successfully throughout 2005. In addition, Sakhalin Energy developed a strong working relationship with the Global Road Safety Partnership – an initiative of the World Bank, aiming to promote road safety issues worldwide. This relationship resulted in the creation of the “Sakhalin Road Safety Partnership”, between business, the Sakhalin Administration, the Sakhalin Traffic Militia, and NGOs. Three projects were developed in 2005 (a Seat Belt Campaign, a Black Spots Improvement Campaign, and a Crash Data Analysis Project). The Sakhalin Vice-Governor Vladislav Nikitin launched the Sakhalin Energy funded Seat Belt Campaign in November, with a target audience of 500,000 Sakhalin Island residents.

H E A L T H , S A F E T Y , E N V I R O N M E N T , S E C U R I T Y

Left: Road Safety Holiday in Korsakov.

Below (left to right): Korsakov school children particip�

Campaign funded by Sakhalin Energy; Sakhalin Energy provides Road Safety lessons at one of the local schools.

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In February, a formal Lifting Steering Committee was formed and charged with developing and implementing a comprehensive lifting safety initiative, which resulted in the launch of the ‘Lift Safe’ programme which was spread project-wide, using mobile classrooms to reach remote worksites. The Lift Safe message was delivered on 98 occasions to 1487 Project personnel throughout 2005. Sakhalin Energy achieved its target of having no serious lifting incidents in 2005.

EnvironmentTo meet the requirement of relevant Russian Federation and international environmental legislation, Sakhalin Energy enforced environmental protection measures and created improvements using a variety of environmental controls and activities. Highlights of Sakhalin Energy’s environmental activities included the ninth successive year of research and monitoring carried out on the Western Gray whale (WGW), and the final year of a three year monitoring and research programme on the Steller’s sea eagle.

An acoustic monitoring programme was successfully implemented during the installation of the Lunskoye and Piltun Concrete Gravity Based Structures that confirmed that 2005 construction activities did not produce a level of noise that could harm WGWs.

External independent observers were recruited to monitor and document every crossing of ecologically sensitive rivers during the winter period, and development of a Biodiversity Action Plan (BAP) was commenced across the whole project, including bio monitoring in Aniva Bay. The overall objective for the biodiversity planning process is to ensure that the ecological impacts of the Sakhalin II Project are minimised and that during the lifetime of the project there is no net loss of biodiversity as a result of project activities. The BAP will ensure ongoing commitments to managing ecological issues, and will put in place an integrated approach to data management, surveying, monitoring and reporting for the Project’s lifetime.

H E A L T H , S A F E T Y , E N V I R O N M E N T , S E C U R I T Y

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The Vityaz complex (including the Molikpaq platform) had a number of notable environmental achievements in 2005: Vityaz operations implemented a flaring policy which set far lower annual targets than had been achieved in previous years and excluded routine flaring during operations; the Molikpaq platform flared less than half the challenging target of 1.9 billion standard cubic feet (flaring only 0.87 billion standard cubic feet of gas) and met the target of no routine flaring: ISO14001 certification of the Environmental Management System to the new ISO14001:2004 standard was also achieved.

SecurityThree external reviews were conducted in 2005. The first was an assessment of the security threats on Sakhalin and in the Russian Far East. The second was a standard security review conducted by a team from Shell Group Security. These reviews involved site visits to the main onshore and offshore assets, and to a number of pipeline construction sites and associated camps. The third review was an evaluation of potential evacuation requirements.

With the exception of a burglary that resulted in a fatal stabbing in a contractor’s apartment in Yuzhno, these reviews found that there were no major security incidents in 2005. This very regrettable incident was thoroughly analysed, several guidelines were produced, and preventative measures 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 accommodation, and street related crime.

Successes in the year included the establishment of a Security Response Service for Yuzhno and Air Exclusion Zones for our major hazardous facilities.

H E A L T H , S A F E T Y , E N V I R O N M E N T , S E C U R I T Y

Left: the OPF construction site, safety coordination of concurrent lifting activities.

Below (left to right): the Molikpaq platform; Steller’s sea eagle monitoring programme.

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S O C I A L

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Sakhalin Energy recognises the role it plays in the development of Sakhalin Island. The Company aspires to set a benchmark in the way that is operates and addresses economic, social and environmental impacts on Sakhalin not just because it makes good business sense, but because we believe it is the right thing to do.

In 2005 Sakhalin Energy continued consultations with a wide group of people and organisations interested in our project, about our plans to mitigate the social impacts of the project and how we can maximise the benefits to the community.

In order to fulfil the Company’s commitments to contribute to sustainable development, a Sustainable Development Council was formed in 2004. Sakhalin Energy is the first oil and gas operator in Sakhalin to establish such a dedicated body to manage its social contribution in the course of day-to-day business, and to oversee the selection and implementation of social programmes. In 2005 the Council continued its activities and established an Extended Sustainable Development Council, co-chaired by the Phase 2 Project Director, and the Vice-Governor of the Sakhalin Oblast.

In 2005 the Company elected to prioritise all the social projects under various themes (namely Environment, Business and Infrastructure Development, Health, Education, Sport, and Road Safety), which were chosen on the basis of feedback during public consultations and projects received from the Oblast Administration. Projects were developed under each theme. All proposed projects were ranked against established and agreed criteria prior to selection.

A number of programmes have been reviewed and supported by the Council in 2005. Some of these are described in detail below.

Project title: Restoring the Planting Capacity of Smirnykh ForestryTheme: Environment The Project was started in August 2004 and involved spruce cones collection, preserving of cones in appropriate storage, processing and further planting. Laboratory analyses were also made and Quality Certificates for the seeds were obtained. Smirnykh Forestry has signed several agreements with other forestry enterprises for seeds storage, processing and further planting for forest reproduction.

Project title: English Language Training Programme Theme: EducationThe project has been implemented in cooperation with the British Council and Department of Education of Sakhalin Oblast. The project is intended to develop and introduce a new multi-functional model of in-service training programmes for primary and secondary school teachers, which will enable teachers to implement Russian Government reforms in English Language teaching on Sakhalin.

Project title: Victory’s 60th Anniversary Programme Theme: Health In 2005 Sakhalin Energy implemented the partnership project with Oblast Veterans’ Association. The project included addressing the individual needs of World War II and Labor Front veterans. The Expert Council, consisting of the Company and the Veterans’ Association representatives, reviewed the proposals submitted by district veterans’ organisations, and provided support to 540 veterans from all Sakhalin districts, who received household appliances, medicines etc.

Left: restoring the planting capacity of Smirnykh Forestry.

Below (left to right): English language training programme; supporting the fish farm in Ozersk; World War II Viktory’s 60th Anniversary Programme; the World War II Veteran presents

thank you letter to Sakhalin Energy representative.

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2004 2005ENVIRONMENTGreenhouse gas emissions million tonnes CO2 equivalent 0.351 0.249

Methane (CH4), thousand tonnes 1.185 0.561

Carbon dioxide (CO2), million tonnes 0.321 0.232

Flaring Exploration and Production, million tonnes 0.05 0.018

Sulphur dioxide (SO2), thousand tonnes 0.836 1.007

Nitrogen oxides (NOx), thousand tonnes 2.49 2.61

CFCs/halons/trichloroethane, tonnes 0.389 0.359

Volatile organic compounds ( VOCs), thousand tonnes 2.233 2.191

Spills, thousand tonnes 0.028 0

Oil in effluents to surface environment, thousand tonnes 0 0

Fresh water use, million cubic metres 0.144 0.068

Waste, thousand tonnes

Hazardous 0.004 0.015

Non-hazardous 1.939 0.567

Total 1.943 0.582

ENERGY EFFICIENCYExploration and Production energy efficiency, Gigajoule per tonne production 1.34 1.4

SOCIALFatalities Employees 0 0

Contractors 4 5

Total number 4 5

Fatal accident rate - Number of fatalities per 100 million working hours (employees and contractors)

0.084 0.076

Injuries – total reportable case frequency (TRCF) Per million working hours (employees and contractors)

3.3 3.56

Lost time injury frequency (LTIF) Injury hours per million working hours (employees and contractors)

1.2 0.89

Total reportable occupational Illnesses frequency (TROIF) per million working hours (employees only)

11.31 4.39

SECURITY Total number of Sakhalin Energy employees 1165 1644

Russian nationals 638 950

Expatriates 527 694

Gender diversity, percent women

In supervisory/professional positions 16.3 21.4

In management positions 14.7 14.1

In senior leadership positions 4.6 4.1

Social investment (equity share), $ thousand 400 500

Sustainable Development Fund ($ million) 4.053 5.778

n/c – non calculated

D A T A 2 0 0 4 – 2 0 0 5

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2 0 0 5 A T A G L A N C E I N P H O T O S

Main pic: the LNG construction site, aerial view.

Banner inset: Sakhalin II Project customers’ visit to the LNG construction site.

Right insets from top: Pipe laying to the trench;Offshore pipelines welding at the SEMAC vessel; the Molikpaq platform.

Above left to right: the PA-B Topsides under construction at the Samsung Heavy Industries shipyard, South Korea; Storage tankers at the OPF

construction site.

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2 0 0 5 A T A G L A N C E I N P H O T O S

Main pic: PA-B CGBS during the installation.

Banner inset: Signing agreement with Tohoku Electric, June 2005.

Right insets from top: Sakhalin II Project customers’ visit to the LNG construction site; David J Greer, Deputy CEO and Project Director, at the

meeting with Sakhalin Fishery Club representatives; pipe laying near the LNG construction site, Section 4.

Above left to right: the OPF construction site, aerial view; Signing agreement with Tohoku Electric, June 2005.

www.sakhalinenergy.com

Sakhalin Island (Head Office)Sakhalin Energy Investment Company Ltd

35, Dzerzhinskogo Str

Yuzhno-Sakhalinsk, 693020, Russia

Moscow branchSakhalin Energy Investment Company Ltd

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Moscow, 123242, Russia