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TENGIZ EXPANSION PLANS SUSPENDED:
THE NEXT MOVE IS KAZAKHSTAN’S
by Laurent Ruseckas
Tengizchevroil Puts Further Investment on Hold
With major upstream projects maturing across the region, the Caspian is not
the dramatic frontier that it once was.
Suddenly some drama has returned.
Tengizchevroil (TCO), the region’s biggest foreign operator and oil producer,
announced on November 14 that it was suspending its planned next phase of
development at the six- to nine-billion-barrel Tengiz field.* The specific reason
cited by TCO was an inability on the part of the consortium to reach agreement
on a funding plan for a $3 billion expansion that would bring oil production
to near or above 450,000 barrels per day [bd] by 2006 (from today’s level of
290,000 bd) while also beginning to reinject some of the field’s associated
sour gas.
The past 18 months have seen steadily increasing pressure on foreign oil
investors by the government of Kazakhstan.** Against a backdrop of rhetorical
criticism of foreign oil companies by senior officials, the government has
sought in a number of ways to rebalance the flow of revenues from major oil
projects in favor of the Kazakhstani state—and to the detriment of investors.
In several cases Kazakhstani actions have amounted to a direct challenge to
agreed-upon contractual terms. Confidence in the investment climate and in
Kazakhstan’s commitment to the stability of contracts has been seriously
undermined as a result. The broad perception in the market—which CERA
shares—is that the authorities have been testing the situation, trying to discover
just how far they could push foreign investors before meeting with consequential
resistance.
TCO’s decision to call a halt to its expansion plans demonstrates that the
Kazakhstani investment climate has now deteriorated to the point where major
capital expenditures cannot reasonably proceed. It is clear that yesterday’s
announcement was not a bluff. Companies with
major contracts for the expansion program have
been informed that the project is on hold; one
major contractor has already announced that its
2003 earnings could be negatively affected as a
result. It should be emphasized that no changes
are envisioned for the existing management of the
field; TCO has advised that it will refocus in the
near term on the optimization of current operations
at Tengiz. But Kazakhstan’s ambitious oil plans
are based not on maintaining today’s status quo
but on major expansion of the country’s oil
production capacity, from current levels of about
980,000 bd up to 2.0 to 2.3 million bd by 2010.
Without a resolution of the current impasse at
Tengiz, this goal will not be realized.
The Core of the Conflict
Although the precise details of the disagreement
over funding the next phase of Tengiz development
are not publicly known, a tax issue appears to be
at the heart of the matter—specifically, the
depreciation rate for the new capital assets to be
built in TCO’s planned $3 billion expansion. In
recent years capital investment at Tengiz has been
funded from project cash flow, allowing for
moderate but steady growth in oil production; TCO
has averaged a bit more than 11 percent production
growth annually for the past four years. This
“steady state” development reduced temporarily
the importance of the depreciation terms and
schedule, avoided the problem of cash calls for
shareholders, most notably state company
Kazmunaigas which has a 20 percent noncarried
interest in the project, and produced a substantial
flow of tax revenues for the Kazakhstani
government.
The next phase envisions a significant increase in
the rate of production growth, as well as major
investments to implement plans for the technically
complex reinjection of associated gas into the high-
pressure reservoir. This implies a shift from reliance
on internal cash flow to a requirement for new
infusions of capital—thus triggering a contractually
mandated accelerated depreciation schedule that
will speed up cost recovery for TCO while
temporarily reducing the tax revenue accruing to
the state. This temporary falloff in tax revenues
seems to be unacceptable to the authorities.
A separate irritant in TCO’s relationship with the
government of Kazakhstan is an environmental fine
of five billion tenge ($71 million) which was
imposed on the company in February 2002 by the
Ministry of Natural Resources and Environment
and the Atyrau regional administration. The fine
has been levied on the basis of alleged
environmental damage being caused by the
approximately five million tons of sulfur (extracted
from the field’s associated gas production) which
is being stored near the Tengiz site. TCO has
appealed the fine to the Supreme Court of
Kazakhstan (thus far to no avail), arguing that the
sulfur poses no serious environmental risk and citing
the fact that similar storage of sulfur is considered
environmentally acceptable under the laws of the
United States and other Western countries.
What Comes Next?
TCO’s decision to halt its expansion plans puts
the ball squarely in the court of the Kazakhstani
authorities. If indeed the government has been
trying to determine just how far it could go with
its squeeze on foreign investors, it now knows the
answer. It is clear what Kazakhstan will need to
do in order to rectify the current situation: any
resolution that can be imagined will start with the
authorities acknowledging the validity and stability
of their contractual commitments, and then
approaching any desired renegotiation of the details
of these commitments in a spirit of compromise
and mutual benefit.
Kazakhstan should be highly motivated to
compromise. It is not in the country’s interests to
see its flagship oil investment project put on ice,
and for the current deficiencies in the country’s
investment climate to be so publicly exposed.
Political pressure as well as commercial pressure
will be brought to bear, given the strategic interest
of the US government in seeing additional
Kazakhstani oil supply brought smoothly and
rapidly on line.
At the same time, Kazakhstan now faces a
conundrum as a result of its recent rhetoric, and in
political particular the often-repeated statement that
foreign investors do not deserve “special
treatment.” In reality, private companies (domestic
or foreign) investing in multibillion-dollar upstream
oil projects anywhere in the world inevitably do
receive—and need—special treatment because of
their scale and their heavy requirements for front-
end capital expenditures. For these projects, the
issues of depreciation and/or cost recovery are
critical, and they tend to be addressed by specific
language intended to balance the interests of the
host government with the requirements of the
investor. Thus for the Kazakhstani government, to
acknowledge the validity of TCO’s position would
come close to contradicting the approach that it
has itself been promoting.
The Kazakhstani authorities will thus seek a
solution that avoids the impression a wholesale
and rapid retreat from previous policies. Initial
statements for public consumption may well
contain fiery and aggressive language, but these
should be taken with a grain of salt. A best-case
scenario would see a relatively rapid resolution
that demonstrates a renewal of Kazakhstan’s
commitment to the stability of contracts and its
relationships with foreign investors, and which
allows for TCO expansion to get back on track
without major delays. A worst-case scenario would
see the Kazakhstani government continuing to
manifest the intransigence that has recently
characterized its approach, resulting in major delays
at Tengiz and a wholesale loss of confidence among
the foreign investment community.
The reaction of the Kazakhstani government will
have implications that extend far beyond Tengiz.
A first-phase development plan for the supergiant
discovery at Kashagan is currently being elaborated
by the Agip KCO consortium, with the target of
sanction before the end of 2002.* But the issue of
cost recovery is even more fundamental for Agip
KCO than it is for TCO, given the monumental
scale of the Kashagan project as well as its
greenfield character, which rules out any early cash
flow. The production-sharing contract for Kashagan
reportedly provides for high
levels of cost recovery
in the early stages of the project—a reasonable
thing given the scale and risk of the project, and
presumably a
sine qua non
for its investors. A
failure to reach a mutually acceptable agreement
at Tengiz will bode poorly for the fate of the
Kashagan production-sharing agreement, while also
undermining investor confidence as proposals for
new exploration in the Kazakhstani sector of the
Caspian Sea are considered.
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