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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 regions 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 todays level of 290,000 bd) while also beginning to reinject some of the fields 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 stateand 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 Kazakhstans commitment to the stability of contracts has been seriously undermined as a result. The broad perception in the marketwhich CERA sharesis that the authorities have been testing the situation, trying to discover just how far they could push foreign investors before meeting with consequential resistance. TCOs 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 yesterdays

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 Kazakhstans ambitious oil plans are based not on maintaining todays status quo but on major expansion of the countrys 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 matterspecifically, the depreciation rate for the new capital assets to be built in TCOs 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 capitalthus 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 TCOs 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 fields 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?
TCOs 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 countrys interests to see its flagship oil investment project put on ice, and for the current deficiencies in the countrys 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 receiveand needspecial 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 TCOs 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 Kazakhstans 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 projecta 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.

sefi, YuS © 2000-2011

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