Analysis of Possible Outcomes of the Kashagan Dispute

Summary

The dispute over the development of the Kashagan field and the future of Eni as the operator of the field quickly escalated over the last month. Kazakhstan has been expressing its displeasure with Eni’s management of the project and at the same time trying to renegotiate the PSA originally signed in 1997. While some analysts compare the dispute to that over the Sakhalin II project last year when a consortium led by Shell was basically forced to give up control of the natural gas project to Russian Gazprom, I argue that the Kashagan phenomenon has to be examined rather in the context of Kazakhstan itself than in the context of resource nationalism as seen in Russia. There are two main differences between the Sakhalin and the Kashagan situations. First, Kazakhstan, due to its location and relatively small population size, has to balance the interest of its two powerful neighbors—-Russia and China--and of the United States. As it does not have the resources to develop the field on its own through the national oil company KazMunaiGas, removing the current consortium would mean ceding control to either Chinese or Russian companies which would significantly affect the equilibrium that Kazakhstan has been trying to maintain over its strategic resources. Second, it is in Kazakhstan’s best interest to have the project up and running as soon as possible, and presently the best option is to keep the current consortium and the operator in place.

Background

At the end of July, Italian Eni SpA, the operator of the Kashagan project, announced that the cost of the project would more than double, while the projected date of when commercial production was to begin would be delayed for two years until 2010. This is already the second announcement of cost overruns and delays on this notoriously difficult field. As a result, in 2005, Eni was supposedly forced to pay Kazakhstan $150 million in fines.

This time, however, it can be said with certainty that the costs for the consortium will be much higher. Various Kazakh government officials spoke about consequences ranging from fines in excess of $10 billion to an increase of Kazakhstan's share in the PSA from 10 percent to 40 percent to removal of Eni as the operator of the field.

The dispute intensified during the month of August when Kazakhstan's authorities accused the consortium of not following Kazakhstan's environmental laws and fire codes. At the same time they began criminal investigation of a subsidiary of Agip KCO for tax fraud in connection with importing two helicopters. On August 27, Kazakhstan suspended all work on the field, initially for three months, citing environmental and fire safety violations. This escalation occurred just prior to the negotiations between the Agip KCO and the Kazakh government scheduled to begin this week.

Generally, Kazakhstan analysts believe that the above mentioned allegations (while possibly true) and the timing are of political nature and serve the Kazakh authorities to establish a strong negotiating positions prior to talks with the representatives of the consortium.

Allegations of Environmental Violations

As many energy analysts in the former Soviet Union pointed out, (random) enforcement of environmental and tax laws is becoming the favorite weapon to put pressure on international (Shell in Sakhalin) as well as domestic operators (Yukos). Until recently, this approach was to a greater extent limited only to Russia, but it seems that Kazakhstan has decided to use the blueprint as well.

The Kashagan field is extremely complex--it's located several thousand meters deep under the shallow water of the northern Caspian Sea where the volatile temperatures range from -40 degrees Celsius in the winter to +40 degrees Celsius in the summer. In addition to this complexity, it is located in the complicated and endangered ecosystem of the Caspian Sea that was ravaged for years by the Soviets and again in the free-for-all years after the fall of the Soviet Union. The endangered beluga sturgeon and Caspian seal are among the species that have their home on the northern shores of the Caspian Sea.

Consequently, it is virtually guaranteed that some violations of environmental laws will take place regardless of the efforts of the operator. It is the selective application of those laws that raise questions about the intentions of Kazakh authorities. The Ministry of Environmental Protection accused Agip KCO of long-term systematic abuse of environmental codes and blamed the company for a dramatic decline in the number of certain species of fish and birds and Caspian seals. While this “environmental watchdog” did not (yet) make the claim officially, it marks a drastic turnaround from previous treatment of the issue. As late as in April 2007, when hundreds of Caspian seals washed up dead on Kazakhstan's Caspian coast, their deaths were blamed on the unusually warm winter and not on the oil industry. As far as the Kashagan field is concerned, in 2006 the Ministry of Energy and Mineral Resources awarded Agip KCO a prize for its environmental protection program.

Kashagan vs Sakhalin

While the use of environmental protection laws as a tool for putting pressure on international oil and gas companies in Russia and Kazakhstan appear nearly identical, I believe that it would be shortsighted to compare the two directly. The method may be the same, but Russia and Kazakhstan find themselves in completely different positions when dealing with foreign investors. There are several reasons for the differences, but the three main factors are technical expertise, location and infrastructure.

When Gazprom took over the Sakhalin II project from a consortium led by Shell, many energy analysts doubted Gazprom’s ability to develop the field. In case of Kashagan, there is a near unanimous consensus that the Kazakh national oil company simply does not have the means and expertise to develop the field alone or as a sole operator of the consortium. The Kashagan project is crucial for Kazakhstan since only the development of thie field will allow the country to reach its economic agenda set by central authorities. This obviously weakens Kazakhstan’s negotiating position significantly.

Second, Kazakhstan is a landlocked country located between energy-rich Russia and energy-starved China. Russia tends to see Kazakhstan as competitor for international markets and as a potential weak point in its natural gas influence over Europe, and subsequently tries to use it for its own geopolitical objectives. China, on the other hand, sees Kazakhstan as the potential source of fuel for its enormous economic engine. So far, Kazakhstan has been very skillful in neutralizing these powers, and the continuous interest and presence of Western countries and oil companies contributed greatly to its ability to maintain its role.

Third, almost all the oil and gas pipelines transporting oil and gas from Kazakhstan to international markets go through Russian territory. In order to bring Kashagan oil to markets, new pipelines will have to be built. The presence of a Western-led consortium developing the field favors the construction of a route that will bypass Russia and will allow Kazakhstan to diversify its export routes.

Possible Outcomes

There are several possible outcomes of the current negotiations between the consortium and the Kazakh government. I would argue that it is a given that the consortium will pay a steep fine – maybe not in excess of $10 billion as suggested by the deputy finance minister Daulet Ergozhin - but significantly more than the $150 million it paid in 2005. And the PSA will be renegotiated to give Kazakhstan a bigger share of the revenues.

The real question is whether Eni will maintain its current position as the operator of the field, and if not, who will replace it. The following are possible scenarios:

1) Eni remains the only operator.
2) Eni remains the operator but KazMunaiGaz joins in at the co-operator of the project.
3) KazMunaiGaz becomes the sole operator.
4) Another member of the consortium becomes the only operator.
5) Another member of the consortium becomes the operator and KazMunaiGaz joins in at the co-operator.
6) A company from outside the consortium becomes the only operator.
7) A company from outside the consortium becomes the operator with KazMunaiGas joining as the co-operator.

While in theory all these outcomes are possible, I believe that the first, second and fifth are probable and the second most likely. The ultimate goal for Kazakhstan is to have Kashagan developed as early as possible. Therefore, I don’t believe that major changes like bringing in an operator from outside the consortium are very likely. On the other hand, Kazakhstan will likely want KazMunaiGas to take a more active role in operation of the field, if only to develop its own technical expertise. These assumptions would favor the scenario in which Eni remains the operator of the field and KazMunaiGas joins as the co-operator.

Conclusion

Throughout the hysteria over resource nationalism and the possibility that a Western company may be removed as operator of the biggest oil field outside the OPEC, it is important to keep in mind all facts:

1. Agip KCO was unable to honor the terms of the PSA – whether through its own fault or just because of the sheer complexity of the project. The fact that Kazakhstan wants to renegotiate the PSA and threatens the removal of Eni as operator may not be within its rights as far as the PSA goes, but from a neutral point of view is certainly understandable.
2. Kazakhstan needs the Kashagan oil field to be developed in order to reach its own economic objectives and to be included in the prestigious club of the top ten oil producing countries in the world.
3. Kazakhstan’s location and existing infrastructure strongly favor Russia to exert her influence. While Kazakhstan cooperates with Russia closely on many levels, it simultaneously works very hard to neutralize the influence and to diversify its oil and gas export routes. The presence of Western oil companies is absolutely necessary to reach this goal.
4. The allegations of violations of environmental, fire safety and customs laws are clearly used selectively in order to improve Kazakhstan’s position prior to negotiation with the consortium.

These conclusions point to the outcome outlined above that Kazakhstan is unlikely to make any dramatic changes to the current status quo. Kazakhstan needs Kashagan, and Eni is still the best option as the operator of the field. Kazakhstan will also probably push for KazMunaiGas to take the role of a co-operator in order to increase the share of its revenues and also to gain technical expertise which would allow it to develop other technically challenging fields on its own.