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.

Kazakhstan's Pipeline Dependence: Current State and Future Outlook - Part One - Russia

This is the first part of an analysis of current state of Kazakhstan's distribution system - the study will show the existing and potential distribution options for both oil and natural gas out of Kazakhstan to markets in Europe and Asia.



Background

When in May 2007 the presidents of Russia, Kazakhstan, and Turkmenistan met in the Turkmen city Turkmenbashi on the Caspian Sea and agreed on two major gas pipeline deals to export Kazakh and Turkmen gas through the Russian gas pipeline system while at the same time ostentatiously shunning the Krakow energy summit focusing on alternative routes of bringing Caspian oil and gas to European markets, observers proclaimed Russia the victor of the geopolitical struggle for influence in Central Asia. In the race to build pipelines to deliver oil and gas from the landlocked Central Asian countries between the U.S., China, Iran and Russia, Vladimir Putin seemed to achieve a significant victory. Three months later, Putin’s victory seems less certain as both Kazakhstan and Turkmenistan announced new deals with China to transport their vast reserves of oil and gas to the East, and even the almost buried and forgotten Trans-Caspian-Pipeline received a boost when the U.S. State Department announced that it commissioned a feasibility study for the project.

Kazakhstan and Russia

Despite the fall of the Soviet Union and the (in the case of Kazakhstan very reluctant) independence of the former Soviet republics, Russia still considers its former territories firmly within its sphere of influence. While its influence was represented in a diminished form in the 1990’s, with the arrival of Vladimir Putin as Russia’s president and the prices of oil and other commodities reaching all-time highs, Russia’s claim to influence in the “near abroad” has become more and more accented. It has been manifested in many ways from subsidizing oil and natural gas exports as a reward to friendly regimes to actively supporting separatist movements in countries considered on anti-Russian path.

While the influence-seeking behavior may be a result of Russia’s imperial ambitions and desire to regain its superpower status, it is strongly pronounced by the remnants of Soviet Russia-centric infrastructure. It is important to note that while the fall of the Soviet UnionRussia and never before existed as independent nation states. created independent republics, the majority of them actually had no infrastructure in place to exist independently of Kazakhstan is a clear example of Soviet social and geopolitical engineering that left the country as a supplier of natural resources for the Soviet Union. The result is that even now 15 years after the Soviet Union became history and Kazakhstan is hailed as the new source of accessible oil, Kazakhstan is still almost completely dependent on Russia.

While its vast oil and natural gas reserves place Kazakhstan among the world’s top producing countries and perhaps the only non-OPEC country which will experience a significant growth in production in the coming decades, it faces major obstacles in getting its oil and natural gas to the markets. During the existence of Soviet Union, Kazakhstan was connected to the Soviet pipeline system which in Russia is currently operated by Gazprom (natural gas) and Transneft (oil). This link still exists today und up until this date amounts for the majority of Kazakh oil and gas exports. The obvious disadvantage of this situation is the reliance on one partner in getting oil (and the same goes for natural gas) to markets. Even if Russia’s (we have to consider the two pipeline companies as Russia’s political tools and pretty much an extension of the government) intentions towards Kazakhstan or the end-users of its oil were completely harmless, any kind of turmoil or unrest in Russia could have catastrophic consequences for Kazakhstan as oil exporter. The fact that Russia has its own interests and objectives and does not shy from using its pipeline operators to reach them makes this issue for Kazakhstan inherently more alarming. This reliance was decreased with the construction of the CPC pipeline in 2001 that connects Kazakhstan Tengiz field operated by Chevron to Russian Black Sea port Novorossiysk. This pipeline was originally developed by international oil companies and the governments of Kazakhstan, Russia and Oman. While the CPC pipeline is not part of the Transneft system, Russia has lately increasingly frustrated the partners with demands for higher tariffs and a greater share in ownership. Therefore, despite avoiding Russia’s state-controlled pipeline system, the transit through Russian territory to the Black Sea ports and from there to European markets still remains highly vulnerable. Currently, 84 percent of Kazakhstan’s oil exports pass through Russia both through the CPC pipeline and the Transneft system, and with increasing production in the Tengiz and Karachaganak field, the number will grow in the coming years.

Oil pipelines

CPC pipeline

The 1,580-kilometer CPC pipeline connects Kazakhstan’s Caspian oil deposits (currently mainly the Chevron-operated Tengiz field) with Russia's Black Sea port of Novorossiysk. Oil loaded at Novorossiysk is then taken by tanker to world markets. The project was finished in October 2001 with an initial capacity of 500,000 barrels per day and a projected capacity of about 1.4 million barrels per day by 2015. Although the pipeline transverses Russian territory and was developed in conjunction with the Russian government, it was initially hailed as a viable alternative to the Russian pipeline system operated by Transneft. The reasons for developing the pipeline were twofold. First, a reduction of the political influence Russia exerted over oil exports going through its own pipeline system. Second, to ensure that Kazakhstan’s high-quality, sweet crude oil did not mix with heavier, sourer Russian crude oil which was the case when Kazakhstan exported its oil through Transneft’s Atyrau-Samara pipeline. In retrospect, Kazakhstan and the Tengiz-operators accomplished only the second objective. Recent events when Russian government sought increases in transit fees and hit the Chevron-led consortium with repeated back tax claims, showed that despite being a private pipeline outside the realm of Transneft, it is not immune from politically motivated pressure coming from Russian authorities.

Atyrau-Samara pipeline

Kazakhstan's other major oil export pipeline, from Atyrau to Samara, is a northbound link to the Russian distribution system Transneft. The 691-kilometer line was recently upgraded through pumping and heating stations additions and has a capacity of approximately 600,000 barrel per day. Before the completion of the CPC pipeline at the end of 2001, Kazakhstan exported almost all of its oil through this system. In June 2002, Kazakhstan and Russia signed a 15-year oil transit agreement under which Kazakhstan will export 340,000 bbl/d of oil annually via the Russian pipeline system in addition to exports through the CPC pipeline. Russia's trade ministry also pledged to increase the capacity of the line to around 500,000 barrels per day. As the Kazakh production in the Tengiz and Karachaganak oil fields grows, and as the Kashagan field is set to start producing oil (currently predicted for 2011), the pipeline is likely to gain both in absolute volume and significance. Russia’s government openly favors the Atyrau-Samara pipeline option over the privately owned CPC pipeline, and since Transneft currently controls 24 percent of the shares of the CPC, it is debatable how fast the planned expansion of the CPC pipeline will proceed.

Kenkyak-Orsk pipeline

The Kenkyak-Orsk pipeline transports oil from the Aktyubinsk fields in western Kazakhstan to the Orsk refinery in Russia at a current capacity of approximately 130,000 barrels per day.