From the Economist Intelligence: Kazakhstan turns the screw: The government gets tough with foreign investors

Aug 1st 2007

The Kazakh government has warned Western investors in the giant Kashagan oil project that delays and massive cost overruns amount to a breach of contract, which demands renegotiation of the deal. Currently, this seems likely to be limited to financial penalties rather than redistribution of equity in favour of the national oil company. However, it underlines the growing assertiveness of the Kazakh authorities in dealing with foreign investors that were welcomed with open arms in the 1990s.

Speaking at a government meeting on July 30th, Kazakhstan’s prime minister, Karim Masimov, warned the western consortium developing the giant offshore Kashagan oilfield that the failure to start production on time was tantamount to a breach of contract, and that the government would take “adequate measures” in response.

Kashagan has recoverable reserves estimated at 7bn-9bn barrels and total reserves of 38bn barrels. Kashagan is operated by ENI, which like fellow shareholders ExxonMobil, Shell and Total has a stake of 18.5%; Conoco, Inpex and Kazmunaygaz are also in the consortium. Kazakh concern over delays in starting production at Kashagan—the target date has slipped from 2005 to 2008 and now 2010—have been brewing for some time. Mr Masimov’s remarks were probably occasioned by ENI formally notifying the government last week of the 2010 start-date and of an increase in project costs (according to Kazakh sources) from US$57bn to US$136bn, as a result of foreign-exchange movements and the increased cost of security and environmental-protection measures.

Precisely what punitive measures the government has in mind is unclear. Baktykozha Izmukhambetov, the energy minister, told the meeting the government intended to raise the national share of “oil profit” from Kashagan to 40% from the current 10%.

No great suprise
For those who have followed the development of Kazakhstan’s business environment, the decision is no great surprise. In April Mr Masimov announced that the ministry of energy and mineral resources would audit all existing subsoil contracts with a view to determining whether there were licence violations.

The contracts under investigation include those for three sizeable oil and gas fields: the Tengiz oilfield, which is 50% owned by Chevron and 25% by ExxonMobil, and has estimated recoverable reserves of 6bn-9bn barrels; Karachaganak, in which ENI and BG have 32.5% stakes, with reserves of 1.2bn cu metres of gas and 1bn barrels of oil and condensate; and Kashagan, which is the largest oilfield discovered in the world in the last 30 years.

The review seemed designed to meet several objectives: to ensure that more of the sub-contracting work at the foreign-run projects goes to Kazakh companies; to increase mineral processing on Kazakh territory and so move the economy up the value chain; to improve conditions for local workers; and to maintain leverage over foreign investors. Of course, revenue-raising also figured prominently in the government’s calculations.

Turning of the tide
President Nursultan Nazarbayev welcomed foreign investors in the 1990s with open arms and generous terms. The recovery of oil prices after 1999 marked a turning point, for it strengthened the hand of the Kazakh authorities vis-à-vis foreign investors. Since then, there has been an effort on the part of the government to rewrite the terms of existing investments—and to drive a harder bargain with new investors.

The experience of Canadian-owned PetroKazakhstan, which quit the country in 2005 in favour of Chinese investor CNPC, is illustrative. Local interests in southern Kazakhstan repeatedly attempted to drive the Western investor out of the country. In 2005 the government demanded that PetroKazakhstan stop flaring gas, alleging environmental contraventions under a law adopted in December 2004. The result was to force the company to cut production by about one-third. Subsequently the government launched court proceedings against two PetroKazakhstan executives, and in July 2005 a court fined the firm US$55.4m for alleged monopolistic practices by its refined products distribution companies. Soon after its owners agreed to sell to CNPC, the government intervened to ensure that the Chinese firm sold a stake to Kazmunaygaz.

PetroKazakhstan’s experience was by no means unique. The Tengiz consortium has faced threats of legal action over the stockpiling of 9m tonnes of sulphur, which the government says is a by-product of oil production that should be processed. Earlier this year, the consortium agreed to spend approximately US$300m a year over three years at Tengiz on environmental measures; the government, in turn, agreed to drop its lawsuit. The ENI-led grouping at Kashagan have already paid over US$150m in fines for delays in starting production at the giant field.

Muscling in?
The precedent set by Russia’s government at the Sakhalin-2 and Kovykta projects looms large. In those cases, the government used licence violations to force the foreign investors to cede control. At Sakhalin-2, Shell, Mitsui and Mitsubishi were forced to concede a bare majority to Gazprom in return for a below-market US$7.5bn at a time when large-scale production was about to begin. At Kovykta, which was a smaller field and remains some way from starting full-scale production, BP’s Russian joint-venture was forced to give up entirely in return for a few hundred million dollars. These incidents followed the state-directed bankruptcy of private oil giant Yukos, and the transfer of the lion’s share of its assets to state champion Rosneft for fire-sale prices in de facto closed auctions.

Is this the Kazakh gameplan too? Laws on production-sharing agreements (PSAs) and subsoil use passed in the last few years stipulate that Kazmunaygaz shall have mandatory participation of 50% in new projects. Does Mr Nazarbayev intend to see Kazmunaigas become the largest single shareholder at Kashagan? The limited capabilities of the state company suggest not, as it is not in a position to be project operator. Yet under the template on which Russia seems to be settling, it is possible for a foreign company to have a minor share and still be asked to serve as operator.

An asset grab is not consistent with the shrewd, cautious approach adopted by Mr Nazarbayev, however. Also, it carries a foreign policy risk. Kazakhstan has constructed a delicate balance in its economy between investors from the US, Europe, Russia and China, and a major attack on Western interests—as distinct from the low-level assault on PetroKazakhstan—would undermine this. Moreover, the Kazakhs are eager to harness these foreign investors as agents of economic modernisation and diversification. On balance, the government seems more likely to punish the Kashagan consortium for production delays and cost overruns through financial measures alone. Still, Mr Masimov’s warning serves as a further reminder that the Kazakh elite is getting more confident and more willing to test just how much leverage over foreign investors it can actually exert.

http://www.economist.com/agenda/displaystory.cfm?story_id=9573066

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