Caspian Business Journal

Should Investors In The Oil And Gas Sector Fear The Kazakh Government?

With the introduction of a new taxation regime and the revision of a number of contracts, foreign investors in the Kazakhstan’s oil and gas sector have been feeling a bit uneasy. Aziz Burkhanov explains the motivation behind recent changes, and suggests that in reality investors have nothing to fear.Following the fall of the Soviet Union, the newly independent Government of Kazakhstan pragmatically turned to the country’s significant oil and gas reserves as a tool for overcoming economic difficulties. Thanks to relatively liberal economic policies, Kazakhstan managed to attract more than $25 billion in foreign investments [1]. Such a significant investment flow confirms that the significant potential of the Caspian region as a major source of oil and gas is indisputable, even if the Caspian oil has not been explored in quantities that would fundamentally affect world markets and current production levels do not reflect the potential for future production. Thanks to increasing revenues from the oil and gas industry and high world market oil prices over the last decade, Kazakhstan has registered annual GDP growth rates of around 10% for several years.

A gas station in the village of Yerbent, Turkmenistan. Photo by Sam Tranum.

The development of the oil and gas sector in Kazakhstan has also had a positive effect on other sectors of economy, such as construction and services. Alongside major international oil and gas corporations, Kazakhstan’s oil and gas sector has become a significant market for Western medium and small-size businesses and sub-contractors. Various oil and gas field equipment and technologies have been in demand, and according to the United States Commercial Service, plenty of opportunities exist for American companies producing oil and gas field equipment and machinery such as drilling and wellhead equipment, turbines, compressors and pumps for pipeline applications, control and monitoring systems for refineries, gas processing and petrochemical plants, seismic processing and interpretation, petroleum software, sulfur removal and disposal technologies and field abandonment services [2].

As recent developments have demonstrated, however, in the last few years the Government of Kazakhstan has become increasingly demanding of foreign companies working in country’s oil and gas industry and has started to change a number of policies and regulations. These changes raise obvious questions whether foreign investments and contracts are secure enough. This article provides an overview of recent major changes in Kazakhstan’s oil and gas industry, where contracts have been questioned and policies towards international companies have been modified.

Early Contracts: Inexperienced Government and Limited Exploration

After independence, Kazakhstan opted for a “multi-vector” foreign economic policy which was aimed at building beneficial relationships with all major economic players [3]. Almost all of the numerous pipeline projects designed to ensure transporting of oil and gas from land-locked Kazakhstan to world markets have been realised, and the country has managed to attract major international oil and gas corporations. Kazakh authorities pragmatically considered its Caspian oil and gas reserves as a tool for overcoming economic difficulties and the liberal economic policies of technocrat cabinets in the 1990s led to a massive foreign investment flow.

In the early years, however, Kazakh Government officials had very little experience in dealing with international energy companies and were desperate to attract foreign investors. This meant that most of the contracts signed in the mid-1990s have clearly favored foreign companies. For instance, according to the initial contract on the Kashagan oil field exploration, Kazakhstan would not have received any profit until the participating foreign companies had fully recovered their initial investments [4]. A few years down the line, after Kazakh officials had accumulated a certain amount of experience, they came to realize that international companies were getting too large a share of the profits and started a campaign aimed at correcting previous mistakes. There are signs that Astana’s assertiveness is threatening even major international energy conglomerates.

In 2007, Kazakhstan adopted a law allowing the government to unilaterally break contracts with foreign companies if hypothetical national interests are endangered [5]. Shortly afterwards, the government announced its decision to revise oil contracts depending on whether companies have met their contractual commitments on exploring oil and gas fields. Furthermore, in early 2008, officials in Astana announced that oil industry contracts will no longer include ‘production sharing agreements’ (PSAs) advocated by the international energy companies, because these agreements tend to outline taxation obligations [6]. Kazakh Energy Minister Sauat Mynbayev further specified that that just over half of 831 contracts between the government and oil and gas companies were fully meeting their financial and logistical obligations [7]. Kazakh Prime Minister Karim Masimov then tried to calm investors by confirming that all existing PSAs signed between Kazakhstan and energy companies would be secure and the new framework would only apply to new investors. Such behavior obviously created a feeling of uncertainty among foreign investors working in Kazakhstan.

There is no doubt that foreign energy companies commit numerous contractual violations and the reasons behind these violations can vary significantly. In most cases, limited progress on the oil fields has been caused by contractors’ problems with funding, a lack of technical expertise and a shift in resources to other priority projects. At the same time, as some analysts point out, it is important to note that exploration development programs were designed by the companies themselves, and not by the Kazakh government. Some of these work programs were arguably too ambitious, and went far exceeded contractors’ financial, logistical and personnel capabilities. In other cases, some of these contracts and bids were specifically aimed at getting exploration licenses from the government, with little or even no intention of actually exploring the oil fields. Still other contract holders intensively slowed down development works with the purpose of being acquired by a larger oil company [8]. All in all, a slower-than-expected progress on the Caspian oil fields made the government anxious and led to the stricter policies.

Some analysts argue that the Kazakh authorities are following the example of other oil-rich countries and compare recent implementations with the Fallow Initiative of the United Kingdom. In the British case, the governmental strategy granted a 24-month period to allow exploration companies to fulfill work commitment on their sites before electing to continue for an additional two-year period. Companies were required to surrender their exploration licenses if they had not met the criteria during this period (and many of them were obliged to do so) [9]. Unlike Britain, the Kazakh government reviews contracts after a much longer period than 24 months, and this fact alone throws doubt on claims about the repressiveness of new governmental policies [10].

Kazakhstan Steps In

The highest-profile case of oil contract revision in Kazakhstan’s favor concerned the large Kashagan oil field, explored by a consortium led by Italian ENI. Initially planned to start in 2005, exploration works have been postponed several times on the company’s requests, all accepted by the government. The project costs have also more than doubled from $54 billion to $136 billion and analysts argue that ENI was constantly and carelessly testing the patience of the Kazakh officials [11]. Hardly surprising then, that in 2007 the Government of Kazakhstan accused the Italian ENI of violating the terms of contract in the delays and cost overruns at the Kashagan field, and demanded to increase its share (through state-controlled KazMunaiGas) in the project from 8.33% to 30%. The government also accused ENI of violating ecological standards on the ground and claimed the total environmental damage to be around $10 billion [12].

A series of negotiations at the highest levels culminated with the involvement of Italian Prime Minister Romano Prodi in October 2007 [13]. In the end, ENI managed to preserve its role as the main project operator, but numerous contractual terms have been revised. Kazakhstan was granted the right to take 5% of the profit even before the foreign partners recover their investments costs, [14] KazMunaiGas paid $1.78 billion to increase its Kashagan stake to 16.8%, and the consortium agreed to pay $5 billion to compensate for lost revenues [15].

The new Tax Code of Kazakhstan, adopted in the early 2009, brought some other major changes in the oil and gas industry regulations. It affected the taxation procedures of foreign contractors but as some observers argued, they remained more favorable than those of Russia and other CIS countries [16]. The Code has established a new ‘Mineral Extraction Tax’ (MET), which replaced previously existing royalties. At the first glance, the new tax seems to bring a higher tax load as the MET rates are set in a range of 5-18% for 2009 depending on production volumes, whereas most royalty rates ranged within 2-8%. Also, the rent tax on exports of oil and gas condensate which replaces the export duty, is calculated on a progressive scale of 0-32% depending on the oil price [17]. But these changes are compensated for by other initiatives, such as the gradual decrease of corporate income tax from 30% from 20%, with a further 5% cut planned in 2011.

International observers claim that when effectively implemented, the new Tax Code will establish a clearer and more effective legal framework for taxation in the oil and gas industry, which in turn could improve Kazakhstan’s overall investment climate in the future. All oil and gas companies operating in Kazakhstan are subject to the new Tax Code; production sharing agreements concluded before 2009 (including Tengizchevroil and Kashagan, two main projects of Kazakhstan oil and gas sector) will be exempted from the new regulations [18].

But despite this, some international players were quite unhappy with the new taxation regime and questioned the newly implemented tax policies. The British BG Group Plc, a Karachaganak consortium participant, submitted a judicial claim to the international arbitration court against the Government of Kazakhstan, seeking compensation of more than $1 billion for oil export duties that the company has been charged incorrectly [19]. As of October 2009, Kazakhstan officials are trying to reach an agreement with the Karachaganak consortium over mandatory tax payments before the issue reaches a court and most likely will offer BG some form of compensation without revising the new tax policies.

Other international companies have chosen to adopt a more cooperative strategy and not to confront the Government in the changing environment, which, as ENI’s example suggests, could potentially lead to greater trouble and losses. For instance, according to the “de facto” existing practice, international companies are often informally “asked” to support regional and municipal social development projects in the cities and villages of Kazakhstan in which they have facilities. Some companies are more willing to be involved in these peripheral projects than others, although recent stricter governmental policies have seemed to bring a more cooperative mood. For instance, Tengizchevroil opted not to raise the price at which the company sells natural gas to the Atyrau oblast, despite a contractual term allowing it to increase the tariff every six months [20].

Possible outcomes

Following the contract review process, licenses and contracts of ineffective participants can be canceled and made available for new contractors. In principle, the license review should only concern those contractors who have failed to make any progress on the ground [21]. This could obviously create a space for newcomers in the Kazakh oil and gas industry, since Kazakhstan remains a highly attractive oil and gas destination. If initially the new tax policies of the Kazakh Government called to mind similar taxes imposed by Algeria and Venezuela, they have ended up being considerably less punitive than in those countries. While dealing with major international companies, Kazakhstan may occasionally seek compensation from consortiums as stakes increases, but a termination of a major contract or Latin America-style expropriation of facilities are highly unlikely. Such aggressive policies would ruin the international reputation of the country just before it assumes the long-hoped for OSCE Chairmanship and would destroy further plans for the development of the oil industry. All indicators suggest that the Kazakh authorities remain committed to increased oil and gas exploration and are keen to attract serious developers.

Footnotes:

[1] Spechler, Dina & Spechler, Martin “Trade, Energy, and Security in the Central Asian Arena”, in Strategic Asia 2006-2007: Economic Independence and Security, Ashley Tellis and Michael Wills (eds.), National Bureau of Asian Research, 2006, p. 209, http://www.nbr.org/publications/element.aspx?id=152

[2] Kazakhstan, “Oil & Gas Equipment and Services, Overview,” United States Commercial Service, http://www.buyusa.gov/kazakhstan/en/oil_gas_equipment.html

[3] Spechler & Spechler, p. 209.

[4] Nariman Gizitdinov, Lucian Kim “Eni-Led Group Cedes Kashagan Oil Stake to Kazakhstan” (Update10), http://www.bloomberg.com/apps/news?pid=20601085&refer=Europe&sid=abyb0RsGe3w8

[5] Raushan Nurshayeva “Kazakhstan Law Lets Government Break Oil Contracts”, http://www.reuters.com/article/companyNewsAndPR/idUSL266281520070926

[6] Joanna Lillis “Kazakhstan to Foreign Investors: It’s Our Way, or the Highway”, http://www.eurasianet.org/departments/insight/articles/eav022208a.shtml

[7] Lillis, op. cit.

[8] Sam Kiri “Kazakhstan’s Oil Contract Review? Only Guilty the Need to Worry! (Issue: 0), http://www.proactiveinvestors.co.uk/columns/politics_and_markets/224

[9] The Fallow Process, Oil & Gas UK, http://www.oilandgas.org.uk/issues/operations/licensing_fallow.cfm

[10] Kiri, op.cit.

[11] “Would the OSCE Chairmanship Bail Out Beleaguered Foreign Oil”, http://www.proactiveinvestors.com/columns/politics_and_markets/68

[12] Raushan Nurshayeva “Kazakhstan Seeks $10 bln Over Oilfield Delay”, http://www.reuters.com/article/latestCrisis/idUSL04483944

[13] Bruce Pannier “Kazakhstan: Prodi Visit Eases Strain Over Major Oil Venture”, http://www.rferl.org/content/article/1078889.html

[14] Gizitdinov & Kim, op. cit.

[15] “Kazmunaigaz Says Kashagan Is a Done Deal, At Last”, http://www.ihsglobalinsight.com/SDA/SDADetail11349.htm

[16] Евгений Арсюхин “Табачок врозь. Казахстан резко меняет правила игры. Чего ждать российскому бизнесу?”, Российская Бизнес-газета, 15 июля 2008 г., http://pda.rg.ru/2008/07/15/astana.html

[17] “Fitch: Kazakh oil, gas tax changes positive”, http://silkroadintelligencer.com/2009/03/17/fitch-kazakh-oil-gas-tax-changes-positive/

[18] Idem.

[19] “BG, Kazakhstan to Reach Agreement on Duty without Court”, Dow Jones, http://english.capital.gr/news.asp?id=826913

[20] Lillis, op.cit.

[21] Kiri, op.cit.