ISSUES FACING NEW INVESTORS IN THE UPSTREAM OIL INDUSTRY OF KAZAKHSTAN
Hans Braakman, General Director, Grata Petroleum Consultants Ltd.
I wrote this article to share with new investors some of my experience about starting and operating exploration and production ventures in Kazakhstan. I address various issues that I came across during my work in Shell International in the New Ventures Department and as General Manager of Shell Temir in Kazakhstan. The issues are mostly viewed from the point of the operator, but are equally valid for non-operators, whether Kazakhstani or foreign, as they all affect the bottom line.
The new investor will first define what type of venture he wants to pursue. This depends on the investor’s objectives and strategy. The investor could either have the ambition to become an operator and establish a long-term presence in Kazakhstan or just to earn a quick financial return in a developing major oil province and then sell and leave. The strategy also determines the risk that the investor will accept and the amount of investment capital put at risk.
There are several choices to make, e.g. between an exploration venture (high risk, low investment) and a development and production venture (low risk, high investment). Oil projects have less complications with access to the market and pricing than gas projects that therefore typically need a longer-term commitment.
Exploring in proven oil basins (Fig.1 ) is less risky than in virtually unexplored basins.
An example of a proven basin is the Pri-Caspian Basin where already very large (world-class) volumes of oil and gas have been discovered. The oil occurs mainly in carbonate reservoirs below the Permian salt layer that forms a good seal to trap the oil in the Karachaganak and Tengiz fields and in the new Kashagan discovery by OKIOC offshore in the Caspian Sea. Still, various operators of exploration areas in the same basin have left without success, so exploration is still a game of chance even in this mature area. This is because geological parameters vary across the basin, especially the quality of the reservoirs below the salt and the access to oil charge for reservoirs above the salt. Regional studies that can be ordered to be carried out on this and other basins by consultants can be useful to pinpoint the more attractive blocks, especially for companies that do not have a lot of data and expertise on these areas in house.
The immature and unexplored basins are the playing ground of the real “wild-catters” who have a high risk/ high reward strategy. The Government will have to offer investors into those areas a lot more favourable contract terms than those in the more mature areas, to assure a high reward in case of success to this type of investor.
Most international oil companies have their own sets of assumptions for the economic analysis of investment opportunities, especially for the forecasted future oil price and the inflation and discount rates. Opportunities are ranked with the help of a mathematical formula to determine their relative attractiveness. Both mainly subjective assessments such as the probability of success (POS) and more tangible calculations such as the costs of the exploration programme and of field development are combined in a formula to arrive at an expected monetary value (EMV) for the project. It is important to understand that the EMV itself is a value that is unlikely to be realised, as it is an outcome of a combination of success and failure cases that are mutually exclusive. It is not more than a tool to compare “apples and pears” and put a number to the attractiveness of a great variety of opportunities. The net present value (NPV) of the exploration programme in the failure case is equivalent to the capital put at risk, and the NPV of the discovered field is the reward in case of success. The latter can be derived from a statistical simulation of several likely field sizes, e.g. with the so-called Monte Carlo method.
Let’s review some of the parameters for the economic analysis that are typical for the situation in Kazakhstan. First of all, there are the high transportation costs of the oil to the market (long distance by rail and/ or pipeline) that can easily amount to some $5-8 per barrel depending on the location. A second item is the timing of the work programmes to allow for delays caused by the harsh winter climate (see below under operational issues). Relatively favourable contract terms do generally compensate these negative factors, but the recently introduced requirement to deliver part of the produced oil to the domestic market, restricting export earnings, could have a major downgrading effect on the attractiveness of new ventures in Kazakhstan.
The Government should be aware that potential investors need fixed and stable contract terms for the production phase to make a sound economic evaluation of a new exploration opportunity. Without an agreement on the production terms the Government will have more difficulty to conclude new contracts and holders of contracts will have difficulty in finding a partner or a buyer in case they would want to (partially) divest.
Before making an economic analysis, it is important to be aware of operational issues that could greatly affect the timing and costs of the exploration programme. The most striking one is the harsh continental climate with temperatures in winter dropping to minus 40° C. In those conditions, only fully winterized rigs can operate, which are expensive and not available from local contractors. Seismic operations can be continued through the winter, although it is preferable to do it in spring and autumn. In summer, temperatures of plus 40° C make the operations less pleasant for the field crew. During the thaw period (March/April) seismic operations and rig moves should be avoided because of the wet and muddy soil condition.
Therefore, the timing of the programme has to be carefully planned, taking into account the time needed for obtaining all relevant licences to operate: The “project” for a well or seismic has to be drawn up in a standard way and to be approved by a multitude of authorities and institutions; also an environmental impact assessment has to be delivered. If any required item is missing from these, even if it is non-essential, the bureaucracy can cause significant additional delays for operators with strong business ethics. Subsequently, drilling locations have to be prepared (by local contractors) and water wells drilled, which typically takes another six weeks. It is clear that for multiple well programmes the locations should be picked and approved well in advance to avoid the rig waiting for the next location to be ready if drilling of the first well(s) was quick.
Especially in a high-risk venture, the planning and costing of the exploration programme has a high impact on the EMV, as it is clear from the economic evaluation scheme (Fig 2.).
The recent contracts for exploration and production are signed by the Agency on Investment of the Republic of Kazakhstan (AI), as the official competent authority on behalf of the Government.
However, new investors will soon discover that there are many more state institutions to deal with while operating in Kazakhstan, and that the AI is not equipped with sufficient staff and other resources to effectively serve as the one-stop shop that it was originally meant to be.
Monitoring by the Ministry of Natural Resources and Environmental Protection is through their regional institutions ZapKazNedra (west), YuzKazNedra (south), etc. Certain licences have to be obtained from the Ministry of Energy, Industry and Trade, especially when producing. That Ministry is also the source of the recent export restrictions as it deals with the interest of the refining and marketing sector. Furthermore, there is the ambiguous position of the State Oil Company KazakhOil, who on one hand represents the Government in several joint ventures and other contracts and on the other hand is operating as an independent oil company.
Apart from these “big four”, there are numerous other institutions who have to give approvals and need reports, such as the standards committee (Gosgortechnadzor), the sanitary department, and the various institutions and ministries dealing with customs duties, taxes, labour regulations, statistics, etc. Often, there are both national and regional (and even district) offices to satisfy for the same subject. In the production phase the state owned KazTransOil and its subsidiary KazTransGas will play an increasingly important role.
The Government would do the oil industry in Kazakhstan a great favour if the control and monitoring of the upstream oil industry were carried out by one institution only.
In addition to this complex system of licencing, there are a number of other legal issues facing the new investor, such as the type and registration of the company, the assignment of interest in case of an existing contract and the obtaining of work permits. All these issues require competent legal assistance, such as which can be provided by my partners, Grata Law Firm, who have a long experience especially in these issues related to the oil industry.
I already touch upon the importance of fixing the terms for the production phase in the Contract. This avoids possible lengthy negotiations, e.g. on the percentage of Royalty in case a discovery is made. Without those terms, it is even impossible to determine if the discovery is a commercial success or not for the licence holder.
Other issues that should be made clear in the contracts concern taxes. According to clause 8 of Article 61 of the Tax Code, the operator is exempt from VAT for “geological exploration”. The lawmakers obviously had the intention to lighten the burden on the investor in the phase that his investment is at risk, and a better wording would have been that the exemption would apply to all expenditures on items that are included in the exploration work programmes and budgets. I recommend to include wording into the contracts to clarify this, to avoid a too restrictive or arbitrary interpretation of the exemption by (local) tax authorities.
Another tax that would need clarification is the Land Tax. If the level of that tax is not specified in the contract, it could be subject of negotiations with regional or local authorities and lead to animosity. The best solution would be a low level of land tax combined with a certain commitment to invest in community projects in the area of operations. This not only assures that the money is used for a good cause, but also gives the investor goodwill and support of the local population in return.
Personal income tax of employees is paid in the form of withholding from the payroll. The beneficiary is the tax authority in the place of registration. A new investor could consider to register its branch or representative office in the area of operations, which will cause this benefit to go to the Regional or the District authorities where the impact will be bigger and more visible than in a large city like Almaty.
Almost all contracts and licences have articles about the requirement or strong preference to hire and train Kazakhstani personnel and sub-contractors. For many foreign operators this could create conflicts with their requirements for western quality and technology. In order to satisfy both the contractual and the technological requirements, an acceptable balance has to be found between obtaining services from Kazakhstani and foreign companies. Even better would be to obtain the services of joint ventures, i.e. Kazakhstani legal entities with a foreign interest and often foreign management to ensure quality and training of Kazakhstani staff. My company is presently forming such a joint –venture, “KazNIGRI International Ltd.”, to provide geological services to operators in Kazakhstan.
Through partnership with Favel International Associates (UK), a whole range of specialist services will be offered in the range of well site geology through biostratigraphy, core analysis, geochemistry to seismic interpretation, 3D reservoir modelling and field development planning.
KazNIGRI in Atyrau will provide part of these services in close cooperation with the foreign experts. They contribute their local knowledge based on more than 50 years experience in the oil and gas industry in Kazakhstan.
By using such joint ventures, the contractual issues can be solved and the operator will have less problems and more cooperation with respect to obtaining work permits for their own expatriates.
Responsibility for the environment in the licence area is often in one way or another a contractual item. It is important to restrict liability to environmental impact of the operations under the contract only, because there could be a significant heritage of environmental damage in the area caused by previous operators. Even with such a restricted liability, though, it still is important, for the public image of licence holders to actively pursue the solution of environmental problems in the licence area. This brings me to the next subject.
Social and Political Issues
An example of a positive impact by the licence holders on the environment is the clean up and abandonment of an old leaking well by Shell and Veba in the Temir area. The leaking oil was threatening to pollute a small river near the town of Shubarkuduk, and the local authorities asked Shell to use its expertise to help them with this problem (Fig.). The result was much appreciated by the local community.
In most rural areas of Kazakhstan, the main social problems are unemployment and the resulting poverty. Anything that the licence holders can do to alleviate these problems will be highly appreciated by authorities and community. Operators should urge their contractors to recruit their labour force as much as possible from the local population. This may be impossible where certain skills are required that take a long time to acquire, but to spend time to train the local work force in the simpler jobs will have a big return in terms of goodwill. The direct provision of medical services, heating, grants for education or other basic needs that can presently not be funded from the local budgets will give the investor a similar return.
To be a successful operator, it is important for the investor to behave as a good citizen in Kazakhstan and to be considered as such by the population and by the authorities at all levels. That status will provide the required goodwill and cooperation to solve all other problems.
As a last point, I want to make clear that many of the above statements are based on my own personal view and that they are meant not to criticize, but to indicate improvements that could be made to the mutual benefit of the State and the investors. I hope with this article to contribute to this process.
Hans Braakman, a citizen of The Netherlands, studied geology and geophysics at the University of Leyden, then joined Shell for a 25-year international career in oil and gas exploration. He worked in Brunei, Malaysia, Oman, the USA, The Netherlands, Syria and most recently as General Manager of Shell Temir in Kazakhstan.
In April this year he founded a consultancy firm in Almaty together with Grata Law Firm (Grata Petroleum Consultants Ltd.). He is presently forming a joint-venture service company with KazNIGRI in Atyrau and Favel International in the UK. He is planning for both these companies to play an active role in the further development of the oil industry in Kazakhstan.
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