Kazakhstan Oil & Gas Industry – Emerging Potential
Fitch Ratings in this report analyses the main trends in Kazakhstan’s oil and gasindustry, its position in the world markets, and implications for the ratings. Keyconclusions include:
· Fitch expects oil production in Kazakhstan to expand at a compound annualgrowth rate (CAGR) of 5.7% over 2007-2015 – to 2.3 million barrels per day in2015 – driven by the output growth at the main onshore and offshore fields ofTengiz, Karachaganak and Kashagan. The risk to this forecast on the downside isdue to uncertainties inherent in the Kashagan project development.
· In light of the tightening of the Kazakh state’s grip on the sector, Fitch believesthat an increased state role might create a more stable operationalenvironment with established rules, but that a balance needs to be maintainedbetween the interest of the state and its ability to develop the fields withoutinternational assistance.
· While the Kazakh oil and gas companies operate on a smaller scale than theirRussian counterparts, planned expansion is likely to transform them intomedium-size players with output of over 500,000 barrels of oil equivalent perday (boed).
· The hydrocarbon producers in Kazakhstan (except for the gas pipelineoperators) compare well with their Russian and international peers – based ontheir solid credit profiles. However, some risks are arising which includeplanned aggressive capex programmes, and the introduction of a new tax on thesector.
· Fitch expects the favourable global industry environment to continue tounderpin the development of the Kazakh hydrocarbons companies. Althoughsome softening factors for oil prices have emerged, prices are expected toremain high relative to historical averages.
· Fitch rates KazMunaiGaz National Company (NC KMG, ‘BBB’/Negative) using theagency’s Parent and Subsidiary rating methodology, and aligns its ratings withthat of the sovereign. Other Kazakh companies in the sector are rated primarilyon a standalone basis. Fitch does not anticipate any positive rating actions inthe short term, but will monitor developments which might impact the ratingsof the Kazakh producers in the medium term, i.e. financing of the capexprogrammes and planned production expansion.
As competition for hydrocarbons grows, Central Asia is emerging as an importantplayer in the energy markets due to its vast reserves. As the largest country in aregion rich in natural resources (Kazakhstan accounts for 83% of proven oil reservesand 25% of proven gas reserves in Central Asia), Kazakhstan has captured theattention of the energy community.
Fitch covers three areas in this report. The first discusses the main trends in theKazakh oil and gas industry as influenced by global industry dynamics, while somedistinguishing characteristics of the Kazakh sector evidently stem from its evolvingnature and its links to the Soviet era. The second focuses on the global industrylandscape and the future trajectory for oil prices, and the third area examines howthe impact of the development of the Kazakh oil and gas companies is reflected intheir rating levels.
Kazakhstan Oil and Gas – Key Developments
Domestic Industry – Production on the Rise, Consumption GrowthRekindled
Kazakhstan was among the few oil producing countries in the world to post higheroil output in 2007 versus 2006. During 2000-2007, the country achieved a robust10.4% CAGR of oil production. Oil output reached 1.49 million barrels per day (p/d)in 2007, up by 4.5% yoy, compared with less than 800,000b/d in 2000. Kazakh oilproduction also grew in the first seven months of 2008, in contrast with stagnantRussian production. Despite this growth, Kazakhstan still lacks the scale that wouldallow it to influence world petroleum prices.
The Kazakh government forecasts oil production of 1.5 million b/d in 2008, slightlyhigher than in 2007. Fitch expects oil output growth to remain limited inKazakhstan until the expansion of two onshore mega-projects – TengizChevrOil(TCO, Series A Notes rated ‘BBB-’) and Karachaganak – is successfully implementedand the main offshore field, Kashagan, also comes on stream (Table 1).
Both Karachaganak and Tengiz have experienced delays in implementing theirexpansion projects. At the same time, with many onshore fields reaching maturity,the country’s future oil potential is in the long-run tied to the development ofoffshore fields. The complex geology of these offshore fields – in conjunction withenvironmental challenges – could lead to delays and cost overruns, as evidenced bydevelopments at Kashagan. Kashagan’s initial oil delivery date was pushed backfrom 2005 to 2013-2014, and capex was revised upward from USD57bn to USD136bn.
Fitch forecasts Kazakh oil production to grow at a CAGR of 5.7% over the period2007-2015 to 2.3 million b/d by 2015. The risks inherent in this forecast are skewedto the downside amidst operational uncertainties related to the development of theKashagan field, which is expected to be the main driver of oil output expansionafter 2013-2014. At present, Kazakhstan operates on a much smaller scale than theRussian oil industry. However, if Kazakhstan is able to develop its oil fields asplanned, Fitch expects its crude oil output to rival that of Norway in the next six toseven years.
Domestic Kazakh consumption of crude oil began to decline with the end of theSoviet Union. By 1996, consumption had fallen to nearly half 1991 levels.Consumption in 2007 rebounded to 219,000b/d. Fitch expects this figure to increaseto about 300,000b/d by 2015 – back to 1993 levels – which still leaves considerableheadroom for exports.
Kazakhstan has a respectable reservebase; second only to Russia among theformer Soviet states, and equal to twoof OPEC’s smaller members, Libya andNigeria. BP plc (‘AA+’/Stable) estimatesKazakhstan’s 2007 proven oil reserves at39.8 billion barrels (3.2% of provenworld reserves). At current productionlevels, Kazakhstan has a reserve-toproduction(R/P) ratio of 73.2 years,close to that of the Middle East – andsignificantly greater than the worldaverage of 41.6 years and the Russianaverage of 21.8 years. At the production level forecast for 2015, the R/P ratiowould still be on the high side, at 43 years, albeit closer to the current worldaverage.
Kazakhstan also has a respectable gas reserve base, with proven reserves of 1.9trillion cubic metres (tcm) in 2007 – similar to Iraq and Uzbekistan. The R/P ratiofor gas is also strong, at 69.8 years. The current natural gas production level is low;in 2007, the country produced 27.3 billion cubic metres (bcm), up 11% yoy.According to the Ministry of Energy and Mineral Resources, gas production isforecast to increase to 43bcm by 2010 and to 62bcm by 2015.
Market Structure – Rebalancing of Power
In contrast with Russia, Kazakhstan’s oil and gas industry is still evolving and goingthrough the final stages of a consolidation and rebalancing of the current ownershipstructures. The industry is primarily focused on upstream business, with only threerefineries in the country left over from Soviet times (Atyrau, Shymkent andPavlodar) – with a total refining capacity of less than 350,000b/d, a fraction ofRussia’s 5.6 million b/d.
The exploration and production (E&P) segment comprises the state-owned NC KMG,established to represent the interests of the government in the industry,international consortia developing themajor oil and gas fields in the country,and a number of small players (Chart 4).Virtually all the large international oilcompanies have some activity in thecountry, as Kazakhstan requiresinternational expertise and technologyfor the development of its untappedreserves — many of which face extremeweather conditions, complex geologyand technical issues. This has resultedin a more investor-friendly environmentcompared with some other oil-producingcountries. Two international consortia(TCO and Karachaganak) accounted forthe bulk of the country’s oil production(33%) in 2007, whereas NC KMG was responsible for about 20%.
Overall, the oil and gas industry is crucial for the Kazakh economy, contributing 25%of revenue and 58% of export earnings in 2007. At the same time, Fitch expectsover 60% of oil output in 2015 to be derived from the fields which are at presentmainly operated by international oil majors. These factors, in conjunction with thecurrent favourable oil and gas industry fundamentals, provide an impetus for theKazakh government to tighten its grip on the industry – a process which has beenwitnessed in other oil-producing countries like Russia and Venezuela.
In light of this, the Kazakh government made a number of changes to oil and gaslegislation conducive to the further consolidation of existing smaller entities underNC KMG’s umbrella, and to increasing state control over the industry – includingprovision to NC KMG of a pre-emptive right for the acquisition of any assets offeredfor sale in the domestic market, as well as the right to acquire a minimum 50%stake in new offshore projects. These rights were exercised by NC KMG for theacquisition of a 33% stake in PetroKazakhstan, a 50% interest in Kazgermunai, and a50% interest in CCEL which owns the Karazhanbas oil and gas field. Furthermore, NCKMG was able to increase its stake in the Kashagan project from 8.33% to 16.81%following severe delays in the development of the field.
In Fitch’s view, an increase of the state’s role could underpin greater stability andcertainty for all the players in the sector, as well as setting clearer operationalrules, albeit in the context of a stricter regulatory environment. Nevertheless, asevere tightening of state control (which seems to be unlikely) could jeopardise theimplementation of the country’s ambitious oil and gas production expansionprogramme, which continues to rely on substantial international investment andexpertise. Thus the balance between national resources and the ability to exploitthem without foreign assistance needs to be maintained.
Operations – A Mixed Bag
Since the Kazakh oil and gas industry is emerging as a player on internationalmarkets, many Kazakh companies are still reporting their reserves under the Kazakhclassification (A+B+C1) – which technically makes their data incomparable withthat of their international and Russian peers reporting under internationalstandards. However, this is likely to change and is expected to increasetransparency. For example, NC KMG is contemplating a move to internationalstandards within the next one to two years.
As of September 2008, all Kazakh oil and gas companies are operating on a smallscale – with oil and gas production below 500,000boed, as shown in Table 2.Although NC KMG and KazMunaiGas Exploration Production (KMG EP, ‘BBB-’/Stable)reported impressive oil output growth in 2007 of 5.1% (to 301,000 barrels of oil perday) and 12% (to 215,000 barrels of oil per day), respectively, it was drivenprimarily by acquisitions. In the event that TCO and Karachaganak successfullyimplement their expansion projects, they should be able to reach a scale in linewith medium-size companies after 2009-2010.
Most of the Kazakh oil and gas companies in Fitch’s rated universe have reportedstrong reserve replacement rates (RRR) well above 100%, but their R/P ratios werelower than those of their Russian peers. Kazakh producers, however, are wellplaced based on lifting costs. The future operating statistics of the Kazakhcompanies may be positively impacted by the successful development of the majorfields discussed above.
Taxation – Some Win, Some Lose
In April 2008, Kazakhstan announced the introduction of a crude export duty ofUSD109.9 per tonne (based on the average oil price in Q108 of about USD94/barrel),to be periodically adjusted based on oil price developments. The duty is expectedto be levied on companies that do not have customs stability clauses in theircontracts, including the largest subsidiary of NC KMG - KMG EP. However, thegovernment is also considering an option to levy this duty on the foreign operatorsof the Karachaganak and Tengiz fields, which were initially expected to be exempt.
Fitch believes that the impact of the crude export duty on all Kazakh oil and gascompanies can be cushioned by their higher profitability compared with theirRussian and international counterparts. Furthermore, the proposed Kazakh crudeexport duty is less punitive than that currently operating in Russia, as demonstratedin Chart 5.
Nevertheless, in early September 2008 the government submitted to the parliamenta draft of a new tax code which proposes to set mineral extraction tax rates for oilproduction – at 7%-20% of the crude oil’s market value from 2011. It also proposessome changes to the oil export tax and a possible reduction or elimination of valueaddedtax (VAT).
Given the ambiguities of the new taxation proposals, it is difficult to estimate theirimpact on the sector’s credit profile. Therefore, Fitch will closely monitor thechanges which a new tax code might entail, and any possible credit impact on therated entities.
Infrastructure – Challenges Ahead
As Kazakhstan is a land-locked country, its future oil and gas expansion potential isheavily reliant on the availability of pipeline infrastructure. Most of the currentpipelines were built in Soviet times as part of the ‘unified system’. As of September2008, the country plans to implement aggressive pipeline expansion projects forboth oil and gas, with the main Kazakh pipeline operators – KazTransOil (KTO,‘BBB-’/Stable), KazTransGas (KTG, ‘BB’/Stable) and Intergas Central Asia (ICA,‘BB+’/Stable) – earmarking about USD10bn for investment over the next five years.
The main risks inherent in the implementation of these projects are potentialdelays and cost overruns. Some of the projects have already experienced significantdelays, for example attempts to almost double the capacity of the CPC pipeline to67 million tonnes (about 1.3 million b/d) by 2010 have been resisted by Russia(which owns 24% in the pipeline consortium) ostensibly due to its concernsregarding the economics of the project. Financing of the abovementionedinvestment programme – whilst maintaining a prudent financial policy – could alsobecome a challenge, although some mitigating factors are in place, namelyflexibility of financing (including non-recourse, state funding).
Financial Profile – Staying Afloat
Favourable oil and gas industry fundamentals set a base for the solid credit metricsof the Kazakh oil and gas companies (Chart 6). The latter compare well with theirRussian and international oil and gas peers – based on profitability, with a medianEBITDAR margin of 48.1% (42.7% for the Russian and 29.7% for the internationalpeers, respectively).
The Kazakh companies also posted strong EBITDA per boe (USD32.8/boe for NC KMGand USD36.2/boe for KMG EP) compared with the range of USD14/boe to USD22/boefor the Russian peers, which demonstrates not only profitability but also theefficiency of operations. Fitch anticipates strong revenue growth and healthymargins for the Kazakh companies amid an expected benign industry environment – as discussed in detail in the World Oil and Gas section below. However, it should benoted that since the Kazakh companies are primarily involved in the upstreambusiness, they are more exposed to the volatility of oil prices than the Russianintegrated oil and gas producers.
Strong profitability resulted in ample cash flow for the Kazakh producers, whichwere able to maintain a relatively high CFO/revenue ratio – with a median figureof 36.7% that places them in a good position compared with both Russian (23.5%)and international (17.6%) counterparts.
Nevertheless, Fitch believes that the planned capex might cause a drain on cashflow. At present, most of the Kazakhcompanies are able to cover their capexneeds in full with internally generatedcash flow, as reflected in their medianCFO/capex ratio of 1.1x. An exceptionto this trend is small-scale companiesinvesting heavily in order to maintaintheir production (for example, TristanOil Ltd. (Tristan, ‘B+’/Negative)), aswell as gas pipeline operators such asKTG/ICA. At the same time, mostcompanies plan aggressive capexprogrammes over the next five years,e.g. NC KMG intends to invest aboutUSD29bn over 2008-2012. Theimplementation of investmentprogrammes on such a scale will probably require external financing, and thus couldadversely impact credit metrics.
In 2007, the Kazakh oil and gas companies (with the exception of the gas pipelineoperators and small-scale producers) posted low net leverage (ranging fromnegative 1.2x to positive 0.6x) underpinned by strong profitability and ample cashpositions. This is another ratio whereby they compare favourably with Russianentities (median figure of 0.6x) and others worldwide (0.8x). However, debtfundingof future capex may lead to a rise in leverage, and could result in adeterioration of coverage ratios which are at present already in line with those oftheir international and Russian counterparts (see Table 3 for comparison offinancial coverage metrics with selected peers).
In addition to financing flexibility as mentioned above, another mitigating factor forthe intensive capex planned, is the ample liquidity demonstrated by the Kazakh oiland gas companies — despite the credit crunch which has had an effect on thebanking system in Kazakhstan and led to a change of Outlook on the sovereignratings to Negative (Chart 9). Fitch has applied a ratio of (Cash + FCF)/short-termdebt to carry out a comparison of theliquidity positions of the rated entitiesin the industry. The Kazakh companies’median figure of 2.5x is well above thatof Russian peers (1.1x) and alsoselected global entities (2.1x).
World Oil and Gas – SteadyConsumption But SlowingProduction
Global oil consumption remained strongin 2007, up 1.1% yoy whereas global oilproduction fell by 0.2% – down for thefirst time since 2002. Oil prices were onthe upward trend for the sixthconsecutive year. The tightsupply/demand balance underpinnedthe recent sharp rise in oil prices.Another contributing factor was the increased appetite of investors for exposure tocommodities.
However, Fitch believes that softening factors for oil prices have emerged – including the slowdown of the US and Chinese economies as well as expectedimprovements in spare OPEC capacity. Despite the anticipated downwardcorrection in oil prices, Fitch still expects oil prices to remain high on a historicalbasis throughout 2008-2010.
The trends of rising finding and development (F&D) and production costs,difficulties in finding and replacing reserves, and resource nationalism are likely tosubsist. High volatility in prices is also expected to persist, reflecting theuncertainty regarding the ramp-up of expansion projects worldwide, amongst otherthings.
Implication for the Ratings – Testing Times
When rating national oil and gas companies, Fitch applies the Parent and Subsidiarymethodology which enables the agency to assess the strategic, operational andlegal ties between a parent (the state, in this case) and a subsidiary (nationalcompany).
This methodology was used for theanalysis of NC KMG, the ratings of whichare aligned with the sovereign’s and arein the same category as the largeRussian integrated oil and gas producers – including OAO Gazprom (Gazprom,‘BBB’/Stable), OJSC OC Rosneft(Rosneft, ‘BBB-’/Positive) and OAOLUKOIL (LUKOIL, ‘BBB-’/Positive). NCKMG’s ratings reflect implicit andexplicit state support (i.e. state fundingof some projects, pre-emptive rights)and state ownership.
In Fitch’s view, although the oil and gasindustry is important for both theKazakh and Russian economies, theKazakh economy operates on a muchsmaller and less diversified scale thanthe Russian one, which makes it more reliant on the hydrocarbons markets. Thisfactor provides additional impetus for the ratings of the Kazakh national companyto be aligned with the state, whereas the ratings of the Russian state oil and gascompanies (e.g. Gazprom and Rosneft) are more focused on their standalone creditprofile, whilst factoring in less tangible state influence and support.
The other Kazakh entities owned by NC KMG – KMG EP, KTO and KTG/ICA – are allrated on a standalone basis, albeit with implicit state support via NC KMG beingincorporated into the ratings, as well as their inter-dependencies.
While analysing both private and national oil and gas companies, Fitch places anemphasis on their financial profile and operational statistics (including outputgrowth potential, reserve replacement, and costs associated with oil discovery andproduction). For example, the rating in a single ‘B’ category for Tristan, a Kazakhprivate oil producer, reflects its small scale of operations, with oil and gasproduction of less than 50,000boed, as well as limited opportunities for growth andlimited financial flexibility. Although Fitch does not rate TCO itself, it does rate theSeries A Notes at ‘BBB-’ – which is reflective of the underlying creditworthiness ofthe entity, including its growth opportunities discussed above.
Fitch notes that the ratings of the Kazakh oil and gas entities have been relativelystable over the last two years. In the agency’s view, an upgrade for the rateduniverse in the Kazakh hydrocarbons industry is not anticipated in the short-term.However, the agency will monitor the following aspects, which may pose a risk forcredit profiles in the medium-term:
· Financing of planned aggressive capex programmes without jeopardising creditmetrics
· Delivery of planned production growth and reserve replacement without severedelays and cost overruns
· General production cost containment
· Any impact of new taxation.
Copyright © 2005 by Fitch, Inc., Fitch Ratings Ltd. and its subsidiaries. One State Street Plaza, NY, NY 10004.
Reproduction or retransmission in whole or in part is prohibited except by permission. All rights reserved. All of the information contained herein is based on information obtained from issuers, other obligors, underwriters, and other sources which Fitch believes to be reliable. Fitch does not audit or verify the truth or accuracy of any such information. As a result, the information in this report is provided "as is" without any representation or warranty of any kind.
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