Politics & Markets

Kazakhstan -- Would the OSCE chairmanship bail out beleaguered foreign oil c (Issue: 12)

Much to the delight of Kazakhstan?s politicians and policy makers, the Organisation for Security and Corporation in Europe (OSCE) awarded its chairmanship in 2010 to Kazakhstan. Officials have been lobbying for this honour in their attempts to project Kazakhstan as a force to reckon with from the Former Soviet Union. The appointment and its timing becomes a matter of importance in the context of recent controversies that engulfed Kazakh oil contracts with foreign companies.

OSCE was formed in 1973 during the cold war to promote East-West cooperation. It is now a 56-member organisation that is involved in a wide range of activities such as conflict prevention, crisis management, security issues and post-conflict rehabilitation. OSCE also monitors human rights and elections. Given Kazakhstan?s less than free and fair past elections, awarding the coveted chair post to Kazakhstan would perhaps appear as a paradox.

The appointment is widely perceived as an attempt by other members to avoid Kazakhstan moving further towards Russia, which used its clout in the OSCE decision-making councils to support Kazakhstan?s bid. It is also viewed as an attempt to block Kazakhstan forming closer ties with China through its membership in the Shanghai Co-operation Organisation (SCO). SCO is a security forum formed by Kazakhstan, China, Russia, Uzbekistan, Tajikistan and Kyrgyz Republic. The west it appears wishes to have Kazakhstan in their camp not leaning too much towards Russia or China.

Timing at least appears to be right. Kazakhstan is currently in the process of changing its oil and gas laws, which some argue may lead to ?Gazprom like acquisitions?. Authorities have been critical of oil contracts with foreign companies and were looking to change the ownership and impose higher taxes. Kazakhstan at the helm of OSCE is likely to slow down such endeavours. Arbitrator after all can not be seen as a violator by haphazardly changing contract terms with foreign companies from OSCE member countries!

It was only few weeks earlier, the Kazakh government demanded a share of profit from the Eni SpA-led Kashagan oil project earlier than planned, delaying the cost recovery time for investors. The original agreement had no provision for a share of production in the ?cost oil? phase, which enables investors recover their initial investment. Kazakhstan originally demanded only a greater share in ?profit oil phase,? the stage that follows once the project?s costs have been recovered. 
 
Reminiscent of Gazprom?s encroachment into foreign energy projects such as Sakhalin II and TNK-BP, the Kazakh government accused the Eni-led group over production delays and cost overruns amounting to US$136 billion at Kashagan - an offshore oilfield in the northern Caspian Sea. The consortium includes ExxonMobil, Royal Dutch Shell, Total, ConocoPhillips and Impex of Japan. Invoking memories of Kremlin?s overtures through Gazprom, the government demanded a larger stake in Kashagan (30% from the current 8.33%) for KazMunaiGas, the state oil company.

In defence of Kazakhstan there were frustrating delays on Eni?s part. Extensions were sought few times, which the Kazakh government granted. The project cost also increased by almost three fold from an estimated $54 billion to $136 billion. Cost increases would of course extend the cost oil phase and delay the profit oil phase which looks after the government interest. Eni admittedly was testing the patience of the Kazakh government. 

While Kazakhstan is unlikely to terminate the contract it would seek compensation from the consortium. It also sets an ugly precedent prompting oil companies to view Kazakhstan with considerable mistrust. The incident led to bitter disputes amongst consortium members themselves with some making independent proposals to the government including the replacement of Eni as the operator.

Meanwhile, the Kazakh government sprang another surprise and unveiled its aspirations to revise the tax code which could lead to a blanket tax covering all oil production to replace existing royalties and rents. The government has been critical of contracts secured by foreign oil companies when oil prices were low and the country was in the throes of an economic recession. The draft tax code is expected to be debated in the parliament early next year and rang the ?Excess Profit Taxes? (EPT) imposed by countries such as Algeria and Venezuela.

This makes Kazakhstan?s elevation to the chair of OSCE an important development. Chairing the OSCE is a matter of national pride to Kazakhstan and is viewed as a token of acceptance as an equal player in world affairs. The appointment however is conditional. Euro-Atlantic members supported Kazakhstan?s candidacy under two conditions, namely, progress in institutional building including greater democracy and that Kazakhstan remains independent. This places Kazakhstan on a sticky wicket in regards to oil contracts in general and Kashagan in particular.

As the chairman of the OSCE, Kazakhstan can not be seen as a violator and is likely to soft peddle its squabbles with Eni. Likely outcomes are a reduced compensation from the consortium or KazMunaiGas settling for an increased ownership but not as high as 30%. Eni is likely to remain the operator. More importantly, the Kazakh government will not terminate the contract and there will be no aggressive measures such as direct expropriation.

Provisions of the new tax code are unlikely to be as draconian as those in Some Latin American countries. The new tax code in any case is expected to be drafted in consultation with foreign oil companies that have already secured contracts. In other words, anxious investors in the Kazakhstan energy sector can consider themselves to be lucky with the Kazakhstan?s appointment to the OSCE chair.

We contacted some oil companies with operations in Kazakhstan in an attempt to get further insight to the current developments. When we contacted Eni, they confirmed that the Kazakh government has been seeking compensation and a higher stake. Negotiations are currently underway and Eni anticipates KazMunaiGas to secure a higher stake but less than 30% they originally sought. Eni also confirmed that the new tax code has been less than specific and is yet to spell out the blanket rate or how it will alter the current tariff structure.

Licencing terms of Kazakh oil contracts with foreign companies entail royalty payments and profit taxes. Royalty rates vary between 2 ? 12% but most of the companies are subject to a royalty rate closer to 2 to 4% rather than at the upper end of the range. Profit tax is 30-33.5%. Should the government impose an EPT, profit taxes are expected to increase. However, there is no clarity with regard to the EPT at this stage.

EPT on hydrocarbon contracts in Kazakhstan is computed at incremental tiered rates based on each contracts cumulative internal rate of return in excess of 20%. EPT ranges from 0 to 30%.

We contacted London listed Max Petroleum. Max Petroleum?s operations in Kazakhstan comprise three contract areas consisting of four oil and gas blocks in the pre-Caspian Basin. Two contracts, namely A & E Blocks and East Alibek, were acquired in 2003 and are exploration and Production (E&P) licences with initial six year exploration licence periods with two further 2-year extensions.  The A&E contract has a production period of 25 years with the possibility to extend it to 40 years. The terms of the production phase of the East Alibek would need to be negotiated at the end of the exploration license period.

The A & E Blocks and East Alibek contract terms are fairly standard for traditional contacts, including royalty rates based on production levels and a corporate tax rate of 30%, and an EPT which kicks in when the cumulative internal rate of return of the contract exceeds 20%. As is the case with contracts signed prior to 2003, contract terms are ?grandfathered?, and should not be impacted by future changes in tax legislation. The Company estimates the ultimate government take on these two contracts to be approximately up to 45%.

Terms of recent contracts in Kazakhstan are not grandfathered and are therefore subject to future changes in tax law. New contracts also entail additional export tariff over and above 2-6% royalty rate and EPT. Due to the higher tax regime under the license, the government take on new contracts could be as high as 70%.
 
We interviewed Tethys Petroleum (TSX: TPL) management as well in order to confirm the nature of their tariff structure with Kazakh authorities.  Tethys has three onshore licences in Kazakhstan. Contract terms of all three blocks are governed by the traditional royalty rate followed by the regular corporate tax rate which is 30%. In the absence of EPT, the government take is estimated to be approximately 45% of production.

Tethys has a long-term take-or-pay contract for its initial production with the gas trading company GazImpex. The contract relates to 30 billion cubic feet (Bcf) of gas from the initial Kyzyloi development only, and has been assigned to Kazakhstani Petrochemical Company. The contract price is US$1.03 per thousand cubic feet (Mcf) including VAT. Tethys can sell gas from new fields at market prices to any buyer of choice. The company started production in December 2007 and is expected to benefit from Kazakhstan?s rising gas consumption in the wake of its impressive economic growth.
 
Summing up
Kazakhstan?s proposed tax changes can not be viewed in the same light as EPT in Algeria or ownership changes in Venezuela. Given the delays and cost overruns by Eni led consortium, one is hard pressed to find fault with the Kazakh government for its apparent aggression. The government has historically remained friendly save Kashagan controversy. Its appointment to the OSCE chair should usher an even friendlier environment for energy companies.

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