KAZAKHSTAN’S OUTLOOK-3: Business environment still seen as risky in Kazakhstan

July 17, 2006
Kazakhstan is a large, remote, and sparsely populated region that serves as a land bridge between Europe and Asia.

Kazakhstan is a large, remote, and sparsely populated region that serves as a land bridge between Europe and Asia.

Considered a moderate, pro-Western, secular Muslim state, Kazakhstan continues to have high levels of bureaucracy, evolving petroleum legislation, and persistent corruption. Kazakhstan seeks to secure investment while retaining control of the sector, but there is no agreement on how this can be accomplished.

Because of the uncertain and risky business environment, a high-risk premium is placed on investment capital. Kazakhstan needs to continue to improve its institutional framework, combat corruption, and entrench the rule of law. In the final article of this series we describe the current business climate and regulatory changes that have occurred over the past 2 years.

Legislative changes

Several statutes govern the terms of E&P activity in Kazakhstan: the Petroleum Law,25 the Subsoil Law,26 27 the Tax Code,28 and the 2005 PSA Law.29

A number of legislative changes have been made over the last two years that affect both new and previously signed agreements. The aim of this section is to highlight the primary changes that have occurred.

Other articles contain detailed description of these provisions and other changes,2 13 30 31 32 and general background on taxation issues.6 33 34

We begin with the most controversial legislative change, the state preemptive right clause.

State preemptive right

On Dec. 1, 2004, President Nazarbayev signed Law No 2-III.27

One of the most important features of the law amends Article 71, “Guarantee of Subsoil User Rights,” as follows:

“With the aim to preserve and strengthen the reserves and power resources of the economy in new and existing contracts for subsoil use the State shall have a preemptive right over any other party to the contract or participants in a legal entity having a subsoil use right, or other persons to buy an alienated subsoil use right (or part thereof), or part of a share (stockholding) in a legal entity having a subsoil use right, on the conditions not worse than those offered by other buyers.”

The state preemptive right clause grants the government a preemptive right to acquire any subsoil use right and-or equity interest that a subsoil user wishes to transfer. The clause applies to all existing and future contracts.

Ownership transfer rights are normally covered under the Rights and Obligations of Contractor clause in PSCs.35 Ownership transfer, also known as transfer of rights (or assignment), is an important aspect of contract negotiation, with most contracts giving the contractor the right to assign “in whole or in part any rights, privileges, duties, or obligations” to any third party acceptable to the national oil company or appropriate authority.

Some contracts will cede to the national oil company a right of first refusal-the option of taking up the interests being transferred under the same terms offered-but these terms are negotiated “up-front” at the time of signing and not imposed through unilateral action at a later date.

Barge rig drills a well at supergiant Kashagan field in shallow waters of the North Caspian Sea (Fig. 1).
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The government initiated the preemptive right clause after British Gas (BG) announced its intention to sell its share in supergiant Kashagan field in the North Caspian Sea (Fig. 1). In March 2003, BG announced that it intended to sell its 16.67% share in the North Caspian PSC (Kashagan) to China National Offshore Oil Corp. and Sinopec for $1.23 billion.

The consortium partners exercised their preemption rights in May 2003, nullifying the Chinese entry, but the government did not approve the transaction and argued that legislation governing the deal granted the government ultimate preemptive rights. The government’s argument was that since it owns the subsoil rights, it has a preemptive option to buy.

Ownership rights of the field remained unclear for nearly 2 years, and little progress on field development was made during this time. In November 2004, legislation was passed that granted the government preemptive purchase rights in any energy project shares under sale. After drawn-out negotiations, consortium members agreed to distribute half of BG’s share to Kazmunaigaz (8.33%), splitting the other half among themselves.

According to the Kazakhstan Petroleum Association, an industry lobby group representing 47 companies from 20 countries, the preemptive right clause “will adversely affect the investment climate in Kazakhstan and will undermine investors’ confidence in the republic’s commitment to providing a stable and predictable legal and contractual regime.”36

One of the main concerns among the partners is KMG’s ability to fund its share of development cost over the life of the project. There is also concern over the government’s influence in the consortium. According to the government’s public statements, the main interest in acquiring an interest in Kashagan is to gain access to reserves to back its participation in export routes to China, Iran, and the Baku-Tbilisi-Ceyhan pipeline.30

Local content requirements

Governments typically receive more revenue from taxes by local firms than foreign contractors, who may be exempted from such payments or who source their supplies outside the country.

The size of the oil and gas equipment sector in Kazakhstan and the distribution of market share are depicted in Table 1. The low levels of local production are one of the reasons the government has begun to regulate local capabilities through quota.

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Tender proposals seeking E&P rights must now specify the user’s commitments to infrastructure and other economic/social developments of the country; identify their commitment to hire local personnel; and define the percentage of local content of works, goods, and services. Failure to comply with the obligations can result in being sued by any potential supplier of the good.

Tenders must also express a commitment to local content by including proposals for the development of high technologies (first priority), new production processes (second priority), and construction and joint use of other infrastructure (third priority). Regulating local capabilities through quota and compulsion is unlikely to be sustainable, however, and the economic viability of the proposal remains to be seen.

Expanding KMG’s power

Kazmunaigas was created in February 2002 by the merger of Kazakhoil and Transport Nefti Gaza to ensure a single state policy in the countries mineral resources and to compete with international companies on E&P contracts.34

KMG currently plays a pervasive role in the oil-gas sector, as investor and partner on several joint ventures; monopoly operator of the domestic oil and gas pipeline network (except CPC); and in a regulatory and supervisory role. Since KMG took control of the government’s interest in the oil and gas sector, oil companies have been subject to additional oversight, with foreign investors generally being held to higher standards of accountability.

In 2004, the government introduced legislation further expanding KMG’s participation in new ventures. KMG now has the right to participate in all oil/gas projects, either as contractor (on its own or jointly with companies) or on the side of the government. KMG’s expanding power is likely to create additional friction among investors. The creation of an independent regulatory structure to oversee the industry remains an outstanding and neglected issue.

More changes

A number of other changes have also been made in the petroleum legislation that we refer to only briefly:

  • Offshore exploration acreage conveyance.
  • Gas utilization/flaring requirements.
  • Minimum state “take” in PSCs.
  • Royalty tax PSC exclusion.
  • New royalty schedule on concessionary systems.
  • Crude oil export tax.
  • Tax stability clause.

New offshore blocks may only be conveyed through PSCs after tenders for E&P on terms set by the government prove unsuccessful. KMG has been given the right to first tender on all new blocks with minimum 50% ownership.

Development of oil-gas fields without the full utilization of gas is now prohibited. Punitive measures for violation include contract suspension, termination, fines, and criminal liability.

In early contractual agreements, cost recovery limits were negotiated on an individual basis, while under new PSCs, cost recovery cannot exceed 75% gross production before payback; 50% gross production after payback.

The state’s total tax “take” must now be at least 10% of the value of production prior to payback and 40% after payback (having been adjusted downward from 20 and 60% in 2004). On new projects, excluding PSCs, a sliding scale tax has been imposed on all crude oil exported from the country ranging from 1% (when P = $19/bbl) to 33% (when P > $40/bbl). The stability of tax treatment on new concessionary contracts has also been revoked, so that investors are no longer protected from future changes in tax legislation.

Rising tensions

Since KMG took control of the government’s interest in the oil and gas sector in 2002, all oil companies have been subject to additional government oversight. Frequent conflicts continue to arise between the government and foreign partners over attempts to revise previously signed contracts.

A portion of the production facilities at supergiant Tengiz oil and gas field. Photo from Chevron (Fig. 2).
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At Tengiz field (Fig. 2), disagreements between the government and TCO over financing a gas processing and recycling project became so serious that TCO suspended its activities. TCO wanted to finance field expansion by reinvesting profits from its exports, as prescribed in the joint venture agreement, while the government wanted TCO to pay tax in full on its exports and borrow cash abroad to finance the work to preserve its shares of revenue.

The parties eventually agreed in January 2003 that TCO would revise the financing terms, pay $810 million in taxes through 2005, and take out a loan to finance the government’s share of the expansion.7 37 The government emerged from the standoff in a strengthened position and has become more confident in dealing with foreign investors and challenging contract terms.

At Kashagan, the government created a special working group in August 2005 to explore the terms and conditions of the 1997 PSC, especially with regard to the customs and tax payments, “...taking into account the present, medium and long-term interests of Kazakhstan,”38 The total cost of Kashagan over its lifetime is expected to be $30 billion, and according to the trade press, if the contract terms are changed, costs may rise by 10-20%.

The government has stated that it may link the stability of the tax regime to guarantees to hire local companies. A $50 million fine for every year Kashagan’s production is delayed beyond 2005, the originally scheduled production date of the project, was also imposed.

Misplaced focus

The government perceives state revenue from oil production has been “low” and has been seeking more appropriate contract terms while modifying its tax environment.

The government’s focus is generally misplaced, however, as contract terms in Kazakhstan are already quite “tough” by international standards. Field developments in the Precaspian basin are technically challenging and expensive, and are one of the primary reasons why contracts are so heavily “back-loaded” with cost recovery mechanisms.

Public vs. private debate

The flow of income to Kazakhstan from hydrocarbon resources has allowed the government, rather than the private sector, to take a central role in the economy. This presents a macroeconomic risk the long-term impact of which is likely to be a misuse and misallocation of resources.

Western economists would say that the role of the state is to support the private sector, so that the private sector can make investment decisions, since it is generally recognized that people who invest their own money are more likely to make better decisions than bureaucrats. And despite Kazakhstan’s movement toward a market-based economy, corruption continues to play a large part of the cost of doing business and contributes to high levels of uncertainty.

The remarks of the British Ambassador to Kazakhstan provide sound advice: “The government should focus on creating a level playing field, entrenching the rule of law, combating corruption, reducing the regulatory burden, and insuring transparency.”39

An uncertain future

Recent changes in Kazakhstan’s petroleum laws have considerably strengthened the state’s control of large enterprises with foreign investors and will enhance the state’s role in the oil and gas sector.

The impact on investor discontent is difficult to predict, but general trends are apparent. In the near-term, significant investments are planned or under way at Tengiz, Karachaganak, and Kashagan, and it is unlikely that the operators of these fields will make major changes in development plans.

Majors will protect their investments and are likely to proceed cautiously to increase their presence in the region or in joint ventures as strategic partner with KMG. Less engagement by Western firms and less technology transfer is the anticipated result.

The geographic proximity and political influence of China and Russia will fill any voids that develop. China and Russia are natural trading partners for Kazakhstan, but historically both of these countries have also played ambiguous, if not antagonistic, roles in Kazakhstan’s political aspirations.

Kazakhstan’s oil policy shows signs of converging to that of Russia, which is expected to improve the conditions for regional joint business arrangements. As Kazakhstan’s reserves base and infrastructure matures, foreign capital will continue to find a home in the country.

Transparency and corruption

The World Bank has performed a number of comparative studies on the quality of governance and corruption around the world.

In a study that involved 199 countries and 25 separate data sources collected by 18 organizations, the quality of governance was compared across countries. For the 4 years assessed (1996, 1998, 2000, and 2003), most government indicators for Kazakhstan-including voice and accountability, effectiveness, regulatory quality, rule of law, and control of corruption-were substantially negative and deteriorating, and only political stability showed an improvement.40 41

Two World Bank surveys concluded that corruption is widespread throughout Kazakhstan,42 43 and according to the Corruptions Perceptions Index published by Transparency International,44 which ranks countries by the degree to which corruption among public officials and politicians is perceived to exist, Kazakhstan’s score fell from 3 in 2000 to 2.4 in 2003. The index ranges from 0 (“highly corrupt”) to 10 (“highly clean”).

Recent indications by government officials to join the UK government’s Extractive Industries Transparency Initiative, which aims to enhance the transparency and accountability of revenues derived from natural resources, have been well received by company officials and international observers, but its ultimate impact, if any, remains to be seen.

The marine terminal at Novorosiisk serves the Caspian Pipeline Consortium crude oil system. Photo from CPC (Fig. 3).
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Widespread allegations of bribery, corruption and diversion of funds, as well as increasing ownership and policy influence of the President, members of his family, and close associates continue to be made.12 There is also a consistent but unpredictable pattern of ownership behavior and government response.

As described by Peck, well-connected Kazakh officials acquire ownership in an oil field or refinery but do not meet pledged investment schedules or attempt to rebuild the facility. The government does not hold these firms to the same standards of accountability as foreign investors and has applied pressure selectivity, heavily in some cases (PetroKazakhstan, CNPC, Agip KCO) and lightly in other cases (Mangistaumunaigas).

Another market test

In May 2003, the government announced a Caspian Sea development plan that called for new offshore blocks to be auctioned in 2004.45

According to the plan, KMG is to be given first offer and has the right to individual share of no less than 50% as contractor in all PSCs with tenders conducted with other companies as strategic partners. The development plan failed to draw investor interest in 2004.

The government plans to reopen the tender process in 2006. The success/failure of the latest tender will serve as the second test of the attractiveness of the new fiscal regime and investor interest in the country.

The future

The oil and gas sector is the engine that drives Kazakhstan’s economy, and the government recognizes the need to develop policies and reforms that support sustainable growth.

There continues to be risk from overreliance on the oil sector, although according to a recent IMF report, “...management of petroleum resources appears prudent, with few, if any, indicators of the resource curse. Nonetheless, Kazakhstan still needs to follow established world practices to account for resource-related transactions.”

The government has sought to diversify the transport infrastructure of the country and the connectivity of the region. Continued planning and investment in this area is essential for expected growth in the future. Pipeline capacity is not yet binding, but as fields continue to develop, diverse export options are essential to ensure that Kazakhstan crude can be sold at competitive prices.

In order to convert its mineral assets into financial resources, Kazakhstan must attract capital to explore for, develop, and produce its natural resources. Kazakhstan’s ability to develop and bring its oil to market depends on its ability to establish and maintain commercial relationships with international oil companies and political equilibrium with regional powers.

As Kazakhstan’s reserves base and infrastructure matures, investment capital will continue to find its way to the region, but the mix of the investment is likely to change.

Unresolved divergences in perceptions of contract fairness, risk sharing, and the relative attractiveness of Kazakhstan’s oil reserves is likely to remain a source of friction with investors.

If contract terms continue to be “rebalanced” with ever-evolving model contracts and tax code changes, investor confidence will deteriorate.

Kazakhstan’s strategic positioning appears aligned to strengthen economic cooperation and political relationships with China and Russia. This is part of Kazakhstan’s geostrategic policy, which is expected to improve the conditions for local joint business arrangements, but may prove ominous for the majors. Along with the increased role of KMG and selective government involvement, opportunities for corruption are expected to grow.


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