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Closing Case Sour Oil, Soured Deal With the price of oil surging to over $145 a barrel in 2008. you'd think that rights to develop the Kashagan oil field in Kazakhstan (see Map 3.4) would bring a smile to any oil exec- utive's face. Instead, it has produced nothing but headaches for the Western oil companies involved. The Kashagan field is currently the world's largest oil development project. It holds an estimated 13 billion barrels of oil, making it the fifth largest reservoir in the world and the largest discovery in 30 years. The Soviet Union was aware of the field's potential but chose to avoid the techni- cal difficulties of offshore drilling there in favor of its more easily exploited Siberian oil deposits. When the Sovie Union collapsed and Kazakhstan gained its independence in 1991, the new country lacked the technology and manage ment skills to develop the field, for most of the available talent was Russian. Accordingly, it offered exploration rights to Western oil companies using a production sharing agreement (PSA). PSAs are common in the oil industry The companies bear all of the costs of exploring, develop ing, and operating the oil field but are allowed to recover al of their costs before having to share any revenues with th host government Kazakhstan and the Caspian Sea Region In 1997, a consortium of oil companies Shell, BP. Total Mobil (now purt of ExxonMobil). ENT of Italy, Statoil of Norway, and the BG Group of the United Kingdom won the rights to develop Kashagan under a production sharing agree ment signed with the Kazakh government. (In 2003 BG dropped out of the project, the state-owned Kazakh company Kaz MunarGas (KMG) bought half of BG's share, with the other half being split among the other partners.) The consor- tium hoped to be pumping 250.000 barrels of crude oil per day by 2011 and 1.5 million barrels a day by 2019. Originally Shell was selected by the companies to serve as the lead operator. But after a series of misadventures with a drilling barge that Shell had used in Nigeria and proposed to transport to the Caspian Sea, the other partners demanded a new operator. ENI was the compromise choice, The challenges facing ENI were numerous. The Caspian Sea freeres over four months of the year because winters in the region are cold and its waters are shallow in the Kashagan region Ice floes and pack ice driven by fierce north winds would be constant threats to any drilling rig. ENI's solution to the challenges of drilling in these difficult conditions was to build a martmade island on which the rigs would operate 80 kilometers offshore, sur- munded by curved reefs to protect it against the destructive power of the Caspian Sea. Over 4 million tons of rock would be needed to build the island complex. This approach was initially rejected by Kazakh authorities, as it would postpone production until 2005. However, after a year's delay, they granted approval. agreeing to a revised start date of 2008, although they also announced the government would fine the oil companies' $50 million each year production was delayed beyond the original 2005 start date, While the sea is shallow the Kashagan deposits lie 3.700 meters below the Caspian's seabed. The field is plagued by extremely high gas pressure--500 times that at sea level- requiring the use of expensive stress-resistant pipes and sophisti caled compressors to reinject these gases back into the ground, And the oil flowing from Kashagan's reservoirs is full of deadly hydrogen sulfide gas. Crude oil with a hydrogen sulfide concen tration of over 1 percent is considered to be "sour." Sour oil is more expensive to reline into gasoline, and more of the barrel tends to be used to make lower-priced products like fuel oil and diesel fuel. The hydrogen sulfide concentration of Kashagan's oil can reach 15 percent: 3 percent would be considered extremely high. The high levels of hydrogen sulfide substantially increased the dangers facing the drilling and operating crews.forcing ENITO invest heavily in protecting its workforce. Employees on the rigs are subjected to daily evacuation drills. Gas detectors and oxygen canisters are nearby, as are high-speed boats to evacuate the workers should an emergency arise. The facilities on the island had to be redesigned when it was determined that the living quarters were too close to the compressors that injected the hydrogen sulfide back into the reservoir, making even minor leaks a major danger. And one major problem is yet to be resolved: how to transport the oil to market. The three existing pipelines in the area are at capacity, as are the local railroad facilities. ENI had budgeted $10 billion to develop the Kashagan field. However, in mid-2007, ENI announced large budget Overruns the estimated development costs ballooned to $19 billion and pushed back the estimated start of production to 2010 ENI blamed the cost overruns on escalating daily lease rates for drilling rigs, soaring steel prices, and shortages of skilled personnel, including project managers and oilfield engineers. All told, estimated total costs over the 40-year expected life of the field rose from 557 billion to $136 billion Needless to say, the Karakh goverment was not pleased with this news. The cost overruns and project delays reduced the mag. nitude of the revenues it had anticipated, as well as postponing their arrival. In August 2007, the Karakh government demon strated its displeasure by suspending the consortium's operating licenses for three months on environmental grounds, arguing that EN had failed to protect the breeding grounds of the endangered beluga sturgeon and harmed the local seal population. It also threatened to investigate the consortium for customs violations and for violating the country's fire safety regulations In September, Kazakh officials demanded that the state oil company, KMG, be made co-operator of the Kashagan field. inasmuch as ENI had demonstrated an inability to fulfill the terms of the original contract. After several months of negotia- tions, the dispute was settled in January 2008. The Western oil companies agreed to allow KMG to double its stake in the con- sortium, to 16.6 percent, for $1.8 billion, a bargain basement price given the revenues that the Kashagan field is expected to generate for the next 40 years. In addition, the consortium agreed to increase the royalties paid directly to the Kazakh government by an additional $2.5 billion to $4.5 billion. depending on the future price of oil. Operators of other oil fields in the country have run into sim ilar problems as the price or oil has soared and the leverage of the Kazakh government has increased. In September 2007. for example, a prominent Kazakh politician argued that Chevron's operations in the Tengiz field, another major reservoir in the Caspian region, should also be shut down for failure to comply with environmental regulations. To deal with its hydrogen sulfide problem. Chevron had been transforming the gas into harmless sulfur pellets, which can then be used as an ingredient to produce fertilizer. However, Chevron was forced to store 9 million tons of the pellets in huge warehouses because most of the available transportation capacity was devoted to hauling oil from its Tengiz operations to market. Chevron agreed to spend $300 million to improve protection of the local environment. Similarly, two years earlier Petro Kazakhstan, a Canadian- owned company was forced to sell out its operations in south- ern Kazakhstan to a Chinese company, CNPC, after Kazakh regulators accused it of engaging in monopolistic practices in the marketing of petroleum products and demanded that the company stop flaring natural gas, which forced the Canadian AND POLITICAL ENVIRONMENTS 105 company to cut oil production by one thind Once the sale was completed. CNPC Sol a stake in its operations to KMG. Case Questions 1. Characterize the types of investments that are most vulnerable to political risk. Characterize those that are least vulnerable. What factors influence an investment's vulnerability? On a scale of 1 to 10 with 10 heing the highest, how vulnerable are complex vil development projects to political risk 2. Suppose you are employed by a pension fund this has been asked to lend 5100 million to help finance the Kashagan project. The consortium members are willing to pay an interest rate 5 percent above the rate currently being paid by U.S. Treasury bills, so your boss is definitely interested in examining the proposal Your boss assigns you the task of conducting a political risk assessment of the project Begin by listing all the types of political risks that could possibly affect the ability of your pension fund to receive interest payments and the retum of its principal in a timely fashion Having developed this list, assess the likelihood that the risks will arise. Which ones are most critical to you? What can you do to reduce these risks to your pension fund? 3. The price of oil has risen substantially since the contract was signed between the Kazakh government and the consortium of oil companies developing the Kashagan field. Is it appro- priate for the Kazakh government to demand that the terms of the contract be renegotiated in light of the higher market price of oil? If you were a member of the consortium, would you be willing to let the contract be renegotiated? 4. In his novel Kim, Rudyard Kipling introduced the phrase "The Great Game" to describe the struggle between the Russian czars and the British Empire to control the wealth of Central Asia and the Caspian Sea. Clearly, the great game is being replayed as countries fight to control access to the area's oil and natural gas reserves. What can interna tional businesses do to protect themselves from the geopo- litical struggles of Russia, China, Iran, the United States, and other nations that are taking place in this region? Reference: "ENI. Net Soaring. Wal Renegotiate Wall Street Journal February 16, 2008, p. 35: "Exxon Knows When to Fold Wall Street Journal, January 15, 2008, p. C14: "Kashagan Dispute Ends A State Doubles Stake, Wall Street Journal, January 14, 2018. p. 3. "Standort on Kazakh On Field. Wall Street Journal, November 30, 2007, p. AX "Kazakh Official Urges Hall of Chevron O Project." Wall Street Journal September 21, 2007. p A12. Kazakhstan seeks bigger role in Kashagan Financial Times, September 6, 2007 (online): "In Caspian Big Oil Fights Ice Lethal Fumes -- and Kazakhs. Wall Street Journal August 28, 2007 p. Al: "Kazakhstan halts work at Kashagan field," Financial Time August 27, 2007 (online)