Originally published in Pipeline & Gas Journal, August 2007.
Kazakhstan has progressed from nomadic, to communistic, to free enterprise in its long and turbulent history. But over the last 10 years, the country has grown up and matured at a staggering rate. It is now poised to take its place among the most prosperous countries of the 21st century.
The key to effectively doing business in Kazakhstan is understanding its cultural, business and legal realities, and using representation positioned to take advantage of the Caspian region’s vast potential for growth. Kazakhstan is unique in that it is well-positioned to be a leading powerhouse linking the economies of Asia and Europe.
Essentially Moslem, this large Central Asian country covers more than 1 million square miles, making it the ninth largest country in the world. Additionally, Kazakhstan is extremely rich in oil and natural gas reserves with the potential to triple its oil production rate to more than 3 million barrels of oil per day (bopd) by 2015.
Some in Kazakhstan are dubious, of course. An intensive program of industrial development to exploit these resources during the Soviet era resulted in catastrophic industrial pollution, fallout from nuclear testing and shrinkage of the Aral Sea. However, since its independence in 1991, the Kazakhstan government has encouraged broad foreign investment and liberalized the economy to promote growth.
Strength Through Credit And Stability
Kazakhstan has nurtured stable relations with all of its neighbors and is a member of the Commonwealth of Independent States (CIS), NATO, the UN, Organization for Security and Cooperation in Europe (OSC), the Organization of the Islamic Conference (OIC), the Economic Cooperation Organization (ECO), and the Shanghai Cooperation Organization along with Russia, China, Kyrgyzstan, Tajikistan, and Uzbekistan.
Because of its strong economic performance and financial health, Kazakhstan became the first former Soviet republic to repay all of its debt to the International Monetary Fund (IMF) in 2000- -seven years ahead of schedule. In September 2002, Kazakhstan became the first CIS country to receive an investment-grade credit rating from a major international credit rating agency.
Kazakhstan, Belarus, Kyrgyzstan, and Tajikistan established the Eurasian Economic Community in 2000 to re-energize earlier efforts at harmonizing trade tariffs and the creation of a free trade zone under a customs union.
Energy is Kazakhstan’s leading economic sector. In 2003, the country produced 360 million barrels of crude oil and natural gas condensate, of which more than 86% was exported. Natural gas production in 2003 was 490 Bcf. Oil reserves exceed 30 billion barrels and natural gas reserves exceed 70 Tcf. Compared to the U.S., Kazakhstan has 1.5 times as much oil reserves and over three times the natural gas reserves.
The Kashagan Experiment
Much of the more than 30 billion barrels of oil reserves are located in the western portion of the country around the coastline of the Caspian Sea. The world’s largest oil discovery in the past decade was made in 2000 in the northern portion of the Caspian Sea, in the shallow-water Kashagan oil field, with original oil-in-place reported to be 38 billion barrels.
Reserves, based on pressure maintenance through gas injection, are estimated to be 13 billion barrels of light crude oil of 42-45 degrees API. The field covers an area of 47 miles by 22 miles located about 50 miles south of the city of Atyrau.
The field is operated by ENI (18.52% interest) and partners ExxonMobil (18.52%), Shell (18.52%), Total (18.52%), ConocoPhillips (9.26%), KasMunaiGaz (KMG) (8.33%) and Japan’s Inpex Holdings (8.33%). Due to the technical difficulties in extracting sour crude in a harsh climate, initial production has been delayed until 2010. This will trigger penalties paid to the government of $250 million at a rate of $50 million per year from 2005--the original planned start-up date.
Investors were originally overoptimistic regarding Kashagan and the delays come as no surprise to people familiar with the climate and situation. Kazakhstan must grow slowly and every infrastructural development helps not only the country itself, but foreign chances for oil extraction.
The Kashagan development project is a unique combination of complex geology, technical problems, and environmental challenges. It is also one of the world’s largest upstream projects. Harsh climate in this part of Kazakhstan has temperatures varying from minus 40 degrees F in winter to 104 degrees F in summer.
The sea waters are frozen for five months of the year with thicknesses of up to two feet. Sea level can fluctuate (principally due to wind tides) from zero to 12 feet. To combat these problems, ENI has begun using artificial islands for drilling locations. Wells are up to 16,000 feet deep.
The sour crude contains 16-20% hydrogen sulfide which must be removed and re-injected at high pressures, up to 12,000 psi. ENI has awarded a contract to GE to supply the required ultra-high-pressure sour gas injection system. Eventually, a $4 billion processing plant will be built to recover elemental sulfur from this gas. Project investment will exceed $19 billion by 2011 and $30 billion by the time the plateau production rate of 1.5 million bopd is reached by 2019.
Fortunately, ENI is assisted by a consortium of the largest majors in the world, with access to capital and vast experience in challenging projects. However, few projects even approach Kashagan in its need for innovative, cuttingedge technologies.
Additionally, several partners have dropped out of the Production Sharing Agreement (PSA) area formed in 1997. KMG and Inpex came into the PSA and other partners have used rights of pre-emption to increase their interests. These changes caused delays in project approval, which finally occurred on Feb. 25, 2004.
So far, only the reserves of Kashagan field have been determined. The adjacent reserves of three other fields--namely Aktote, Kairan, and Kalamkas in the same PSA area--have yet to be adequately explored.
Tengiz And Karachaganak
The Tengiz oil field in western Kazakhstan anchors a new pipeline built by the Caspian Pipeline Consortium (CPC) which extends to the Russian Black Sea port of Novorossiysk. The pipeline began operating in 2001. Discovered in 1979, Tengiz contains 25 billion barrels of oil originally in place, of which recoverable reserves are estimated at 6-9 billion barrels.
This makes Tengiz the sixth-largest oil field in the world. The crude oil contains 16% hydrogen sulfide which is being removed, converted to sulfur, and stored on site in a huge and growing mountain.
The TengizChevOil (TCO) joint venture has developed the field since 1993. The major partners in TCO are Chevron (50%), ExxonMobil (25%), KazMunayGas (20%), and Russian LukArco (5%).
Approximately one third of Kazakhstan’s daily oil production comes from Tengiz’s 450,000 bopd output. TCO has indicated that production could reach 700,000 bopd by 2010. The Baku-Tbilisi-Ceyhan Pipeline (BTC) is a competing pipeline put forth by U.S. interests to bypass dependence on the Russian pipeline.
In addition, Total is interested in developing a pipeline south from Kashagan and near Tengiz to extend through Iran--the cheapest route. Due to the geopolitical climate surrounding Iran, however, the U.S. does not favor this route.
Karachaganak is the largest gas condensate field in Kazakhstan, located in the northwest border region near Orenburg, Russia. Discovered in 1979, the same year as Tengiz, it is contained in an immense Permian and Carboniferous reef build-up that is one mile thick in the middle. This type of reservoir structure is seen in analogous fields like Tengiz and Astrakhan in the North Caspian Basin.
The lowest 620-foot-thick Carboniferous section contains a light oil reservoir which underlies the 4,500 foot-thick Permian gas condensate column. The reservoir initially contained 42.4 Tcf of sour gas with 3.5 5% hydrogen sulfide and 5% carbon dioxide, in addition to 6.5 billion barrels of liquid condensate and crude.
Production began in 1984 under the operatorship of KarachanakGazprom with limited quantities of gas and condensate exported to Russia via pipeline to the processing facilities at Orenburg. On Oct. 3, 2006, Kazakhstan and Russia signed an agreement to create a joint venture for processing gas from Orenburg.
More than 200 vertical wells were drilled in Karachaganak by 1990 when production had reached 425 MMcf/d and 100,000 bopd. Beginning in 2000 under the operatorship of Karachaganak Petroleum Operating Company (KPO), the field underwent a redevelopment program. This involved an investment of more than US$ 1 billion for construction and enhancement of facilities, new gas and liquid processing and gas injection equipment, a workover of 100 wells, and a 120 MW power station and connection to the CPC via a 400- mile pipeline to Atyrau.
When this program was completed in 2004, production was projected to reach 700 MMcf/d of gas and 200,000 bopd. Actual production rates have been lower due to pipeline offtake limitations.
The KPO is a partnership with joint operators, BG Group and ENI, each with a 32.5% stake, and with non-operating partners, Chevron (20%) and Lukoil (15%) owning the balance of the company. During the 40-year contract period, KPO plans to recover 2 billion barrels of liquid hydrocarbons and 30 Tcf of gas.
Regional Financial Center
The modern Kazakh banking system boasts a single regulator, effective laws, and a group of healthy, rapidly growing banks with total assets of more than $36 billion. This forms a solid base for the country’s brand new Regional Financial Center of Almaty (RFCA).
Seen as an essential stage in the development of the national financial sector, the RFCA follows the pattern of other world financial centers that promote the host country as an investment destination, create a regional financial hub with a first class financial services marketplace, and allow domestic investors to access foreign capital markets.
The RFCA was established in 2006 under direct control of the president of Kazakhstan as a special zone with a dedicated regulatory framework and single multifunctional regulatory authority. The Center encompasses an International Council to guide its strategic development and a specialized financial court to serve as a dedicated dispute resolution forum.
Members of the RFCA may include both domestic and foreign broker-dealer firms registered and licensed under the RFCA authority. These firms will only be allowed to operate on the special floor of a stock exchange located in Almaty and regulated by the RFCA Authority.
Financial offerings will include government securities, equity and debt securities, credit-linked notes, and derivatives. There will be special emphasis on domestic securitized assets and on financial instruments that comply with Shariah (Islamic law).
In June 2006, the Kazakhstani Parliament passed a number of RFCA-related amendments to the country’s Tax Code of 2001. These nominally took effect on Jan. 1, 2007 although--because the RFCA has not yet begun operation--their practical effective date will likely not be until 2008.
Under the amended Tax Code, RFCA members will receive income tax preferences with regard to dividends and capital gains from securities purchased or sold on the RFCA trading floor.
The amendments also exempt a number of activities from income tax. These include broker services, underwriting, research and analysis, and market-making. The following summary of the tax code changes defines the RFCA investment environment and demonstrates the investment opportunity that the Center presents:
- There are three significant transactional exemptions from corporate income tax: dividend payable on debt securities purchased on the RFCA, capital gains from securities sold, and income from the provision of financial services by RFCA members.
- Capital losses from the sale of securities on the RFCA trading floor shall be compensated at the expense of the capital gain received from selling other securities. If those losses may not be compensated in the period in which they were incurred, then they can be carried forward for a period of up to three years and be compensated at the expense of the income from capital gain received from selling other securities.
- Interest payable on debt securities purchased on the RFCA trading floor are not subject to tax at the source of payment (i.e., withholding taxes).
- Under the amendments tax control over RFCA participants is established only on the basis of tax reports to be confirmed by the auditor’s report under the form established by the RFCA Authority.
- The Authority will also determine the list of authorized RFCA auditing organizations and will register taxpayers as legal entities.
- The procedure for the state registration and accounting registration of taxpayers as well as the list of the documents attached to the applications for registration and deregistration shall be established by the RFCA Authority.
When creating its new civil code, Kazakhstan adjusted traditional models to the specific requirements of its economic evolution. The legislative intent was to guide the country’s transition from a managed economy to a market economy. Initially the new law provided incentives to privatize property and to establish ownership rights.
The civil code details property rights and regulates the legal relationships between business parties, involving such commercial necessities as contracts, loans, security interests, and equity capital. While the civil code sets forth the general principles, specific rules for business conduct are created in laws that are subordinated to the civil code.
The civil code has been frequently amended as the economy develops. This demonstrates the importance that Kazakhstan places on reflecting market efficiency in its laws. Corporate law has evolved over time to give corporate or limited liability entities the ability to raise debt or equity capital in the markets efficiently. The protection afforded to minority shareholder rights promotes the raising of equity capital.
Regulators for Kazakhstan banks have recently tightened the limits on foreign borrowing, a situation which could be good news for Kazakh bank bonds, and outside investment generally for Kazakhstan’s broad emerging marketplace.
Kazakhstan’s financial sector is dominated by private commercial banks and has become one of Kazakhstan’s fastest growing features as a result of deep financial sector reforms and unobtrusive, yet necessary, oversight.
While Kazakhstan’s three largest banks hold roughly 65% of deposits by individuals, according to the IMF, about half of Kazakhstan’s banks have some foreign participation. Over the past 11 years Kazakhstan’s legislation has become more predictable as ongoing amendments continue to promote the development of a market economy.
However, those considering doing business in Kazakhstan should consult with a legal advisor to consider all the possible risks and rewards. As the legal system develops in this emerging market, uncertainty and contradictions between laws still remain. Despite roadblocks, it is clear that Kazakhstan’s evolving legislation is on the right track to support and align with foreign investment.
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