COMMENT: IOCs in need of new Eurasian energy business model

By bne IntelliNews October 5, 2007

Ariel Cohen of the Heritage Foundation -

At the end of September, both houses of Kazakhstan's parliament adopted amendments to the law on subsoil use that would allow the government unilaterally to reconsider contracts with subsoil users. In the future, the Kazakh government could use this prerogative if subsoil users' actions pose a threat to Kazakhstan's national security and possibly affect the country's economic interests.

The amendment, which comes against the backdrop of the government's dispute with the Eni-led international consortium developing one of the world's largest oil fields, Kashagan - is likely to be signed by President Nursultan Nazarbayev in early October. The government accuses the firms of violating the contract terms. Astana demands the consortium should pay up to $40bn in compensation and hand over the status of the project's second operator to the state-run KazMunaiGaz.

The Kazakh case is symbolic of something much bigger: the rise of state power in regulating hydrocarbon wealth and access to it. International oil companies (IOCs) are now facing the need to develop a business model that would allow them to continue investing in Eurasia.

National power

Much of the world's supply of oil is currently delivered in an oligopolistic market dominated by national oil companies (NOCs). National governments control almost one-third of the world's oil and gas production and more than one-third global oil and gas reserves. In marked contrast, the major oil firms produce about 10% of the world's oil and gas and hold around 3% of reserves.

The IOCs boast superior technical ability and investor capital to make them valuable partners for Eurasian governments and NOCs. For example, Gazprom has recently partnered with France's Total to explore the challenging Shtokman gas field. Partnerships such as the Shtokman production sharing agreement (PSAs), which gives Total a 25% stake in the field (with Gazprom maintaining a controlling 75%) indicate both the unprecedented bargaining power of governments and NOCs, as well as their continued need for Western technology and investment.

This emerging system is the result of extensive competition between IOCs over a limited number of oil and gas fields. In the short and medium term, foreign investment and technology are necessary in order for Eurasian gas and oil providers to meet growing demand and international supply agreements.

There are essentially four types of engagement that sovereign states can enter into with international oil companies to exploit resources. One is a nationalized industry. This model predominates throughout the Gulf region. In this model, foreign companies are eligible to receive technical service contracts - projects that are well defined, take limited amounts of time, and, significantly, stipulate a fixed fee.

The second model is the concession. This is also known as the tax-and-royalty system. The government grants a private company (or a consortium of companies) a license to extract oil. This becomes the company's property. The company then pays the government taxes and royalties for the oil.

The third arrangement is the PSA. This is a more complex system. In a PSA, the state maintains nominal control over the oil, while the company or consortium of companies extracts it. Under a PSA, the private company provides the start-up capital investment for all aspects of development. The first oil is extracted and allocated to the company to cover costs (cost oil). Once costs have been recovered, the remaining oil is divided between the state and company in agreed proportions, while the company is then taxed on the profits from the oil. Often there may be a royalty on all oil produced. It is this third arrangement that has come under much scrutiny in Russia and more recently in Kazakhstan. In Russia, industry players say, the PSA model is dead.

The fourth one is the joint venture. An increasing number of Western companies these days receive a minority stake in joint ventures with NOCs.

It is thus important for both IOCs and Eurasian national energy companies to balance the risks and rewards. In Eurasia, both are plentiful. Western companies must recognize the risks of the political environments in which they are operating in. Specifically, they need to work out political arrangements and understandings. For example, Presidents Vladimir Putin and Nicolas Sarkozy arrived at an understanding regarding Russian demands to purchase energy capital assets in Europe, before the Kremlin gave a green light to the Total-Shtokman deal.

As more access to Western markets is becoming a condition for any deal, IOCs and Western governments would be required to allow acquisitions of downstream assets, as in the case of Austria's OMV, which is currently trying to purchase the Hungarian national oil company MOL, and which has already acquired Slovak energy assets.

IOCs need to keep in mind that at any time, Eurasian governments can enforce costly compromises and renegotiate contracts, while Eurasian monopolies may take advantage of Western capital and technology before assuming the upper hand in the project.

Russia will only grant foreign companies access to its natural resources as long as it needs the technology and capital they bring. Kazakhstan, on the other hand, needs foreign companies in order to produce revenue for its ambitious modernisation programmes, as well as increase production to meet rising demands and fill new pipelines. BP has resolved most of its differences with Gazprom by pursuing a win-win strategy and expanding cooperation with the Russian giant through creation of a global gas marketing venture.

Western companies realize that the time to develop new business models for Eurasia is now. The competition for remaining oil and gas reserves is on.

Ariel Cohen, Ph.D., is Senior Research Fellow at the Heritage Foundation. The article is abridged from the presentation he delivered last month at the Royal Institute of International Affairs (Chatham House) in London.

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