Clare Nuttall in Almaty -

After more than a year of often-tense negotiations, the Kazakh government is due to finalise an agreement with the consortium developing the enormous Kashagan oilfield on October 25. The consortium, which comprises several of the world's largest oil companies, has given a number of concessions in return for the deadline for the start of production being postponed until 2013.

Originally, production had been due to start at Kashagan - named after a 19th century poet from nearby Aktau - in 2005. The delay of almost a decade is mainly because of the immense technical challenges faced by the developers. The projected costs of getting to first oil have also ballooned, from the initial forecast of $57bn to $136bn, as the price of steel and other necessary materials have risen.

In June, the consortium presented a new development plan to the Kazakh government that took into account the delays and increased costs. The government rejected the plan and since then, both sides have been negotiating a new deal.

Kashagan's importance to the Kazakh government can't be underestimated. Total reserves in the oilfield, located offshore in the Kazakh section of Caspian Sea, are around 38bn barrels, making it the world's largest discovery in some three decades - since the Prudhoe Bay in Alaska's North Slope in 1968. According to Agip, the current developer of the field, an estimated 9bn barrels can be produced through natural depletion, and a further 13bn with gas re-injection. Getting the field into operation is at the heart of the Kazakh government's strategy to enter the world's top-10 energy producers by 2015; to achieve this, it will need to more than double oil output to 150m tonnes a year (t/y). In mid-August, it emerged the government had set up a working group to review its strategy in the light of the Kashagan delays.

Not surprisingly, tempers have become frayed within the consortium, whose largest shareholders today are the Kazakh state-owned oil company KazMunaiGas and international oil majors (IOC) Eni, Shell, Exxon Mobile and Total. ConocoPhilips and Inpex have smaller stakes.

The cracks were highlighted in early July when, just after the structure of the new agreement was announced, Exxon chief executive Rex Tillerson complained that meddling by the Kazakh government was a major factor in the delays in starting production. Eni, consortium leader for the initial development phase, attempted to smooth things over, but the Kazakh Ministry of Energy and Mineral Resources shot back with their response to Tillerson's comments. "A chief executive of one of the major oil companies, a Kashagan consortium member, has recently made statements seeking to shift blame to the government for delays," the ministry said. "The government has acted responsibly to protect the interests of Kazakhstan in the face of the consortium's inability to bring the field into production on schedule."

Hard talks

Negotiations were complicated by the number of issues needing to be resolved, a source close to the consortium says. The three key points were the reduction in the IOCs' stakes required to increase KazMunaiGas' holding, the dispute resolution and operating model, and the practicalities of how to make the new agreement work. Given this is arguably the largest engineering project in the world, it was never likely to be easy.

The basic agreement was reached in January, when it was announced that Agip, which is owned by Eni, would be replaced by a new structure comprising all the consortium members. Eni, the sole owner of Agip and the operator for the first phase of the project, will continue to be responsible for the first phase of exploration and production. In later phases, it will share operational responsibility with ExxonMobil, Shell and Total.

A memorandum of understanding signed in June finalised changes to the contract terms and set the new 2013 production deadline. In return, the Kazakh government exacted several concessions from the consortium, notably a new floating royalty structure. This stipulates that the government will receive 3.5% of output when world oil prices are above $45 a barrel, 7.5-8% at $130 a barrel, and 12.5% at $195 a barrel. The oil price stood at about $114 a barrel in mid-August. In addition, the production sharing agreement (PSA) would expire in 2041.

Penalties have also been built into the agreement to prevent further cost increases or delays in production. The consortium will be unable to use proceeds from oil production to reimburse costs that occur after October 2013. "They have already invested $17bn and this money will be refunded in future oil production. But if they continue to spend money beyond October 1, 2013, the sum will not be refunded in oil," Energy Minister Sauat Mynbayev told journalists in Astana after the MoU was signed. "It will be purely their loss. We think this will be the last time there will be a delay."

The agreement also accommodates changes to the consortium's structure after the doubling of KazMunaiGas' stake in Kashagan to 16.18%, putting it on a par with Eni, ExxonMobil, Shell and Total. The increase in KazMunaiGas' stake, which cost it $1.78bn, became effective on January 1, 2008.

The increase was agreed under pressure from the Kazakh government, which in recent years has sought to exert more control over its natural resources. This has become a common theme in Russia and other former Soviet states, as rising prices for oil and other commodities highlight the bargains that western oil companies got in the years immediately after independence.

Asked whether the Kazakh government might seek to further boost KazMunaiGas' stake, a source close to the consortium says this was unlikely, but couldn't be ruled out. "However, KazMunaiGas has a bigger role under the new agreement - for example, the deputy managing director of the joint operating company will be from KazMunaiGas. This will help to reduce the risk," the source says.

Technical aspects

With the agreement on track to be signed in October, the oil companies need to push ahead with development of the field.

As in other republics on the periphery of the former Soviet Union, Kazakhstan's oil and other natural reserves were neglected, relatively speaking, until recently. Some seismic and geological surveys were carried out in the 1960s, but the first systematic geophysical study of the area did not start until two decades later. The first wells were drilled at Kashagan in 2000, and revealed a field even larger than its onshore "twin", the Tengiz field, another super-giant oilfield around 140 kilometres to the southeast with similar geological properties.

However, extracting oil from Kashagan will be considerably more difficult than at Tengiz. Construction of the massive offshore infrastructure and onshore processing facilities is around 50% completed. By 2013, a network of six hub islands, each with several smaller satellite platforms, will stretch across the north Caspian. Oil and gas extracted from Kashagan will be separated on the hub islands, then piped to a facility near Atyrau for processing.

Unlike the temperate south, the northern Caspian Sea where Kashagan is located, is in a region with an extreme continental climate, with temperatures varying up to 80°C within the year - from 40°C in summer down to as low as -40°C in winter. Kashagan is in shallow waters, with a depth of less than 10 metres. In winter, the sea freezes over, putting oilrigs in danger from shifting ice packs. Summer storms can cause rapid fluctuations in the sea level.

Another factor making this one of the biggest challenges to the global petroleum industry is the extraction of oil from a deep and high-pressure reservoir - the field's depth is around 5,000 metres. The reservoir contains around 18% hydrogen sulphide (the 'rotten egg' gas). A re-injection programme had to be designed to deal with the gas, which is so toxic that a single inhalation containing less than 0.1% hydrogen sulphide can put an adult into a coma.

Local environmental groups have already raised concerns. On August 12, several groups held a press conference in which they said that the project would break several of Kazakhstan's environment protection laws. However, given the government's hurry to get the field operational, these are unlikely to carry much weight. Indeed, the consortium's operations until 2013 have been thoroughly thrashed out and the agreement is due to be inked very soon. However, there are other issues that will have to be resolved in the longer term.

Plenty of attention has been given to the way the operating consortium will interact in the current phase. However, the relationships between the different members of the consortium will have to be redefined after 2013, when the field starts producing oil in 2013, until 2041 when the PSA runs out. "From 2013 to 2041, KazMunaiGas and Shell will be running the operations, with management gradually being handed over to Shell," says the consortium source. "The question is, how that agreement is going to work in practice, given that KazMunaiGas' experience is not very high, especially with gas re-injection and high sulphur. I don't think anyone has given much thought to how that is going to work."

There are few precedents for this type of handover. While a similar agreement was implemented in Oman with the handover of control to PDO (Petroleum Development Oman), it was with an onshore and lower-tech project.

Also to be decided is how oil from Kashagan is to reach its customers. Although Kazakhstan now has several pipelines and is in the process of building more, several different routes are likely to be needed, and a major new pipeline will probably have to be built for when the field reaches peak production. Recent events in Georgia and the closure of the Baku-Tbilisi-Ceyhan and Baku-Supsa pipelines have highlighted just how precarious export security is for the Eurasian countries.

Both of these questions will have to be tackled well in advance of the 2013 production start date. The current round of negotiations may be over, but the next has yet to begin.

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