Does Kashagan still make economic sense?

By bne IntelliNews June 26, 2015

Jacopo Dettoni in Almaty -


More than 15 years after its discovery, Kashagan’s oil remains sealed under a thick dome of salt some 4,000 metres below water in the Kazakh section of the Caspian Sea. Mismanagement and technical challenges have repeatedly pushed back the production start date and inflated development costs to an extent that some wonder whether the project still makes any economic sense.

Total investments for the initial stage of production have already reached $44.5bn, up from an original estimate of $10bn. Analysts widely agree that the field will need an oil price above $100 per barrel to cover the development costs and generate reasonable profits under the terms of its production sharing agreement (PSA).

Kashagan remains a one-of-a-kind oil field, likely the largest outside the Middle East, and the operating consortium North Caspian Operating Company (NCOC), which is comprised of six international oil companies (IOCs) plus state oil company KazMunaiGaz (KMG), reiterates its confidence that it will still be profitable over the longer term. “What is remarkable is that despite the huge errors by the consortium, the project has still remained profitable,” Greg Muttitt, a senior adviser with the research and advocacy group Oil Change International, tells bne IntelliNews. “The underlying reason is a grossly unbalanced PSA, which protects profits from almost all risks.”

Yet expected returns will be much lower than originally forecast, and both NCOC and the Kazakh government are looking apprehensively at the future. If a renegotiation of the terms of the PSA is an unlikely scenario, a possible extension of the contract beyond 2041 has been in the air for months and may turn out to be the only feasible way forward.

Kashagan actually finally started producing oil in September 2013, some eight years late. Yet a major pipeline failure forced production to a halt just a few weeks later. It soon became clear that the consortium, whose operatorship for Phase 1 of the project lay with Italy's ENI, would have to replace the whole 200km of leaking pipelines – a time-consuming and costly task in the harsh environment of the northern Caspian Sea, which is characterised by sea ice and temperatures as low as 40 °C in winter time. Replacement works started in May, and production is now slated to kick off in the second half of 2016, NCOC’s head Stephen de Mayo said in an interview with local news agency KazInform on June 9.

Initially, production won't exceed 90,000 barrels per day (b/d), but it will then ramp up to 370,000 b/d in 2017. Kashagan production was supposed to peak at 1.2mn b/d in 2016, under the original development plan. “Much has been invested into the development of the Kashagan field at this point, and we are disappointed that the field has not yet been put into operation,” de Mayo said. “But I am convinced that, with time, the potential of the Kashagan field will be implemented in full, and the field will be profitable.”

Major find

Hailed by the industry as the biggest oil discovery in decades, with recoverable reserves in the range of 9bn to 13bn barrels, Kashagan suffered a first major setback in 2007 when ENI revised upwards the reserve estimates, but at the same time also confirmed massive delays and cost overruns.

The Kazakh government, desperate for the income from Kashagan, retaliated by asking for $10bn in compensation and threatening to sideline the Italian operator. They eventually forced the whole consortium to double the state-owned KMG’s stake to 16.8%. A few years later, Italian prosecutors would accuse ENI of oiling the deal with kickbacks to Timur Kulibayev, son-in-law of President Nursultan Nazarbayev and former head of KMG. Eventually, ENI was found not guilty on procedural grounds: Agip KCO, ENI’s Kazakh subsidiary, is headquartered in The Netherlands, so the Italian court set aside the case for lack of jurisdiction.

As delays accumulated and recurring signs of poor project management came to light, Kashagan gradually turned from oil wonder into oil mess. “It feels good to be out of it,” Al Hirshberg, executive vice president of ConocoPhillips, was quoted by the Wall Street Journal after the US oil firm sold its 8.39% stake in the project to KMG for $5.5bn in 2013 (KMG subsequently sold on that stake to China National Petroleum Corporation).

The pipeline failure caused fresh outrage among Kazakh officials, which forced the consortium to account for the replacement costs, estimated at around $3.6bn, as non-refundable costs, the Kazakh energy ministry confirmed to bne IntelliNews, although it declined to comment on whether KMG would chip in pro rata its stake. The consortium will also contribute to some of the investment needed for the EXPO 2017 Astana exhibition, local press have reported.

The IOCs can still rely on the generous provisions of the PSA, but with oil prices falling well below $100 per barrel, financial models are being tested again. “If such an amount had not been spent on Kashagan, especially given the current situation with low oil prices, today the shareholders would have found it difficult to decide to keep investing into the field’s development,” de Mayo said in the interview with KazInform.

Analysts agree that Kashagan’s breakeven oil price, a level to cover costs and generate a fair profit, is well above $100 per barrel. Investment bank Goldman Sachs estimates that Kashagan would need oil prices between $120 and $130 per barrel to be profitable. Research company IHS Energy puts the breakeven oil price for Phase 1 at $128.9 per barrel, falling to $83.40 per barrel for Phase 2, when production is expected to increase to around 1mn b/d. KMG’s chairman, Sauat Mynbayev, confirmed the breakeven oil price is “in the region of $100 per barrel”, local news agency reported in February.

“Project profitability is positive for the consortium, but fairly modest: the internal rate of return (IRR) for Phase 1 is only 6%, although much better for Phase 2,” Matt Sagers, senior director at IHS Energy, tells bne IntelliNews. As a rule of thumb in the industry, oil companies sanction a project with an IRR of 10% or higher.

Things do not look that good on the Kazakh side either. “The PSA is designed in a way that the payout period is very quick for the consortium,” Per Magnus, head of analysis at oil and gas consulting service Rystad Energy, tells bne IntelliNews. “The government will have to wait ten years from production kick-off to get more than 50% of the field’s profits.”

Not quite Kash-all-gone

Yet in the long run, when investment costs are ammortised, Kashagan should be a cash cow for both the government and the consortium, with operating costs below $50 per barrel, which is why things should look much better in Phase 2 and 3, when production is expected to peak at 1.5mn b/d. Thus, even though red lights are flashing, full development appears inevitable at this stage. “Given Kashagan’s importance for both the government and the companies, some accommodation seems likely, such as an extension of the project’s contract period, to facilitate a decision to proceed with Phase 2,” says IHS’ Sagers. 

There has been great speculation over an extension of the PSA, which currently expires in 2041. Members of the consortium, ExxonMobil and Shell, have been reportedly discussing a 20-year extension with the Kazakh authorities in exchange for higher local content and perhaps a bigger stake for Kazakhstan. Both the NCOC and the energy ministry decline to comment on that, but it’s clear that whenever Kashagan starts producing and a decision on Phase 2 approaches, the time will come for some kind of adjustment, be it in the form of a contract extension, or even of a consortium reshuffle, with Chinese or other Asian partners always knocking at the door.

Only then Kashagan will finally reveal itself as the long-awaited oil blessing, or just another oil curse.

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