Wednesday, 21 May 2014

Kazakhstan's Kashagan Oil Fields Faces Problems and Soaring Costs

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By John C.K. Daly (05/21/2014 issue of the CACI Analyst)

In the past two decades since the collapse of the Soviet Union, Kazakhstan has become a major oil producer. In 2013, Kazakhstan’s oil production surged to roughly 1.64 million barrels per day. A key element in Kazakhstan’s continued growth in oil exports will be the further development of its giant onshore Tengiz and Karachaganak fields and the coming online of its massive Caspian offshore Kashagan fields, along with the development of additional export capacity. But while Tengiz and Karachaganak are already up and running, Kashagan’s development has been far more troubled, and the difficulties in bringing it online persist.

BACKGROUND: Kazakhstan’s offshore Kashagan Caspian Sea field, discovered in 2000, is the largest oil field uncovered in the last 30 years, with potential reserves estimated to be as high as 70 billion barrels. For comparison, the Norwegian sector of the joint British-Norwegian North Sea oil fields contains approximately 30 billion barrels of recoverable crude.

Kashagan is the sole “superfield” to be discovered in the last four decades. The total Kashagan Contract area covers more than 2,125 square miles of northern Caspian Sea waters and contains five separate fields - Kashagan, Kalamkas A, Kashagan Southwest, Aktote and Kairan.

Kashagan is in Kazakhstan’s northern Caspian in shallow waters that freeze over for around five months each winter. Kashagan’s oil reservoir lies 2.6 miles below the seabed at very high pressure (770 psi), and the associated gas reaching the surface is mixed with hydrogen sulfide (H2S) content of 19 percent. Admixed with the hydrocarbons, these are some of the highest concentrations of the toxic, metal-eating acid ever encountered. H2S is heavier than air, very poisonous, corrosive, flammable, and explosive. The northern Caspian’s shallow depth and extreme winter climatic conditions have precluded the use of conventional drilling and production technologies such as fixed or floating platforms, forcing the offshore facilities to be installed on a series of costly artificial islands (drilling and hub islands) that house drilling and processing equipment far out at sea. Accordingly, delays, environmental concerns and costs have soared.

Under terms of the North Caspian Sea Production Sharing Agreement signed in 2001, Italy’s ENI under the joint-venture company name of AgipKCO (Agip Kazakhstan North Caspian Operating Co., or NCOC) currently manages Kashagan. AgipKCO consists of Kazakhstan’s national hydrocarbon concern KazMunaiGas and Japan’s Inpex, both of which originally held an 8.33 percent share in the project, while ConocoPhillips holds a 9.26 percent share. Four major foreign oil companies currently dominate the project – Italy’s ENI, France’s Total, U.S. ExxonMobil and Anglo-Dutch Shell, which all held 18.52 percent stakes each.

In autumn 2007, however, the Kazakh government, citing environmental concerns and cost overruns, renegotiated the PSA agreement. When the dust settled in January, KazMunaiGas increased its share in the Kashagan project from 8.33 percent to 16.81 percent as a result of its foreign consortium partners surrendering 2 percent apiece of their stake while agreeing to pay up to US$ 5 billion as compensation for lost profits due to cost overruns and significant delays in commercial production.

IMPLICATIONS: Oil revenues have played an increasingly important role in the Kazakh economy. Among its Commonwealth of Independent States neighbors, Kazakhstan was the first to pay off its International Monetary Fund debts following economic reconstruction in 2000, seven years ahead of schedule; it was the first regional state to obtain a favorable credit rating; the first to implement financial institutions approaching Western standards of efficiency and reliability; and the first to develop and introduce a national fully funded pension program.

In validating the structural reforms carried out by the Kazakh government with its oil revenues, the European Union formally recognized Kazakhstan as a market-based economy in October 2000, while Washington accorded Kazakhstan similar recognition in March 2002.

Kashagan finally started producing oil on September 11, 2013, but a mere 13 days later production was suspended after a gas leak at the pipeline from Island D to the onshore Bolashak refinery was discovered. After the leak was repaired, production resumed but on October 9 output was again halted when another gas leak was discovered. The cause of the problem was identified as “sulfide stress cracking,” a form of corrosion caused by Kashagan’s H2S. On April 23 a NCOC executive said that the company had concluded that 55 miles of subsea pipelines carrying natural gas and oil from Kashagan offshore wells for processing onshore oil fields will need to be replaced.

The Kazakh government had based its economic forecasts on revenue from Kashagan, which was expected from an initial 180,000 barrels a day (bpd) to 370,000 by 2015. NCOC estimates Kashagan’s reserves at 38 billion barrels, with 10 billion barrels recoverable, along with estimated natural gas reserves of more than 1 trillion cubic meters.

Kashagan has cost an estimated US$ 50 billion so far, five times early estimates.

It is obvious that the highly optimistic production output figures of 370,000 bpd by 2015 and rising to 1.5 million bpd soon after will not be met anytime soon. NCOC Chairman and Managing Director Pierre Offan resigned on May 1 and will be replaced by ENI’s head of exploration and development Claudio Descalzi. As for when production might resume Descalzi said, “It's worse than we considered. We have already put in place contingency plans to cover a possible lack of production in 2015.”

The Kashagan pipeline debacle may be just the tip of the iceberg. If the pipeline issue is the result of not using sour service steel pipe as required for the H2S content of the reservoir fluid and if they also used regular pipe instead of sour service pipe for the well completions, then there is a very good chance that very expensive well work-overs are necessary, which would along with the pipelines cost billions in additional repairs.

However, teething problems aside, it is too early to count Kashagan out. At least one investor is betting that Kashagan will fulfill its potential. On September 7, 2013, Chinese President Xi Jinping signed a US$ 45 billion agreement with Kazakhstan’s state energy company KazMunaiGas for state-owned China National Petroleum Corp. to purchase an 8.33 per cent stake in Kashagan.

CONCLUSIONS: Kazakhstan urgently needs Kashagan’s projected production cash inflow revenues to hit its fiscal targets for 2014, earlier estimated at up to three percent of gross domestic product. But for the moment, the Kazakh government is downplaying the impact of the Kashagan delays. On May 2, Kazakhstan’s Minister for the economy and budget planning Erbolat Dossaev said, “For the state budget, we were not expecting any addition of income this year or next year,” he said. “For GDP growth, yes: maybe half a percent [impact], but we are trying right now to cover this with more exploration.”

Further financial trauma at Kashagan may occur as the full extent of the H2S corrosion is determined. MFX Broker analyst Sergei Nekrasov said, “After replacing, the new pipelines, consisting of a special alloy, will be 10-15 times more expensive than those used previously. The replacement cost could reach US$ 250-500 billion,” which could balloon Kashagan’s costs to US$ 400-600 billion. 

Kashagan, now the world’s most expensive energy project, symbolizes that the easy oil is truly gone. Other potential opportunities, such as Brazil’s offshore southern Atlantic fields, are just as tough as Kashagan, if not more difficult. Kashagan has failed to live up to the expectations of constituting Kazakhstan’s energy crown jewel, and the only certainty at this point is that increased costs will be substantial before production resumes.

AUTHOR’S BIO: Dr. John C.K. Daly is an international correspondent for UPI and a Nonresident Senior Fellow with the Central Asia-Caucasus Institute & Silk Road Studies Program Joint Center.

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