C O N F I D E N T I A L ALMATY 001944

SIPDIS


STATE FOR EUR/CACEN (JMUDGE)
ENERGY FOR SECRETARY BODMAN

E.O. 12958: DECL: MAY 13, 2015
TAGS: EPET ENRG AJ GZ KZ WMD ECONOMIC
SUBJECT: KAZAKHSTAN: SCENESETTER FOR SECRETARY BODMAN'S
MEETING WITH PRESIDENT NAZARBAYEV

REF: BAKU 738

Classified By: CDA Mark Asquino for reasons 1.4 (b) and (d)


1. (C) SUMMARY: In advance of your planned meeting with
President Nazarbayev in Baku, Embassy Almaty wanted to offer
background on energy and non-proliferation issues in
Kazakhstan, and suggest key issues where your engagement
could be crucial. Kazakhstan's market-driven development of
its oil sector promises to catapult it into the ranks of the
world's top ten producers by 2015. American companies have
been at the forefront, with Chevron, ExxonMobil, and
ConocoPhillips either operating or developing world class
fields. President Nazarbayev shares our goal of diverse
export routes for Kazakhstani crude, especially along
east-west corridors. U.S. companies lead in other energy
sectors, especially AES in power generation and Access
Industries in coal. Problems, however, threaten to slow this
esteemable progress. The GOK has worked to claw back equity
through excessive tightening of its hydrocarbon fiscal regime
and assaults on contract sanctity. U.S. companies -- even
the majors -- face spurious tax charges and questionable
audits. Corruption is a problem at all levels. Some in the
U.S. oil patch here worry that insider deals might exclude
them from the next round of Caspian tenders. Despite the
negatives, "the geology", as one oil man here quipped, "keeps
us coming back." Switching themes, non-proliferation is an
area close to President Nazarbayev's heart, and one where you
may find him amenable to increased cooperation. For this
reason, a signal from you would be of great help to us in
breaking the bureaucratic logjams that plague our
non-proliferation cooperation. END SUMMARY.

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Talking Points
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2. (C) During your meeting with President Nazarbayev you may
wish to raise some of the following points:

-- The United States and Kazakhstan have worked together to
quadruple oil production to 1.25 mbd. US companies are
leaders in the hydrocarbon sector here. They are eager to
participate further in your ambitious plan to develop Caspian
reser

ves and produce 3 mbd by 2015.

-- We must, however, find the proper balance between the
needs of Kazakhstan's citizens and those of foreign
investors. Amendments to the 2005 hydrocarbon tax regime were
a step in the right direction. We hope that further
amendments for 2006 will continue this trend and jump start
offshore Caspian development. There have been no offshore
Caspian tenders since December 2003.

-- We hope that any new tender process will be transparent
and give all capable companies fair access. I understand that
ConocoPhillips would like to participant in a tender for the
North Sultan offshore Caspian field. ConocoPhillips is a
first-rate, integrated oil company with expertise in
developing offshore gas fields.

-- We are pleased that the Kashagan dispute was resolved
amicably. Contract sanctity is the foundation of keeping
Kazakshtan the FDI-leader in the region. I congratulate
Kazakhstan on acquiring a share in a world-class project.

-- We understand that talks on CPC expansions are nearing
completion, though important issues still remain. The USG
supports a timely resolution respecting the interests of all
parties, both private and state shareholders.

-- We understand that Kazakhstan and Azerbaijan are down to
the wire on signing an IGA to move oil through BTC, the
so-called Kazakhstani Caspian Transport System (KCTS). We
support this and hope that the IGA respects investor
interests and is similar in spirit to the BTC agreement. A
follow-on Host Government Agreement (HGA) is no less
important and must also respect investor rights.

-- We understand that since January 1994 the State Property
Commission is no longer authorized to negotiate with AES, the
power generation company. Also, the Supreme Court issued a
ruling that seems to strip the company of the right to
international arbitration. AES is a leader in its field, and
in Kazakhstan produces power at one-third the cost of its


competitors. Former Secretary of Commerce Donald Evans
brought this issue up with you in a January 2004 letter, as
did Ambassador Ordway with Prime Minister Tokayev in a May
2005 letter. We seek your assistance in allowing the State
Property Commission to negotiate with AES.

-- We are eager to establish a Second Line of Defense program
with Kazakhstan in response to your June 2001 request for
assistance. This program has proven its value in our
successful collaboration with Russia, and we believe that
there is great potential for cooperation with Kazakhstan. We
need to conclude an Implementing Agreement in order for
cooperation to move forward.

-- We reiterate our December 2003 offer to repatriate both
fresh HEU fuel and bulk material from the Alatau research
reactor to Russia, at no cost to Kazakhstan. If this is not
acceptable, we would also be willing to fund the downblending
of the HEU to LEU at the Ulba Metallurgical Plant in
Kazakhstan. We are prepared to assist in accelerating the
conversion of Alatau to LEU fuel.

--------------
Background
--------------


3. (C) Kazakhstan has proven or probable hydrocarbon reserves
of around 22 billion barrels. That figure may be low. A
study by the U.S. Geological Survey indicates that there may
be another 22 billion barrels of proven or probable reserves.
Companies working here share that belief. The country
representative for Shell, Martin Ferstl, hinted that the 9-13
billion barrels of proven or probable reserves for the giant
Kashagan (AGIP-KCO) field was "low." The largest fields --
Kashagan, Tengiz (TCO), and Karachagank (KPO) -- are high
pressure and sulfuric, though there is sweet oil. Production
is presently 1.25 million bpd, all on-shore.


4. (SBU) Most oil is produced under production sharing
agreements (PSA), though TCO is a joint venture. A PSA will
be the vehicle to develop off-shore Caspian development. A
2004 law based on a 2003 presidential decree gives the state
oil producer, KAZMUNAIGAS (KMG), a minimum 50% stake in any
new project. In 2003, the state published a program to
develop offshore Caspian oil and gas reserves. Under it, the
GOK hopes to boost production to 2 million bpd by 2010 and 3
million bpd by 2015. That goal is achievable.


5. (SBU) U.S. companies enjoy a large and respected presence.
The lion's share of U.S. FDI, about $9 billion, is in the
hydrocarbon sector. ChevronTexaco is the operator of TCO,
with a 50% share. It also has a 20% stake in KPO. ExxonMobil
has a 25% share of TCO and 18.52% of AGIP-KCO. ConocoPhillips
is also an AGIP-KCO partner, with 9.26%. U.S. service
companies such as KBR, Parker Drilling, Baker Hughes, to name
a few, are also active.

--------------
Clawing Back Equity
--------------


6. (C) Since 2002, the GOK has sought to increase its share
of the oil pie. Rising oil prices and an absence to date of
dry holes fuel this drive. Also, many in government, as well
as opposition leaders, believe that western companies took
advantage of Kazakhstan in the 1990s and struck lopsided
deals. While President Nazarbayev, at least publicly, does
not ascribe to this view, KMG and Ministry of Energy
officials readily point out that political and technical risk
are down. Consequently, the GOK share of any project should
increase, both in terms of profit and involvement.


7. (C) The GOK's successful grab for a share in the AGIP-KCO
project, against the wishes of the consortium and in
violation of the PSA, epitomizes this new aggressiveness.
After British Gas (BG) announced its intent to sell its
one-eighth share, the GOK asserted a preeminent right,
thereby vetoing the partners' right of first offer. It then
passed a December 2004 law giving it a preeminent right to
acquire, at market value, a share in new and existing
projects should they come up for sale. Eventually, the
consortium partners and the GOK split the BG share down the
middle, but not after months of rancorous back-and-forth.


8. (C) The government has also tightened the tax screws. 2004


amendments to the hydrocarbon tax law reduced internal rate
of return (IRR) from between 16-23% to around 7-9%. Further
amendments in 2005 brought IRR on big offshore projects back
up to around 11-12%. That, however, is still far from the 15%
the industry expects in Kazakhstan. Consequently, no new
offshore projects have been inked since December 2003.
Amendments for 2006 are presently in parliament. It is too
early to calculate their effect.

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Corruption
--------------


9. (C) Companies, both large and small, face corruption.
They range from tax inspections that are little more than
revenue fishing trips to demands for discount crude or
refined products. Sometimes corruption is in the guise of
demands for supporting "social" activities, while others
include attempts to deny work permits to get relatives on the
payroll. Oil transport, especially oil flowing through Aktau
port, is a prime area for rent seekers. Oil companies, which
ship through Aktau and are well-known to the Embassy, report
that KMG VP Timur Kulibayev is behind traders who charge
exorbitant premiums to transship oil. Kulibayev, who is
married to one of President Nazarbayev's daughters, also
appears to be behind recent attempts to hit up TCO for
discounted feedstock for KMG's Atyrau refinery. Direct
payment of royalties and profit oil to the GOK appear less
subject to manipulation. The reorganized National Fund, with
over $5 bn in assets, is a good step towards transparency and
good governance. To our knowledge, U.S. companies are doing
their best to adhere to FCPA standards.

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New Tenders
--------------


10. (C) Fair access to new offshore Caspian tenders is
another problem area. New legislation gives KMG a 50% share
in all new tenders plus the option to pick a "strategic
partner" to develop blocs. Lawyers for DentonWildeSapte
report that the law leaves it unclear whether a "strategic
partner" will be chosen competitively or through sweetheart
deals. ConocoPhillips fears that it will lose out on
competing for the North Sultan offshore Caspian bloc, which
may hold 4-5 bn in proven or probable reserves, to a
combination of Shell and Nelson Resources. Nelson Resources
is believed by most oil analysts here to be linked to
Kulibayev. We have also observed increasing contact between
Shell and Nelson since late 2004.

--------------
CPC Expansion
--------------


11. (C) The last CPC shareholders meeting, held in Almaty on
April 26, ended badly and without resolution of issues
crucial to expansion. Kazakhstan has, in the view of some,
supported Russia, though others hope that President
Nazarbayev will ultimately seek a compromise or support
private shareholders. Russia continues to demand creation of
a CPC-Russia board of directors that would be open to
manipulation and take over by Russia, Kazakhstan, Oman and
one other partner. The two main U.S. CPC shareholders,
Chevron and ExxonMobil, fiercely resist this, along with the
other private companies. Russia is also demanding a variable
tariff on operating and capital expenditures. Chevron Eurasia
Business Chief Guy Hollingsworth told us that expansion
approval should come no later than December 2005, otherwise
the project will seriously fall off schedule.

--------------
KCTS
--------------


12. (C) Azerbaijan and Kazakhstan are close to signing an
Intergovernmental Agreement (IGA) on bring Kazakhstani oil
across the Caspian by tanker, and later possibly pipeline,
into BTC. Both parties have accepted that the IGA is above
domestic law in both countries, though issues remain over
taxation, competition, and customs. The so-called North
Caspian Shippers, the AGIP-KCO consortium partners, worry
that getting the oil to the port of Aktau or to the planned
port of Kuryk from Kashagan will cost them dearly.
Consquently, it is important that a follow on HGA provide

adequate protection and protect investor investors.


---
AES
---


13. (C) U.S. power generation giant AES has been under GOK
assault since entering the market here in 1996. President
Nazarbayev even complained about AES to Ambassador Ordway
when he presented his credentials. The GOK ire is hard to
explain. AES has invested around $200 million since arriving
here, plans another $130 million in the next two years, and
produces power at one-third the cost of its nearest rivals.
Presently, two Kazakhstani national AES accountants face
criminal tax evasion charges in what appears to be a highly
questionable trial; the company had to date passed five state
audits (1999-2004) without problems. Since January 2004 the
State Property Commission is no longer authorized to
negotiate with AES. Also, the Supreme Court issued a ruling
that seems to strip the company of the right to international
arbitration. A January 2004 letter from Former Secretary of
Commerce Donald Evans to President Nazarbayev remains
unanswered. Ambassador Ordway inquired about the status of
the issue in a May 2005 letter to FM Tokayev, and Nazarbayev
may bring up the issue.

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Non-Proliferation Issues
--------------


14. (C) With regard to the Second Line of Defense program,
the GOK has been strangely slow to accept DOE/NNSA's offer of
assistance to combat trafficking in nuclear and radioactive
materials. Given the fact that discussions began in response
to a June 2001 request for assistance from the Kazakhstani
Customs Control Agency, the prolonged interagency delays are
puzzling. Embassy Almaty has been pushing both the MFA and
the (recently renamed and reorganized) Customs Control
Committee to continue negotiation of the necessary
Implementing Agreement. We have also emphasized the fact
that the SLD program began with Russia, in an effort to allay
any possible GOK fears that cooperation with the U.S. in this
sphere would be frowned upon by Kazakhstan's northern
neighbor.


15. (C) Post alerted Minister of Energy and Mineral Resources
Shkolnik, as well as the MFA, that you may raise disposition
of the HEU at the Alatau research reactor with President
Nazarbayev. Minister Shkolnik emphasized the need to keep
the reactor running continuously. In the past, President
Nazarbayev has been vigorously opposed to proposals to
repatriate fuel to Russia. We expect that the downblending
option, combined with reactor conversion assistance, will be
more acceptable to him.

--------------
COMMENT
--------------


16. (C) The two issues that you will discuss with President
Nazarbayev, energy and non-proliferation, are seen as crucial
to Kazakhstan's national security and international image.
For that reason, many decisions that would typically be
handled at the working level in other countries are the
exclusive domain of Nazarbayev himself. The meeting presents
an excellent opportunity to focus Nazarbayev on issues near
to his heart, and encourage him to take decisive action to
move the bilateral relationship forward.
ORDWAY


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