KAZAKHSTAN: SHELL EXECUTIVE WARNS OF FURTHER

C O N F I D E N T I A L SECTION 01 OF 02 ALMATY 001085 SIPDIS SIPDIS DEPT FOR EB/ESC; EUR/SNEC (MANN); SCA/CEN (MUDGE) E.O. 12958: DECL: 03/26/2015 TAGS: ENRG EPET KZ SUBJECT: KAZAKHSTAN: SHELL EXECUTIVE WARNS OF FURTHER KASHAGAN DELAYS REF: ALMATY 886 Classified By: Amb. John Ordway for reasons 1.4(B) and (D). ¶1. (C) Summary: Martin Ferstl, Country Manager for Shell, told Ambassador on March 3 that the Kashagan project contained a "serious" design flaw in the design of its offshore facilities. As a result, the one-year design process would have to begin anew, with corresponding delays in first production. Ferstl termed the design error "unprecedented" in the oil industry, and predicted that the issue would provoke the GOK to seek damages for non-performance under the Production Sharing Agreement (PSA). Ferstl also voiced concern about the direction of CPC expansion negotiations, and asked hypothetically if the USG would support an initiative to resolve the dispute via international arbitration. Ferstl confirmed Shell's continuing interest in a Bosphorus bypass pipeline, telling Ambassador that he was concerned by the apparent ease by which a terrorist act could block oil transit through the Straits. Ferstl was less enthusiastic about the idea of a Trans-Caspian gas pipeline, suggesting that Kazakhstan lacked sufficient gas to simultaneously pursue re-injection, a petrochemical industry, and the Chinese and Trans-Caspian gas pipelines. End Summary. Kashagan Facing Serious Technological Problems -------------- - ¶2. (C) Ferstl (strictly protect) told Ambassador on March 3 that the Kashagan project (in which Shell is a partner) contained "serious design flaws" which would set the project back at least a year, and likely result in lower initial production volumes than planned. Ferstl said that the design problem presented serious safety risks, including the possibility of high-pressure sulfurous gas leaks, and thus the consortium had no choice but to restart the entire design phase of the offshore facilities -- a one-year process. Ferstl told Ambassador that the design error was "unprecedented in the oil industry." For the time being, project partners weren't speaking publicly about the delays, which could push "first oil" back to 2011. ¶3. (C) Ferstl predicted that the delay would lead to an extended dispute in the framework of Kashagan's PSA, as KazMunaiGaz's (KMG) up-front costs would be increased, and the GOK's revenue stream delayed. No government in the world would accept this magnitude of cost and time overruns, Ferstl said, and "the GOK has an excellent case for a claim of non-performance under the contract." Ferstl noted that this latest setback has only intensified the resolve of Kashagan partners to strip a measure of control from operator AGIP. "We're working on changes to the operating agreements," Ferstl concluded. On a "positive" note, Ferstl laughed, the Kashagan delays would ease the looming shortage of oil pipeline capacity caused by delays in CPC expansion and BTC-IGA negotiations. CPC Expansion: A Hardening of the Russian Position -------------- -------------- ¶4. (C) Turning to the subject of CPC expansion negotiations, Ferstl noted that, at the end of 2005, the private company CPC shareholders had offered a compromise which gave the Russians "80% of what they had asked for." However, Russia's position had hardened even further since then, Ferstl said, leaving him with the impression that the Russians had resolved to either obtain terms as favorable as they had on their own pipelines, or "let the project sit there." Even taking into account Kashagan production delays, the CPC deadlock was posing transportation problems. Chevron had decided to ship its "second generation" Tengiz volumes out by rail -- but at what point would the region's railways become congested? Ferstl concluded the topic by asking the Ambassador how much political support the USG would offer if the CPC partners resolved to take the dispute to international arbitration. Ambassador offered to raise the question with Washington. ALMATY 00001085 002 OF 002 Shell Interested in Bosphorus Bypass -------------- ¶5. (C) Asked if Shell had interest in a Bosphorus bypass, Ferstl said "yes." Commercially, he said, Samsun-Ceyhan was a better option, because the deep-water Ceyhan port could support "maximum trading operations." Burgas-Alexandroupolis was shorter, and therefore cheaper, and had Transneft/TNK-BP backing. However, it had a major disadvantage -- supertankers would have difficulty skirting all the tiny islands in the Aegean. One way or another, Ferstl concluded, a bypass was needed. He told the Ambassador that he had been struck recently by how easily a terrorist act could shut down the Bosphorus strait -- potentially until a new bypass was built. At a cost of $1 - $1.50 per barrel, he said, a bypass was an excellent "long-term insurance policy" against a Bosphorus closure. Skepticism About a Trans-Caspian Gas Pipeline... -------------- --- ¶6. (C) Ferstl was less enthusiastic about the prospect of a Trans-Caspian gas pipeline. Turkmenistan, he and the Ambassador agreed, would not be a reliable partner in such a venture until political change took place. However, Ferstl said, "Kazakhstan is not a gas-rich country." Tengiz and Kashagan had a lot of gas, but if the gas was extracted rather than re-injected "you lose the oil." Karachaganak, in turn, was "a long way to the North"; furthermore, its gas was tied to the Orenburg gas-processing plant. Overall, Ferstl said, Kazakhstan lacked the gas in the short-term to simultaneously pursue a petrochemical industry and gas pipelines both to China and to the West. ...And the Petrochemical Industry -------------- ¶7. (C) Ferstl told Ambassador that he was skeptical of Kazakhstani ambitions to develop a local petrochemical industry. Kazakhstan's cost structure wasn't comparable to that of potential competitors in the Middle East, he said, citing Qatar, with easy access to the sea and thus world markets, as an example. The GOK wanted to build a "small" petrochemical industry, he added, but the competition was global, and based on economies of scale. Even selling to the Chinese was costly. Railroad costs were high, and the Chinese markets were on the coast -- where they could be served by ships. The only thing that saves the idea of a local petrochemical industry, Ferstl said, is WTO. After accession there will be a flood of products coming into Kazakhstan from China, he explained. "Something will have to go the other direction." ¶8. (C) Comment: Ferstl, sanguine by nature, was clearly worried, not only about Kashagan delays and further cost overruns, but also about potential GOK legal action against the consortium. We will report the opinion of Kashagan partners ExxonMobil and ConocoPhillips -- consistent with Shell's, if slightly less alarmed -- via septel. Per reftel, we wonder if it is time to use USG influence to marshall what appears to be widespread company interest behind one or the other Bosphorus bypass option. End Comment. ORDWAY