KAZAKHSTAN'S PETROCHEMICAL AMBITIONS:

C O N F I D E N T I A L SECTION 01 OF 04 ASTANA 000116

SIPDIS

NOFORN
SIPDIS

DEPT FOR EB/ESC; SCA/CEN (O'MARA)

E.O. 12958: DECL: 01/11/2016
TAGS: ENRG EPET KZ PGOV PREL
SUBJECT: KAZAKHSTAN'S PETROCHEMICAL AMBITIONS:
FORWARD-THINKING OR FOLLY?

REF: A. 06 ASTANA 737


B. 06 ASTANA 738

Classified By: Charge d'Affaires Kevin Milas; reasons 1.4 (b) and (d).


1. (C) Summary: The Government of Kazakhstan (GOK) is
aggressively encouraging foreign investment in a domestic
petrochemical industry as part of its strategy to diversify
the economy and to "climb the value chain" of hydrocarbon
production. The GOK has authorized a predictable set of tax
benefits for petrochemical investors, but the largest
incentive to invest may be the 2005 law governing offshore
oil contracts, which makes explicit the GOK's intent to favor
exploration and production bids from companies which commit
to investing in the petrochemical industry. Western oil
company executives are uniformly skeptical of the economics
of petrochemicals in Kazakhstan, pointing out that the
country is disadvantaged, especially in comparison with the
Middle East, in terms of feedstock availability, distance to
market, and supporting infrastructure. Numerous potential
petrochemical projects have been discussed in the media over
the last year, but the one which appears to be furthest along
-- a plan to build a $4 billion complex in Atyrau using
ethane from the Tengiz field -- does, indeed, appear to be
"uneconomic" and dependent on high-level political will to
remain on-track. The 2005 law, along with the growing
perception that building a petrochemical plant would "please
the President," creates an interesting dilemma for Western
oil companies which would prefer to focus on producing and
transporting crude oil. End summary.

Outlining the GOK's Vision
--------------


2. (C) The development of a petrochemistry industry is, upon
first analysis, a logical extension of Kazakhstan's oil
extraction-based economy, and evidence suggests that the GOK
has entertained the thought for years. ConocoPhillips (CP)
Vice President Bill Berry recently told the Ambassador that
the GOK had pressured CP to invest in a petrochemical
facility in 1997, during discussions surrounding CP's entry
into the super-giant Kashagan project. The petrochemical
initiative appears to have first gained official status in
2003, with the publication of the Republic's "Industrial and
Innovation Development Strategy for 2003-2015." This document
singles out petrochemicals as a sector in which Kazakhstan
has a likely competitive advantage. (Note: This document,
which focuses on the development of competitive,
export-oriented non-raw materials production, is often seen
as the starting point for Kazakhstan's subsequent "cluster
theory" approach to economic diversification. End note.)
The initiative gained further footing with the 2004
publication of a six-year plan for developing a Kazakhstani
petrochemical sector. The clearest sign that this has become
a GOK priority, however, are 2005 revisions to the offshore
oil production law (see para. 7) which made explicit the
GOK's intent to favor companies in the bidding process which
pledged to invest in petrochemicals. President Nazarbayev
touted the petrochemical industry in his 2004 and 2006 annual
addresses, but has been relatively low-key in his public
approach to the issue. This contrasts, we are told, to his
private approach in talking to international oil companies --
on November 19 CP Country Manager Nick Olds told the
Ambassador that Nazarbayev had talked to "all the oil
companies" about investing in petrochemicals.


3. (C) While Nazarbayev has not made the connection explicit,
many observers believe the petrochemical initiative has also
gained momentum from the President's drive to make Kazakhstan
one of the fifty "most competitive" nations, and the
concurrent emphasis on diversifying the economy. (Comment:
While petrochemical production would clearly add value to
Kazakhstan's gas resources, it would, as a
technology-intensive industry, add relatively few jobs. End
comment.) Shell's Country Chairman, Martin Ferstl (whose
company advised the GOK on a petrochemical strategy in 2005)
told Energy Officer recently that he believed Nazarbayev's
motivations for promoting the industry were driven in part by
fears that, once Kazakhstan joined the WTO, the country would
be flooded with Chinese products. Kazakhstan hoped to export
petrochemicals to China, Ferstl concluded, in order to help
balance trade flows.


4. (C) In 2005 the state-owned Center for Marketing and
Analytical Research (CMAR) undertook a feasibility study of
the industry, contracting with Nexant to produce a detailed

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"Petrochemical Masterplan," the fundamental conclusions of
which -- that an ethane-based petrochemical complex based in
Atyrau would have an expected internal rate of return (IRR)
of 13-16% -- were presented during a November 2005
petrochemical conference in Astana. (Note: There was
widespread skepticism of this IRR figure. Two oil company
executives whispered to Energy Officer on the margins of the
conference that Nexant had originally returned a much lower
IRR -- in the single digits -- only to be told to go back and
change the study's assumptions. End note.)

Existing Facilities / Planned Future Facilities
-------------- --


5. (U) In the Soviet era, Kazakhstan's petrochemical
industries (a polyethylene plant in Aktau, a polypropylene
plant in Atyrau, a tire-manufacturing plant in Shymkent, and
a complex of rubber plants in Karaganda) functioned as part
of a larger Soviet production chain, importing raw materials
from Russia and distributing the resulting value-added
products throughout the USSR. While several of the rubber
plants have survived since independence by exploiting the
same interconnections with the Russian market, the Aktau and
Atyrau plants have struggled. Both had shut down prior to
being purchased, in 2004, by "Atoll" -- a Kazakhstani
joint-venture which, in 2006, joined with Dutch-based Basell
to become "Kazakhstan Petrochemical Industries" (KPI). Atoll
re-tooled the Aktau plant to begin polystyrene production in
September 2005, using feedstock from Russia and selling the
resulting plastics inside Kazakhstan (12%),to Russia and the
CIS (30-40%),and to China (48-58%).


6. (C) KPI has not restored polypropylene production at the
Atyrau facility; this site is now one of several being
considered as the location for KPI's planned ethane complex
in Atyrau (par. 10). The KPI project is merely one of
numerous new potential projects which have been discussed
publicly in the past year. At the November 2005
petrochemical conference, then-Energy minister Vladimir
Shkolnik singled out a $3.6 billion KMG / Lukoil gas chemical
complex planned in Kazakhstan, near the North Caspian border
with Russia. (Note: This project now seems less likely, with
Russia reportedly favoring a Russian landing for the offshore
gas. End note.) KMG and Marubeni, a Japanese company, are
reportedly developing a feasibility study to explore the
possibility of producing benzene at the Atyrau refinery, for
use as a feedstock for polystyrene production at the Aktau
plant. "GS Caltex," a South Korean company, has reportedly
launched a feasibility study (with KMG) for construction of a
$1.5 - $3 billion plastics plant. On December 15, Iranian
Foreign Minister Mottaki was quoted in the press as
indicating Iran's interest in building a petrochemical
complex in Atyrau. These announced deals and discussions may
only scratch the surface of active interest: Michael
Sturdivant, an Almaty-based Deloitte tax advisor, told Energy
Officer on November 28 that "four or five" companies had
recently sought Deloitte's advice on possible petrochemical
investments in Kazakhstan.

Legal and Financial Promotions
--------------


7. (C) Kazakhstan's 2005 law governing offshore oil
operations (informally, the "Production Sharing Agreement"
law) formalized the GOK's intent to favor international oil
companies which invest in petrochemical facilities in
Kazakhstan. The law states that, in assigning offshore
production and exploration rights, the State will favor
proposals which further the development of "high technology"
-- of which "petrochemistry" is listed as the highest
priority. Prime Minister Akhmetov articulated this
connection clearly in his keynote speech at the 2005
petrochemical conference, stating "we will prioritize
companies who invest in petrochemicals when signing
exploration and production contracts."


8. (C) ConocoPhillips' (CP) bid to secure Kazakhstan's
offshore "N" block (Ref A) provides one example of how the
GOK is implementing this law. CP related to Post that,
during CP CEO Jim Mulva's meetings in Astana in May 2006,
Prime Minister Akhmetov and other officials told Mulva that
the surest way to win a share of the "N" block was to commit
to partner with KMG in building a petrochemical facility
which would utilize "N" block gas. Akhmetov answered Mulva's
skepticism about the commercial feasibility of such a project
by referring to Nexant's finding that an ethane cracker

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complex had an expected IRR of 13-16%.


9. (SBU) The GOK has also created tax and other financial
incentives for petrochemical investment. The 2006 Tax Code
(Article 119-1) provides a five-year exemption on corporate
income tax for petrochemical projects established from
2004-2007 and meeting minimal investment thresholds. (Note: A
local accountant -- and skeptic of the petrochemical sector
initiative -- minimized the significance of this article as
an incentive to investment, pointing out that an exemption on
corporate income tax has value only if the company has
taxable profits in the first place. End note.)


10. (SBU) Finally, the GOK has launched a feasibility study
for the creation of a "National Industrial Petrochemical
Technopark" in Atyrau, where investors will enjoy the
benefits of operating in a "special economic zone," including
exemptions from land and property tax, VAT exemptions on
service turnover, and exemptions from customs duties on
imported goods. (Note: The "technopark" is a key element in
Kazakhstan's "industrial innovation" strategy -- the 2003
initiative at diversifying the economy which gave rise to
Kazakhstan's "cluster" approach to diversification.) While
the technopark plans feature prominently in the Atyrau
oblast's short-term economic development vision, no
institutions have yet been built.

Atyrau Petrochemical Facility
--------------


11. (C) The petrochemical project which has received the
most press, and appears to be furthest along in development,
is KPI's planned $4 billion ethane-based cracker, an
associated LPG-based Propane Dehydrogenation Plant, and
downstream polyethylene and polypropylene facilities, based
in Atyrau. The project's first stage envisions building a
cracker utilizing 3 billion cubic meters (bcm) of gas
annually from the nearby Tengiz oil field, and a second
complex, further in the future (2013-18),based on gas
volumes from the Kashagan field.


12. (C) The project still appears to face considerable
hurdles despite much forward-leaning press and clear
government support. The First Deputy Akim of Atyrau told the
DCM on November 28 that the oblast based "many hopes on
petrochemicals," and listed development of a petrochemical
industry as the oblast's second economic priority, trailing
only further development of oil and gas production.
Nevertheless, TengizChevrOil (TCO) General Manager Todd Levy
recently told DCM (Ref B) that negotiations between KPI and
TCO for Tengiz gas supplies were proceeding only because
Nazarbayev had asked Chevron Chairman David O'Reilly to
support the project. TCO had agreed to supply KPI with
below-market gas, Levy said, but even so the project appeared
to be "uneconomic," and the deal would likely fail without
additional political intervention. Access Industries (parent
company of KPI participant Basell) Vice President Paul
Rodzianko seemed to have reached the same conclusion when, on
December 7, he asked Energy Officer how the Embassy might
react to a request from Access to "put some pressure" on TCO
to conclude a gas deal. "The project has to happen,"
Rodzianko explained, "because it's important to Nazarbayev."


13. (C) Although KPI recently announced signature of an MOU
concerning "mutual intent to proceed with negotiations over
gas supplies," with Kashagan operator AGIP KCO, the
consortium is not factoring gas supplies for a petrochemical
plant into their project development plans. Ferstl told
Energy Officer on December 8 that the GOK had recently
"seemed to drop" the idea that AGIP KCO should allocate gas
for a petrochemical plant; for this and other reasons the
consortium had recently adopted a "full re-injection plan"
for Kashagan gas. AGIP KCO's Astana Office Manager, Luka
Rogoz, confirmed this on December 6, telling Energy Officer
that "all" of Kashagan's gas would be re-injected, beginning
six months after first commercial oil production. As a
consequence, he continued, Kashagan engineering and
construction was proceeding on the basis of 100%
re-injection. If the GOK came back to the consortium with a
request to support the petrochemical industry, he concluded,
"I don't have the faintest idea how we would accommodate the
request."

Private Sector Skepticism
--------------


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14. (C) Among local oil company executives, skepticism of the
GOK's petrochemical ambitions run high. The skeptics
articulate three primary disadvantages faced by Kazakhstan:
lack of available feedstock, distance from market, and
inadequate supporting infrastructure. To outline the
argument concerning feedstock: seventy percent of
Kazakhstan's known gas resides in three fields: Karachaganak,
Kashagan, and Tengiz. Karachaganak is reportedly near to
signing a long-term deal to supply gas to the Orenburg gas
refinery in Russia which would commit the field's gas
supplies well into the next decade. Kashagan partners are
pursuing full re-injection. While TCO has lower re-injection
goals for Tengiz, and the field's high ethane content makes
it attractive for use in petrochemical production, two
independent industry studies (by Shell and ExxonMobil) have
concluded that Tengiz does not have sufficient gas to drive a
cost-competitive cracker. Intertwined with the idea of gas
"availability," of course, is the issue of gas economics: how
can Kazakhstan's gas -- often highly-sulfurous, and thus
expensive to process; and associated with oil, and thus
valuable for raising reservoir pressure for high-value oil --
compete with gas from the Middle East which (a) is often
found separate from oil; (b) is often "stranded" (or isolated
from market),and thus cannot be monetized on its own; and
(c) often receives governmental support which lowers the
price below export parity?


15. (C) In terms of infrastructure, the ExxonMobil study
suggests that the "green field" costs for petrochemical
development in Kazakhstan are approximately twice that of
"brown field" costs on the U.S. Gulf Coast -- a difference
which reflects both significantly higher constructions costs
in cold and isolated Kazakhstan, and the relative lack of
surrounding road, port, rail, and electrical infrastructure.
This lack of infrastructure exacerbates Kazakhstan's third
major disadvantage, that of geography: thousands of miles
from either the European or Chinese markets, the country
suffers a logistical disadvantage in relation to existing or
potential competitors, especially in the Middle East. These
disadvantages add up, in ExxonMobil's detailed study, at
least, to single-digit returns on investment in
petrochemical facilities in Kazakhstan. While the study
suggests that the GOK can do much to reduce Kazakhstan's
disadvantages -- primarily by investing in infrastructure --
the necessary changes are years, if not decades, away.


16. (C) Comment: There is a clear contradiction between the
oil companies' calculations that a petrochemical plant in
Kazakhstan is not economic, and the GOK's evident will that
one (or more) be built. The GOK can, to some extent, improve
project economics even further with tax cuts and, in the long
term, infrastructure improvements. The 2005 PSA law, of
course, broadens the relevant economic calculation,
essentially inviting companies to "write off" a low- (or no-)
profit petrochemical plant in return for access to a
potentially lucrative offshore oil field. And finally,
pleasing President Nazarbayev carries benefits that cannot be
captured by purely economic models. These reasons appear to
explain the private sector interest expressed so far, and
will likely, sooner or later, lead to a company taking the
petrochemical plunge, if adequate supplies of gas can be
secured. These investments will likely occur in partnership
with KMG -- which, as a state-owned company, may have the
mandate and leeway to undertake "strategic" projects with low
expected rates of return. End comment.
MILAS