KASHAGAN: THUS FAR, COMMERCIAL DISPUTE, NOT

C O N F I D E N T I A L SECTION 01 OF 03 ASTANA 002586

SIPDIS

SENSITIVE
SIPDIS

DEPT FOR SCA/CEN
DEPT PASS TO OPIC - BALLINGER
DEPT PASS TO TDA FOR STEIN, EXIM, FOR GLAZER
DEPT PASS TO AID - EE PHILIPS/RUSHING
USDOC FOR 4231/ITA/MAC/MLONDON, 4201/BISNIS
USDOC FOR 6110/ITA/TD/BI/RHALPERN
ANKARA FOR CFC

E.O. 12958: DECL: 09/19/2017
TAGS: ECON EIND ENRG EPET EFIN EINV KZ
SUBJECT: KASHAGAN: THUS FAR, COMMERCIAL DISPUTE, NOT
SAKHALIN II

Classified By: AMBASSADOR ORDWAY FOR REASONS 1.4(B) AND (D)


1. Summary: (SBU) Spurred on by further delays and rising
costs at Kashagan, the Government of Kazakhstan (GOK) has
made clear to the international consortium developing the
huge oil field of its dissatisfaction with the current
profit-sharing scheme. The GOK leadership has indicated that
it seeks a significant increase in Kazakhstan's share of
profits under the production sharing agreement and immediate
compensation "in the billions of dollars" for the latest
delays. In the interim, development at Kashagan is suspended
for three months because of environmental violations at the
site. With talks underway, both government officials and oil
company representatives characterize the current conflict as
a commerical dispute likely to be resolved. End Summary

Kashagan: Further Delays, Rising Costs
--------------


2. (SBU) In June, the North Caspian Project consortium Agip
KCO officially notified the GOK of delays and cost overruns
on Kashagan, one of the world's largest oil projects, with
estimated reserves of 13 billion barrels. Commercial
production is to be delayed from 2008 to 2010 and the costs
to increase from $56 billion to $136 billion over the life of
the forty-year contract. Costs for the first phase of
development will nearly double, from $10 billion to $19
billion.



3. (SBU) The June announcement was only the latest setback on
the Kashagan project. Originally, commercial production was
to have started in 2005. In February 2004, AGIP KCO and the
GOK agreed to delay production until 2007-2008. At the time,
AGIP paid the GOK $150 million for the delays in commercial
production. Some experts have criticized Eni, the project's
operator (the consortium also includes Exxon Mobil, Shell,
Total, Conoco Phillips, and IMPEX) for an overly exuberant
forecast of costs and production schedules for an extremely
difficult project.

Kashagan Shut Down, New Terms Sought
--------------


4. (SBU) Agip's difficulties have continued through the
summer. On August 27, the Ministry of Environmental
Protection declared that it was suspending work at Kashagan
for three months due to environmental violations. Serzhan
Duysenbayev, acting Chairman of the Finance Ministry's
Customs Control Committee, announced that several criminal
cases have been initiated against Agip's affiliates for
evading customs duties. The Ministry of Emergency Situations
stated that it will shut down Agip's oil and gas processing
facility, which is under construction, for non-compliance
with fire norms.


5. (SBU) Most significantly, Agip has faced a GOK clearly
displeased with the latest developments and dissatisfied with
the terms of its production sharing agreement (PSA). Prime
Minister Masimov stated publicly that "the change in the
terms of the Kashagan development means the contract's
change." Kazakhstani officials have declared in discussions
that they seek to raise Kazakhstan's share of profits under
the PSA from 10% to 40%. The GOK has also bemoamed the
near-term detrimental effects of further delays. According
to Vice-Minister of Finance Yergozhin, the GOK had been
expecting $1.2 or 1.3 billion in revenue from the project
starting in 2008. Kazakhstan, he told the media, is expecting
compensation in "the range of billions of dollars." (Note:
Under the terms of the PSA, Agip is not obligated to make
payments to the GOK until development costs are recovered.
End Note)


6. (SBU) Eni's position as operator of the Kashagan project
has also been made tenuous by the delays and cost overruns.
At the Eurasia Energy Forum in Astana on September 6, Masimov
suggested a larger role for KazMunayGas. "In line with our

ASTANA 00002586 002 OF 003


targets and requests voiced by the president of our country,
KazMunayGas has to become a second operator of the project.
If consortium members decline Kazakhstan's terms, we have
plan 'B,' about which I will tell you later," he said.
Yergozhin stated to the media that Kazakhstan would "look
positively" on a proposal to put a local company in control
or to operate the project jointly.


7. (SBU) On September 11, MasimNO)6nnounced that negotiations with
Agip will last until October 22.


8. (SBU) On September 12, Yerlan Nigmatulin, head of the
Mazhilis (lower house of parliament) Committee on Ecology and
Mineral Resources, stated that the Mazhilis is considering an
amendment to the "Law on Subsoil and Subsoil Use." The
proposed amendment gives the GOK the right to annul or amend
contracts in cases of "national security threats caused by
investors' actions." The new law would apply retroactively.
The basis for the move was "the Kashagan conflict", he said.
Nigmatulin expects the amendments to be adopted by October
22, the end of the 60 day period of "friendly negotiations"
between the GOK and Agip KCO.


GOK: Foreign Investors Have No Cause For Concern
-------------- ---

9.(C) In a meeting with the Ambassador, Prime Minister
Masimov emphasized that Kazakhstan is "not trying to push
foreigners out." Masimov described Kashagan as a commercial
dispute, noting that according to GOK analysis Kazakhstan
will net nothing under the current PSA because of the rising
costs. Masimov also said that "everyone agrees that Eni has
been totally incompetent." Nevertheless, no criminal charges
will be brought, and foreign investors have no cause for
concern. Masimov laughed at a rumor that Lukoil might take
the lead at Kashagan. In a separate meeting with the DCM,
Minister of Finance Yergozhin said that the environmental
inspections at Kashagan have been part of normal
investigations.


10. (C) Representatives from Conoco Philips told the
Ambassador that the GOK is seeking compensation outside of
the PSA. They were not panicked about the conflict, saying
that everyone agrees it will be settled and noting that, in
comparison to Russia, they still feel welcomed in Kazakhstan
("it is always refreshing to come here"). Nick Olds,
Conoco-Philips Kazakhstan Country Manager, did not refute
criticisms that have been levelled at Eni. "Eni is not doing
a lot to redeem themselves," he said.


11. (C) In a September 17 conversation with the Ambassador,
First Vice President of KMG Maksat Idenov, who is now the
GOK's chief negotiator with the consortium, acknowledged that
the GOK cannot, under the terms of the PSA, change the
operator. He noted, however, that the companies in the
consortium can and are now interested in doing so. Idenov
played down the September 12 expulsion of a Conoco Philips
representative from a GOK-consortium meeting. The
Kazakhstani side, Idenov explained, had asked consortium
members to send to the meetings executives empowered to make
decisions ("not notetakers") which, he asserted, Conoco
Philips failed to do. Speaking to the Ambassador, a Conoco
Philips representative blamed the episode on a
misunderstanding of the company's corporate structure.


12. (C) Comment: The GOK has strong reason to be displeased
with events at Kashagan. Despite the public fireworks,
however, we expect the matter will be resolved in a manner
acceptable to all parties, although likely after the October
22 date established for the end of negotiations. While the
GOK will seek better terms, and is almost certain to receive
them, it is unlikely to make any rash moves that will

ASTANA 00002586 003 OF 003


negatively impact the foreign investor climate in Kazakhstan,
particularly when Kazakhstan is aggresively seeking
investment in its non-extractive sectors. Furthermore,
Kazakhstan has generally proven itself a reliable partner in
the energy sector; while Kashagan has gathered most of the
recent publicity, the country's two other huge oil projects,
Tengiz and Karachaganak, continue to proceed smoothly and to
the satisfaction of all parties involved. End Comment
ORDWAY