PROJECT KUWAIT STILL STALLED; ROLE FOR FOREIGN OIL

C O N F I D E N T I A L SECTION 01 OF 07 KUWAIT 000707

SIPDIS

NOFORN
SIPDIS

EB/ESC/IEC FOR GALLOGLY AND GRIFFIN, NEA/ARP FOR JACKSON
AND BAGWELL, ENERGY FOR IE

E.O. 12958: DECL: 04/13/2017
TAGS: EPET ENRG EINV KU OIL SECTOR
SUBJECT: PROJECT KUWAIT STILL STALLED; ROLE FOR FOREIGN OIL
COMPANIES MAY TAKE A DIFFERENT FORM

Classified By: Ambassador Richard LeBaron for reasons 1.4 (b) and (d).


1. (C/NF) SUMMARY AND COMMENT: Based on a series of recent
meetings with Oil Ministry officials, leaders in Kuwait's
state-owned petroleum companies (the K-companies),
representatives of the major international oil companies
(IOCs) in Kuwait, and local managers of international oil
service companies, Post assesses that the
short-to-medium-term outlook for Project Kuwait (the $8.5
billion proposal to invite IOCs to participate as partners in
the development of Kuwait's upstream oil sector) is bleak.
Despite recent press statements by the Amir and Oil Minister
in apparent support of the Project, a lack of leadership
within Kuwait's oil sector, strained relations between the
Parliament and the Government, and exceptionally strong
government finances all undermine the case for pushing
Project Kuwait through the Parliament.


2. (C/NF) Summary and Comment cont'd: Nevertheless, the
fundamental issues that created the need for Project Kuwait
are even more pressing now than they were a decade ago when
the Project was first proposed. Kuwait continues to
overproduce its cash cow, Burgan oil field, thereby limiting
its ultimate potential productivity. In the absence of
state-of-the-art technology and professional expertise,
Kuwait Oil Company (KOC) struggles to increase the output
from the difficult fields in the North that would be covered
by the Project. Within KOC, underinvestment in training, the
constraints of civil service pay scales, and the lack of
professional ambition typical of a government-owned company
in a cradle-to-grave welfare state mean that without the
partnership of major IOCs, Kuwait faces enormous opportunity
costs in terms of lost production due to mismanagement.


3. (C/NF) Summary and Comment Cont'd: A strong Oil
Minister could present a compelling case for the Project to
the Parliament and the public, but the current Minister
appears indecisive, risk-averse, and overwhelmed by the
challenges facing an industry in which he has little
background. In the long absence of any progress on Project
Kuwait, K-company managers and some of the IOCs are now
pursuing "enhanced" technical service agreements (ETSAs) as
an alternative. Under this model, Kuwait would pay premium
prices to have IOCs assign engineers and managers to Kuwait
Oil Company as long-term consultants. High fixed fees would
be complemented by variable, performance-based pay contingent
upon meeting agreed production targets. The advantage of
ETSAs is that, legally, the contracts could be signed without
Parliamentary approval, although there could still be
political challenges depending on the magnitude of the fees
and the size of the IOC footprint. The downside is that the
overall level of participation of IOCs would likely be less
than it would under Project Kuwait. There is also a danger
that IOCs may be incentivized to maximize short-term
production to the detriment of the long-term productivity of
the reservoirs.


4. (C/NF) Summary and Comment Cont'd: The IOCs seem to
consider ETSAs to be a reasonable alternative as long as the
fees are large enough to justify reassigning scarce personnel
resources from other profitable international projects.
Overall, the IOCs express pessimism about the Kuwait Project
and guarded optimism about ETSAs. The better positioned
IOCs, including Chevron, ExxonMobil, and BP see possible
opportunities to profitably grow their business through
ETSAs. All of the IOCs that are currently doing limited
business with Kuwait, through limited TSAs that barely cover
costs, say they are finding it increasingly difficult to
justify their continued presence here after ten years of
effort with little to show for it. END SUMMARY AND COMMENT.


5. (C/NF) This report is based on views expressed in a
series of meetings between late March and early May 2007 with
the Oil Minister; the managers of Kuwait Petroleum
Corporation (KPC),Kuwait Oil Company (KOC),Kuwait National
Petroleum Company (KNPC),and Oil Development Company(ODC);
members of the Supreme Petroleum Council (SPC),and country
managers from ExxonMobil, Chevron, BP, Shell, Total,
Halliburton and Schlumberger.

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Project Kuwait: From 1997 until Now
--------------


6. (U) In 1997, Kuwait's Supreme Petroleum Council approved
the concept of allowing foreign oil companies to participate

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in development of Kuwait's northern oil fields and tasked KOC
(responsible for domestic exploration and production) with
developing proposals on what form foreign participation might
take. Kuwait's constitution forbids foreign ownership of the
country's upstream oil resources, so traditional production
sharing agreements were off the table. There were two
principal reasons for the proposal which became known as
Project Kuwait. First, from an engineering and geological
standpoint, the northern fields are difficult to develop, and
KOC needed the help of IOCs to boost their production,
thereby allowing KOC to correspondingly reduce production
levels at its super-giant Burgan field to avoid damaging the
field. Second, following the Iraqi invasion of Kuwait in
1990, there was a security argument for Project Kuwait. The
Kuwaitis hoped that the presence of major international oil
companies near the border with Iraq would give the Western
powers an additional incentive to protect the integrity of
that border.


7. (U) Draft legislation was introduced in Parliament in
2003 enabling KPC, the parent corporation of Kuwait's
state-owned petroleum companies, to sign contracts with
foreign oil companies giving them operational control over
certain oil fields. The Parliament's Financial and Economic
Affairs Committee began to study the legislation in 2004 and
issued a favorable report on the enabling legislation in

2005. However, after the State Audit Bureau questioned the
constitutionality of the legislation, the committee withdrew
the report. In December 2005, the Government estimated that
the legislation would pass with 33 out 50 votes in the
Parliament. However, the Government sought even stronger
Parliamentary support and decided to defer the vote to early

2006. In January 2006, the Amir died, and the vote was
delayed to accommodate the mourning period and succession.
At the same time as it again appeared that the legislation
was finally going to be brought forward for a vote, the new
Amir dissolved the Parliament due to ongoing confrontation
with the Government. The new Parliament was elected in June
2006 and a new Government was appointed in July. However,
the new "reformist" Parliament took the Government to task on
a number of alleged corruption issues and called a number of
Ministers for questioning until the Government decided to
resign in February 2007. A new Government was appointed in
March, but the initial indications are that the relationship
between the Government and Parliament will continue to be
largely adversarial.


8. (SBU) Under the terms of the existing draft legislation,
generally described as an Operating Service Agreement (OSA),
IOCs would be compensated for 50% of operating costs on a
monthly basis and for 50% of capital costs over 10 years.
They would be paid fixed fees per quantity of oil and gas
produced up to a baseline level, with the fee per barrel
increasing for any production beyond this threshold. The
companies would be required to "Kuwaitiize" 80% of their
local work force within 18 months. The current draft
contracts were prepared as commercial agreements between two
companies: Kuwait Oil Company and an IOC. Some MPs now
argue that these contracts should be rewritten as government
contracts which would have to adhere to more stringent
standards.


9. (SBU) Shortly after assuming his post in July 2006, the
new Oil Minister hired Morgan Stanley and Lazard to review
the economics of Project Kuwait. These two studies were
completed and delivered to the Minister at the end of April

2007. Their conclusions are unknown. The Minister announced
in April that following the completion of the study, the way
forward for Project Kuwait would be announced within two
months. The terms and conditions of the draft contracts have
been revised a number of times since they were last reviewed
by the IOCs in 2003. At that time, the IOC country managers
said that the terms and conditions were not economically
attractive enough to make it worthwhile for them to bid. We
do not know if any subsequent work has been done on the
contracts to make them more attractive, and of course, if
tenders are released, the IOCs would need to conduct due
diligence to examine the current condition of the fields and
production facilities. IOC country managers say that
individuals within KPC understand how the market and
investment climate have changed over the past ten years, but
the institution as a whole does not. These IOC managers
suspect that the current terms and conditions of contracts
would not reflect current market conditions. Thus even if
the Kuwait Project legislation is approved by the Parliament,
there is a risk that the major IOCs may decline to bid.

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--------------
Industrial Context: Aging Fields, New Gas
--------------


10. (C/NF) One of the principal reasons for passage of
Project Kuwait has always been the need to increase the
production of Kuwait's northern fields to allow Kuwait Oil
Company (KOC) to "rest" its super-giant Burgan field while
maintaining the country's overall level of production.
Burgan has been producing the lion's share of Kuwait's crude
output for decades and still accounts for more than half of
total production, but decreasing reservoir pressures and
increasing water flow from producing wells are causing KOC
engineers to fear that they could do permanent harm to their
"cash cow" oil field unless they reduce the rate of
production. Beyond Burgan, Kuwaiti engineers and geologists
recognize that the era of "easy oil" in Kuwait is coming to
an end. In order to increase production in accordance with
established targets (3 mb/d by 2010, 3.5 mb/d by 2015, and 4
mb/d by 2020),they recognize that they will need to acquire
new technology and expertise to develop more complex
reservoirs and process heavier and more sour crudes. Thus
far, KOC has relied on service companies (such as Halliburton
and Schlumberger) and limited technical service agreements
with IOCs (BP, Chevron, Exxon, and Total) to provide some of
these capabilities, but there is increasing recognition among
the senior management that their ambitious production targets
will never be reached without the more robust participation
of IOCs in every aspect of production.


11. (C/NF) Kuwait announced the discovery of a 35 tcf
(est.) non-associated gas field in February 2006 which could
ultimately allow Kuwait to join the club of gas-exporting
countries. Preliminary studies completed by Schlumberger and
Shell indicate that there is indeed a vast quantity of gas in
this field but also suggest that the characteristics of the
reservoir will make it technically difficult to produce. A
detailed study is still underway, but reliable contacts say
that the gas is mostly condensate and very sour. The Oil
Minister and KPC and KOC managers have told the Ambassador
that IOC help will be essential if Kuwait is to achieve its
established gas production targets of 600 mcf/d by the end of
2011 and 1 bcf/d by 2015. Until large-scale gas production
begins, Kuwait continues to seek imported gas to support its
rapidly growing domestic power needs. With potential
pipeline imports from Iran, Qatar, and Iraq off the table for
different political reasons, Kuwait is now approaching
several suppliers including Shell and RasGas to discuss the
option of importing LNG for offshore, shipboard
regasification during its peak power demand season of May
through October of the next 2-3 years.

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Organizational Context: K-companies are in Bad Shape
-------------- --------------


12. (C/NF) The K-companies are increasingly looking to IOCs
to help them with education, training, and research and
development. KPC has asked IOCs to serve as partners in the
development of world-class petroleum research and training
facilities, to replace the underperforming Kuwait Institute
for Scientific Research and KPC Petroleum Training Center. At
the same time, Kuwait University's petroleum engineering
department has difficulty attracting talented students and
graduates only 20 petroleum engineers per year. A petroleum
engineering professor and member of Kuwait's Supreme
Petroleum Council (SPC) told econoff that he encourages his
best students to work for IOCs, where they will receive
mentoring and continual professional development, which they
would not receive at the K-companies. He said that the
K-companies typically end up with the D-students from the
petroleum engineering department. This contact added that,
in his opinion, the 1975 nationalization of Kuwait Oil
Company was one of the greatest blunders in the history of
the country. He contrasts the high level of training and
exposure that his generation of petroleum engineers received
from BP and Gulf (now Chevron) with the lack of attention
paid to professional development in today's KOC. One IOC
country manager explains that "within KOC, employees are
treated as a cost center, rather than as assets to be
invested in."


13. (C/NF) Several contacts have remarked that the
Government effectively uses K-companies as a jobs program.
Senior managers complain that a significant portion of their

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calendar is taken up by meetings with politicians seeking
positions for their supporters, regardless of their
qualifications. Within the Kuwaiti system, job placement and
advancement are generally based on family connections more
than talent and qualifications, so there is little extrinsic
incentive to excel at work. Those with an innate desire to
achieve tend to gravitate towards the private sector. In
recent years, a number of the more talented engineers and
managers at the K-companies have left to join IOCs or start
consultancies or services companies.

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Political Context: Strain between Government and Parliament
-------------- --------------


14. (C/NF) Implementation of the Kuwait Project would
require the approval of enabling legislation by the
Parliament. In the past year friction between MPs and the
Government led the Amir to dissolve the Parliament once and
appoint a new Government twice. The current Parliament was
elected last June largely on an anti-corruption, pro-reform
platform. Many of the most serious allegations of corruption
had circled around the previous Energy Minister, Shaykh Ahmed
Al-Fahd, who had been strongly supportive of the Kuwait
Project. As a result of this and a number of other
corruption allegations related to major investment projects,
the Government has appeared very risk-averse in the promotion
of major projects, and MPs have been especially aggressive in
scrutinizing and obstructing such projects. One embassy
contact from the Supreme Petroleum Council says that most MPs
understand the need for the Kuwait Project but continue to
play politics and cater to special interests in a system in
which patronage and tribalism frequently trump broader,
long-term national interests. Eager to distinguish himself
from his predecessor, the new Oil Minister seems focused on
appearing transparent and avoiding contentious decisions that
could invite public scrutiny. He also seems willing to make
concessions that could make the Project even more difficult
to execute. He announced publicly that he had no problem
with a demand that each contract with an IOC under the
Project be approved by the National Assembly.

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Economic Context: Huge Trade and Budget Surpluses
-------------- --------------


15. (SBU) Over the past few years, Kuwait's economy has
grown significantly on the back of high oil prices. GDP
growth in the last year was approximately eight per cent. In
the fiscal year that ended on March 31, Kuwait is estimated
to have amassed a $17 billion budget surplus (19% of GDP).
The 2006/7 trade surplus is estimated to be $40 billion (44%
of GDP). Largely due to Kuwait's bloated public sector,
unemployment among Kuwaiti citizens is virtually
non-existent. Nominal GDP per capita is about $29,000. The
Kuwait Investment Authority manages approximately $180
billion in assets abroad, and while private outward
investment is more difficult to measure, it is believed to
have reached a comparable level. Although the Kuwait economy
is still heavily dependent on the petroleum sector for about
50% of GDP, 95% of exports, and 90% of Government Revenue,
Kuwait has seen strong growth and international expansion in
its banking, telecommunications, and construction sectors.
Overall, the Kuwaiti public enjoys a high standard of living
and economic security supported by a cradle-to-grave welfare
state which covers the costs of health care, housing, and
education, and heavily subsidizes the costs of fuel,
electricity, and water. In this context, the Kuwaiti public
does not perceive any pressing economic need to grant foreign
entities a major stake in Kuwait's oil resources which they
consider to be their national patrimony.

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The Leadership Problem: No Vision, No Action
--------------


16. (C/NF) Though the current Amir, Shaykh Sabah Al-Ahmed
Al-Jabr Al-Sabah, was a strong proponent of the Kuwait
Project while Prime Minister, his support for the Project
since becoming Amir in January 2006 has been more subdued, up
until late April, in which he publicly stated on at least two
occasions that the Project should be one of the nation's
priority areas of legislation. However, the Supreme
Petroleum Council, which is supposed to set the strategic
direction for Kuwait's oil sector, has not been convened by
the Prime Minister in months.

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17. (C/NF) At the ministerial level, the Project has
received very little attention until recently. As Minister
of Energy from July 2006 until March 2007, Shaykh Ali Jarrah
Al-Sabah seemed too preoccupied with severe problems in
electricity and water to devote much of his time or attention
to the upstream oil sector. In recent weeks, the Minister
has begun to express more public support for the Kuwait
Project. In a recent meeting with the Ambassador, the
Minister confided that he thought the security rationale for
Project Kuwait was re-emerging due to the potential spillover
from instability in Iraq. Meanwhile, the Minister's managers
in the K-companies suggest that he is still suspicious of the
project and has not made up his mind how, or whether, to go
forward. In general, contacts in the K-companies
characterize the Minister as risk-averse, distrustful of
them, and much more comfortable with finance, his background,
than with the technical aspects of the oil sector. A member
of the SPC confided to econoff, "I don't understand this
Minister, and I don't think he understands the oil sector."
Understanding of oil aside, the KPC CEO told the Ambassador
that Shaykh Ali clearly lacks the political skills and
influence of his predecessor.


18. (C/NF) Within the leadership of the K-companies, there
seems to be little confidence or optimism that the Kuwait
Project will go forward, despite the Amir's recent
statements. At all decision-making levels within the oil
sector, there seems to be a lack of will to aggressively
champion the Project in the face of expected parliamentary
opposition. The KOC Chairman and outgoing KPC CEO were both
much more enthusiastic about the potential for using ETSAs to
accomplish many of the same goals for which the Kuwait
Project was originally intended, and without having to face a
political battle.


19. (U) Several contacts cite the historically short terms
of oil ministers and K-company CEOs as a major contributing
factor to the lack of progress. Typically, Kuwait's
Oil/Energy Minister changes every eighteen months to two
years. K-company CEOs serve terms of three years. With such
a short tenure, it is difficult for oil sector leaders to
take a long-term view regarding investment and development
decisions that won't bear fruit during their term of service.
For the Ministers, many of whom assume their posts with no
professional background in oil, they barely have enough time
to develop a firm comprehension of the issues and workings of
Kuwait's oil sector before they are replaced.

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Enhanced TSAs: Less Controversial, but Less Effective
-------------- --------------


20. (C/NF) Due to the lack of movement on Project Kuwait,
the K-companies and IOCs have been considering an alternate
model which they call an Enhanced Technical Service Agreement
(ETSA),described by the KOC Chairman as a hybrid of
Production Sharing Agreements (PSAs) and traditional TSAs.
One of the most important selling points of the ETSA model is
that it would allow IOCs to provide a broad array of
"consulting services" and receive the commensurate level of
compensation to justify a significant commitment of resources
without requiring approval from the Parliament. KOC Chairman
Farouk Al-Zanki told the Ambassador in January 2007 that
under existing TSAs - with Exxon, Chevron, BP, and others -
the IOCs do "everything for us" (i.e. provide assistance with
exploration, reservoir mapping, production planning, and
field operations),and "they don't get paid enough" for doing
it. In private conversations, IOC managers in Kuwait confess
that revenues from TSAs barely cover costs, and that they
enter into these contracts only to maintain a relationship
with KOC in the hope of eventually being awarded an Operating
Service Agreement (OSA),which is the model envisioned in
Project Kuwait. "We admit that it's a consultation
relationship with the IOCs," Al-Zanki said. The enhanced TSAs
would incentivize the IOCs to increase their scope and level
of involvement in upstream activities while giving them more
supervisory authority and allowing them to be rewarded for
helping KOC reach designated production targets. The
difficulty, he said, was that enhanced TSAs were likely to be
closely scrutinized by the State Audit Bureau, with questions
asked about why the GOK was paying ten times more for
services and technical expertise than under a standard TSA.


21. (C/NF) Barring the possibility of an OSA (under Project
Kuwait) or a PSA (which seems constitutionally impossible),

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IOCs would prefer ETSAs which would include production
incentives, over existing TSAs, which only provided a fixed
fee for limited services rendered. The difference between an
OSA and an ETSA seems to be fine and largely semantic, but
the primary distinction appears to be that OSAs include an
implied, and controversial, level of foreign control of oil
resources that ETSAs do not. It seems that ETSAs would be
written to resemble a more standard fee-for-service contract,
though, in reality, there would be a fairly robust level of
IOC involvement in management decisions.


22. (C/NF) KOC is enthusiastically considering ETSAs for
both oil and gas. Outgoing KPC CEO Hani Hussein told the
Ambassador in early May that he has convinced the Oil
Minister that ETSAs are an excellent option. Furthermore, he
said he linked bonuses for KOC managers to the effective
crafting and implementation of ETSAs. KOC Chairman Al-Zanki
now seems much more focused on ETSAs than on Project Kuwait.
There have been no formal announcements or commitments but
contacts suggest that KOC intends to eventually sign ETSAs
with: ExxonMobil for managing production and processing of
high specific-gravity, heavy crude (which comprises a growing
proportion of Kuwait's overall reserves as access to
relatively easy-to-produce, lighter crude gradually
diminishes); Chevron for managing production of and extending
the productive life of the aging super-giant Burgan field
(which still accounts for half of Kuwait's overall crude
production); BP for planning and managing production in
Kuwait's northern and western fields; and possibly Total for
assisting with production in the onshore partitioned neutral
zone shared by Kuwait and Saudi Arabia. Shell may be in
talks regarding ETSAs for managing production in the offshore
neutral zone and the newly discovered, 35 tcf (est.)
non-associated gas field in the northern Kuwait. (The Total
contract may depend on whether Saudi Arabian Chevron's
neutral zone concession is renewed by the Saudis.) A big
question that remains to be answered is whether the Kuwaitis
will be willing to offer the level of compensation that the
IOCs would demand in exchange for a significant commitment of
resources in the absence of any bookable reserves.
ExxonMobil and Chevron are both fond of citing that, on
average worldwide, they earn $4 million in annual revenue per
engineer. KOC will have to offer substantial service fees to
persuade the major IOCs to reassign engineers from other
profitable projects. Another question is whether ETSAs would
be a less effective, albeit easier to implement, substitute
for the Kuwait Project. This will largely depend on whether
the incentives for IOCs are structured in such a way as to
invite a significant level of technological investment and
encourage a long-term approach to production planning and
reservoir management.

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IOCs not Optimistic about Project, but Considering TSAs
-------------- --------------


23. (SBU) Currently, BP and Chevron each have about 20
people in country, down from 30 and 40 last year,
respectively. BP is working in the North and West, Chevron
is working in Burgan. Total has 15 people spread around the
country, but concentrated in the onshore neutral zone. Shell
has one consultant working downstream in refineries.
ExxonMobil has a handful of engineers working on specific
projects around the country. All of these IOCs admit that
their current TSAs, which barely cover their costs, are
primarily a means of maintaining a relationship with the
Kuwaitis until the day comes when they are invited to take on
a larger and more lucrative role. After ten years of
waiting, and given the current climate, they are skeptical
about the near-term prospects for Project Kuwait despite the
recent public endorsements by the Amir and Oil Minister, but
they do express growing optimism over ETSAs. Chevron seems
to view ETSAs as an intermediate step towards an OSA under
Project Kuwait, whereas ExxonMobil seems to consider ETSAs to
be an alternative to the Project. One perception that all
the local IOC country managers share, however, is that none
of the relevant Kuwaiti decision-makers seem ready to
demonstrate the political will required to bring the Kuwait
Project to fruition. They also agree that once the security
situation in neighboring Iraq improves, the level of IOC
interest in Kuwait is likely to diminish sharply.


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For more reporting from Embassy Kuwait, visit:
http://www.state.sgov.gov/p/nea/kuwait/?cable s

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Visit Kuwait's Classified Website:
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********************************************* *

LeBaron