KAZAKHSTAN: A BILLION-DOLLAR QUESTION

UNCLAS SECTION 01 OF 03 ASTANA 000450

SENSITIVE
SIPDIS

STATE FOR SCA/CEN, EEB/ESC
STATE PLEASE PASS TO USTDA FOR DAN STEIN

E.O. 12958: N/A
TAGS: PGOV ECON EPET EINV KZ
SUBJECT: KAZAKHSTAN: A BILLION-DOLLAR QUESTION

REF: (A) ASTANA 0317 (B) 08 ASTANA 2259 (C) ASTANA 1868

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1. (U) Sensitive but unclassified. Not for public Internet.


2. (SBU) SUMMARY: On March 13, the director of Chevron's
operations in Eurasia told the Ambassador that Tengizchevroil (TCO),
in which Chevron has a 50% share, has come under "renewed attack"
from the government over sulfur storage practices in Tengiz. Jay
Johnson, Managing Director of Chevron's Eurasia Business Unit
(protect throughout),said the issue has "escalated dramatically"
since February and has the potential to become a multi-billion
dollar claim, which Chevron would dispute via international
arbitration if necessary. Johnson said local authorities have
already frozen one TCO bank account and he expects them to seize
other assets soon. In a related development, TCO sent a letter of
protest last week to the British Embassy, which characterized sulfur
as a "waste" and not a "product" on a website and in official
correspondence promoting their sulfur management program in
Kazakhstan. According to recent amendments to the Tax Code, sulfur
is now considered a "waste" and its production is subject to
taxation and penalties. Also this week, Royal Dutch Shell, which
leads offshore development of the Kashagan oil field, hosted a
meeting with U.S., UK, and Canadian Embassy Officers to plan for a
sulfur management conference in Astana in July. The purpose of the
conference is to present a legislative package that meets
international standards and to promote sulfur in value-added
products such as sulfuric acid, fertilizer, concrete, and asphalt.
END SUMMARY.

2007 COURT RULING PUNISHES TCO


3. (SBU) According to Chevron's Johnson, in November 2007, a court
in Atyrau oblast ordered TCO to pay $342 million for environmental
permits for the storage of sulfur at Tengiz. Johnson said this
decision represented a change in government policy. Previously, the
government had based its fee on TCO's annual sulfur production and
storage. With this ruling, however, the government calculated its
fee based on the cumulative amount of sulfur produced and stored at
Tengiz since 1993, and calculated the amount (erroneously, according
to Johnson) as if TCO did not pay for sulfur stored in previous
years. Johnson also said that TCO initially applied for a permit to
pay for sulfur storage on a cumulative basis, but was denied and
told permits would only be issued on an annual basis. Johnson told
the Ambassador that TCO protested the government's assessment
methods at the time, but paid the fine in order to maintain
production.

TCO DISPUTES ADMINISTRATIVE PENALTY


4. (SBU) In February 2008, Johnson said TCO was surprised to learn
that the Atyrau court had levied a $310 million administrative
penalty on TCO, on top of the $342 million fee the company had
already paid. TCO refused to pay the penalty, appealed the ruling,
and protested directly to First Deputy Prime Minister Umirzak
Shukeyev, who "tacitly agreed" that the government would not pursue
the matter further. Johnson said Shukeyev has been helpful keeping
this issue "in a holding pattern" and has intervened personally on
at least three occasions to block the Atyrau court from holding a
hearing that would force TCO to pay the administrative penalty.

ATYRAU COURT DENIES APPEAL, FREEZES ASSETS


5. (SBU) Nevertheless, Johnson told the Ambassador that the Atyrau
court convened last week and rejected TCO's appeal -- without
notifying or inviting TCO, presumably to prevent the company from
appealing for assistance to Shukeyev. (NOTE: Johnson said he
wasn't surprised by the court decision, which he suspected was
pre-determined. He told the Ambassador that TCO's lawyers have gone
to court in other cases and have seen the judge's ruling already
signed, sealed, and delivered, before the hearing even begins. END
NOTE). On March 12, soon after the court ruling, Johnson said local
authorities froze one TCO bank account and seized the assets, which

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amounted to less than $100, since the account is no longer actively
used. "Once they realize their mistake," Johnson said, "they'll
come after our active accounts." He added that TCO does not have
sufficient cash on hand to pay the administrative penalty, even in
its offshore accounts.

TAX CODE AMENDMENT DEFINES SULFUR AS "WASTE"


6. (SBU) On February 21, parliament attached a rider to the Islamic
Banking Law that amended the Tax Code, classified sulfur as
"industrial waste," and established a formula for calculating sulfur
storage penalties. Johnson said that if the tax authorities apply
the formula based on accumulated volumes at Tengiz, the charge could
amount to more than $5 billion. (NOTE: According to the amended
Tax Code, the fee for storing one ton of sulfur would be 3.77 times
the "monthly estimated unit," which is determined annually in the
budget and is currently 1,273 tenge, or $8.50. Therefore, TCO would
be forced to pay $32.00 per ton of sulfur. END NOTE). Johnson
contends that the new law violates a protocol the government signed
with TCO in 2008, agreeing that sulfur would be treated as a product
and not "waste", as well as the bilateral investment treaty
governing Chevron's investment in TCO. "The irony," said Johnson,
"is that the government has amended the Tax Code to target TCO, when
it has already determined that TCO's tax stability clause means the
Tax Code does not apply to TCO." Johnson said that Chevron CEO Dave
O'Reilly has already written to President Nazarbayev to protest the
government's action and has requested a face-to-face meeting at the
end of March.

TCO ORDERED TO RE-FILE TAX RETURNS


7. (SBU) In addition to losing the court appeal and having sulfur
classified as waste, TCO learned this week that the central
government's Tax Committee has ordered the company to re-file its
tax returns for 2003-2006, based on a re-calculation of the fee for
TCO's cumulative sulfur storage at Tengiz. As Johnson said, "We
simply cannot do that. Each year, we must declare that our tax
return is accurate and correct. If we re-file the returns, it would
be an admission of wrong doing, which would open us up to other
fines and penalties." When asked to speculate why the government
seemed to be increasing pressure on TCO at this time, Johnson did
not hesitate: "This is money-driven," he said. "The head of the
Presidential Administration, Aslan Musin, was the Akim (governor) of
Atyrau oblast when all this started. He launched the original
battle and now he's in a much stronger position to carry it out."

THIS COULD GET UGLY


8. (SBU) Although he stopped short of requesting the Ambassador to
intervene, Johnson said that Chevron may indeed ask for U.S.
government assistance if the parties cannot resolve this issue soon.
In the meantime, he warned, "Things are going to get ugly. TCO
plans to make massive layoffs of working and office staff this
month, in part to send a message to the government, but also simply
because we cannot afford to operate under these conditions."
Johnson added that if TCO and the government cannot resolve the
issue in private, Chevron will reflect the cost and uncertainty of
the tax dispute in its next quarterly filing with the U.S.
Securities and Exchange Commission. That would generate unwelcome
negative publicity, he speculated, and could adversely affect
Chevron's stock value and Kazakhstan's investment climate.

TCO PROTESTS UK CHARACTERIZATION OF SULFUR


9. (SBU) On March 5, TCO's General Director Todd Levy sent a letter
to the British Ambassador to protest the British Embassy's
characterization of Tengiz sulfur as "waste" on their website and in
a Russian-language translation of a letter to Vice Minister of
Energy Askar Batalov. The British Embassy website claimed that "the
high level of sulphur in Tengiz oil poses a negative impact on oil
production" and said that "the (sulfur) wastes are currently stored
in uncovered areas causing considerable environmental damage."

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(NOTE: Chevron's Johnson suspected that the British Embassy may
have been unduly influenced by the British Sulfur Consultancy Group
they have retained to provide technical assistance on sulfur
management. He also suggested that this group may have ties to
Royal Dutch Shell, a competitor of Chevron's. END NOTE). The
British Embassy subsequently pulled the offending article from their
website and sent a Diplomatic Note to the Ministry of Energy
correcting the Russian-language letter. The U.K. government will
continue to fund training and technical assistance in sulfur
management in Kazakhstan, with a focus on developing value-added
products using sulfur and sulfuric acid.

SULFUR CONFERENCE IN JULY


10. (SBU) On March 11, Energy Officer attended a meeting with
Canadian and British embassy officials at the local headquarters of
Royal Dutch Shell. The purpose was to discuss planning for a
conference in July on sulfur management. (NOTE: Shell was the lead
sponsor for a similar conference held in Astana in July 2008. END
NOTE). Neil Carmichael, Shell's General Manager for Central Asia,
said they would welcome TCO's participation in the event this year,
but said bluntly, "We don't want an argument between TCO's lawyers
and the government, like we had last time." Shell proposed, and the
embassy officers from Canada and Great Britain agreed, that this
year's conference should avoid discussion of environmental and tax
issues and instead focus on developing a legislative package that
meets international standards, potentially based on the Canadian
model, and on the use of sulfur in value-added products such as
fertilizer, sulfuric acid, concrete, and asphalt.


11. (SBU) COMMENT: Sulfur is a big deal in Kazakhstan, and not
only because more than 8 million tons of it are stacked up at Tengiz
in pallets the size of football fields. It is a big deal because it
has the potential to make a lot of people very wealthy, whether
through trading contracts or through tax payments and administrative
penalties. Sulfur directly affects the operational, employment, and
investment decisions of Chevron, still the largest single investor
in Kazakhstan, and as such it is an issue that the U.S. government
should continue to monitor closely. Due to the nature of
Kazakhstani crude, as oil volumes go up, sulfur mounds will grow.
Once Kashagan and other new fields come on line, the issues
surrounding sulfur will only become more complex, contentious, and
critical. END COMMENT.

HOAGLAND