Here’s what you need to know about Kazakhstan’s arbitration with oil giants
On October 11, Bloomberg published an article, saying major oil companies running Kashagan and Karachaganak might seek international arbitration in a dispute with Kazakhstan over a $4.8 billion environmental fine, citing sources close to the matter. The dispute has been ongoing for several months. More about what the dispute is about and what circumstances and consequences it might cause is in the latest article of Kazinform.
What are Kashagan and Karachaganak, and who manages them
Kazakhstan is abundant with natural resources. According to the International Energy Agency, there are 271 oil and 61 gas condensate fields in Kazakhstan. More than 90 percent of oil reserves are concentrated in 15 major fields, and about 70 percent of the country’s proved and probable oil and gas condensate reserves are found in the five largest fields - Tengiz, Kashagan, Korolevskoye, Karachaganak and Zhanazhol.
Approximately 98 percent of Kazakhstan's natural gas reserves are also located in the west, with 85 percent concentrated in a few large fields - Tengiz, Kashagan, Karachaganak, Zhanazhol and Imashevskoye.
Kashagan is a significant oil and gas field located in the Caspian Sea, off the coast of Kazakhstan, about 80 kilometers southeast of the city of Atyrau. Discovered in 2000, it is one of the largest oil discoveries in the past several decades, with estimated reserves of approximately 9-13 billion barrels. It has garnered international attention due to its immense reserves, technical challenges, and the geopolitical dynamics surrounding its development.
However, commercial production started only in 2016 because of delays owing to numerous technical challenges due to the harsh environmental conditions in the Caspian Sea, where temperatures can plummet below minus 30 degrees in winter and soar to over 40 degrees Celsius in summer.
NCOC, which runs Kashagan, comprises Shell, Exxon Mobil, Eni, Royal Dutch Shell, Total Energies, China National Petroleum Corporation, and Inpex Corporation, as well as Kazakhstan’s KazMunayGas national company.
Karachaganak is another major oil and gas condensate field located in northwestern Kazakhstan, near the border with Russia. It is one of the country's largest and most significant hydrocarbon reserves and plays a crucial role in Kazakhstan's energy production and export. Karachaganak was discovered in 1979, and development began in the 1980s. It is considered one of the world's largest gas condensate fields, with substantial reserves of oil, natural gas, and natural gas liquids. The field is operated by Eni, Shell, KazMunayGaz, Chevron and Lukoil.
According to the data from the Kazakh Prime Minister’s Office, in 2022, 84.2 million tons of oil and condensate were produced in Kazakhstan, including 29.2 million tons at the Tengiz field, 11.3 million tons at Karachaganak, and 12.7 million tons at Kashagan.
Prime Minister Alikhan Smailov is confident the Kashagan field can increase production to 75 million tons per year from 12.7 million tons in 2022.
“According to experts, Kashagan’s production potential can reach 1.6 million barrels of oil per day, which is about 75 million tons per year,” said Smailov in September at the ceremonial event celebrating the 30th anniversary of the start of development of the Kazakh Caspian shelf.
Over the years, nearly 90 million tons of oil and 55 billion cubic meters of gas were produced at the field, and investments worth more than $60 billion were attracted, including over $17 billion invested in the development of local content.
An environmental dispute
In March, the Kazakh authorities ordered the North Caspian Operating Company (NCOC), which runs Kashagan, the country’s major oil and gas field, to pay a 2.3 trillion tenge ($5.1 billion) for allegedly storing too much sulfur at the project, according to the Ministry of Ecology and Natural Resources. In an article published by Bloomberg on March 29, the ministry confirmed that NCOC had exceeded the permissible sulfur storage limit on the premises by more than twofold.
NCOC, however, denied any wrongdoing, saying it manages “production and storage of sulfur responsibly, and in accordance with the requirements of the legislation of the Republic of Kazakhstan, as well as in accordance with applicable standards and best practices.”
On March 6, the Ecology Department of the Atyrau Region, where Kashagan is located, announced that it conducted an inspection of NCOC activities. According to the region’s statement, the audit revealed several violations of environmental legislation.
These include excessive placement of sulfur at the storage sites of the Bolashak oil and gas processing plant in the amount of more than 1 million tons and a temporary sulfuric acid storage site without approved design documents and environmental permits.
Among other violations are “not a full implementation” of the environmental protection action and unauthorized emissions at the evaporation tanks of the housing and communal services facility without the presence of permits.
In June, however, the specialized interdistrict administrative court of Astana deemed claims regarding excess storage of sulfur to have no grounds.
Disputed project costs
In April 2023, the Kazakh government also initiated international arbitration proceedings against several foreign oil companies, including ExxonMobil, Shell, and TotalEnergies, for over $16.5 billion in disputed project costs ($13 billion in Kashagan and $3.5 billion in Karachaganak). The dispute arises from two production sharing agreements (PSAs) signed in the 1990s for the development of the Karachaganak and Kashagan oil fields, two of the largest in Kazakhstan.
Under the PSAs, the oil companies were allowed to deduct certain costs, such as capital expenditures and operating expenses, from the revenue generated from the oil fields before calculating the government's share of the profits. However, the Kazakh government now alleges that the oil companies have improperly deducted certain costs, resulting in a shortfall in government revenue. The oil companies have denied the allegations.
The claims cover the period from 2010 to 2018 for Kashagan and from 2010 to 2019 for Karachaganak. The cases contain allegations that the companies violated tender procedures on both projects and did not fully complete the work of contractors at Kashagan.
Minister of Energy Almasadam Satkaliyev said while he was “limited in comments,” the only thing he could say is that “these claims were filed in the interests of the people of Kazakhstan.”
The arbitration proceedings are ongoing, and it is unclear when they will be resolved. However, the case has the potential to have a significant impact on the relationship between the Kazakh government and foreign oil companies.
How does PSA work
PSA is a contract between one or more investors and the government that outlines rights to prospection, exploration and extraction of mineral resources from a specific area over a specified period of time. While the government retains ownership of the resources, the investors are in charge of all capital and operating costs at their own expense and receive compensation in return.
When commercial oil production begins, the produced oil can serve as compensation for investors’ investments, and this is what is known as “cost oil.” The remainder of the oil produced is called “profit oil,” divided between the parties in a specific proportion as agreed between the state and investors.
Experts agree the PSA, which was implemented for the first time in 1966 in Indonesia in the form that it is known today, entails legal controversies. But back in the 1990s, Kazakhstan had no other choice.
Due to a lack of expertise, machinery and financial resources, Kazakhstan was unable to fully tap into the potential of its oil and gas sector without foreign investment. PSAs seemed the sole viable method to attract substantial foreign investments to the country and unlock the vast reserves of oil fields such as Kashagan, Tengiz, and Karachaganak.
At Kashagan, the North Caspian PSA was established in November 1997, lasting for a contract period of 40 years between Kazakhstan and an international consortium.
Some experts noted the controversy of KazMunayGas being on both sides. The company has a stake of 16.81% in the project and while it is a state-owned company, it is also a party to the PSA.
In 1997, the government of Kazakhstan and international oil companies signed the Karachaganak Field Final Production Sharing Agreement (KFFPSA), with a term of 40 years.
Distribution of revenues
In April, the Energy Monitor analytical channel explained that the distribution of profits at Kashagan is structured in such a way that until the investors recover their initial investments, multiplied by the LIBOR (London Interbank Offered Rate) + 2.5 interest rate (approximately 6-7% annually), Kazakhstan will not receive significant profits.
Experts say this is a common arrangement in large investment projects, ensuring that the investors receive a return on their capital before the host country or entity starts to benefit significantly from the project's earnings.
“This is where the main struggle lies: the lower the amount of reimbursable costs, the faster the period of income tax payments will come. This is what the republic is fighting for,” writes the analytical channel.
Not beneficial terms
In an interview with the Russian TV channel in June 2022, President Kassym-Jomart Tokayev explained why the country had to opt for PSA.
“The terms of the agreement themselves were signed in accordance with the understanding of investment agreements of that period of time. 30 years ago, there was one understanding: we rejoiced at the arrival of the largest foreign companies in our economy; there were no laws on attracting foreign investment. At that time, the production sharing agreement seemed quite acceptable,” said Tokayev back then.
While changing the rules of the game is not an option, considering the long-term interests of the country, Tokayev said, “there must be a correction.”
Environmental concerns
Speaking about the sulfur storage, Kazakh ecologist Aizhan Skakova said the issue has long been on the agenda.
Sulfur is a byproduct of oil and natural gas processing. Sulfur is a common impurity found in crude oil and natural gas, and its extraction and storage can present environmental and logistical challenges. This process is essential to meet environmental and safety standards, as sulfur compounds are toxic and can be harmful to both the environment and human health.
The Caspian region is fragile in terms of environment. There are many rare species, including sturgeon fish and the Caspian seal, listed as threatened species on the International Union for the Conservation of Nature Red List.
“The issue of sulfur storage from oil and gas fields has been a long-standing concern, more than a decade ago, during the peak period of mass sulfur collection at Tengiz [referring to Tengiz field]. At that time, Tengizchevroil (TCO) began addressing not only sulfur storage but also the elimination of sulfur pads,” she explained.
Skakova said back then, a joint plan for sulfur utilization was developed in collaboration with the government, TCO, and environmentalists, leading to the discussions on creating a sulfur repository and the idea of establishing a National Sulfur Storage Center.
“This topic generated significant debate at the time, and many experts viewed it skeptically. Nevertheless, sulfur continued to accumulate, and it was clear that this issue would resurface sooner or later,” said Skakova.
The case is an “interesting precedent” where Kazakhstan can, for the first time, assess environmental damage in monetary terms, according to her.
“I believe it is the right course of action for our government in Kazakhstan to stand up for our rights. In previous contracts that were signed, sulfur was considered waste, and Kazakhstan had to address its disposal at its own expense. Now, we have a new environmental code that aligns with international principles. It includes the principle that the polluter should pay for pollution. This is why I think the government has a solid legal basis to rely on, which we have today, and to demand that the subsoil user comply with all the conditions and norms of the legislation of the country where they are operating, especially those related to safety,” she said.
What are the latest updates?
In August, it became known that Kazakhstan rejected investors’ proposals to resolve disputes over Kashagan and is ready to push until the end. Bloomberg reported the Ministry of Energy told Kashagan shareholders that it would seek arbitration over the $13 billion dispute, contrary to multinational companies that had hoped for a settlement.
Kazakh economist Arman Baiganov sees Kazakhstan defending its interests as a positive sign.
“The fact that the Kazakh side does not negotiate suggests that our government is adamant, which means there are reasons. In any case, I think that the fact that Kazakhstan is defending its interests is a good precedent. International investors must comply with our laws and regulations on environmental protection,” said the economist.
An October 11 article published by Bloomberg, which cites people close to the matter, said the oil companies behind the Kashagan oil field “have told Kazakhstan’s government that they may seek international arbitration in a dispute over a $5 billion environmental fine.”
Before discussing the potential outcomes of the dispute, an independent oil and gas expert, Dinmukhamed Kudaibergenov, said one should first “clarify what goals are being pursued by the government - whether it is increasing share in the project, achieve cost optimization or changing the terms of agreements.
“The environmental aspect of the issue is also not being cancelled, but here it is more like leverage that is increasingly strengthened in light of the increasing responsibility of oil and gas corporations on the environmental, social, and corporate governance (ESG) agenda,” said the expert.
What are the consequences?
While President Kassym-Jomart Tokayev pushes strongly to make the investment climate favorable for investors, including foreign ones, the Kazakh government’s actions do the opposite. It might raise concerns among foreign investors, who worry that the government is becoming more unpredictable and less reliable. But there is a delicate line between defending national interests and also playing to ensure the market remains attractive for investors.
Kudaibergenov believes in a worst-case scenario, consequences might be different, ranging from consequences from declining investment attractiveness to brain drain.
The ongoing arbitration proceedings will provide an indication of how the Kazakh government is willing to treat foreign companies.
