Environmental issues tarnish Caspian expectations

In early May, the Kazakhs are to finish drafting the new Law on [Continental] Shelf, which will make environmental protection one of the most material items in the budget of foreign oil and gas operators, and also hamper insurance of environmental risks in Northern Caspian.

1. Executive summary
Before yearend Kazakhstan is planning to prepare a schedule of international tenders for exploration and development rights to offshore blocks in Northern Caspian. These blocks are located close to the huge Kashagan deposit discovered in July 2000 by the OKIOC international consortium. Kashagan is believed to be the world's largest oil and gas discovery in the past three decades.
The discovery news coincided with promising reports on the approaching solution of Kazakhstan's oil export problems. The Caspian Pipeline Consortium has completed the construction of the Tengiz-Novorossiysk pipeline to the Black Sea coast and in late March started to fill the pipes with crude. In addition, Westerncompanies operating in Azerbaijan intensified their efforts aimed at building the Baku-Ceyhan pipeline to the Mediterranean Sea, which, in perspective, may be also used to export Kazakh oil.
All these factors considered, Kazakhstan-and particularly its sector of the Caspian Sea-is becoming one of the most enticing areas for oil and gas operators, because large reserves there are accompanied by the availability of new export outlets. However, companies with plans of investments in this area will have to consider some factors, which are capable of making Kazakhstan-based energy projects much more complicated than seen at first glance.

The first of these negative factors is high environmental risk of oil and gas development in the Northern Caspian area. The exceptionally complex geological structure of reservoirs piled upon other ecological issues requires additional expenditures both for field operations and environmental risks insurance.
The second such factor is the severe environmental laws of Kazakhstan. The Kazakh legislators are currently streamlining these laws, and when they finish this job, operators may be obliged to reconsider the economics of their projects under a less favourable scenario.
The third factor of risk is the Kazakh government's treatment of foreign companies. As the nation attracts more and more international consortia, the authorities become more and more demanding. Any company considering, or already launching, a project in Kazakhstan will have to bear these factors in mind. This report outlined the character and scope on the issues faced by foreign oil and gas operators in Northern Caspian.

2. Kashagan at a glance
In March, the international OKIOC consortium of several international majors led by Italy's ENI as the operator completed the second exploration well at Kashagan in the Kazakh sector of the Caspian Sea. The well, drilled 40 km west of the first wildcat finished in July 2000, reached the depth of 4,850 meters. The tests showed that the sandstone samples and their hydrocarbon content are similar in character to those found in the first well.
This piece of news demonstrates that the drillers have most probably struck two areas of the same huge oil-and-gas-bearing structure. If further tests confirm this idea, then Kazakhstan will be the owner of the world's largest oil and gas discovery in the past thirty years.
It is still premature to discuss the size of the Kashagan reserves, but Kazakh experts believe that it might exceed by 150 % the reserves of Tengiz, which belongs in the world's ten largest oilfields. As to Kashagan, it has good chances to make it to the five largest. Last summer, President of Kazakhstan Nursultan Nazarbayev declared that the reserves of Kashagan were at least 50 bn barrels, or 6.8 bn tons, of oil, although none of the members of OKIOC has confirmed this assessment in public.
Currently, OKIOC consists of ENI (Italy), ExxonMobil (US), Shell (UK/The Netherlands), TotalFinaElf (France/Belgium), Phillips Petroleum (US) and Inpex Nord (Japan). In the beginning of this year TotalFinaElf said it was buying the stakes in OKIOC abandoned by Statoil and BP, but this deal has not been finalized yet.

3. Chronology of oil leaks
On April 17, during tests performed at the second exploration well of Kashagan, a gust of wind extinguished the flare and about 210 litres of oil went into the sea from the Sunkar drilling platform. In addition, an unidentified quantity of rich-rich gas leaked in the air. The Kazakh government formed an ad hoc committee and demanded an investigation of the incident. Prime Minister Kasymzhomart Tokayev ordered OKIOC to suspend all operations at the Sunkar until the investigation is over.
OKIOC will have to eliminate the cause and the consequences of the environmental contamination. The operator has been officially reprimanded according to the Code of Administrative Breaches. The experts of the Kazakh Ministry of Natural Resources and Environmental Protection are calculating the scope of the harm inflicted on the nature.
The host government blames OKIOC for failing to inform the authorities on the incident at Kashagan and presenting distorted data of the leak. The ad hoc committee claims that the wellhead tests started without consent of ecology experts. Moreover, Kazakh officials say that OKIOC violated the principal document of the project, the production-sharing agreement, regarding the terms that regulate oil and gas operations in the extremely vulnerable environment of the Caspian Sea.
Just before that, in February 2001 OKIOC had to deal with another unpleasant incident at the Sunkar. When the second well was being drilled, a piece of pipe some 100 meters long was stuck at the depth of about 2,000 meters, and it took the work teams over one month to recover the faulty piece of metal. Over a year ago, the same OKIOC had to admit that its workers could not prevent an escape of some drilling mud into the sea.
In March 2001, OKIOC helped Kazakhstan eliminate a leak from a flooded idle well at a neighbouring field, South-western Tazhigali. It used to be an onshore project but the rising level of the Caspian engulfed the site. Tazhigali belongs to state-owned Kazakhoil, which has neither funds nor equipment to seal the leaky abandoned wells. The job is estimated to cost $ 20 mm, and OKIOC will probably have to assume this expense, jointly with TengizChevrOil JV, which operates a neighbouring onshore project, to clean up the mess left by the Kazakh company.

4. Geologic peculiarities
OKIOC drills to the depths approaching 5,000 meters, in sub-salt horizons, where the pressures may reach 850 atmospheres and the temperatures, 1,500 degrees Centigrade. Oil there frequently has high sulphur content, up to 18-25 %. "Drilling such reservoirs is almost the same as breaking open a powder keg," Muftakh Diarov, director of Atyrau-based Scientific Centre of Environmental Problems, says.
The comparison is quite reasonable. When the sub-salt horizons of the neighbouring Tengiz oilfield were being tapped in 1987, a fountain of oil and gas broke free from well No 37 and caught fire. The fire continued for several months before it could be extinguished.
Tengiz is an onshore project. If a similar incident occurs at Kashagan, the consequences will be much more harmful. The Northern Caspian is a natural wildlife reserve, where over 350 species of fauna, including seals and sturgeon, live and migrate.
Oleg Obryadchikov, senior official of the All-Russia Scientific Research Institute of Geology, who is one of Russia's leading experts on Caspian, says: "The subsoil in this sector of the Caspian Sea abounds in geological faults that have torn apart the natural borders of oil-bearing structures. Theoretically, any drilling may provoke a leakage of oil through those faults, from fissures located at the outer side of the well."

5. Environmental policies of Kazakhstan
Given the fact that three incidents have already occurred at Kashagan or near it since the beginning of theyear, the Kazakh government's worries about the safety of the environment are understandable. The severe tone the government assumes when talking to OKIOC shows that the hosts will hardly soften their ecology-related demands.
In early May, the Ministry of Energy and Mineral Resources of Kazakhstan is slated to complete drafting the Law on [Continental] Shelf. The cabinet of ministers will possibly receive the draft for consideration in June and submit it to the lower house of the national parliament in early September. It is expected that the president of Kazakhstan sign the law into effect this fall.
Kazakhstan already possesses several laws and regulating documents influencing offshore oil and gas operations, but the new Law on Shelf will become the key set of rules for them. On one hand, the preparation of this law is good news for foreign companies, because it will usher in a series of new bidding rounds for offshore licenses. On the other hand, the law will make the operators' lives less comfortable. The principal idea of this document is protecting the environment during all and any offshore operations.
To make things worse, Kazakhstan demands that the oil and gas operators use as much as possible of Kazakh labour, locally-made equipment and services provided by domestic suppliers. However, Kazakh drillers and almost all equipment producers are not internationally certified as far as the quality is the issue. Domestic teams have no experience of offshore work, because all 39 exploration wells drilled in the Northern Caspian in the Soviet era had Russian and Azerbaijani drillers perform the job. Moreover, none of those wells did reach the dangerous sub-salt depths.

6. Operators' collective liability
Sub-salt drilling makes the risk of incidents significantly higher, and Kazakh officials cannot fail to understand the danger. While the government needed consent of OKIOC and TengizChevrOil to help eliminate the leak at South-western Tazhigali, the new Law on Shelf will oblige all operators to provide such assistance in all similar cases.
This law, when it comes into effect, will legitimise the existing National Plan of Prevention and Containment of Oil Leaks at Sea and in Internal Waters of the Republic of Kazakhstan. Both the plan and the draft law require all operators to take part in elimination of leaks and the ensuing contamination in the areas of their operations, even if the leak occurred beyond the borders of their licenses.
These two documents oblige the faulty operator to compensate the costs incurred by other companies but in many cases no compensation will be possible. For example, state-owned Kazakhoil, due to political considerations, is practically immune to financial liabilities of this sort.
The privileges enjoyed by Kazakhoil appear even more worrisome in the eyes of foreign companies because it intends to start drilling soon at its offshore blocks, South Zaburunye and Southern Zhambai. Insufficient experience and inadequate equipment of Kazakhoil drillers threatens to make its sites a permanent source of problems and unplanned expenses for neighbours.
There are also about 100 old flooded wells in the Kazakh sector of the Caspian Sea. They are all the responsibility of Kazakhoil, but the energy ministry has forced OKIOC and TengizChevrOil into accepting the costs of investigating the state of these wells and developing a plan of dealing with them for the government.

7. Growth of environmental costs
Overall cost of developing Kazakhstan's offshore reserves is estimated by government experts to total at least $ 50 bn. Most probably, the figure will be higher, because OKIOC officials expect the costs of commercial production from only five identified structures within the licensed acreage to reach $ 20 bn. Even this estimate appears too low in view of additional, and probably unforeseen, factors that adversely influence the economics of the project.
The Kazakh environmental organization Kaspiy Tabigaty, for instance, wants OKIOC to buy a $ 50-bn ecological risks insurance for the project. Even a 1 % instalment for this insurance will cost $ 500 mm. Meanwhile, OKIOC has had its drilling operations insured for $ 1 bn.
Growth of ecology-related costs looks like a long-term and strategic factor of the Kazakh investment climate. By yearend, Kazakhstan is expected to draft another law, On Ecological Insurance, which will make such insurance mandatory for oil and gas operators. After the law is in place, the government will issue an ordinance setting the insurance sums depending on the size of the risks.
A legal expert at Grata Consultants servicing foreign oil companies in Kazakhstan says: "We have reasons to fear that the insurance sums as defined by the government will be too large to encourage insurance companies to work with offshore operators. We know that OKIOC is already experiencing difficulties with its search for an insurer willing to cover environmental risks of the big project."
Operators may find themselves trapped between the host government's demands of mandatory insurance and insurers' unwillingness to cover the overpriced environmental risks. Without this cover, offshore projects will be extremely vulnerable politically, because the Kazakh government will use the lack of mandatory insurance as leverage against the operator and a tool for obtaining benefits beyond those defined in the original contract.
The first samples of such tactics are already visible. In March 2001, the Kazakh government made TengizChevrOil form a task force for resettlement of the inhabitants of the nearby Sarykamys village. The resettlement is estimated to cost $ 46 mm, and the government wants TengizChevrOil to pay half of that sum.
Offshore operators may be approached in the same manner for assistance to such programs as saving Caspian sturgeon, which suffers from pollution and illegal fishing. In 1998, OKIOC already provided some funds for a sturgeon-breeding farm in the estuary of the Ural river.

8. Evaluation of compensation
The environment-minded strategy of the Kazakh government is already making foreign oil and gas companies earmark new expenses when planning offshore projects. Apart from direct costs of eliminating the possible pollution aftermath, any environmental accident will entail additional payoffs to various organizations.
The list of those willing to get such compensations is long, with the Kazakh and Russian federal and regional governments at the top of it. The Moscow government has already officially warned Kazakhstan that, if polluted water reaches Russian shores from Kazakh rigs, the Russian side will expect an adequate compensation for the damage.
The size of fines and compensations for oil leaks has not been determined yet, but the authors of the Law on Shelf from the Ministry of Energy and Mineral Resources intend to develop a scale of such payments, which will come into effect by a special governmental ordinance. Six-digit and seven-digit figures, in dollars, are being contemplated at the ministry.
Penalties for gas flares are also expected to grow from the current average of $ 50,000 per month. The Kazakh officials believe, somewhat overoptimistically, that large fines will make operators develop the means of utilizing associated gas, regardless of the lack of the required infrastructure close to the Caspian shores.
This situation results in larger ecology-related costs of offshore projects and the need to plan for great unpredictable expenses. These considerations will undoubtedly influence the position of foreign negotiators, when they discuss the terms of future production-sharing agreements with the Kazakh hosts.

9. Conclusions
Northern Caspian becomes increasingly attractive for international oil and gas companies due to the combination of two factors, newly discovered large reserves and availability of export outlets. Kazakhstan intends to encourage foreign companies' participation in the development of Northern Caspian oil and gas reserves, andis currently preparing a schedule of bidding rounds for offshore licenses close to the huge Kashagan field.
Kazakhstan is developing a legislation, which will toughen the conditions of operating oil and gas projects. The key idea of this legislation is higher liability for environmental damage. Investors should be prepared to see that environmental risks in Northern Caspian are higher than in other allegedly similar areas, mostly due to the combination of such negative factors as difficult geology and vulnerable environment.
Ecology-related costs are expected to be influenced not only by the operator's own project but also by accidents at neighbouring licenses. The legislation to be adopted in Kazakhstan makes operators share the responsibility for eliminating environmental damage. The Kazakh government's insistence on hiring local contractors is an additional risk factor for offshore projects.
Foreign companies can make an effort to make the new Kazakh legislation more investor-friendly before the laws are in effect. They can also use the new requirements as an excuse for obtaining better commercial terms of negotiated contracts.