Bureaucratic Inefficiency Adding To Kashagan Challenges

BMI View: Technical challenges have already caused significant delays at Kazakhstan's giant Kashagan oil field. However, adding to these difficulties is the non-traditional model being used to jointly operate the field which is creating inefficiencies in management of the project. We expect the ongoing technical and bureaucratic challenges, as well as our forecast for a lower oil price environment, will delay Phase II development beyond the expected 2019 start up.

We have previously highlighted the technical challenges facing Kazakhstan's largest oil project at Kashagan ( see, 'Kashagan Gives Little To Sing About', November 11 2013). The oil extracted from the project is 4,200m under the sea floor at an extremely high pressure (770 bar), while the associated gas holds some of the highest hydrogen sulphide levels ever recorded. Less than two months after the start up of production in September 2013, output was halted due to pipeline leaks. It now appears that cracks in the pipe were caused by the erosive effect of a hydrogen sulphide and water reaction, though it still remains unclear as to why this happened. Consortium partner Total has been put in charge of conducting the investigation into the leaks.

Collective Model Impeding Pace Of Development

Crude Prices May Not Support Kashagan Expansion
Brent Crude Benchmark Price 2010-2020, US$/bbl

BMI View: Technical challenges have already caused significant delays at Kazakhstan's giant Kashagan oil field. However, adding to these difficulties is the non-traditional model being used to jointly operate the field which is creating inefficiencies in management of the project. We expect the ongoing technical and bureaucratic challenges, as well as our forecast for a lower oil price environment, will delay Phase II development beyond the expected 2019 start up.

We have previously highlighted the technical challenges facing Kazakhstan's largest oil project at Kashagan ( see, 'Kashagan Gives Little To Sing About', November 11 2013). The oil extracted from the project is 4,200m under the sea floor at an extremely high pressure (770 bar), while the associated gas holds some of the highest hydrogen sulphide levels ever recorded. Less than two months after the start up of production in September 2013, output was halted due to pipeline leaks. It now appears that cracks in the pipe were caused by the erosive effect of a hydrogen sulphide and water reaction, though it still remains unclear as to why this happened. Consortium partner Total has been put in charge of conducting the investigation into the leaks.

Collective Model Impeding Pace Of Development

Further exacerbating the technical challenges at Kashagan, is the altered operating model by which the project is run. Recent analysis by Reuters, which included comments from sources with first-hand knowledge of the project's working model, has highlighted the frailties of the current management format. Initially Italian company Eni was awarded operatorship of Phase I of the Kashagan field, though this structure was reorganised to a collective model in 2009 due to delays and cost escalations. It is also suspected that some of the larger consortium partners were unhappy that a company with limited experience on mega-projects was awarded operatorship. However, the switch to a collaborative model in 2009, where each company takes on different tasks, has hampered the speed of development as there has been no authoritative project leadership. Each company has its individual processes which then are overseen by others, slowing operations, while communication between the large number of project managers and engineers has caused inefficiencies. Decisions are also made by a committee of all companies as there is no single commanding operator, meaning difficult decisions, such as a final investment decision (FID) for Phase II, could take time. This inefficiency in decision making and operation is likely another reason behind the delays and cost overruns at the project, supporting our conservative outlook for oil production growth in Kazakhstan.

Mixed Responsibilities Of Kashagan Consortium Partners
Company Share (%) Major Responsibility
Shell 16.81 Jointly manage production of all phases with KMG
Phase II engineering & offshore development
ExxonMobil 16.81 Phase II drilling activities
Total 16.81 Pipeline leak investigation
Eni 16.81 Phase II onshore developments
KazMunaiGaz (KMG) 16.87 Jointly manage production of all phases with Shell
CNPC 8.33 Investor
Inpex 7.56 Investor
Source: North Caspian Operating Company

Delays Expected To Phase II Development

Kashagan Phase II - for which a FID has yet to be made - is therefore expected to see significant delays as a clearer understanding of the technical problems experienced during Phase I will be needed in order to mitigate similar challenges in Phase II. All parties will also need to agree on moving forward despite the expected high cost of the 600,000 barrel per day (b/d) Phase II. Concern over the difficultly and cost experienced in bringing Phase I online, could make consortium members more wary of investing in Phase II unless development costs can be brought down significantly. Moreover, pressure from shareholders to be more conservative with capital expenditure over coming years as a result of unsatisfactory financial results would also make Kashagan's investors, ExxonMobil, Shell, Total and Eni in particular, hesitant about making another risky gamble on further investment in the troubled field. Shell is outlined to conduct the engineering studies and offshore construction for Phase II, Eni will carry out onshore construction and ExxonMobil the drilling.

We also highlight our forecast for global crude oil prices which we expect to fall over the coming years due to an increasingly adequately supplied market and soft demand. This could create an even more complex situation in which to justify the expensive and unpredictable Phase II development of the Kashagan field. This is unless developers are satisfied that technical and other development problems faced in Phase I would not be carried into Phase II at the expense of another cost blowout.

Crude Prices May Not Support Kashagan Expansion
Brent Crude Benchmark Price 2010-2020, US$/bbl

Although Kashagan is the largest oilfield to be discovered in the past 30 years, it has also been the most expensive oil development ever, with Phase I costing around US$50bn so far. Full field development which would be conducted in three Phases could see Kashagan alone produce more oil than Qatar with output of as much as 1.6bn b/d. However, due to the delays and cost overruns of Phase I from both a technical and bureaucratic stand-point, we believe it is unlikely this production goal will be achieved within our forecast period to 2022. This also underscores the downside risk to Kazakhstan's oil production outlook. We expect Kashagan Phase I to restart commercial production in 2014 and play a crucial role in lifting Kazakhstan's oil output. However, production from Phase II is looking increasingly less likely to be implemented within our forecast period.

Oil Production Growth To Fall Short Of Potential
Kazakhstan Oil Production Forecast (With Kashagan Phase II), '000b/d

In 2010 it was announced that Phase II of the Kashagan field would be delayed to 2019, however seeing as Phase I production has seen further delays since this announcement we do not expect Phase II to begin commercial production within our forecast period. We therefore anticipate Kazakh oil production to rise from 1.58mn b/d in 2013, to 1.99b/d in 2018 and 2.38mn b/d in 2022. While this is still a shows a strong growth scenario, output remains somewhat underwhelming considering the potential of the 13bn barrel field.

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Sector: Oil & Gas
Geography: Kazakhstan
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