US embassy cable - 05ALMATY1944

C O N F I D E N T I A L  ALMATY 001944 
 
SIPDIS 
 
 
STATE FOR EUR/CACEN (JMUDGE) 
ENERGY FOR SECRETARY BODMAN 
 
E.O. 12958: DECL: MAY 13, 2015 
TAGS: EPET, ENRG, AJ, GZ, KZ, WMD/Non-proliferation, Energy, ECONOMIC 
SUBJECT: KAZAKHSTAN: SCENESETTER FOR SECRETARY BODMAN'S 
MEETING WITH PRESIDENT NAZARBAYEV 
 
REF: BAKU 738 
 
Classified By: CDA Mark Asquino for reasons 1.4 (b) and (d) 
 
1. (C) SUMMARY: In advance of your planned meeting with 
President Nazarbayev in Baku, Embassy Almaty wanted to offer 
background on energy and non-proliferation issues in 
Kazakhstan, and suggest key issues where your engagement 
could be crucial. Kazakhstan's market-driven development of 
its oil sector promises to catapult it into the ranks of the 
world's top ten producers by 2015. American companies have 
been at the forefront, with Chevron, ExxonMobil, and 
ConocoPhillips either operating or developing world class 
fields.  President Nazarbayev shares our goal of diverse 
export routes for Kazakhstani crude, especially along 
east-west corridors. U.S. companies lead in other energy 
sectors, especially AES in power generation and Access 
Industries in coal. Problems, however, threaten to slow this 
esteemable progress. The GOK has worked to claw back equity 
through excessive tightening of its hydrocarbon fiscal regime 
and assaults on contract sanctity.  U.S. companies -- even 
the majors -- face spurious tax charges and questionable 
audits. Corruption is a problem at all levels. Some in the 
U.S. oil patch here worry that insider deals might exclude 
them from the next round of Caspian tenders. Despite the 
negatives, "the geology", as one oil man here quipped, "keeps 
us coming back."  Switching themes, non-proliferation is an 
area close to President Nazarbayev's heart, and one where you 
may find him amenable to increased cooperation.  For this 
reason, a signal from you would be of great help to us in 
breaking the bureaucratic logjams that plague our 
non-proliferation cooperation.  END SUMMARY. 
 
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Talking Points 
-------------- 
 
2. (C) During your meeting with President Nazarbayev you may 
wish to raise some of the following points: 
 
-- The United States and Kazakhstan have worked together to 
quadruple oil production to 1.25 mbd. US companies are 
leaders in the hydrocarbon sector here. They are eager to 
participate further in your ambitious plan to develop Caspian 
reserves and produce 3 mbd by 2015. 
 
-- We must, however, find the proper balance between the 
needs of Kazakhstan's citizens and those of foreign 
investors. Amendments to the 2005 hydrocarbon tax regime were 
a step in the right direction. We hope that further 
amendments for 2006 will continue this trend and jump start 
offshore Caspian development. There have been no offshore 
Caspian tenders since December 2003. 
 
-- We hope that any new tender process will be transparent 
and give all capable companies fair access. I understand that 
ConocoPhillips would like to participant in a tender for the 
North Sultan offshore Caspian field. ConocoPhillips is a 
first-rate, integrated oil company with expertise in 
developing offshore gas fields. 
 
-- We are pleased that the Kashagan dispute was resolved 
amicably. Contract sanctity is the foundation of keeping 
Kazakshtan the FDI-leader in the region. I congratulate 
Kazakhstan on acquiring a share in a world-class project. 
 
-- We understand that talks on CPC expansions are nearing 
completion, though important issues still remain. The USG 
supports a timely resolution respecting the interests of all 
parties, both private and state shareholders. 
 
-- We understand that Kazakhstan and Azerbaijan are down to 
the wire on signing an IGA to move oil through BTC, the 
so-called Kazakhstani Caspian Transport System (KCTS). We 
support this and hope that the IGA respects investor 
interests and is similar in spirit to the BTC agreement. A 
follow-on Host Government Agreement (HGA) is no less 
important and must also respect investor rights. 
 
-- We understand that since January 1994 the State Property 
Commission is no longer authorized to negotiate with AES, the 
power generation company. Also, the Supreme Court issued a 
ruling that seems to strip the company of the right to 
international arbitration. AES is a leader in its field, and 
in Kazakhstan produces power at one-third the cost of its 
 
 
competitors. Former Secretary of Commerce Donald Evans 
brought this issue up with you in a January 2004 letter, as 
did Ambassador Ordway with Prime Minister Tokayev in a May 
2005 letter.  We seek your assistance in allowing the State 
Property Commission to negotiate with AES. 
 
-- We are eager to establish a Second Line of Defense program 
with Kazakhstan in response to your June 2001 request for 
assistance.  This program has proven its value in our 
successful collaboration with Russia, and we believe that 
there is great potential for cooperation with Kazakhstan.  We 
need to conclude an Implementing Agreement in order for 
cooperation to move forward. 
 
-- We reiterate our December 2003 offer to repatriate both 
fresh HEU fuel and bulk material from the Alatau research 
reactor to Russia, at no cost to Kazakhstan.  If this is not 
acceptable, we would also be willing to fund the downblending 
of the HEU to LEU at the Ulba Metallurgical Plant in 
Kazakhstan.  We are prepared to assist in accelerating the 
conversion of Alatau to LEU fuel. 
 
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Background 
---------- 
 
3. (C) Kazakhstan has proven or probable hydrocarbon reserves 
of around 22 billion barrels.  That figure may be low.  A 
study by the U.S. Geological Survey indicates that there may 
be another 22 billion barrels of proven or probable reserves. 
 Companies working here share that belief.  The country 
representative for Shell, Martin Ferstl, hinted that the 9-13 
billion barrels of proven or probable reserves for the giant 
Kashagan (AGIP-KCO) field was "low." The largest fields -- 
Kashagan, Tengiz (TCO), and Karachagank (KPO) -- are high 
pressure and sulfuric, though there is sweet oil. Production 
is presently 1.25 million bpd, all on-shore. 
 
4. (SBU) Most oil is produced under production sharing 
agreements (PSA), though TCO is a joint venture. A PSA will 
be the vehicle to develop off-shore Caspian development. A 
2004 law based on a 2003 presidential decree gives the state 
oil producer, KAZMUNAIGAS (KMG), a minimum 50% stake in any 
new project. In 2003, the state published a program to 
develop offshore Caspian oil and gas reserves. Under it, the 
GOK hopes to boost production to 2 million bpd by 2010 and 3 
million bpd by 2015.  That goal is achievable. 
 
5. (SBU) U.S. companies enjoy a large and respected presence. 
The lion's share of U.S. FDI, about $9 billion, is in the 
hydrocarbon sector.  ChevronTexaco is the operator of TCO, 
with a 50% share. It also has a 20% stake in KPO. ExxonMobil 
has a 25% share of TCO and 18.52% of AGIP-KCO. ConocoPhillips 
is also an AGIP-KCO partner, with 9.26%. U.S. service 
companies such as KBR, Parker Drilling, Baker Hughes, to name 
a few, are also active. 
 
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Clawing Back Equity 
------------------- 
 
6. (C) Since 2002, the GOK has sought to increase its share 
of the oil pie. Rising oil prices and an absence to date of 
dry holes fuel this drive. Also, many in government, as well 
as opposition leaders, believe that western companies took 
advantage of Kazakhstan in the 1990s and struck lopsided 
deals. While President Nazarbayev, at least publicly, does 
not ascribe to this view, KMG and Ministry of Energy 
officials readily point out that political and technical risk 
are down. Consequently, the GOK share of any project should 
increase, both in terms of profit and involvement. 
 
7. (C) The GOK's successful grab for a share in the AGIP-KCO 
project, against the wishes of the consortium and in 
violation of the PSA, epitomizes this new aggressiveness. 
After British Gas (BG) announced its intent to sell its 
one-eighth share, the GOK asserted a preeminent right, 
thereby vetoing the partners' right of first offer.  It then 
passed a December 2004 law giving it a preeminent right to 
acquire, at market value, a share in new and existing 
projects should they come up for sale. Eventually, the 
consortium partners and the GOK split the BG share down the 
middle, but not after months of rancorous back-and-forth. 
 
8. (C) The government has also tightened the tax screws. 2004 
 
 
amendments to the hydrocarbon tax law reduced internal rate 
of return (IRR) from between 16-23% to around 7-9%. Further 
amendments in 2005 brought IRR on big offshore projects back 
up to around 11-12%. That, however, is still far from the 15% 
the industry expects in Kazakhstan. Consequently, no new 
offshore projects have been inked since December 2003. 
Amendments for 2006 are presently in parliament. It is too 
early to calculate their effect. 
 
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Corruption 
---------- 
 
9. (C) Companies, both large and small, face corruption. 
They range from tax inspections that are little more than 
revenue fishing trips to demands for discount crude or 
refined products. Sometimes corruption is in the guise of 
demands for supporting "social" activities, while others 
include attempts to deny work permits to get relatives on the 
payroll. Oil transport, especially oil flowing through Aktau 
port, is a prime area for rent seekers. Oil companies, which 
ship through Aktau and are well-known to the Embassy, report 
that KMG VP Timur Kulibayev is behind traders who charge 
exorbitant premiums to transship oil. Kulibayev, who is 
married to one of President Nazarbayev's daughters,  also 
appears to be behind recent attempts to hit up TCO for 
discounted feedstock for KMG's Atyrau refinery. Direct 
payment of royalties and profit oil to the GOK appear less 
subject to manipulation. The reorganized National Fund, with 
over $5 bn in assets, is a good step towards transparency and 
good governance. To our knowledge, U.S. companies are doing 
their best to adhere to FCPA standards. 
 
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New Tenders 
----------- 
 
10. (C) Fair access to new offshore Caspian tenders is 
another problem area. New legislation gives KMG a 50% share 
in all new tenders plus the option to pick a "strategic 
partner" to develop blocs. Lawyers for DentonWildeSapte 
report that the law leaves it unclear whether a "strategic 
partner" will be chosen competitively or through sweetheart 
deals. ConocoPhillips fears that it will lose out on 
competing for the North Sultan offshore Caspian bloc, which 
may hold 4-5 bn in proven or probable reserves, to a 
combination of Shell and Nelson Resources. Nelson Resources 
is believed by most oil analysts here to be linked to 
Kulibayev. We have also observed increasing contact between 
Shell and Nelson since late 2004. 
 
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CPC Expansion 
------------- 
 
11. (C) The last CPC shareholders meeting, held in Almaty on 
April 26, ended badly and without resolution of issues 
crucial to expansion. Kazakhstan has, in the view of some, 
supported Russia, though others hope that President 
Nazarbayev will ultimately seek a compromise or support 
private shareholders. Russia continues to demand creation of 
a CPC-Russia board of directors that would be open to 
manipulation and take over by Russia, Kazakhstan, Oman and 
one other partner. The two main U.S. CPC shareholders, 
Chevron and ExxonMobil, fiercely resist this, along with the 
other private companies. Russia is also demanding a variable 
tariff on operating and capital expenditures. Chevron Eurasia 
Business Chief Guy Hollingsworth told us that expansion 
approval should come no later than December 2005, otherwise 
the project will seriously fall off schedule. 
 
---- 
KCTS 
---- 
 
12. (C) Azerbaijan and Kazakhstan are close to signing an 
Intergovernmental Agreement (IGA) on bring Kazakhstani oil 
across the Caspian by tanker, and later possibly pipeline, 
into BTC. Both parties have accepted that the IGA is above 
domestic law in both countries, though issues remain over 
taxation, competition, and customs. The so-called North 
Caspian Shippers, the AGIP-KCO consortium partners, worry 
that getting the oil to the port of Aktau or to the planned 
port of Kuryk from Kashagan will cost them dearly. 
Consquently, it is important that a follow on HGA provide 
 
adequate protection and protect investor investors. 
 
 
--- 
AES 
--- 
 
13. (C) U.S. power generation giant AES has been under GOK 
assault since entering the market here in 1996. President 
Nazarbayev even complained about AES to Ambassador Ordway 
when he presented his credentials. The GOK ire is hard to 
explain. AES has invested around $200 million since arriving 
here, plans another $130 million in the next two years, and 
produces power at one-third the cost of its nearest rivals. 
Presently, two Kazakhstani national AES accountants face 
criminal tax evasion charges in what appears to be a highly 
questionable trial; the company had to date passed five state 
audits (1999-2004) without problems. Since January 2004 the 
State Property Commission is no longer authorized to 
negotiate with AES. Also, the Supreme Court issued a ruling 
that seems to strip the company of the right to international 
arbitration. A January 2004 letter from Former Secretary of 
Commerce Donald Evans to President Nazarbayev remains 
unanswered. Ambassador Ordway inquired about the status of 
the issue in a May 2005 letter to FM Tokayev, and Nazarbayev 
may bring up the issue. 
 
------------------------ 
Non-Proliferation Issues 
------------------------ 
 
14. (C) With regard to the Second Line of Defense program, 
the GOK has been strangely slow to accept DOE/NNSA's offer of 
assistance to combat trafficking in nuclear and radioactive 
materials.  Given the fact that discussions began in response 
to a June 2001 request for assistance from the Kazakhstani 
Customs Control Agency, the prolonged interagency delays are 
puzzling.  Embassy Almaty has been pushing both the MFA and 
the (recently renamed and reorganized) Customs Control 
Committee to continue negotiation of the necessary 
Implementing Agreement.  We have also emphasized the fact 
that the SLD program began with Russia, in an effort to allay 
any possible GOK fears that cooperation with the U.S. in this 
sphere would be frowned upon by Kazakhstan's northern 
neighbor. 
 
15. (C) Post alerted Minister of Energy and Mineral Resources 
Shkolnik, as well as the MFA, that you may raise disposition 
of the HEU at the Alatau research reactor with President 
Nazarbayev.  Minister Shkolnik emphasized the need to keep 
the reactor running continuously.  In the past, President 
Nazarbayev has been vigorously opposed to proposals to 
repatriate fuel to Russia.  We expect that the downblending 
option, combined with reactor conversion assistance, will be 
more acceptable to him. 
 
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COMMENT 
------- 
 
16. (C) The two issues that you will discuss with President 
Nazarbayev, energy and non-proliferation, are seen as crucial 
to Kazakhstan's national security and international image. 
For that reason, many decisions that would typically be 
handled at the working level in other countries are the 
exclusive domain of Nazarbayev himself.  The meeting presents 
an excellent opportunity to focus Nazarbayev on issues near 
to his heart, and encourage him to take decisive action to 
move the bilateral relationship forward. 
ORDWAY 
 
 
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