In Kazakhstan, Saving the State Oil Company May Devastate the Sector

Forecast

• As KazMunaiGas struggles to secure international investment, it will prepare to take full ownership of its lucrative subsidiary, KazMunaiGas Exploration Production (KMG EP).
• The aggressive move could drain KMG EP's cash reserves, which are needed to expand energy production through 2020 and shield the company from the effects of a sluggish economy.
• Should the deal move forward, KMG EP's Western board members might resign in protest, reducing investor interest in Kazakhstan, but it is a risk the government will be willing to take to increase its control of the country's energy sector and finances. 

Analysis

The minority shareholders of Kazakhstan's lucrative energy firm, KazMunaiGas Exploration and Production (KMG EP), will vote Aug. 3 on whether or not to sell their shares to the firm's parent company, effectively consolidating the two. The parent company, KazMunaiGas (KMG), is fully owned by the state and is involved in some capacity in most of the country's major energy projects, including Kazakhstan's largest oil fields, transportation firms, refineries and sales groups. In 2004, the Kazakh government established KMG EP to act as a separate exploration and production company. KMG currently owns 57 percent of it, but KMG EP has been fairly autonomous since its foundation — a fact that has at times put the two at odds.

KMG has a reputation for being highly political, bullying its way into the three major international projects in the country: Kashagan, Tengiz and Karachaganak. It changed the country's laws on energy, levied outlandish fines and amended contracts with international energy firms to ensure that it had a sizable stake in each of the three projects. Such behavior has kept many foreign firms from expanding cooperation with or investment in Kazakhstan. KMG EP, by contrast, is known for operating in line with standard international corporate governance practices, making it the preferred partner of foreign firms and investors. Moreover, the firm legally has the right of first refusal, giving it the leeway needed to succeed independently of its parent company. In recent years, KMG EP has launched a series of projects across the country with foreign partners, including the United Kingdom's BG Group and Exploration Venture Ltd.; Denmark's Maersk; Hungary's MOL Group; and China's PetroChina, CITIC Group and China National Petroleum Corp.

The Case for Consolidation

With low oil prices weakening Kazakhstan's financial position, KMG is looking to gain full control of KMG EP. It first proposed buying out the subsidiary's minority shareholders in July 2014, but under political pressure from KMG EP's board it retracted its offer in December 2015. Since then, however, KMG's position has only worsened. Though it experienced a slight uptick in profits in 2015, it was wholly due to the government's currency manipulations — in return for which it paid higher taxes. In actuality, KMG's revenue is half of what it was in 2011, and it owes $17 billion over the next four years.

The company already put off nearly all of its planned maintenance and upgrades in 2015 and 2016, and it has deferred large strategic investment projects beyond 2017. In 2015, KMG resorted to selling half of its 16.81 percent stake in the Kashagan megaproject to the government's sovereign wealth fund, Samruk-Kazyna, for $4.7 billion, with the stipulation the firm can buy back the shares in the future. KMG also sold all its international assets in Spain and France. Though it has attempted to raise funds in the international market, it has had little success convincing lenders that it is stable enough to invest in. In late 2015, the Kazakh government allowed KMG to start claiming the cash reserves of its subsidiaries, no matter how small, as its own on its balance sheets. This shrunk KMG's net debt (at least on paper) from $17 billion to $4 billion, even though KMG does not actually have access to the cash reserves of most of its subsidiaries. KMG was on the verge of defaulting on its loans, but the balance book tactic helped the company win a $3 billion pre-paid oil deal with commodity trader Vitol and six international banks: Bank of China, HSBC, Mitsubishi UFJ Financial Group, UniCredit, SMBC and Societe Generale.

Now that its other options have been exhausted, KMG is once again turning to KMG EP. The former is refusing to pay for oil supplies it received from KMG EP in late 2014, and it paid less than market value for oil it received from the company in early 2015. But what it really wants is full control over KMG EP's finances. The subsidiary has made a decent recovery from the steep drop in oil prices, has minimal debt, and currently holds $3.1 billion in cash. KMG argues that KMG EP is not using its cash reserves properly and says the buyout would lower costs by reducing bureaucratic red tape between the firms.

Making the Deal

In recent weeks, KMG has held talks with the largest holder of KMG EP's minority shares: China's sovereign wealth fund, China Investment Corp. (CIC). The fund holds 11 percent of the 37 percent accounted for by minority shares; the rest are primarily dispersed through the London Stock Exchange. The minority shareholders are calling for KMG to drop its demand for veto power over the appointment of the subsidiary's directors — something KMG has recently said it would consider. CIC and KMG EP's board also claim that KMG's offer is too low. (As of this writing, the company is offering $7.88 a share, which is about equal to the market value. However, KMG reportedly offered CIC $9 a share in their recent meeting.) KMG EP's board, though, says that share prices are artificially low because of the threat of a KMG buyout; according to the firm, its shares are actually worth at least $18.50. China may yet take the deal, since Chinese firms have been divesting from riskier projects, moving away from the Soviet model of harming one company to benefit another.

If the deal goes through, it will affect the entire Kazakh energy sector. KMG EP has planned to use its cash stockpiles to drill hundreds of new wells over the next two years as its current fields age and decline. Now the company is delaying those projects, waiting to see if its finances are plundered. Because energy revenue makes up 40-60 percent of the government's budget, the Kazakh state has an interest in increasing the country's energy output. The Chevron-led consortium behind the Tengiz field agreed in March to ramp up production, and the Kashagan megafield is expected to start production by the end of the year after a decade of delays. But a Tengiz expansion may simply make up for a decline in the aging onshore fields, and Kashagan's revenues will repay the $67 billion investment for at least the next decade. If the government actually wants to raise its revenue, it will need the new wells that KMG EP is planning.

KMG EP, meanwhile, needs the assurance that its reserves will not be exhausted and that the payments owed to it by KMG will be paid. But even if it gets these things, the company will be stretched by government requirements to cover shortfalls in workers' salaries caused by currency instability and inflation. The Kazakh currency, the tenge, slid 19 percent in 2014 and another 23 percent in 2015. In the past month alone, the currency lost another 5 percent, and in the past year inflation has risen by 14 percent. The state is concerned that any job or salary losses will result in strikes or riots, as they did in 2011.

Another problem for the government is that the Western board members of KMG EP have threatened to resign if the state allows KMG a full buyout. They argue that the buyout would weaken KMG EP's ability to act independently and meet international financial and energy standards. KMG EP's independent non-executive directors were largely responsible for fostering warmer relations between foreign firms and the Kazakh company. If they resign, investor and business sentiment toward the firm and the country will deteriorate, which would undermine Kazakhstan's plans to privatize part of KMG in 2017.

Despite the risks, the government seems to think that prioritizing the health of KMG over that of KMG EP and the country's investment environment, at least in the short term, is the best option. In the past, foreign firms have pulled out of Kazakhstan because of KMG's aggressive business practices, but others have stayed, considering the risks just part of doing business in Kazakhstan.

Natural Gas Europe is pleased to provide this article in cooperation with Stratfor, a Natural Gas Europe Knowledge Partner.  For more visit www.stratfor.com Follow Stratfor: @stratfor on Twitter | Stratfor on Facebook