SPECIAL REPORT KAZAKHSTAN: RISKS AND OPPORTUNITIES IN A CHANGING ENERGY LANDSCAPE

SPECIAL REPORT KAZAKHSTAN: RISKS AND OPPORTUNITIES IN A CHANGING ENERGY LANDSCAPE

Contents 1 4 6 8 10 12 14 15 16 18 20 21 22 Managing expectations in Kazakhstan's new era Economic outlook hinges on oil and reforms Unleashing Kazakhstan s gas potential Kazakhstan: gas in figures Growth in Kazakh oil output set to continue Kashagan field ramps up oil and gas production Tengiz to increase production beyond 2022 Karachaganak commits to 20 years of gas exports Power sector needs cash to wean itself off coal Renewables: ambitious targets but slow progress Coal output may decline despite recent gains Concluding remarks Sources

SPECIAL REPORT KAZAKHSTAN 1 Managing expectations in Kazakhstan's new era Kazakhstan's increasing focus on renewables and natural gas brings about new opportunities for investors in the energy sector. However, oil production is expected to remain the backbone of the economy for many years to come, and efforts to diversify have yet to gain momentum. Drilling in Kazakhstan. (Gazprom) This report aims to shed light on some of the risks and opportunities in Kazakhstan s evolving energy sector. Research has been carried out by interviewing a number of experts and by drawing on existing research material. The report concludes that, although Kazakhstan wishes to expand in the areas of renewables and natural gas, its dependence on oil revenues is likely to remain significant in the future. Moreover, regulatory, economic and political uncertainties represent a number of risks for potential investors. Introduction Kazakhstan is a large, land-locked country in Central Asia. It is sparsely populated, being 66 times the size of the Netherlands but with roughly the same size population (around 18 million people). Multicultural to its roots, Kazakhstan has more than 100 ethnic groups. The majority are ethnic Kazakhs (60%) who are descendants of Mongolian and Turkic tribes and Russians (26%). Islam is the largest religion, representing around 70% of the population, and the vast majority of its adherents are Sunni. Christians make up around 26% of the population, most of whom are Russian Orthodox. In 1997, the capital was moved from Almaty to Astana, a planned city in the north of the country. Kazakhstan is an authoritarian regime and President Nursultan Nazarbayev has been in power since 1990. The country opened its hydrocarbon sector to foreign investors after gaining independence from the Soviet Union 26 years ago, and several of the world s oil majors are active there. Oil revenues have helped reduce poverty, although more so in cities than in rural areas. Kazakh and Russian are the official languages in Kazakhstan. Nazarbayev recently signed a decree that will see the country follow the example of other post-soviet states and gradually phase out the Cyrillic alphabet and replace it with Latin characters by 2025. He has also vowed to gradually increase the use of the English language in schools. Lower oil prices represent a challenge for Kazakhstan s energy sector and for its economy as a whole. Rich in natural resources, the country s oil production has supported strong economic growth since it gained independence from Russia. However, the government has set out a modernisation strategy to become less dependent on oil revenues and increase the proportion of non-oil products in its exports. The government has high hopes for the agricultural sector it sees the potential for exports of organic foods, for example to China as well as new technologies such as electric vehicles. A large factory was recently opened for the assembly of hybrid and all-electric vehicles for China s JAC Motors, and the government wants to expand further in this area. Nazarbayev has said he wants Kazakhstan to be among the world s top 30 developed countries by 2050. Even if this is achievable, the transition will not be an easy one. Analysts expect Kazakhstan to see annual GDP growth of 3-4% over the

2 SPECIAL REPORT KAZAKHSTAN coming years, far lower than the growth seen when oil prices were booming. "Diversification of Kazakhstan's economy has been talked about for many years, but in reality it is proving very difficult to accomplish. The country remains very reliant on oil revenues in particular, Camilla Hagelund, principal Central Asia analyst at risk consultancy Verisk Maplecroft, told Interfax. Many back the view that the diversification of Kazakhstan s economy will take time and require patience despite the country s prospects in areas other than oil. EXPORT MARKETS FOR KAZAKH OIL AND OIL PRODUCTS Italy 38% Netherlands 12% Switzerland 12% France 8% Spain 5% China 5% Greece 4% Romania 4% Others 13% "Looking at the medium-to-long term, Kazakhstan, as many other oil producers, faces problems of economic diversification. This is the case even if Kazakhstan is not a total oil monoculture such as Azerbaijan or some Gulf countries in fact, it also exports other commodities such as metals and grain," Marek Dabrowski, a scholar at Brussels-based thinktank Bruegel and professor at the Higher School of Economics in Moscow, told Interfax. There has been some progress in reducing the role of the state in the economy and in paving the way for small-to-mediumsize enterprises and private investors. However, substantial reforms are needed to improve the business environment. "Kazakhstan is moving towards a market economy, but the bureaucracy s instincts still reflect the strong legacy of the command economy. You see this, for example, in relatively high levels of regulation, such as electricity price caps, and this makes it a fairly difficult place for private investors to operate in," Hagelund said. Kazakhstan s judiciary is not fully independent, with presidential appointment of judges seen as a tool to uphold political influence over the courts. However, Nazarbayev has vowed to fight corruption and strengthen the rule of law. Moreover, the planned financial hub in Astana the Astana International Financial Centre is expected to open next year. It will boast independent courts based on the principles of English law. Higher oil and gas output Oil and gas production in Kazakhstan is forecast to grow in the future, driven by the country s three largest fields: Kashagan, Tengiz and Karachaganak. This should benefit foreign oil companies including the likes of Shell, Eni and Chevron, which have been active in the country for a long time. "Kazakhstan currently produces around 76 mtpa of crude oil based on 2016 figures. The energy ministry expects this to grow to 81 mt this year and to be around 87 mt by 2021. Much of the production growth will come from Kashagan and Tengiz," Dmitriy Sheikin, a senior economist with Almaty-based investment bank Tengri Capital, told Interfax. Kashagan was originally due to start production in 2013, but it has suffered years of delays and cost overruns because Source: Samruk-Kazyna, Statistics Committee, Kazenergy, IHS Energy of technological challenges in the harsh offshore environment in the northern Caspian Sea. The field finally started producing in late October last year, and its output is now 200,000 barrels of oil per day (b/d), Interfax reported on 4 October, citing Kazakhstan s deputy energy minister, Makhambet Dosmukhambetov. Production from the field was initially expected to reach 370,000 b/d in the second half of 2017, but this was revised down recently to 250,000 b/d by the ministry. Output of 370,000 b/d is now expected in 2018. "Kashagan is the major money-spinner in Kazakhstan. It will be developed to its full capacity despite being a technologically very complex project," said Sheikin. A large share of Kazakh oil is transported via the Caspian Pipeline Consortium pipeline to Novorossiysk, Russia s main port on the Black Sea. From there, it is loaded onto ships and transported to Europe. The largest importers of Kazakh oil and oil products are Italy (which takes 38% of them), the Netherlands (which takes 12%) and France (which takes 8%). China takes 5% of Kazakhstan s oil exports, according to a report released this year by Kazakhstan s sovereign wealth fund, Samruk-Kazyna. Key foreign players Unlike its neighbours Uzbekistan and Turkmenistan, Kazakhstan was quick to open the door to foreign investors in the oil and gas sector after it gained independence from the Soviet Union. In order to exploit its oil reserves, it needed the large investments and expertise that Western oil and gas companies could provide. However, Kazakhstan has since gained technological expertise and a strong capital base, reflected in its $58 billion sovereign wealth fund. It is now in a much stronger position than it was previously when negotiating terms for future oil and gas projects within its borders. Now, the situation is very different for Kazakhstan; they have more money, more experience and more self-confidence as a nation, said Hagelund. That said, developing Kazakhstan's

SPECIAL REPORT KAZAKHSTAN oil and gas fields will always be costly and technologically challenging, and the implied need for foreign expertise and resources represents a constraint on Kazakhstan s ability to push back in negotiations with foreign companies," she added. PROVEN ENERGY RESERVES IN KAZAKHSTAN 3 Although Kazakhstan boasts large gas reserves, its production is modest compared with neighbouring Turkmenistan and Uzbekistan, and much lower than Russia s. It produced 37 bcm of gas in 2016, excluding gas used for reinjection, according to the International Energy Agency. Total 34.9 btoe Coal 15.9 btoe Uranium 10.3 btoe Oil 5.2 btoe Gas 3.5 btoe Almost 40% of the gas produced in Kazakhstan is reinjected to enhance hydrocarbon recovery. However, gas production in the country is expected to increase moderately over the coming years, with incremental volumes coming from Kashagan. Commercialisation of its vast reserves has so far been muted because of low domestic prices and the expense of processing the high-sulphur gas produced from the field. Kazakhstan remains an important transit route for gas from Turkmenistan and Uzbekistan to China and, to a lesser extent, Russia. Exports of Kazakh gas to China are also on the horizon. A 5 bcm/y agreement with China started in October this year, and the first rail shipments of LNG to China started in January. Although the contracted volumes are still small, Kazakhstan s well-developed rail infrastructure has the capacity to transport significant volumes of LNG in the future. Kazakhstan also could export synthetic gas converted from its vast coal reserves via rail as LNG in the future, and the same could be achieved with CBM. Transporting Russian gas as LNG through Kazakhstan s rail network for example to China is also a possibility. Source: World Bank, Committee of Statistics of Kazakhstan is able to absorb a smaller amount of variable renewable energy, it may not be able to provide flexible backup for intermittent supply from substantially scaled renewables," Mirlan Aldayarov, a senior energy specialist at the World Bank, told Interfax. However, Kazakhstan has committed to a 15-25% carbon dioxide reduction target compared with 1990 levels under the COP21 Paris agreement. This, coupled with feed-in tariffs linked to US dollars for renewables, should help the business case for renewables. The European Bank for Reconstruction and Development has also shown willingness to help finance renewable projects in the country. The bank has so far invested 1.7 billion in sustainable energy and resources in Kazakhstan, and this investment is expected to continue, the bank said in October. The power sector in Kazakhstan remains regulated, with price caps set by the government for the wholesale market. An auction-based capacity market is expected to launch in January 2019 in a move to support new investment in generation. The World Bank has said that wholesale prices in Kazakhstan should be around $31.1-41.50/MWh to attract investment, but prices are well below that level. According to Fitch analysts, wholesale power prices are currently averaging around KZT 6/kWh ($0.018/kWh). Coal provides around 80% of Kazakhstan's installed power capacity, although there are plans to build some more gas-fired plants and perhaps convert some plants from coal to gas. Renewables currently play a negligible role, but the government has set ambitious targets for drawing 3% of electricity from renewables by 2020 and 10% by 2030. Kazakhstan has vast potential for wind and solar power, but a roll-out of renewables is expected to be costly and some see the targets as unrealistic. "My concern is the that the government, as a whole, may not fully appreciate the costs of the very ambitious renewables expansion. Coal plants account for about 75% of installed generation capacity in Kazakhstan and, while the Kazakh system Kazakhstan s economy has grown beyond expectations in recent months, supported by the oil, mining and metallurgical sectors. The weakness of Kazakhstan s domestic currency, the tenge, has boosted exports particularly of metals to China and this has also led to higher domestic demand for coal and electricity. However, some expect demand for and production of coal in Kazakhstan to decline in the coming years as its main export market Russia is increasingly switching to gas-fired power. It remains to be seen if low-quality Kazakh coal can find its way to new markets, for example China and Turkey. Kazakhstan has enjoyed relative political stability under Nazarbayev. However, there is much uncertainty linked to his succession, and his presence is likely to be felt long after his departure. The president has now turned 77, and some investors will want to wait until after the political outlook becomes clearer before making big commitments. To purchase the full report, call +44 (0)20 3004 6206 or e-mail customer.service@interfax.co.uk