Kazakhstan's oil and oil product market: problems and alternative solutions
Hagler Bailly Services*
(*This is a summary of a review of Kazakhstan's oil and oil product market carried out by Hagler Bailly Services for the Government of the Republic of Kazakhstan. Hagler Bailly Services works under contract with the US Agency for International Development (USAID) as an advisor to the governments of Central Asian countries on reforming the oil and gas sector and power engineering.)
The Government of the Republic of Kazakhstan (GOK) has attempted to rectify budgetary revenue shortfalls, and structural and market-related problems in domestic crude oil and petroleum product supply and demand through a series of recent legislative, regulatory, and policy decisions. These decisions have included the imposition of oil export restrictions (now lifted) coupled with the mandated requirements to supply domestic refineries, an unsubstantiated rise in crude oil pipeline and rail tariffs, and requirements to utilize domestic goods and services. Such steps could have the unintended effect of slowing the pace of foreign investments and reducing oil revenues to the GOK.
The problems in the oil sector that need to be addressed are very complex and have no singular solutions. They exist within the context of a nebulous legal and regulatory structure; a tax regime undergoing reform; and severe budgetary burdens, including the ongoing appeals to subsidize the agricultural sector and to fund local oblast administration concerns, infrastructure reconstruction needs, debt servicing, and other social and sectoral obligations. Any attempt by the GOK to address individual problems of the oil sector in isolation, and without full transparency, is likely to create new problems.
Due to the nature of the worldwide oil business, oil companies willingly make long term investments in sustainable operations, primarily based on project costs, level of perceived risk and return on investment in comparison to other investment opportunities. Coherent, consistent and transparent government policies generally attract greater investment, which typically translates into direct and indirect local employment, infrastructure improvements, greater tax revenues, and other social contributions. It should be recognized that the level of continued investment significantly depends on the perceived risk and stability of investments the government can insure and a legal and regulatory regime that recognizes the importance and sanctity of contracts upon which the investments are made. Correspondingly, oil companies should recognize that they are, by contract and business relationships, partners with the host government and maintain an appreciation of the political, economic, and social concerns confronting the host government, particularly during the complex transition to a more market-oriented economy. Oil companies, therefore, need to be flexible and responsive to the difficult situations that may arise and require their immediate assistance and resources. They should also acknowledge their role as responsible corporate citizens and be willing to reasonably invest in long-term value-added projects and activities that enhance the well-being of the host country and its people.
A comparison analysis from the wellhead to the retail oil market was conducted between Kazakhstan and other regions in an effort to find opportunities for greater balance of the domestic oil sector. It examined how fluctuations in world crude oil prices influenced the mechanics and segments of the Kazakhstan oil sector. Based on assumptions and specific scenarios, the following findings and conclusions were made:
• Since 1997, domestic refineries have demonstrated a linear decline in crude oil inputs (from 8.861 MT to 5.955 MT) and petroleum product outputs (from 7.975 MT to 5.360 MT);
• In the near future, it cannot be expected that all three domestic refineries will operate in tandem at their full design capacity, based on a number of factors, including high domestic refinery capacity versus relatively low demand, excess refinery and petroleum products capacity in neighboring countries, low purchase price of crude oil by domestic refineries, virtually no export market for domestically refined petroleum products, low imported petroleum product prices, the lack of an efficient market, and many other factors; and
• From 1999 data, Kazakhstan domestic refinery gasoline and diesel wholesale prices generally cannot compete with imported gasoline and diesel wholesale prices.
As part of the purpose of this Study, an effort was made to “determine the root causes of chronic dislocations of crude oil and petroleum products in the domestic market”. Investigations were conducted on the following outstanding issues and dislocations that continue to limit the pace of growth of the oil sector in Kazakhstan:
• Oil sector regional geo-economics and geopolitics, from a perspective of excess refinery capacity and refined petroleum products. Refineries throughout Central Asia, Azerbaijan, western Siberia, and western China operate at about 50% of their design capacities, thus they are able to meet or exceed market demand in the region. Because of differing laws and regulations, economic conditions, subsidy regimes, and taxation policies of surrounding countries, imported petroleum products can be sold at deeply discounted prices in Kazakhstan.
• The complex problems that impact domestic refinery operations and management. There are specific economic and political factors that have created problems for the domestic refineries. These factors include certain GOK subsidization policies, pervasive non-payment problems, excess refinery capacity in the region, imports of low priced or illegal contraband petroleum products, continuous changes in ownership and management, an inability to pay competitive market prices for crude oil, concerns over monopolistic practices, and several other factors.
• The distinct advantage to Russia in the bilateral intergovernmental crude oil agreements. Probably, in part, related to Russian pipeline quotas assigned to Kazakhstan, the bilateral intergovernmental crude oil agreements allow for a 7.3% gain to Russia in the swap of western Kazakhstan crude oil for western Siberian crude oil that is shipped to Pavlodar Refinery. The other factor, which allows for this unbalanced swap mechanism, is the perceived lower quality of Kazakhstan crude oil. Kazakhstan oil companies that participate in this swap mechanism are concerned over their overall loss of revenues based on these bilateral intergovernmental crude oil agreements.
• The inflow of illegal contraband and underpriced petroleum products into Kazakhstan. Some informal estimates of illegal contraband and underpriced gasoline and diesel that are imported to Kazakhstan are as high as 50% of the total sales in wholesale markets. The GOK has recently responded by adopting Resolution Number 339 “Concerning the Program on Intensification of State Regulation of Petroleum Products Turnover”, which if properly implemented, could resolve many of the downstream petroleum product issues.
Taking into account the comparison analysis and the issues and dislocations that affect the domestic oil sector, this Study concludes that, first and foremost, the GOK needs a more rational governmental organizational structure to clearly separate policy-implementation, regulatory, and commercial functions of the oil and gas sector, so it can serve to benefit both government and industry. It also concludes that the GOK needs to review the economics of oil supply and demand on a national scale in order to obtain a more comprehensive grasp of the operational and financial requirements of the industry, specifically the codependence of the upstream and downstream oil sectors for their mutual long-term viability. This is critical to overcoming the temptation to adopt short-term or ad hoc responses to problems, rather than comprehensive, long-term solutions. In dealing with oil sector issues, it is important to recognize that there is little parity between privately owned oil companies, primarily based on foreign investment, and State-owned oil companies, more characterized by reliance on the GOK and an absence of commercial risk. While distinctions may have to be made, balance, objectivity, and fairness in the treatment of all commercial oil company establishments should be favored. Additionally, collection of data on crude oil and petroleum product market prices and revenues to the GOK should be standardized and an improved tracking system for such prices and revenues established. With more consistent and reliable data available, economic planning would be improved and policy responses could more precisely target identified revenue collection problems.
A corollary to the foregoing is the need for greater cooperation between the GOK and the oil industry in the development and implementation of policies affecting the oil sector. The formation of a Presidential appointed permanent GOK/Industry Oil and Gas Advisory Board (Board) composed of high level GOK and industry representatives is an appropriate vehicle to accomplish this critical task. The purpose of the Board shall be to provide advice, counsel, and recommendations to the President on structural and institutional, policy-related, and market-oriented initiatives proposed by GOK or industry, as well as such other matters as may be referred to the Board by the President. The President shall appoint each of the nine Board members for a three-year term of service, subject to reappointment for one additional three-year term. This Board should seek consensus on oil industry issues, with consideration of the impact of any recommended actions on other sectors of the economy and the social welfare of the nation. This should instill confidence in investors and the GOK alike that their relationship is collaborative rather than adversarial. Preferences given one company over another should be eliminated and State-owned enterprises should be encouraged to become more commercially competitive.
The recommendations and alternative solutions derived in this Study are those of best judgment based on available data, information, time, and resources to consider possible outcomes. Taken collectively, they attempt to define a comprehensive balance in resolving these very complex economic, political, financial, intergovernmental, and social oil sector issues. The recommendations and alternative solutions are grouped into three categories, those that are structural and institutional, those that are policy-related, and those that are market-oriented.
Structural and Institutional Recommendations and Alternative Solutions:
• Appoint, by Presidential Edict, a Government/Industry Oil and Gas Advisory Board to consider structural and institutional, policy-related, and market-oriented initiatives
• Establish a comprehensive tracking system for Government of Kazakhstan oil, gas, and petroleum product sector data, information, and revenues
• Clearly separate and consolidate Government of Kazakhstan entities responsible for policy-implementation, regulation, and commercial activities in the oil and gas sector
• Promote the role of the Ministry of Energy, Industry, and Trade to implement political policy
• Establish an “independent” Oil and Gas Regulatory Agency to exercise sole jurisdictional authority in the regulation of industry activities
• Limit the responsibility of KazakhOil, and its State-owned oil and gas subsidiaries, solely to representing the Government of Kazakhstan commercial interest in oil and gas operations
• Limit the responsibility of KazTransOil, and its State-owned oil transportation subsidiaries, solely to representing the Government of Kazakhstan commercial interest in oil pipeline transportation
• Determine oil transportation tariffs through cost of service methodologies and a public hearing process
Policy-related Recommendations and Alternative Solutions:
• Create a fair “quality bank” oil pipeline transportation mechanism to achieve parity in crude oil swap arrangements with Russia and establish a checkpoint against transfer pricing schemes
• Increase import fees for petroleum products and decrease the excise tax for domestically refined petroleum products
• Address suspected illegal activities of transfer pricing schemes by oil companies individually, rather than collectively
Market-oriented Recommendations and Alternative Solutions:
• Initiate steps to foster a more competitive market for wholesale and retail sales of petroleum products
• Resolve ownership, management, and business operations issues at Pavlodar Refinery and sell it to a qualified vertically integrated oil company
• Create an open and transparent market mechanism for the trade of additional crude oil export pipeline quotas received from Russia
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