October 1997

Excerpt from The Caspian Investor newsletter, published monthly with news and analysis for oil and gas executives interested in the Caspian region. For more information or a sample copy of The Caspian Investor newsletter, contact Jamie Cullen by telephone at 818-343-8474 ext. 132, or via e-mail at JamieC@rpi-inc.com.

LAND AHOY!

A fundamental revision of Baku's investment policy for onshore fields is reaping quick results: Azerbaijan's first production-sharing agreement for an onshore field is scheduled to be signed in November and implementation is expected to begin early next year. The agreement marks a softening of Azerbaijan's once-tough stance on projects to develop onshore deposits that permitted investors to participate only through joint ventures. Now Azeri officials appear willing to consider options for onshore projects ranging from full-fledged production-sharing agreements to JVs with PSA-like features. After all, they have little choice: Their commitment to provide at least partial financing for five or more offshore projects in the near future will leave them with little extra capital to spend onshore. Baku's new approach should render attractive an array of projects that in the past appeared unprofitable.

In late November, the State Oil Company of the Azerbaijan Republic (SOCAR) plans to sign an agreement on the basic principles that would govern a production-sharing agreement with the Commonwealth Oil & Gas Co. Ltd. (Canada)/Union Texas Petroleum (US) alliance. The agreement will specify development terms for the Southwestern Gobustan block, which is located 300 kilometers southwest of Baku and contains in-place oil reserves totaling 100 million tons. The US-Canadian tandem was only one of several international companies seeking to develop onshore fields on PSA terms, according to a SOCAR official. Other companies that expressed interest include UNOCAL (US)/Delta (Saudi Arabia), Texaco, Frontera Energy Resources/Baker Hughes (all US), Elf Aquitaine (France), RAMCO, Lasmo (both UK), and Russia s LUKOIL.

The November agreement will be significant not only to Commonwealth and Union Texas, but to the entire foreign investment community, since it will demonstrate that Baku has significantly relaxed its policy toward onshore projects. Evidently persuaded that the allure of a production-sharing agreement would whet investor interest, SOCAR officials have also expressed, at least privately, a willingness to offer the UNOCAL/Delta group a production-sharing agreement for the Kyursanga-Karabagly field. In a joint venture, a foreign company can have a maximum ownership stake of 49% and must pay eight separate taxes, a SOCAR official involved in drafting PSAs said. Under a production-sharing agreement, an investor could hold a greater interest than SOCAR does and would be subject only to the profit tax.

Loosening Up
SOCAR officials offer no reasons for the company s sudden flexibility. However, experts at the Russian Academy of Sciences' Institute of Oil and Gas Issues suggest that Baku got caught in a trap common to developing countries devising ambitious plans to solve its economic problems through unrealistic megaprojects. Until May, SOCAR hoped that once petrodollars began flowing from its first offshore projects, it would be able to divert money to develop onshore fields. But as a result of the six contracts it signed from May to September with different international companies, Baku has only five years before it must begin financing its participation in a string of costly offshore projects. (See "Seller's Market," RPI/May 97.) Its strategy backfired, however: The commitments it assumed under the six contracts have left Baku without the money it requires for investment in onshore projects. As a consequence, Azerbaijan desperately needs to launch onshore projects that would offer a speedy return on investment that it could then reinvest.

The apparent shift in the attitude of Baku authorities also reflects their dissatisfaction with the slow progress of onshore projects. "The results of the joint ventures' operations leave much to be desired," conceded Prime Minister Artur Rasi-zade. "One cannot say that JVs have exhausted their potential, but another form of cooperation is needed to boost crude production and to lure foreign investment." Azeri officials hope that Baku s new attitude toward production sharing will transform the investment climate. Next year in Azerbaijan will be the year of the land," said Ibragim Guliyev, deputy director of the Azerbaijan Academy of Sciences' Geology Institute. "Its [onshore] oil reserves are enormous and the outlook for extracting those reserves is already as attractive to foreign companies as [the outlook for] offshore projects."

Production-Sharing Joint Venture?
Even before the Common-wealth/Union Texas agreement, Azerbaijan had already signaled investors that it was prepared to compromise. In September, White Hall (UK) and SOCAR formed the Shirvan Oil JV to tap the Kyurovdag oilfield, which contains in-place reserves of some 150 million tons. Although a joint venture, the project contains several features distinguishing it from SOCAR's previous agreements for onshore deposits.

First, the JV has some PSA features. White Hall will be entitled to 60% of output rather than the 49% of profits that an investor in a conventional joint venture is eligible to receive. This division will be in force until the company recoups its projected $300-million investment and then, as production declines, the investor's share will drop in stages to 30%. Second, SOCAR has transferred to the JV not only the field but all of the assets, including equipment, buildings, and land, of the oil and gas production association Shirvanneft, which was officially dissolved on September 1. Until this contract, SOCAR had insisted that only a relatively new exploration and production project could be organized as a PSA or a JV with PSA features. The British project envisions for the first time the creation of a joint venture with PSA elements, using standard Azeri technology to rehabilitate a field that had been under development for a long time and that has been depleted. SOCAR officials are also considering the possibility of a PSA to tap the 100 million tons of in-place reserves at the Kyursanga-Karabagly field. An array of companies, including UNOCAL/Delta, Texaco, Frontera Energy Re-sources/Baker Hughes, Elf Aquitaine, and Lasmo, will compete for the right to conduct a rehabilitation and exploration program to augment data collected in earlier seismic surveys and eventually develop the field. "We do not even rule out the possibility of the contract being ratified by the parliament," commented a SOCAR official. The parliament has ratified all of the existing PSAs for large offshore projects, giving foreign investors assurance of their projects' legitimacy and stability.

Poor Track Record
That a new form of JV has arisen is due not only to SOCAR officials' change of heart but also to the extreme reluctance that potential investors have demonstrated to follow in their predecessors footsteps. None of the JVs set up in 1993 and 1994 is capable of consistently producing profits.

Among existing JVs' chief difficulties is the harsh tax regime. According to Britain's RAMCO, which has been negotiating with Baku for more than four years to develop the Muradkhanly field, the taxes that the JV would have to pay after beginning operations would represent 94% of its revenue. Azeri officials argue that the figure is closer to 65%, but even at that level, such a tax burden could hardly be called light or, for that matter, competitive with taxation regimes in other oil-producing countries. Also expensive are the enhanced oil-recovery methods required for the many onshore fields that now have a surplus of water and deficit of oil after decades of Soviet reservoir management.

Another problem that all JVs face is the requirement that they sell base oil - the amount of oil equivalent produced before an investor joined the project - to SOCAR. Although the price of $80 per ton provides an acceptable netback to producers, SOCAR very rarely proffers any payment. And the JVs have few means at their disposal to force it to pay. In the first half of this year alone, the Azeri company's debt to JVs for oil received totaled more than $100 million. Without generating profits, JVs can hardly boost investment or increase the production rate to a level that would enable them to produce enough oil to sell to solvent consumers. Since practically none of the JVs produces at a higher level than the base, all are caught in a vicious bind.

Passing the Buck
SOCAR officials, however, attribute the JVs' lack of success not to the framework in which theymust operate but to the quality of the foreign investors. The problem, they claim, is that all of the existing JVs were formed by small foreign companies that do not have vast experience in upstream activities, such as Turkey's Atilla Dogan and Malaysia's Land & General Berhad, which have a 31.5% and a 17.5% interest in the Anshad Petrol JV, respectively. SOCAR officials say the contracts were signed during the rule of incompetent leaders from the nationalist Popular Front, when specialists did not have a strong say in industry policy. Today, SOCAR would choose different partners based on different criteria. Wealthier companies capable of making larger investments would have been able to ramp up production and ensure the sale of crude to solvent consumers and, consequently, ensure their profitability. In the mid-1990s, large companies such as LUKOIL, UNOCAL, and Texaco had been interested in the opportunities onshore but were scared off by the proliferation of demands¥such as fixing the distribution of profits at 49%/51% in Baku's favor that had been placed on them during negotiations.

We hope that the investors who join our onshore projects today will have enough funds to breathe new life into our fields, said Khokhbakht Yusuf-zade, SOCAR s vice president in charge of geology. If one compares the cost and reserves of the Kyurovdag onshore project and the Lenkoran offshore venture, it will take $300 million to produce 120 million tons of oil in the first case and some $2 billion to produce 150 million tons in the second case. These figures speak for themselves. We have quite a few fields and structures onshore where we may invite investors."

The Pendulum Swings
In the past, easing investment policy has increased investor interest, which in turn resulted in signed contracts. For example, Baku's investment policy softened soon after Geidar Aliyev replaced Popular Front leader Albufaz Elchibey as Azerbaijan's president, and the so-called deal of the century, involving the Chyrag, Azeri, and Gyuneshli deposits, was signed, along with four other contracts. At the same time, however, these contracts have had the cumulative effect of encouraging Azeri officials to increase their demands. (See "Seller's Market?" RPI/May 97.)

Therefore, Baku's declaration of interest in attracting investment onshore and the consequent softening of its policies do not necessarily mean that foreign investors can expect an easy time at the negotiating table or even that Baku s open-door policy with regard to onshore prospects will last long. In fact, now that Baku has signed a contract with the US-Canadian alliance and ignited investors interest in onshore projects, it may revert to its earlier, tougher stance. One tactic that SOCAR may employ is to hold out the possibility of a full PSA but eventually insist that foreign companies accept a joint venture with PSA elements instead.

Regardless of how their projects are ultimately organized, the best plan for investors pursuing opportunities onshore may be to focus on projects such as White Hall's that envision both the rehabilitation and exploration of fields and prospective structures through augmentation of data collected in earlier surveys. A tradition of pursuing such projects through JVs already exists, and SOCAR would rather turn over depleted or marginal fields to foreign companies than surrender virgin territory. Geological specialists in Baku suggest that Pliocene, Miocene-Oligocene, and Mesozoic net pay zones and deep horizons could be highly attractive, since they contain a significant part of Azerbaijan's estimated four billion tons of onshore in-place oil reserves.

Cream of the Crop

Local geologists estimate Azerbaijan's onshore recoverable reserves at 684.7 million tons and in-place reserves at 4 billion tons. They contend that the most significant reserves are located on the territory of the Apsheron oil- and gas-bearing area. Baku estimates proven in-place oil reserves at 1.25 billion tons. Soviet geologists discovered the high potential of low horizons in the Bin, Govsan, Kal, Karachukhur-Zykh, Surkhana, and Tyurkan acreage in the eastern part of the area.

The Nizhnekurinsky oil- and gas-bearing area includes the Kyurovdag, Kyursangy, and Garabagly fields, which are to be developed under projects involving White Hall (UK), UNOCAL (US)/Delta (Saudi Arabia), Texaco, Frontera/Baker Hughes (all US), Elf Aquitaine (France), and Lasmo (UK).

The Pre-Caspian-Kubinsky oil- and gas-bearing area occupies eastern Azerbaijan. The Begimlag, Keshchai, and Tekchai Sovetabad structures were identified on this territory. Commercial oil and gas flow were recorded from the Cretaceous and the Middle Jurassic reservoirs. In-place oil reserves stand at 750 million tons.

The Yevlakh-Agdzhabedinsky oil- and gas-bearing area contains in-place reserves of 600 million tons and includes the Muradkhanly, Zardob, and Dzhafarly fields. The oil reserves on the territory of the Yevlakh-Agdzhabedinsky area are characterized by Paleogene-Miocenic deposits. However, this area is best known for the Muradkhanly deposit located on its territory. The right to develop this deposit has been claimed by RAMCO (UK) for the past four years; no talks on the matter are currently under way.

This report is provided courtesy of the Business Information Service for the Newly Independent States (BISNIS)