Kashagan To Continue To Weigh On Exxon’s Returns

A recent report suggests that the giant Kashagan oil field might not produce any oil until at least 2016. The development of the mega oil field located in Kazakhstan’s zone of the Caspian Sea has been plagued by significant delays and cost overruns due to several technical issues. It was initially planned to be brought online in 2005 at a cost of $10 billion. Today, after more than eight years of delay and a cost overrun of more than $30 billion, it is still not producing any oil. This has hit the participating oil companies, such as Exxon Mobil (NYSE:XOM), hard by increasing the time frame they will have to wait in order to generate a desired rate of return on their investments. ^[1]

Exxon, Shell (NYSE:RDS.A), Total (NYSE:TOT) and Eni SpA (NYSE:E) each hold a 16.81% stake in the Kashagan project. Japan’s Inpex and Kazakhstan’s state-owned KazMunaiGaz each own 7.56% and 16.88% stake in the joint venture respectively. In addition, China’s CNPC (China National Petroleum Corp.) acquired an 8.33% stake in the project last year, which was sold by ConocoPhillips (NYSE:COP) for $5 billion.

We currently have a $96 price estimate for Exxon Mobil, which values it at around 11.9x our 2014 GAAP diluted EPS estimate of $8.05 for the company.

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The Kashagan field is located in the Kazakhstan sector of the Caspian Sea and extends over a surface area of approximately 75 kilometers by 45 kilometers. The reservoir lies some 4,200 meters below the shallow waters of the northern part of the Caspian Sea. It is perhaps the largest oil field to be discovered in the past 35 years, and is estimated to hold as many as 35 billion barrels of oil, of which around 13 billion barrels are likely technically and economically recoverable at current crude oil prices. This represents most of Kazakhstan’s offshore proved oil reserves. Besides, the field is also estimated to hold over 1 trillion cubic meters of natural gas. After the completion of the second phase of the project, it is expected to produce oil at a plateau rate of around 1.5 million barrels per day (bpd), which is equivalent to the average rate of crude oil production recorded by all of Exxon’s subsidiaries in 2013. ^[2]

These figures highlight the enormous potential of the field but technical challenges associated with its development have delayed the first oil by almost a decade. The biggest challenge is that the field has oil heavily suffused with hydrogen sulfide, a dangerous gas. The concentrations of this gas are high enough to kill a person in a single breath. In addition, the oil is buried around two-and-a-half miles below the seabed under enormous pressure and conventional drilling and production technologies, such as concrete structures or jacket platforms that rest on the seabed, could not be used in this project due to shallow water and the cold winter climate of the northern part of the Caspian Sea. As a result, offshore facilities have been installed on artificial islands to ensure their protection from harsh winter conditions. Also, these islands are isolated from their environment by an impermeable membrane, which is laid all across them in order to prevent any potential impact of the project’s operations on the diverse fauna and flora of the region. ^[3]

In October last year, just a couple of weeks after the Kashagan oil project finally came online, it was shut down due to a leakage in a gas pipeline connecting one of the drilling islands to the onshore processing facility. April this year, oil companies involved in the project said that the oil would start flowing again next year, as they hoped to replace damaged sections of the pipeline. However, according to a recent report, the companies have now concluded that in order to restart oil production from the field they will have to replace the pipeline entirely. This could further escalate the total cost of the project by billions of dollars and delay its restart until 2016.

After the Kashagan oil project restarts, it is expected to reach a plateau production rate of around 370,000 bpd in a couple of years. According to our estimates, it would take the private players involved in the project at least five years of continuous operation after that just to recover all the development costs in real dollars. Only after that profit oil will start flowing, which will be shared between the government of Kazakhstan and the multinational oil companies. Therefore, the delay being caused by the cracked pipeline issue is expected to increase the project’s required duration to yield the desired rate of return significantly. This does not bode well for Exxon’s already declining return on capital employed (ROCE), which stood at just around 17% last year.

Not only this, it also raises several concerns over the next phase of development of the reserve, which is required to ramp up the production rate to 1.5 million bpd. The private players will need to determine if they will be able to recoup their expenses and reach an acceptable level of profitability before the project’s production sharing agreement (PSA) terminates in 2041. If not, renegotiations with the state government over the PSA agreement could further delay the next phase of development of the mega project.

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1. Production At Kazakhstan’s Kashagan Oil Field Halted Until 2016, wsj.com [↩]
2. Exxon Mobil SEC Filings, sec.gov [↩]
3. Development challenge of Kazakhstan’s giant oilfield, bbc.co.uk [↩]