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In Caspian, Big Oil Fights Ice, Fumes, Kazakhs

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KASHAGAN, Kazakhstan Aug 28, 2007 (From the Wall Street Journal via Dow Jones Newswires)

On an island in the Caspian Sea, the hub of the world's largest oil-development project, a thousand men in orange jumpsuits train for catastrophe.

Oil in the Kashagan field here is potentially lethal, with high concentrations of hydrogen sulfide gas. So workers carry oxygen canisters and gas detectors and do daily evacuation drills. High-tech getaway boats stand ready to whisk them to safety. The place feels more like a hazardous-chemical plant than an oil rig.

"One breath would kill you," says offshore installation manager Ian King.

Since an unlikely alliance of Western oil companies received rights to drill for oil here a decade ago, they've struggled to cope with a combination of rig-wrecking ice packs, bone-chilling winters and noxious, high-pressure gases. Yesterday, the consortium's bid to exploit one of the world's top oil deposits encountered its biggest challenge yet: Kazakhstan's government, stung by delays and rising costs, suspended the group's permit for the field, halting work there for the next three months.

"From today, work on Kashagan will be frozen," said a Kazakh official.

It wasn't immediately clear whether the project had been shut down. The field's operator, Italy's Eni SpA, declined to comment, saying only that consortium representatives were meeting yesterday with local authorities. Sources close to the negotiations said the delay was an attempt by the Kazakh government to pressure Eni and squeeze additional money out of the project.

The day's wrangling added yet another layer of complexity to Kashagan, a field that shows the increasingly hostile environment encountered by Western energy companies in pursuit of crude. With the era of easy oil long gone and international demand climbing to new heights, the majors are focusing on increasingly remote and hazardous corners of the globe. The ultradeep waters of the Gulf of Mexico and offshore West Africa are Big Oil's new frontiers.

The rewards are potentially huge. Kashagan, discovered in 2000 in Kazakhstan's sector of the Caspian, was the world's largest oil find in 30 years. In 2019, production there is expected to plateau at 1.5 million barrels of crude a day, more than the output of established producers Angola or Qatar.

But such projects are also pushing the majors' technical capabilities to the limit, often leading to holdups and soaring costs. That in turn is testing the patience of host countries, which see their payday recede with every fresh delay. As their frustration grows, so does the petro-nationalism that has shifted the balance of power between Western oil majors and oil-producing nations.

Kashagan is a prime example. Under Eni, the original production start-up date had been pushed back from 2005 to the end of 2010. Earlier this year, Eni announced that the cost of the field's initial phase would be $19 billion, rather than the $10 billion it had previously flagged. Oil majors blame rising costs on a shortage of skilled engineers and project managers, soaring steel prices and expensive leases for new drilling rigs.

Kazakhstan was unconvinced. "When costs increase by 5%, by 10%, that's one thing," Kazakh Prime Minister Karim Masimov said in an interview earlier this month. Projected costs over the 40-year life of the project, he said, had increased to $136 billion from $57 billion. "When they rise by two and a half times, either the planning was wrong, or the execution is wrong, or it was deliberate."

Kashagan is now increasingly resembling another energy project that fell victim to its host's rising assertiveness -- Sakhalin 2 in Russia's Far East. When Royal Dutch Shell PLC announced costs at Sakhalin had nearly doubled, Russian environmental regulators began bombarding it with complaints. They ended their campaign only when Shell ceded a majority stake in the project to a Kremlin-run gas company.

Rising out of the Caspian Sea some 50 miles offshore, Kashagan is breathtaking in its scale. Its center is an island set in a shallow lagoon and enclosed by an atoll of long, curved reefs. On closer inspection, the islands and reefs turn out to be man-made -- artificial defenses against a destructive sea.

"This is not like the Arabian desert, where you just extract the oil and put it in a pipe," says Paolo Campelli, Eni's head of operations in Kazakhstan, as his helicopter touches down on Island D, the heart of the Kashagan operation.

Locals have long known of oil deposits in the Caspian. The Soviets carried out seismic tests there but lacked the technology to drill offshore, focusing instead on easier fields in Siberia. Soon after the Soviet Union collapsed in 1991, the newly independent Kazakhstan invited foreign oil companies to bid for exploration rights.

In November 1997, a group of Western oil majors clinched a deal with the Kazakh government to develop reserves in the northern Caspian. Consortium members included Agip, a unit of Eni; Statoil ASA of Norway; Mobil Corp. of the U.S., now part of Exxon Mobil Corp.; Shell; France's Total SA; and Britain's BP PLC and BG Group PLC. Signed in Washington, the pact sealed Kazakhstan's emergence as one of the world's next energy giants.

At the time, the country lacked the know-how, money and manpower to operate big, complex projects on its own. Most of its petroleum engineers had been Russian, and a lot of them fled in the chaos of 1991.

Kazakhstan lured foreign companies with production-sharing agreements, or PSAs, special deals under which companies bear all exploration, development and production costs but can recover them before having to share much revenue with the government. The more costs go up, the longer the host government has to wait for its share of the income, as Kazakhstan was to discover.

Named for a 19th-century Kazakh poet, Kashagan was unusual. Rarely have so many big, rival companies, all with similar-size stakes, been partners in a single consortium. "You had to wear a helmet in meetings," says one person close to the consortium. "It was far from friendly."

There were also the challenges of the Kashagan deposit itself. It's buried about 2 1/2 miles beneath the seabed, under pressures of roughly 500 times that of the atmosphere at sea level. Extracting the oil requires costly stress-resistant pipes, as well powerful compressors to pump the noxious gases back below the sea. Also, the Caspian here is like a shallow wading pool that freezes over for nearly five months of the year. In winter, the wind whips up mounds of pack ice that can destroy a conventional oil rig.

"We've had experience with hydrogen sulfide, low temperatures and high pressure -- but never all together," says Mr. Campelli, the Eni official.

The consortium faced hurdles from the beginning. Shell, delegated by its partners to lead the exploration phase, decided to use a huge swamp barge from Nigeria to drill for oil. It was taken to Louisiana and refitted for frigid conditions, then chopped into pieces and sent halfway around the world to landlocked Kazakhstan. The barge had to be towed across the Atlantic, through the Black Sea and up Russia's Volga-Don canal to the Caspian port of Astrakhan. There it was reassembled and extended with pontoonlike structures until it was the size of a football field.

It all took months longer than planned. In Astrakhan, fires destroyed equipment and tools were stolen. Some of Shell's partners nicknamed Kashagan "Cash All Gone." Shell declined to comment.

Finally, in July 2000, the majors struck oil -- lots of it. It was the biggest discovery since Alaska's Prudhoe Bay in 1968, with recoverable reserves of some 13 billion barrels.

But the other members of the consortium had lost patience with Shell, and decided to choose a new field operator. Exxon Mobil, Total, Shell and Eni's Agip all vied for the job.

A long struggle ensued as contenders presented their rival designs, say participants. "Everyone was blackballing everyone else," said one oil executive familiar with the negotiations. Eni, the smallest of the four, was the compromise option. After winning the most votes in the selection contest, it took over as operator in February 2001.

As it began work, Eni sought cost estimates from oil-industry consultants. They all declined. "They said there were no benchmarks for an offshore field like Kashagan," says Mr. Campelli.

Eni's challenge was figuring out how to drill for Kashagan's oil without using normal rigs, which would collapse in icy waters. Its solution was to house the production platforms on an archipelago of artificial islands.

Kazakhstan, annoyed that Eni's plan promised a delay beyond the original 2005 start-up date, rejected it. A 14-month face-off ensued. The short summer construction seasons of 2002 and 2003 came and went with little work done.

In February 2004, Kazakhstan approved Eni's proposal, under which oil was to start flowing in 2008. The government imposed a $50 million fine on the partners for every year Kashagan's production was postponed beyond 2005.

The Kazakh government continued to apply pressure. When BG said it wanted out of the consortium in 2003 and arranged to sell its stake to two Chinese companies, the other members exercised their preemption rights, intending to divide the stake between them. But the Kazakh national oil company KMG stepped in and laid claim to half the BG stake for itself.

That led to still more negotiations, further slowing work. The uncertainty was compounded by the partners' doubts about KMG's ability to finance its share of the project's mounting costs. The Kazakh company was admitted to the consortium in May 2005.

Meanwhile, Eni started building islands. It dumped more than four million tons of rock on the seabed, secured it with steel piles and covered it with concrete slabs. Gradually, pontoonlike modules and helipads were added. The larger of the two islands, D, was surrounded by reeflike barriers to protect against ice.

Environmental issues weighed heavily on the project. Enclosed waters such as the Caspian are seen as more vulnerable to damage from spills than open seas, where crude is more easily dispersed by currents, winds and tides. Also, Kashagan is in a nature reserve and breeding ground for rare Caspian seals and caviar-yielding sturgeon, including the endangered beluga.

On the consortium's initiative, Eni collects all discharges -- dirty drilling debris as well as run-off rain water -- and sends it for processing to a logistics base on the Caspian shore. Still, local environmentalists say Kashagan-related pollution is behind the deaths of hundreds of baby seals in the area this year. Eni denies any link.

More immediate, Eni believed, was the threat of hydrogen sulfide leaks. "I've worked in Doha, where the H2S content of the oil was 3%, and that was dangerous," says Mr. King, manager of Island D. "Here it's 15%."

Eni commissioned a fleet of four IBEEVs -- ice-breaking emergency evacuation vessels -- in case workers need to flee. Evacuees enter through an air lock, are given personal CO2 scrubbers that filter carbon dioxide from the air of the crowded boat, and then move into sealed compartments. "It can run on its own air supply for 50 minutes -- enough to escape a gas cloud," Mr. King says. "It cuts through the ice like a knife."

Eni also came up with a way to divert the toxic gas. It installed compressors capable of re-injecting it back into the oil reservoir at a pressure virtually unheard-of in the industry -- 800 bars, or 400 times the pressure inside a car tire.

In 2005, a hitch emerged. Eni discovered that its staff living quarters were to be located too close to Island D's treatment plant, which cleanses the oil of impurities and reinjects the H2S. That meant they were at risk of being exposed to a gas leak. Eni reconfigured its plans.

All of this flowed through to the timetable and price tag. In February 2007, Eni broke the news: Kashagan's initial phase would cost $19 billion, nearly double its original estimate. Oil would start flowing two years later than billed, in 2010.

Company officials blamed the overrun on the weak dollar, inflation in the industry, the lack of benchmarks for the project and the expense of changing Island D's layout. Eni's chief executive Paolo Scaroni was unapologetic. "What is really crucial in a project of this kind is to be sure not to make mistakes, particularly because the [natural] environment is so sensitive," he said in an interview.

The rest of the consortium fumed. "There's bitterness about the way Eni has handled this," says Alex Turkeltaub of Frontier Strategy Group, a consulting firm that has advised some of the other Kashagan partners in the past. "They've misled the market with remarkable consistency about the production start-up and costs." Consortium members declined to comment, referring all questions to Eni.

Eni tried to sugar the pill by stressing Kashagan's size. Company officials have revised upwards their estimates for peak production, to 1.5 million barrels a day from 1.2 million barrels. "The more we look at Kashagan, the more we realize that this is a super supergiant," said Mr. Scaroni. "This is a field that's going to last until 2039."

Industry insiders note one benefit from the delays. They have given Eni and its partners more time to figure out how to get Kashagan's oil out of landlocked Kazakhstan and onto world markets. Kashagan is one of the few megaprojects in the world without a dedicated pipeline. There are currently two running from the western shore of the Caspian -- one to Russia's Black Sea coast and another to the Turkish port of Ceyhan on the Mediterranean. Both would need to be expanded to accommodate Kashagan's oil. Another export pipeline from Kazakhstan to China also has limited capacity. Perhaps the most direct route would be across Iran to the Persian Gulf, a plan that regional analysts say would likely be unacceptable to the U.S. government.

At the end of June, Eni presented its revised figures to the Kazakh government. The reaction came a month later, and it was furious.

In an interview in his office in Kazakhstan's new capital, Astana, Prime Minister Masimov said Eni should be fired as the field's operator. Eni, he said, had breached the agreement's terms. Overall costs had ballooned. That meant Kazakhstan would have to wait much longer for its share of proceeds from Kashagan's oil, delaying construction of schools and hospitals. "That's going to provoke a lot of resentment," he said.

Yesterday, the consortium was subjected to a barrage of reprimands. Kazakh authorities said they were suspending the consortium's nature-use permit, one of many licenses it requires to operate, meaning work on the project would have to be halted for three months. A probe would be launched into unidentified consortium officials for alleged customs violations. And the operator would be sued for breaching fire-safety rules at its oil-and-gas processing facility.

Observers see the announcements as an attempt to put pressure on Eni as the two sides started yesterday what is expected to be months of hard bargaining. Kazakh officials say they want to revisit the terms of the production-sharing agreement, aiming to secure a larger take. "The balance of economic interests has been upset, and to our detriment," said Mr. Masimov.

Eni's shares closed down 1.05% at the end of trading in Milan. Most analysts say Kashagan's risks have long been priced in.

Mr. Scaroni, Eni's CEO, still hopes that Kashagan will catapult Eni to the major league of companies capable of operating big, technically complex fields. "This has been a transforming operation for us," he says. "Eni is a different company to what it was before Kashagan."

Mr. Masimov is unimpressed. "Sometimes you wonder whether the investors really want Kashagan to happen at all," he says. International oil companies could profit from high prices on world markets, he suggests, by leaving such a large deposit in the ground. "Do they need our oil? Or is it just a game?"

Copyright (c) 2007 Dow Jones & Company, Inc.

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