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Caspian Oil In 1999: The Imperative of World-Class Performance

By Nick Zana, Managing Director, Eurasia Business Unit
Chevron Overseas Petroleum Inc.

Institute of Petroleum's IP Week Conference on Caspian Oil & Gas

Commonwealth Institute Conference & Events Center, London, England

Can the Caspian oil industry survive the oil-price environment of 1999?

After all the struggles, and the rush of investors into this challenging region, all the progress we've made against the odds, and all the talk of huge undiscovered reserves, and all the debate about pipelines, people want to know if low oil prices have changed the whole picture. Is it really just a matter of time before the investors in the Caspian oil industry fold up their tents and move on?

In response to this, let me borrow a quote from a competitor. He said: "There's nothing wrong with the Caspian . . . what's wrong is the low oil prices." I agree that the Caspian still holds the fundamentals for success, but we have a very tough challenge ahead of us. We have to do everything possible to reduce costs while also keeping the core projects moving forward on schedule.

Today's price environment has nearly erased the Caspian industry's ability to earn a reasonable return - or earn any money at all – and still grow production. And yet, it would not be prudent to stop investing altogether. So we have to work harder on what we can control – our costs – because of what we can't control, which is oil prices.

Today, budget cuts and deferred projects once again are business-as-usual in the worldwide oil industry - and this is universal for both companies and host countries. Where certain investments can wait they will have to wait – and capital budgets must be re-evaluated to find new ways to lower the over-all expense.

These are hard times, but none of this can change the fact that we still have solid, basic, long-term reasons to invest in the Caspian region. And these are: known oil reserves in the billions of barrels, the potential for discovering more and government partners in new nations who are determined to harness their energy resources to help the build new national economies.

A lot of the headlines have focused on the exploration side. But it's going take a lot of years and a lot of wells before we know whether the Caspian region holds 30 billion barrels or 130 billion. And so, for the next two-to-three years, what matters is that we've got something big to produce and something big to search for. We have valuable projects to work on, a reasonable balance of risk to potential rewards and the clear potential to grow reserves and production.

People might think that the low prices have created a situation where there's now just too much at stake to continue investing. But in fact, there's far too much at stake to stop investing.

I can speak for Chevron - and I know many other companies feel the same way - and say that we are not going to walk away. We formed our partnerships in the Caspian region for the long term, and we're going to stay for the long term. You don't have to be an optimist to take this perspective, but you do have to take the long-term view.

I think we've all followed the news reports. The AIOC is still on course for significant investments in 1999, but they've announced a 20 percent cut in their capital budget and they're asking Russia for rate relief on pipeline tariffs.

The Karachaganak group has had serious problems marketing its liquids - and they've had to temporarily cut back production – due partly to the regional economic crisis. But they aren't quitting. They've made it clear that they intend to be one of the long-term "anchor tenants" of the Caspian oil industry.

We're all aware that the offshore prospect at Karabakh was judged non-commercial for oil after three exploratory tests. But this was not unusual or even unexpected. The exploration process will continue – indeed, by some measures, it has barely started – and the wells to watch now include the OKIOC test in the northeastern Caspian and the first Shah Deniz well.

Meanwhile, the industry is working on solving the drilling rig problem for the deeper waters of the Caspian. Two semi-submersible rigs are now working, another is under construction and a fourth is planned. The industry has done a good job of sharing the costs of securing an adequate Caspian rig fleet, which may ultimately cost $600 to $800 million. But what's needed now – in light of the oil-price situation – is to look again at the drilling schedules, look again at the potential for cost savings on building the rigs and consider options for more cost-efficient use of the rigs.

At this time of economic difficulty for the industry, it is important for the government and the industry to work together to find mutually acceptable ways to cut costs and defer expenditures. If done in a co-operative manner it can prepare both for future growth when conditions improve, while channeling the very limited current funds to future projects that provide current growth and profitability.

We must appreciate that it is not a tragedy - nor is it anything new - to slow down certain programs during hard times. Very substantial Caspian regional reserves have already been confirmed, and there's a great deal of critically important work to do just to grow the existing production.

AIOC recently reached 100,000 barrels per day. They're aiming for 800,000 within a decade. Tengiz is aiming for 700,000 barrels per day in the same time frame. Karachaganak is aiming for 170,000 barrels a day by 2001. These are the cornerstone projects of the Caspian, partly because any new oil fields we find won't start producing for three-to-five years at best. And by then, I'm sure we'll be looking at a global oil market and world economic situation that are as different from today as they were five years ago.

Let me spend a little time now discussing the two projects that I know most about - Tengiz, where Chevron has a 45 percent share and the CPC Pipeline, where we have a 15 percent share.

Most people have some appreciation for the linkage of these projects. At Chevron, we've always seen them as complimentary – and in many ways, they are one undertaking. Of course, the oil field and pipeline have different investors and are structured as separate ventures. Indeed, they are distinctly different businesses to manage. But they've always had each other in common. One couldn't be justified without the other. And starting around the end of last year, when the final Russian permits were granted for the pipeline, the two projects truly moved on to a parallel track for the first time.

Tengiz has grown and matured - both as a project and as a partnership. The field is currently producing over 200,000 barrels per day – almost 10 times as much as when the joint venture started in 1993. We especially proud that TCO worked more than 5 million man-hours without a lost-time accident – a world class performance. They also cut their unit production costs nearly in half to about $2.36 a barrel, and I think that number serves as a reminder that economies of scale are another reason to feel positive about the Caspian oil industry's future.

Last year the Tengiz partners OK'd a $500 million capital work program for 1999 - after investing over $500 million in 1998. Despite the need to look harder at both costs and investments in the months ahead, they're determined to keep growing.

It's also important to note that later this year we'll complete the analysis of our first evaluation well at Tengiz, drilled last year. It went to 5,700 meters and was the deepest well ever drilled in the field. In addition last year, we completed a 3-D seismic survey of Tengiz and its smaller sister – Korolev. It was one of the largest land surveys ever conducted by the oil industry. And we're counting on this new well data and seismic information to help us find new ways to minimize field-development costs over the long term.

Turning now to the CPC Pipeline, I'll admit that the delays - at times - were very discouraging. But I always believed we would build it some day, because the Tengiz partners and the nations of Kazakhstan and Russia have so much to gain from this project.

CPC got its final Russian permits late last year and now they've ordered the line pipe - about 60 percent of it from a Russian supplier. CPC has also completed the land acquisitions for the pipeline route. For 1999, the pipeline project has a budget of about $800 million, with an ultimate cost target of $2.2 billion over three years.

CPC announced last month that they'll start construction in May. The ground breaking will happen over on the Black Sea coast, where work will begin on the terminal and tank farm at Novorossyisk, where they plan to fill the first tanker in the summer of 2001.

During the pipeline construction, Tengiz intends to keep growing its capacity, adding a fifth processing train and aiming for a level of 260,000 barrels per day by mid-year 2000. The objective is simple: Tengiz must be producing at that level on the first day the CPC Pipeline opens for business. The pipeline is a very expensive new business asset, and we want to put it to work immediately.

Actually, we expect to start putting Tengiz crude into the line toward the end of next year - it takes quite a while to fill a pipeline initially capable of handling more than half-a-million barrels per day. But now you might ask, if Tengiz oil can't start filling the CPC Pipeline until then, where will we put the higher production in the meantime?

Most of it will keep going where it has been going for several years now - we move it by pipeline, rail and barge through Azerbaijan, Georgia, Russia, Finland, Estonia and the Ukraine. That's a whole story in itself. For example, it might interest you to know that we fill 250 rail cars a day and up to 60 percent of Tengiz production moved by rail last year.

I should add here that today's oil prices are making it almost too expensive to continue shipping by rail. But I'm encouraged that the countries we cross now seem to understand the need for rate adjustments. Meanwhile, some of the growing Tengiz production will move by tanker across the Caspian to Azerbaijan, then through a combination of rail and pipeline it will be shipped across Georgia to the Black Sea port of Batumi. We have plans to continue to evaluate opportunities to invest in pipeline segments in this corridor to lower the overall transportation costs.

Tengiz and CPC Pipeline are the strongest symbols of the emerging Caspian oil industry. They are model projects - one is the pioneer in Caspian field development and the other is the sensible, first regional project to launch a new era of major Caspian oil exports. Tengiz: five partners representing three nations and four companies. The CPC: three governments, plus 10 companies from five different nations. In each project, all partners share both risks and benefits, and each has a major stake in the success of the whole.

In addition, each project directly involves Russia, a necessity for long-term success in the Caspian region. And this can be Russian companies, or Russian suppliers, or Russian customers or the Russian government – or any combination of these. I realize some others still view Russia as an obstacle or a threat, and Russia has been slow to embrace true foreign investment in its petroleum industry. However, the new government has a clear policy of encouraging foreign investment for industrial projects like the CPC Pipeline. And while it clearly took Russia too long to approve production-sharing agreements for oil projects, recent actions are a very positive sign.

Russia has also shown - with the Primakov government and LUKoil as two examples - that they can be a constructive and influential partner. And they have shown that their participation in the Caspian oil industry can be a positive force for the future.

Tengiz and the CPC are symbolic also because they've given us a glimpse of just how important a viable Caspian industry will ultimately be to the economic growth of the host nations. In 1998, the Tengiz venture alone contributed about $450 million in direct and indirect benefits to Kazakhstan, some local, some national and some regional. The venture helped people and business in the project area through payroll and local contracting, and it helped the Kazakhstan treasury and economy.

The Tengiz development has also made very significant contributions to Russia's economy during the 1990s through the purchase of Russian goods and services. These contributions have grown steadily since 1993, when the Tengiz venture's direct purchases from Russia were about $26 million . . . through 1998 . . . when they hit a record $133 million.

In Kazakhstan, Tengiz presently sustains 3,000 direct jobs, and another 4,000 indirect jobs. In Russia, the Tengiz project will sustain more than 1,100 direct jobs per year, on average, and another 5,500 jobs indirectly during the life of the project.

The Tengiz venture invested $50 million in the local community in its first six years, and it continues to play a vital role in the community in the areas of health, education and local business development. Most recently, Chevron announced a major new effort to help and promote small-and-medium business development in the Tengiz area. And we're very pleased to report that we'll be working very closely on that with Citibank, the United Nations and the European Bank for Reconstruction & Development.

As for the CPC Pipeline, it is now one of the most important construction projects in Russia. It is a project of enormous symbolic importance -- a very large, shared investment in regional infrastructure -- which weaves together the fortunes of many diverse partners across the new borders of the old Soviet Union. But the CPC project also serves more concrete and immediate priorities. Direct jobs during construction are expected to peak at 4,000 – and I've already mentioned the line-pipe orders from a Russian supplier.

Put Tengiz and the CPC together, and in the decades to come, the projected indirect and direct economic benefits will add up to more than $150 billion for the gross domestic products of Russia and Kazakhstan.

Now, you might ask: If Chevron had known six years ago that we'd be faced with $11 to $12-dollar-a-barrel oil today, would we still have made a major financial commitment to the Caspian region?

I don't think I can respond directly except to say that we invested in the Caspian with the full knowledge that there would be plenty of risks and challenges – including some we could not foresee – and low prices has turned out to be one of them. I would also answer that question this way: If we had never invested in the Caspian, we would know nothing about how to succeed in the Caspian.

And today, our knowledge of this region and our experience are as valuable - in many ways - as the oil we produce. Nor can we overstate the importance of the time that we and our host-government partners have invested getting to know each other better.

Recently, President Nazarbayev was reflecting on the long campaign to get the CPC Pipeline started, and he said, "The man who would catch fish must not mind getting wet." Chevron knew the first projects wouldn't be easy – and so did the president. And rather than dividing us, the struggles have made our partnership stronger.

Chevron believed when we started at Tengiz six years ago – as we believe now – that world-oil demand will trend steadily and slowly upward over the next 10 to 20 years. We believed that the industry would have to work hard to keep up with that trend, and that the value of a barrel in the ground would reflect a balanced market. We believed oil was a very good business and that it would remain so. Generally, we still believe this – even though we're doing our near-term planning based on weak oil prices for another year or so.

We didn't like the delays in the CPC Pipeline, or the tangle of unexpected problems for transporting the Tengiz crude. But those experiences taught us that we had export options we never fully appreciated until we had to find some, invent others and make them all work for us. In turn, that experience reinforced the value of cultivating multiple transport routes for Tengiz crude.

As I've said, for Tengiz and the industry's progress in general, the CPC pipeline is the most important export project for the near term. It's the most sensible big pipeline to build first even though we know Caspian oil will likely need other large export lines in the longer term.

As for the Russian economic situation, we have already seen how a viable Caspian oil industry can help the Russian economy by feeding Russian refineries, purchasing goods and services, providing jobs, moving more production through Russian pipelines and so on. In fact, Russia's hardships have brought it closer to its Caspian neighbors on oil issues, rather than farther apart.

I realize that even with all these positive observations, most of us will still be wondering whether low oil prices are going to force the Caspian oil industry into a state of hibernation. And in truth, this is an open question. The investments, the growth, the relationships and lessons learned during the 1990s have prepared the industry to survive a period of low prices. But this is not going to be easy.

The Caspian presents major technical challenges: sour crude, complex reservoirs, and the shortage of offshore rigs, to name a few. But these are not the issue. Most of the world's other oil-producing areas have similar challenges of one kind or another.

No, the big disadvantage in the Caspian is shipping expense, the great distances to markets – somewhere between $3 and $4 a barrel just to get it to a sea port for export – and this will be the case no matter how we move the oil or which pipeline we build to move it. Low oil prices make that disadvantage even more acute. This means we have to put in place all the elements of a regional oil industry that can perform at a world-class level, and we have to do it now. This is the imperative for the Caspian oil industry in 1999.

Russia's troubles have reminded us that we can't rely on new demand from markets closer to the Caspian production and cheaper to serve. World market access is still the critical success factor, so we have to do everything in our ability to overcome our shipping cost disadvantage.

This means optimum efficiency, flexibility in relation to market conditions, and the best technological solutions. It means choosing the lowest-cost and most sensible pipeline options. It means working with the government to permanently reduce the cost of doing business and, in the short term, deferring all expenditures that are not absolutely necessary.

And perhaps most importantly – particularly in today's environment – the industry needs a stable and attractive investment climate: fair and fixed taxes, incentives and contracting free from corruption.

Even with major investments in place and the potential for new discoveries, all the oil companies who came to the Caspian in the 1990s now feel the pull of opportunities from other parts of the world, and they must review their priorities anew. Capital is tight and getting tighter, and it will remain tight for quite some time. Standards for new investment are high and getting higher.

The international oil market makes the rules – and they are the same for every country and company around the world. And while the Caspian may be geographically isolated from that market, it is not insulated from the price fluctuations that change the oil industry's fortunes from year to year, as they always will. If we're going to sustain momentum in the Caspian oil industry, we must have a world-class business environment not two or three years from now – but today.

I believe the new Caspian oil industry has the potential – and the will – to adapt, survive and even grow in this difficult period. And I trust that all the leaders of the region will take every opportunity to prove to their commercial partners that the Caspian can be as worthy of investment now as it has been in better times.

Updated: February 1999