What’s Behind ConocoPhillips’ Exit From The Kashagan Project?

ConocoPhillips (NYSE:COP) has struck a $5 billion deal with Indian state-controlled oil and gas company ONGC Videsh Ltd. (OVL) to sell its 8.4% stake in the North Caspian Operating Company (NCOC), the consortium developing the Kashagan field in Kazakhastan. Conoco had announced last month its intention to sell its stake  in the project which has been plagued for long by cost and time overruns. The Kashagan field is the world’s biggest oil discovery since 1968 and is estimated to hold approximately 40 billion barrels of oil. It has big names like ExxonMobil, Royal Dutch Shell, EnI and Total as stakeholders (each with a 16.8% stake). Other stakeholders are Inpex (7.56%) and the Kazakh state-owned firm KazMunaiGas (16.8%). The field is expected to produce its first oil in 2013. ^[1]

So why would ConocoPhillips look to exit a project of such scale and significance?

The factors driving this decision are multiple and complex. From a business perspective, the Kashagan project is expected to provide Conoco with a lower return on capital than what it can generate from investing in shale assets in the U.S. The company has been looking to generate up to $10 billion through asset sales this year. It intends to spend this money to reduce debt and invest in future growth in the next five years. There are also political risks involved in doing business in Kazakhastan where the business environment in strategic sectors like oil and gas is subject to political interference.

While business strategy and company focus have a role to play, the history of how the project has been handled so far would have surely been a factor behind ConocoPhillips decision. The stakeholders of the project have been constantly at loggerheads over various issues and the operator has been changed twice. EnI is currently the field operator for the project.

Below we provide a quick background on this project and provide further analysis on what this sale means for ConocoPhillips’ business.

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What Makes The Kashagan Field Unique?

Although it is the biggest oil discovery in decades, Kashagan is one of the most challenging fields to develop and operate. For one, the oil field itself is geologically complex and fragmented. The winters are harsh and ice packs could potentially wreck the oil rigs. It has oil that is heavily suffused with hydrogen sulfide, a dangerous gas. The concentrations of this gas are high enough to kill a person in a single breath. And the oil is buried around two and a half miles below the seabed under enormous pressure. ^[2]

Technical challenges apart, there are a number of geopolitical and environmental factors at play as well. For more details, you can read a previous article we wrote about the project.

Project History

The Kashagan project has seen costs escalate several fold over the last decade. The oil was discovered in 2000, the development plan was approved in 2004, and the oil was supposed to start flowing in 2008. However, costs ballooned from an original estimate of $57 billion for the whole project to $187 billion, resulting in production targets being cut to 450,000 barrels per day. The second phase of the development, expected to boost output to nearly 1 million barrels per day, may not happen until the next decade. First production is expected to come online in mid-2013. ^[3] Constant infighting among project stakeholders hasn’t helped matters.

Initial production is expected to be about 400,000 barrels per day only, which seems insignificant considering the time and efforts invested so far. While production may rise to 1.5 million barrels per day in future, it’s not clear if the stakeholders will still be able to generate a decent return on their capital. The next phase will require Conoco to fork out more money with future project outlook still hazy. ^[4]

What ConocoPhillips May Have Thought

We think that internal deliberations at Conoco may have concluded that the costs were getting out of hand and returns may not be all that attractive to justify further involvement. Besides, the company can generate much higher returns by investing further in shale oil and shale gas assets in the U.S. where the operating environment is easy, quality assets are available and development costs are low. Considering that the company has stated that it aims to generate 3-5% compounded annual growth rate in production and margins over the next few years and also pay high dividends to shareholders, it will definitely need to invest in assets with a high return on capital. From that perspective, it makes sense to get out of a project like Kashagan which is mired in too many uncertainties.

The capital expenditure budget of the company is $15-16 billion annually over the next five years and Kashagan would have taken a large chunk of it had Conoco persisted with its involvement in the project.

Did Conoco Get Itself A Good Deal?

The book value of these assets is close to $5.5 billion which implies that Conoco will take a charge of roughly $500 million on its balance sheet in the fourth quarter. Despite that, $5 billion looks to be a fair value considering that the project is yet to start producing oil, is still plagued by problems and may not provide a significant upside in the future.

The deal is subject to approval from the Kazakh and Indian governments as well as other partners in the project who have the first right of refusal on the sale. It is believed that Exxon or Shell are unlikely to exercise this option given that they have spent enough already without seeing any benefits so far. KazMunaiGas hasn’t commented on the deal at the time of writing. It may certainly be keen to lap up Conoco’s stake given that the Kazakh government has been seeking to increase its stake in foreign-owned oil and gas projects to boost its share of revenues and profits as well as exercise greater management control. Lyazzat Kiinov, CEO of KazMunaiGas, made a statement to this effect to reporters last month. However, we doubt if KazMunaiGas has the requisite funds available. In May earlier this year, consortium partners agreed to cover $1 billion in project costs owed by KazMunaiGas which was short on funds.

We recently revised the Trefis price estimate for ConocoPhillips to $62, which is 10% higher than the market price.

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1. ONGC-ConocoPhillips strike $5 billion oilfield deal, Reuters [↩]
2. In Caspian, Big Oil Fights Ice, Fumes, Kazakhs, RigZone [↩]
3. ConocoPhillips ‘to sell’ Kashagan stake, UpstreamOnline [↩]
4. ConocoPhillips to Sell Kashagan Stake for $5 Billion to ONGC, Bloomberg [↩]