CASPIAN OIL (A): TENGIZ1

Michael H. MoffettAndrew Inkpen

“Chevron Corp. said Monday that its joint venture with Kazakhstan to develop one of the world’s largest oilfields could produce 700,000 barrels of oil a day and involve a joint investment of $20 billion over 40 years.Earlier this month, Chevron and the former Soviet republic announced a preliminary agreement to developthe Tengiz and Korolev fields, estimated to be even bigger than Alaska’s Prudhoe Bay.”

– “Chevron to Pump Billions into Tengiz,” The Los Angeles Times, May 19, 1992.

“After grabbing a few hours of sleep, the visitors gathered in front of a snooker table on which their Kazakhhosts unfurled a giant set of two-dimension seismic charts and well logs, in effect a geological blueprint ofthe Tengiz field and its surroundings. Inspecting the seismic lines, Hamilton saw that some zigzagged up thecoast from Tengiz, and a few drifted offshore, clearly revealing carbonate reefs. Suddenly, said Hamilton,“we saw this enormous feature .. It wasn’t continuous coverage – a few lines of 2-D. But you could see theenormous reef,” meaning the offshore reservoir, twice the size of Tengiz, that had so tantalized Chevron. Asfor Tengiz itself, Hamilton could not find the bottom of the oil column, it was so deep.

Hamilton and his companions thanked the Kazakhs and suggested that they take a break. “Holy shit,”Hamilton blurted out when they were alone. “These were Ray Charles kind of structures – a blind man couldsee what they were.”

The Oil and the Glory: The Pursuit of Empire and Fortune on the Caspian Sea,Steve LeVine, 2009, p. 110.

The Tengiz Field (Tengiz means ‘sea’ in the Kazak language), was discovered by Soviet geologists in 1979,but was largely ignored for years as the Soviets focused their oil development efforts elsewhere. The fieldsaw some preliminary drilling in the mid-1980s, but only after Chevron (U.S.) entered into a joint venturewith the Kazakh government in 1992 did true scale development take place. Tengiz, when discovered, wasthought to be one of the world’s ten largest fields. But by the spring of 2011, although producing 700,000barrels per day (bbls/d), the joint venture was still yielding only half the oil which all involved agreed it couldand should. Chevron was under increasing pressure from its partners, including the Kazakh government, tobring the joint venture to its productive promise.

Tengiz and Kazakhstan

As illustrated by Exhibit 1, Kazakhstan lies to the north and east of the Caspian Sea, south of Russia, westof China, and to the north of a number of other “stans” including Kyrgyzstan, Uzbekistan, Turkmenistan, andIran. To its west, across the Caspian, lie Azerbaijan, Armenia, and Georgia. Although it borders the CaspianSea, the Caspian is itself land-locked, as is Kazakhstan, the world’s largest land-locked country, and theworld’s ninth largest country. Sparsely populated, it has a population estimated at 16 million. The countryis often classified as either Eastern European or Central Asian. Formerly a member of the Soviet Union, itwas the last to declare itself an independent republic from the Soviet state in December 1991.

Kazakhstan has the largest reserves of crude oil and gas in the Caspian Sea region, estimated to bebetween 9 and 40 billion barrels, putting it on par with OPEC members like Algeria and Libya. But findingit was not the same as producing it and marketing it.

1 Copyright ©2011 Thunderbird, School of Global Management. All rights reserved. This case was prepared byProfessors Michael H. Moffett and Andrew Inkpen for the purpose of classroom discussion only, and not to indicateeither effective or ineffective management.

2

Challenges were great both above and below the surface. The Tengiz field, below the surface, was a deepreservoir for its time, roughly 14,000 feet, but given its size, the deepest large scale producing field in theworld. It lay beneath a 900 foot deep salt dome, adding to the technical challenge. The reservoir was underextreme high pressure, about 0.82 psi/ft, when fields average roughly 0.45 psi/ft globally. The column ofcrude oil was estimated to be 1.6 kilometers thick. The reservoir was hot, averaging 200ºF. And last but notleast, the reservoir was extremely high in both natural gas and sulfur content. The resulting mix, hydrogensulfide (H2S), was highly poisonous to humans and corrosive in pipelines. Tengiz was a sour crude, averaging12.5% in sulfur, when anything above 0.5% was considered sour. Its production therefore required significantprocessing and sulfur extraction before transportation.

The Tengiz field, above the surface, was located in a remote, barren, and forbidding environment. It wassubject to annual swings in temperature from -25º F to 100º F. Infrastructure, particularly in the early years,was very basic and difficult, making construction and support costly.

Chevron, through a variety of political and relationship channels, succeeded in negotiating a 50% interestin the field in June 1990, one day after a summit meeting between President George Bush of the United Statesand President Mikhail Gorbachev of the Soviet Union. But the ink was barely dry when the Soviet Unionbroke apart. With Kazakhstan’s declared independence in December 1991, negotiations began again.

Chevron would be the first major foreign investor in Kazakhstan following its independence, butKazakhstan’s independence was a tenuous one. Russia continued to have strong strategic and financialinterests in the hydrocarbon resources of Kazakhstan. The two countries shared a 4,250 mile border and acommon people; Kazakhstan was home to more than six million ethnic Russians. The war memorial in thecenter of Almaty, the traditional capital of Kazakhstan, celebrated the Twenty-Eight Panfilov Guardsmen –Kazakhs – who defended Moscow from the German offensive in September 1941. The linkages betweenRussia and Kazakhstan ran deep.

Exhibit 1. Kazakhstan’s Major Oil Fields

Tengiz

Karachganak

3

Richard Matzke, President of Chevron Overseas Petroleum, eventually concluded what was termed a“careful agreement” with the Kazakh government in April 1993. Kazakhstan President Nursultan Nazarbayevand Chevron's Chairman, Kenneth Derr, signed a 40-year agreement to found Tengizchevroil on April 6, 1993in Almaty. The business, termed a partnership, allocated a 50% interest in the field to Chevron as well asnaming it the operator.2 Chevron pledged $20 billion over the next 40 years.3 The business organization,TengizChevroil LLP (TCO), was structured as a joint venture between Chevron and the Kazakh state oilcompany rather than the more common forms used in the global oil industry, oil concessions or productionsharing agreements.

One of Chevron’s concerns from that beginning was that Tengiz’s production costs were consideredmoderate to high by global standards, about $3/bbl. Small fields around the world typically averaged $3.5/bblto $4.50/bbl, and a field of the scale of Tengiz should see significantly lower per barrel costs forcompetitiveness during low crude oil price periods. The complexity of Tengiz, however, its pressure, depth,sulfur content, all added significantly to both capital and operating costs.

In an attempt to manage what it considered high political and country risks, Chevron planned to investgradually, using reinvestment of earnings to make up the majority of new investment. For example, Chevronhad carefully avoided making significant up-front payments. One such clause required that annual productionreach 250,000 barrels per day (bbls/d) before Chevron had to make its first $420 million installment on thepurchase price of $800 million. Predictably, the Kazakhs saw this “invest as you go” approach as indicativeof a low level of commitment and relations between the parties were strained from the beginning.4

Pipe Dreams

“All dressed up and no place to go. That's the dilemma Chevron Corp. faces in far-off Kazakhstan. Thenation's third-largest oil company is sitting on one of the world's biggest oil fields in the landlocked formerSoviet republic. Under the lunar-like landscape of the western Kazakhstan desert -- where temperatures cansoar to 130 degrees in summer and plummet to 30 below in winter -- lies a huge pool of crude.

Called the Tengiz Field, it holds an estimated 8 billion barrels of oil, rivaling the 12-billion-barrelPrudhoe Bay Field in Alaska. Trouble is, after more than two years of work and a $1 billion investment,Chevron has yet to make much money on Tengizchevroil, its 50/50 joint venture with the government ofKazakhstan.

Part of the problem is that the company cannot get more than a dribble of crude out of Kazakhstan.That's because the only way out is through Russian territory, and Moscow refuses to allow more oil to flowthrough its old pipelines. But San Francisco-based Chevron's biggest problem is that an effort to build a newoil pipeline around the Caspian Sea and through Russia to the Black Sea has been stymied.”

– “Chevron Struggling in Tengiz,” by Kenneth Howe, San Francisco Chronicle, September 25, 1995.

Somewhat unique to the Caspian, the right to produce oil did not assure the owner much in terms of its rightto sell oil. Transportation would prove the strategic fulcrum for negotiations for the following decade. Asproduction at Tengiz began expanding during the mid-1990s, one of the primary problems for Tengiz oil wasaccess to Western markets. Chevron’s interests were in getting the oil to the Black Sea, where it could thenbe moved by tanker through the Bosporus Straits to the Mediterranean and more profitable markets.

2 Ownership interests have changed over the years. In 2011 Tengiz was 50% owned by Chevron, with ExxonMobilholding 25%, KazMunaiGaz (Kazakhstan) 20%, and LukArco, a subsidiary of Lukoil (Russia) 5%.

3 “Kazakh Fields Stirs U.S.-Russian Rivalry,” The Washington Post, October 6, 1998, p. A1.

4 Chevron also balked at the traditional Soviet habit of expecting foreign investors to support non-business related socialinfrastructure such as roads, schools, and hospitals, limiting social infrastructure spending to 3% of total investment.

4

Once the oil reached the Black Sea, a number of potential market destinations opened up. All of thecountries bordering the Black Sea – Russia, Ukraine, Romania, Bulgaria, Turkey – had their own oil and gasdevelopments and transportation interests. Of particular interest for Kazakhstan oil, however, was the abilityto potentially move its oil farther west through Romania or Bulgaria to markets in Poland by pipeline, or evento Western Europe via the Mediterranean after passing through the Bosporus Straits. But the Straitsthemselves were a problem, as shipping and tanker traffic was now very high, at capacity given the one-ship-abreast passage, as well as anxiety over the possibility of tanker accidents and environmental risks.

One alternative would be for Tengiz oil to gain access to the Odessa-Brody pipeline in the Ukraine. TheOdessa-Brody pipeline, finished in 2001, sat idle for three years because Russia would not allow Kazakhstanoil arriving at Novorossiysk to enter the line and compete with Russian oil and gas in Europe. (The pipelinewas eventually reversed, moving Russian oil southwards to Odessa and the Black Sea for export to theMediterranean.) If, however, Kazakhstan could get its oil to Batumi in Georgia, it would be free of Russiancontrol to move the oil across the Black Sea to Odessa, and then on to Poland via the Odessa-Brody pipeline,once again reversing the pipeline back to its original intended direction.

The construction of a pipeline to the Black Sea quickly became a lightning rod for controversy betweenthe Kazakh government, Chevron, and the Russian government. Russia wished to control the flow of oil fromTengiz, but did not have the capital to fund pipeline construction across Russia to the Black Sea. Chevronopenly refused to invest what it saw as $3 billion to build a pipeline which would be controlled from Moscow.The only real solution, at least temporarily, was a massive mobilization of rail use. By 2000 six trains wereleaving Tengiz daily for the 1500 kilometer trip to the Black Sea. Rail was expensive, however, averaging$6/bbl in the early years.5

Exhibit 2. The CPC Pipeline

Caspian Pipeline Consortium (CPC)

- 980 miles in length from the Caspian Sea oil depositsto the Russian Black Seaport of Novorossiysk

- Phase I capacity of 650,000 bbl/d with a planned capacity expansion to 1,400,000 bbl/d when Tengiz production justified the additional investment

- The consortium has 11 different members, including Chevron (Tengiz operator) and the Russian government (ultimate pipeline control)

5 “Kazakhstan Field’s Riches Come with a Price,” Christopher Pala, The St. Petersburg Times, October 23, 2001.

5

John Deuss, a Dutch oil trader, banker, and general oil entrepreneur, a “fixer” in industry jargon, movedquickly to exploit what he believed to be a golden opportunity to build and control a pipeline for Tengiz oil.Deuss believed that if he could place himself between Tengiz and access to Western markets he could demandsignificantly higher transport tariffs than those traditionally paid by pipeline operators (typically $1 to $1.5per barrel). But Deuss needed capital. Chevron estimated pipeline construction costs at $1.25 billion, butDeuss planned to use a series of older Russian pipelines to cut construction costs to $1 billion.

Deuss had a strong relationship with the Omani royal family, and they were willing to make a minimalequity contribution, $25 million, towards pipeline construction. Deuss’s strategy was to use large quantitiesof debt (not unusual for pipeline financing). Debt financing, however, would require that Chevron committo a throughput agreement guaranteeing pipeline revenues. Deuss moved to form the Caspian PipelineConsortium (CPC), designed to follow the routing described in Exhibit 2.

As part of his capital raising campaign, Deuss approached the European Bank for Reconstruction andDevelopment (EBRD) to gauge its interest in lending for pipeline construction. Although EBRD had beenfounded specifically for the purpose of aiding in the development of business in the region, it objected toDeuss's proposal that pipeline profits be granted a tax waiver by both the Russian and Kazakh governments.EBRD saw this as inconsistent with its mission of building solid market economics in former Soviet states.

Chevron’s CEO, Ken Derr, did not trust Deuss and considered his positioning on the pipeline andproposed pipeline tariff of $3.25/bbl profiteering. But Chevron’s position itself was tenuous, as it had bookedthe Tengiz reserves very aggressively (assuming nearly one-third recovery of the oil-in-place), and neededto ramp-up production quickly, which it could not do until a pipeline became operational. As pipelinenegotiations stretched on, Chevron’s share price and the Kazakh economy both dwindled. Kazakh presidentNursultan Nazarbayev became increasingly critical of John Deuss’s positioning:

“The problem is that money has to be invested. What difference is it to me if it is Americans, Omanis,Russians? The main thing is that oil comes out.”

– Kazakh President Nursultan Nazarbayev

Kazakhstan then brought in its own fixer, an American named Jim Giffen. Giffen, a friend to PresidentNazarbayev and the original relationship link between Chevron and Kazakhstan on Tengiz, now movedquickly to bring other players to the table for pipeline financing. Giffen approached Lou Noto, CEO of Mobil(U.S.), as a possible investor in the pipeline. Noto was interested, but only if Mobil could gain an interest inTengiz itself. Eventually Noto got what he wished, a 5% interest in Tengiz in exchange for $145 million infunds which the Kazakh government badly needed.6

In the fall of 1995 a series of events expedited the pipeline’s construction. First, John Deuss’s relationshipwith the Omanis was broken when his key link, Omar al-Zawawi, a member of the royal family, was killedin an automobile accident. Deuss was pushed to the sidelines in future discussions. Following that, Lukoilof Russia demanded that it gain some interest in Tengiz in order for Russia to support and allow the pipeline’sconstruction. Although Chevron did not wish Lukoil to gain a foothold in Tengiz, the political tensionsbetween Washington and Moscow over a Western oil company developing Kazakh oil and transporting itacross Russian territory to gain access to the Western market was simply too much. Russian interest was inthe words of one analyst, a “necessary evil.”

6 Much later it was announced that Mobil purchased 25% interest in Tengiz for $1.05 billion. It is this Mobil interest thateventually resulted in ExxonMobil’s interest in Tengiz after Exxon’s acquisition of Mobil.

6

But Lukoil had no money. The solution, ironically, was for another American oil company, ARCO, togain a partial interest in Lukoil itself in return for providing a capital injection which would allow LukArco(Kazakh subsidiary now formed) to buy its way into Tengiz, a 5% interest in return for $200 million.

After years of negotiations a final pipeline consortium was created between eight companies and threegovernments to build what would now cost $2.7 billion.7 Russia agreed to a two-phase development. The firstphase would commence immediately. The CPC line would travel 1,510 kilometers (940 miles), use fivepumping stations, and move 650,000 bbl/d. It was indeed built as an extension of an older oil pipeline systemwhich passed across the northern end of the Caspian Sea, as seen in Exhibit 2. Full-time operations of the firstphase began in 2003. A second phase, expanding the line’s capacity to 1.4 million bbl/d, would be undertakenwhen production at Tengiz justified it.8 Production now justified it, but Chevron and its partners had madelittle progress in moving the CPC into phase two.

The Environment

Tengiz also posed major environmental and safety challenges for TCO. In 1985, before Chevron ever gainedentry to Tengiz, an early Tengiz well, well #37, exploded sending a 200-meter high column of gas and oilinto the air. Because the gas contained deadly levels of hydrogen sulfide, the plume was ignited to consumethe gases. The result was a towering inferno visible for nearly 60 miles (and was picked up by U.S. satelliteswatching Kazakhstan at the time). The fire burned for more than a year before Red Adair, the world’s leadingexpert on oil fires based in Houston, was successful in capping it. Although only suffering one fatality, theenvironmental impacts were significant.

In the following years as oil and gas developments were dictated by Moscow, the Kazakhs worried thattheir most precious delicacy, caviar, the eggs of the sturgeon found in the Caspian and Black seas, could beput at risk.9 Any suggestion of oil and gas development near the Caspian, home of the most famous belugasturgeon and caviar, faced serious public opposition. Baku, devastated by oil development in the late 19th

century and lying just across the Caspian, served as a reminder of how devastating unregulated oildevelopment could be, as illustrated by Exhibit 3.

Sulfur was a major problem. Not only did the oil and gas produced from Tengiz require extensiveprocessing for sulfur reduction, dispensing with the sulfur itself was a continual problem. By early 2001Tengiz had 4.5 million tons of sulfur spread out on football-field-sized ‘cakes’ of sulfur 7.5 meters thick(Exhibit 4). Transporting sulfur to European markets was costly. Chevron spent more than $40 million ona pellet processing facility in 2001-2002 to expand marketability (pellets were more attractive commerciallythan powdered sulfur), but with mixed success.

“I don’t think any of us understood the complexities of what were about to get ourselves involved in. Whatthe Kazakh government is worried about is fixing some of the issues that were relatively unknown when someof these projects began. The production of oil and gas in the Caspian is very complex, very difficult. Ten yearsago, fifteen years ago when contracts were written, people didn’t understand the complexities.”

– Richard Matzke, Chevron Texaco Vice Chairman of the Board, 2007.

7 The consortium consisted of British Gas (2%), Chevron (15%), Eni (2%), ExxonMobil CPC (7.5%), Kazakhstan (19%),Kazakhstan Pipeline Ventures (1.75%), LukArco (12.5%), Oman (7%), Oryx (1.75%), Rosneft-Shell (7.5%), and Russia-Transneft (24%).

8 “A Big Oil Field in Central Asia Isn’t Earning What Chevron Planned On,” The New York Times, July 22, 2010.

9 During the 1970s the Soviet government had regularly conducted nuclear tests in Kazakhstan.

7

Exhibit 3. Baku’s Environmental Legacy

Source: “The World’s 25 Dirtiest Cities,” Forbes.com. Baku is number 1 on the list.

Exhibit 4. The Tengiz Complex and Sulfur Storage

Source: “Kazakhstan Field’s Riches Come With a Price,” by Christopher Pala, The St. Petersburg Times, October 23, 2001.

8

Sulfur was not the only problem. Tengiz had been flaring massive quantities of natural gas for years giventhe limited capability to capture and transport it. Kazakh President Nursultan Nazarbayev had argued foryears that TCO needed to capture and utilize the gas, not flare it, but the consortium had argued that thecapital costs for capture were large and the marketability of gas impossible since the only gas pipelineavailable was to southern Russia and the Russians would not pay for the gas.

The oil field’s other eye-catching features are the five flaring towers that, day in and day out, send plumesof smoky orange flames into the air. With all gas pipelines leading to Russia – a country awash in gas –building the facilities to break it down and sell to Russia is not an effort that makes any economical sense.

– “Kazakhstan Field’s Riches Come with a Price,” Christopher Pala,The St. Petersburg Times, October 23, 2001.

As 2001 drew to a close, the Kazakh government pressed TCO to stop its flaring, handle and market thesulfur more aggressively, and expand Tengiz production volumes. After more than $2 billion in development(which was already the largest foreign investment in any former Soviet state), the project needed to enter asecond and more costly stage: to invest in technology to recover and re-inject the gas into the reservoir. Asthe director of TCO at the time put it, “Selling oil is more profitable than selling gas.”10

Growing Tension

Tengiz’s on-going operations from 2002 to 2007 were in constant conflict with both the Kazakh governmentand the CPC pipeline consortium. Not surprisingly, most of the conflicts involved money and politics.

In 2002 Chevron had proposed financing the planned expansion of Tengiz production with thereinvestment of oil export proceeds, as part of its continuing “invest as you go” strategy. The Kazakhgovernment objected. In addition to implicitly supporting a slower rate of growth, the reinvestment wouldreduce the consortium’s taxable profits and payments to Kazakhstan dramatically – and the governmentneeded the money. TCO then announced it was suspending the next stage of development, a $3 billion secondgeneration gas injection project.

In January 2003, after Kazakh courts confirmed fines against the consortium and after much publicdebate, Chevron agreed to finance new production capacity with foreign capital, as well as guarantee Kazakhtax authorities a minimum of $200 million per year regardless of consortium profitability. In conjunction withthis agreement, President Nazarbayev pushed through a new foreign investment law which guaranteed thatexisting foreign investments in the country would not be revised, but that no such guarantee would beprovided future investments.11 Phase two of the project was underway, with significant expansion ofproduction and reduction of flaring. But the sulfur debate continued.

“The two sides [ChevronTexaco and the Kazakhstan government] seemed to patch up some of theirdifferences in December in an equally public display of affection—at least on the Kazakhstani side. It isperhaps surprising, given the degree to which Tengiz is seen as a template for development in the region, thatthe two should have fallen out at all. As the biggest producer of oil in Central Asia outside Russia, and thecountry with the most to gain from an expected surge in demand for its exports, Kazakhstan should becultivating foreign investors. Instead, it is in danger of putting them off.

– “Field of Dreams,” The Economist, January 9, 2003.

10 “Kazakhstan Field’s Riches Come with a Price,” Christopher Pala, The St. Petersburg Times, October 23, 2001.

11 “Kazakhstan’s New Foreign Investment Law,” Robert M. Cutler, Central Asia-Caucasus Analyst, February 26, 2003.

9

In 2006 Kazakh environmental authorities demanded that TCO shut down operations as a result of thecontinued open-air storage of sulfur. TCO believed that the environmental debates were partly the result ofintra-Kazakhstan tax debates, as the Kazakh federal government had recently garnered all consortium taxesto the federal level, eliminating tax flows to the producing region’s government. The local area courts at thattime began imposing ecological damage assessments and fines on the consortium. After paying fines of morethan $150 million in 2006, the consortium agreed to spend another $300 million over the 2007-2010 periodon a variety of environmental protection measures, again primarily around sulfur storage.

TCO now made major new investments in both sulfur pellet production facilities as well as sour gasinjection (SGI) facilities, in which the hydrogen sulfide gases were re-injected into the Tengiz reservoir.Tengiz now had six sulfur processing facilities in operation, the last of which alone cost $7.4 billion. The SGIfacilities came on-line in early 2008, allowing Tengiz production to hit more than 540,000 bbls/d in 2008,and 700,000 bbls/d in 2009, as seen in Exhibit 5.

The Caspian 2010

Thirty years after the field’s discovery, Tengiz production was only now approaching levels thoughtimminent a decade ago. TCO continued to postpone additional production capacity until transportation –primarily CPC pipeline capacity expansion – happens.

0

200,000

400,000

600,000

800,000

1,000,000

1,200,000

Exhibit 5. Tengiz Production and Events

Chevron formsTengizChevroil

(TCO) and enterspartnership with

Kazakhstan todevelop Tengiz

CPC pipelineconsortium

finally organizedMay 1997

TCO & Kazakhgovernment debate

how Tengizexpansion to be

financed

Bbls/day

TCO fined foropen-air

sulfur storage

TCO completes$7.4 billion 2nd expansion

of Tengiz includingSour Gas Injection (SGI)

facilities and sulfurprocessing plants

TCO commitsto $15 billion

expansionby 2016

Tengiz field discovered in 1979 and operated by Kazakh governmenton minimal level until 1992.

In 2010 TCO sending 420,000 bbls/d through CPC, another 200,000 bbls/d by rail to the Black Sea, and100,000 bbls/d to Baku and BTC pipe

TengizChevroil (TCO): Chevron 50% (US), ExxonMobil 25% (US), KazMunaiGas 20% (Kazakhstan), LukArco 5% (Russia).

10

By 2009 Tengiz was exporting 400,000 bbls/d via the CPC pipeline (at capacity) and another 300,000bbls/d (plus sulfur and liquefied petroleum gas, LPG) by rail.12 The rail routes are complex; 200,000 bbls/dgo north around the Caspian and across Russia to the Black Sea, with the other 100,000 bbls/d going southto a Kazakh port on the Caspian, across the Caspian Sea by barge to Baku, where it is loaded once again onrail cars for passage to the Black Sea port city of Batumi in Georgia. Rail transportation continues to becostly, roughly $6/bbl, and capacity limits are in sight. And although both transit routes end at the Black Sea,one is Russian-controlled and the other is not.

The summer of 2010 saw a number of new events, some positive, some negative, for Tengiz’s outlook.First, the Russian government, which had repeatedly argued that it never promised an expansion in CPC’scapacity, announced it would soon begin the expansion after all. TCO responded soon after that it would alsobegin a major expansion of Tengiz, estimated at $16 billion over the 2012 to 2017 period, but only if anumber of other new issues were settled with a variety of government ministries.

C Export tax. The Kazakh Oil and Gas Ministry announced in July that it was re-imposing an export taxon all hydrocarbons, and Tengiz would have to pay. Previously the joint venture had not been subject tothe tax. TCO argued that it had a permanent exemption under its operating agreement.

C Illegal production. The Oil and Gas Ministry launched a criminal investigation against TCO in July forwhat it termed “illegal production,” for producing oil and gas from depths at Tengiz not allowed underits production agreement. TCO argued that the production agreement had no such restrictions.

C Illegal flaring. The Kazakh Environmental Ministry imposed a $1.4 million fine on TCO for recent gasflaring. TCO, which had recently finished a $258 million investment in gas capture and recyclingfacilities, explained that the flaring was the result of an emergency situation.

C International employee work permits. The Kazakh Labor Ministry announced in August that allinternational employees of TCO would now be required to have both work visas and work permits. Thework permits, never required before, are customarily much more difficult to obtain.

Despite Chevron’s continuing problems with the Kazakh government and the difficulty in producing andmoving ever-greater volumes of crude from Tengiz, the development had been an economic windfall toKazakhstan. As illustrated in Exhibit 6, total payments to Kazakhstan had reached $10 billion in 2010,approaching 10% of the country’s entire GDP. Cumulatively, since startup, TCO had contributed $45 billionto the newborn country.

Although Tengiz was now producing and profitable, it was still far from reaching its productive promise.A field with a productive capability of more than 1 million barrels per day continued to produce only 70%of that. Chevron now needed to reassess prospective returns on new investment in Tengiz.

“Kazakhstan’s plans to boost oil output by 60 percent over the next decade may hinge on the state’s abilityto reassure foreign majors that their billion-dollar investments will be protected by law, industry officialssaid. Foreign oil executives say privately they are concerned about growing state influence in Kazakhstan’slucrative energy sector and changes to the tax regime in a country with slightly more than 3 percent of theworld’s recoverable oil reserves.’The laws are relatively simple, but they leave too much to the discretionof the government,’ said a lawyer active in the energy sector.”

– “Kazakh Oil Plans Vex Foreigners,” The Moscow Times, October 13, 2010.

12 “New Regional Export Capability Critical to Realising Kazakhstan’s Oil Potential,” Ian MacDonald, Vice Presidentof Chevron Europe, Eurasia and Middle East Exploration and Production, Exploration and Production, Volume 7 Issue2, 2009, p. 27-30.

11

0

1,000

2,000

3,000

4,000

5,000

6,000

7,000

8,000

9,000

10,000

1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

Payments Distributions Royalties & Taxes

Exhibit 6. TCO Payments to Kazakhstan (millions of US$)

Payments = payments to employees and Kazakhstani goods and services, including salaries, rail and pipeline tariffs, and payments to local suppliers and other. Distributions are dividends distributed by the joint venture to Kazakhstan (KMG). Royalties and taxes are composednearly entirely of corporate income taxes paid by the joint venture to the Republic of Kazakhstan. Source: Tengizchevroil, April 2011.