Kazakhstan's oil supply chain management challenges.

Kazakhstan is endowed with rich oil reserves, which provide an important source of revenues for stable economic growth and improvement of the country's living standard. This paper addresses the challenge the Republic of Kazakhstan faces in managing its oil supply chain. The country's capacity for refining crude oil is minimal and a substantial portion of that refining capacity is outside the Republic; added to that, most of the pipelines and refineries to export oil to international markets are jointly managed by the Republic and multinational corporations (MNCs). Thus there are political, technological and financial risks for the republic's oil supply chain.

Introduction

Kazakhstan has considerable deposits of oil; however, the country faces a serious disadvantage of not having any direct access to the open sea, as the Caspian Sea is landlocked. While her oil industry's upstream cost, i.e., the cost for exploration, development and production of crude oil, may be similar to that of most other oil producing nations, its downstream cost, i.e., transportation of crude oil to the refinery, refining and transportation to markets in particular, is more costly (Sridharan, Canines and Patterson; 2005). For Kazakhstan to transport the oil to world markets, the industry has to depend on pipelines (Cavenagh, 1999) through other countries. Also, maintaining such an operation requires a large number of skilled workers, but Kazakhstan does not have enough of them.

As in other oil producing nations, Kazakhstan's oil industry revenues directly depend on the worldwide prices for oil and oil products, based on supply and demand; and revenues depend on the cost of production and transporting the final product to customers (Rasizade, 1999). For Kazakhstan's oil supply chain, the physical distribution infrastructure connecting supplies of crude oil to refineries and to the world markets through pipelines, has been challenging and costly. Moreover, currently Kazakhstan is equipped with only a few refineries and therefore the major portion of Kazakhstan's crude oil is being refined in Russia. Recently, China has invested heavily in the construction of pipelines across the Republic of Kazakhstan to supply the increased demand for oil in China. Thus Kazakhstan has to manage political, technical and financial risks in the integration of her oil supply chain (Gaudenzi and Borghesi, 2006; Lockamy and McCormack, 2004).

In the era of rapid technological development and globalization, it is imperative that every nation adapts to such an environment. Supply chain management has become an important means for sustaining competitive advantage for all successful industries and businesses (Magretta, 1998). The objective of every supply chain, including the global oil industry, is to maximize the overall value generated. The value a supply chain generates [to an organization, or to a nation] is the difference between what the final product is worth to the customer and the effort the supply chain expends in filling the customer's request. For most commercial supply chains, value will be strongly correlated with supply chain profitability, the difference between the revenue generated from the customer and the overall cost across the supply chain (Chopra and Meindl, 2003; Lee, 2002; Cavinato, 2002). The Republic of Kazakhstan will do well to monitor--especially to sustain growth--the overall value of her oil supply chain in the coming years.

Oil producing countries and global supply chains

Energy makes the wheels of global supply chains go round (Bud La Londe, 2006). A typical oil supply chain begins with the crude oil producer, next, the oil moves to the refiner, the transporter, the retailer and finally to the gas pump where a customer receives the product. The top world oil producers are Saudi Arabia, Russia, the United States, Iran, Mexico, China, Canada, United Arab Emirates, Venezuela, Norway, Kuwait, Nigeria, Brazil, Kazakhstan and Iraq. The Organization of the Petroleum Exporting Countries (OPEC) controls major crude oil by setting production quotas. The values (revenue opportunities) are added by processing and chemically changing the crude oil, which is called "refining." A 42-gallon barrel of crude oil makes about 19 1/2 gallons of gasoline, nine gallons of fuel oil, four gallons of jet fuel and 11 gallons of other products, including lubricants, kerosene, asphalt and petrochemical feed-stocks to make plastics. This adds up to more than 42 gallons because of refinery gain (www.gravmag.com, 2006). It is important to note that greater economic rewards can be gained only with well-integrated global oil supply chain management.

Oil Production Sharing Agreement and Risks in Kazakhstan

The Ministry of Energy and Mineral Resources of Kazakhstan and the Ministry of Fuel and Energy of Russia, periodically set quotas for Kazakhstan's oil flow through Russian territory. For example, on December 25, 2000 the quota for Kazakhstan was set at 17.3 million tons. The memorandum between Kazakhstan and Russia of October 9, 2000 sets the principle of "a single route," whose sole operator is the Kazakh Oil Company. Annual quotas depend mainly on the political relations between the two nations.

Besides politics, there is also a technical risk factor, i.e., the high degree of pipeline wear and deterioration, which may hamper the effectiveness and quality of services provided to exporting countries. In addition, the lack of proper maintenance of these oil pipelines does exist primarily due to the fact that a large number of well-trained local technicians and engineers who are required are not available to day (Doing Business with Kazakhstan, 2004).

Kazakhstan's oil pipeline systems were built in the '70s (more than 60 percent of oil pipelines of the Western branch, to be exact) and the rest in the '80s (75 percent of the Eastern branch). Thus, at the end of the year 2000, 55 percent of the pipelines were 10 to 20 years old and 12 percent had been used for more than 30 years. Only 1 percent has been used for less than 10 years. As time goes by, those pipelines are getting even older and that means not only the risk and cost of maintaining them would be larger, but also the situation presents serious technical problems as well for the Republic of Kazakhstan (Petroleumjournal.com, 2006).

Kazakhstan's Oil Fields and Production

Mangistau and Atyrau oblasts (provinces) are the main oil producing areas in Kazakhstan (see Exhibit 1). They account for more than 70 percent of the total oil extracted in the Republic. The other three extracting regions, Aktyubinsk, Kzylorda and Zapadno Kazakhstanskaya, account for the remainder. International oil projects have taken the form of joint ventures, production sharing agreements and exploration/field agreements.

Oil is recovered from 55 fields. The largest of these fields are: Tengiz (some one billion tons of predicted oil reserves); Karachaganak (340 million tons in oil reserves, more than 1.2 billion tons in gas condensates and more than 1.3 trillion cubic meters of natural gas); Uzen (with over 1.5 billion tons of geological hydrocarbon reserves, of which more than 200 million tons are extractable) and Kumkola (with 350 million tons of oil reserves, of which 80 million tons of oil and 75 billion cubic meters of natural gas are proven). The Caspian and Aral Sea shelf also contain significant reserves. Currently, there are only three major refineries in Kazakhstan: Atyrau, Shymkent and Pavlodar (see Exhibit 2).

Kazakhstan's Oil Production and Distribution Costs

A multitude of different schemes exist for dividing oil revenues between the host country and the foreign partner. The usual target for distribution of revenue from production to market is about 85 percent to the host country and 15 percent to the oil company. This ratio can be construed in a variety of different ways with different types of contractual forms; it also depends on the host country's laws and preferences, but in general oil companies target this ratio. This number has varied over the years. For example, in Saudi Arabia the ratio is much higher in favor of the Saudis due to huge reserves and lower production costs. In the Caspian, the ratio is likely to be lower due to additional transport costs of getting the oil out of the region, i.e., pipeline construction costs and transit fees and political risks in the area. Part of the problems with signing contracts with Caspian nations has been the nations' unwillingness to recognize the economic necessity of decreasing the ratio (Feiveson, 1998).

The upstream breakdown of costs is about 10 percent for exploration to find an economical field (odds are about one in 10 holes drilled will hit a commercial-sized field), 80 percent (or higher) to develop the find and 10 percent operating costs to produce the oil. Exploration costs are cash expenditures, which include payments for exploration licenses to the host countries. Development costs are capital costs depreciated over time and operating costs pay for themselves with the sales of crude oil production. Downstream costs include transportation of crude to the refinery, refining, transportation of products to market and marketing.

If one were to examine the cost breakdown of a gallon of gas (called petrol in some countries) averaged around the world, from ground to market, the distribution would be approximately:

* 2.5 percent for exploration

* 12.5 percent (or more) for production and development

* 20 percent to the host government

* 2.5 percent for transportation to a refinery

* 7.5 percent for refining

* 2.5 percent to transport to market

* 2.5 percent for marketing

* 50 percent in taxes to the consumer at the pump

For example, the costs per barrel for export of Tengiz oil are: lifting costs (the costs to get crude oil extracted from below surface and bringing it to the ground level) $2, pipeline costs $1.42, transit fee $3, shipping by oil tanker (including other means) $1.23. The total comes to $7.65.

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