Relationship of “NC KAZMUNAYGAS” to the government

  Taken in concert, this legislation is designed to create an uneven playing field in the country, one which favors the interests of NC KMG and its daughter companies.

Pursuant to two presidential decrees in 2006 (from January and May), the government shares of  KMG Exploration and Petroleum were transferred to a new holding company “AO Samruk Holding” which was created at the alleged urging of McKenzie, Inc. , to sharply reduce the role of ministerial corruption in the running of state-owned corporation.  Samruk, does not actually run these companies, but is charged with the responsibility of managing the portfolio of shares, functioning as an asset management company.  It votes the government shares, and so effectively establishes the developmental and other policy guidelines for the company.

In October 2006 former BAE chairman Sir Richard Evans, was named chairman of the company. Coincidently BAE owns 49 percent of Air Astana, Kazakhstan’s largest airline. Former Minister of Trade and Industry SuatMinbayev (generally viewed as a trusted ally of Nazarbayev) served as the first Chairman.  TimurKulibayev holds the post of deputy chairman in the five person board.  The Minister of Economics and the Minister of Finance also serve on the Board, as does another independent director.But the structure still gives President Nazarbayev an almost automatic majority.

In addition to KazMunayGas, 100 percent of the shares of Kazpochta (the postalservice), and KEGOC (the Kazakhstan Electricity Grid Operating Company) and Kazakhstan TemirZholy (the railway) have also been transferred to Samruk, and 50 percent plus one share of Kazakhtelecom has been transferred as well.  The transfer of shares to Samruk did not adversely affect the Standard and Poor’s ratings of these companies.

Samruk, though, is in the very early stages of its existence, and it is very hard to predict how it will operate over the long-term, whether it will try first and foremost to be send the message that Kazakhstan is an investor friendly place, increasing the attractiveness of Kazakh offerings in foreign capital markets, or alternatively be an aggressive management fund, seeking to assert strong state influence over the direction of development of key state-held assets.

The stated intent of the fund is the former, but there is nothing in its structural makeup that precludes it from behaving in the latter fashion, especially under some future president or alternative constitutional structure.

KazMunayGas Exploration and Productions Relationship to KMG

NC KMG’s share of KMG E and P will never drop below 60.1 percent, and because of this they will continue to be able to control the majority of votes at general shareholder’s meetings, which in turn will guarantee their control over the Board of Directors of the company.  This, as noted in the global offering, will insure that NC KMG is able to determine the timing and amount of dividends, to influence the hiring of all the key personnel positions in the company, and to enter into mergers or make acquisitions that are deemed important by the government of Kazakhstan, but which may be opposed by minority shareholders. They also are able to effectively block minority shareholders from holding shareholders meetings that they object to, due to the quorum rules set up for the company.

NC KMG and KMG E and P have a relationship agreement which is intended to mitigate some of the influence NC KMG exercises, as NC KMG pledges to allow KMG E and P to operate independently from the NC KMG groups, and that KMG E and P is to be allowed to operate in the interests of all shareholders equally. The relationship agreement is to apply as long as NC KMG holds at least 30 percent of the shares of the company. To this end certain kinds of material transactions must be approved by the Independent Non-Executive directors. These include any transactions between the KMG E and P and NC KMG, any major acquisitions or disposals, the company’s dividend policy, changes in the relationship agreement, the service agreement and the company’s charter and corporate governance code.

But, there is no enforcement mechanism to secure the agreement NC KMG and the directors it appoints to abide by the relationship agreement, save that the KMG E and P directors can withhold payment to NC KMG for the annual service contract.  But of course, if they were to do so NC KMG would withhold services, leaving KGM E and P without the ability to transport and export its oil. 

KMG E and P has a yearly service contract with NC KMG, which expires each December 31 and must be renewed through an annual tender grants the country a significant number of privileges.  As long as this relationship exists KMG E and P will effectively be free to transfer a percentage of its profits directly to NC KMG. Although Nonexecutive (i.e. independent) directors of KMG E and P can try and prevent increases to the sum paid in this service agreement, they cannot affect the size of the current monetary transfer. KMG E and P paid $87.6 million in management fees in 2005 In addition they paid commissions for crude oil sales of $5.7 million and $ 225.6 million transportation services.

The service agreement provides KMG E and P with the right to request the state to exercise the right of first refusal to acquire shares in any on-shore subsoil oil and gas exploration and production contracts that an existing shareholder wishes to transfer. The service agreement also gives KMG E and P the right to request NCKMG exercise its rights to enter into direct negotiations for exploration and production contracts for any unlicensed oil and gas acreage in Kazakhstan, without engaging in a tender process, and the right to acquire oil and gas exploration contracts for such acreage. 

It is theoretically possible that this will not be renewed, especially if NC KMG wants to go in another direction, and form an additional production company.  Similarly KMG E and P can lose its production and exploration contracts in the same way that any other company can. 

KMG E and P has a contract with KazTransOil to ship its oil through the UAS (Uzen-Atyrau-Samara) pipeline through 2012. The tariff for this is set by the Ministry of Energy and Natural Resources and can be reviewed by the Kazakh Antimonopoly Commission at the request of KTO.  The tariff charged cannot be less favorable to KMG E and P than that applied to other pipeline users. 

The service agreement also commits NC KMG to make “reasonable efforts” toprocure KMG E and P sufficient capacity from the CPC pipeline.  Of course there is no guarantee that NC KMG will remain a CPC stock holder, which means that KMG E and P has some risk that it will not have adequate transport options for its oil and gas.  This risk, though, is less than that experienced by other oil producing companies operating in the country, assuming that the Kazakh government doesn’t fundamentally restructure itsoil and gas development strategy.

KMG E and P is also required by KMG to sell a certain percent of its oil to the Atyrau refinery each year, at the cost of production and transport plus three percent.  This is discussed at greater length below. There is also risk that the relationship between KMG E and P and KMG can bring to minority shareholders.  There is a chance that KMG will decide not to renew the yearly service arrangement with KMG E and P.  While this is unlikely in the immediate future, a future Kazakh President (or Prime Minister if the powers of the president were to be constitutionally weakened, could rethink of energy policy, and decide to have several competing firms which would represent national interests.  Or they could decide to largely abandon the idea of a national oil firm, and transform KMG E and P into an entirely private or at least wholly commercial project.  This is what effectively happened to Lukoil in Russia.   

Clearly the biggest risk to KMG E and P is that the Board of Directors nominated by NC KMG will exert an influence which is against the best commercial interests of the company, but which reflects government interests. 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Chapter III. Financial analysis of “NC KAZMUNAYGAS”

      3.1Performance and behavior

KMG articulates its mission and vision on its website, including as its goals the maximization of economic benefits of the company through an increase in the Company’s value, through improvement of the financial and economic parameters, through increasing its reserves of hydrocarbon raw material, through increasing efficiency of production, and through advancing the strategic interests of the State, including gubbaranteeing its energy security.

Many of the goals of the company cannot be fulfilled until some distant future. The company has been a profitable one, largely because it has been able to benefit from favorable trends in the global oil market.  Supported by the unexpectedly high price of oil for most of this year, KMG’s profits grew by 29.7 percent, year on year, for the first eleven months of 2006, and totaled some $5.2 billion.  

Much of this came from KMG Exploration and Production, which produced 10.5 million tons of oil and gas condensate, up 2.2 percent from the previous year. The company reports that the major part of its net profit (some $234 million for the first five months of 2006) was channeled into production. Their gross profit for 20005 was $3.8 million. 

Since the beginning of its operation between eighty and ninety percent of the company’s profit has been made by KMG Exploration and Production, with the extraction outfit, KazTransOil and KazTransGas accounting for most of the rest.

Taxation

Kazakhstan has a complex system of taxation for subsurface users, which is explained in depth by Ernst and Young in their annual publication “Kazakhstan Oil and Gas Tax Guide.”

There are two separate types of subsurface use contracts, Production Sharing Agreements (PSA’s) which the tax legislation calls “model 2” tax regimes, and standard contracts which subject the license holders to excess profit taxes.  These are considered “model 1” tax regimes.  Appendix II describes which kinds of taxes each kind of contract is liable for. 

KMG participates in both kinds of contracts.  Virtually all of the major international consortia development projects are based on PSA contracts, which since the 2004 regulation are only to be granted for off-shore oil projects, whereas the older KMG fields (which are part of KMG Exploration and Production) are based on “model 1” tax regimes.  The tax regimes of PSA’s signed before the new PSA legislation are stabilized, whereas those signed afterward are stabilized only if they have undergone evaluation by tax authorities to guarantee that they are in compliance with the tax regimes in place at the time that the contract was negotiated. The stabilized contracts can be renegotiated to take advantage of changes in the tax regime only with the approval of the government, and require compensation be paid to the government. “Model 1” contracts are not stabilized.  

The Tax code offers very specific information about what must be included in a PSA.It also provides a list of expenses that are recoverable under a PSA, and non-recoverable. The legislation also outlines the triggers to determine the sharing of profit production. 

The newer legislation (the Tax Code and new PSA law) also move Kazakhstan away from a bonus system, and so all contracts negotiated after July 1, 1998, have provisions for royalties only.

Kazakhstan has a system of graduated royalties, applied to each type of mineral resource, payable in cash, and calculated by multiplying the production by a netted back price and applying the appropriate royalty rate. In 2005 an amendment to the Tax Code added a new type of subsurface activity, which seems intended to access royalties on pipelines and oil and gas storage facilities. Ernst and Young accountants believe that the 2005 amendments still leave the royalty structure for pure gas fields unclear, but infer that the calculation should be similar to that offered for associated gas.

Legal entities selling crude oil and gas condensate for export are subject to an economic rent tax, although PSA holders are exempt from this when making sales from their own contract area. This tax is based on a government determined market price, as determined by a Resolution of the Government of Kazakhstan from August 15, 2005.

As already noted, “model 1” contract holders are subject to an excess profits tax, which is levied on net income in excess of twenty percent, and will start to apply once the ratio of cumulative aggregate income to cumulative tax deductions exceeds 1.2. The tax base can be adjusted for expenditures incurred for the education of the local Kazakh work force and/ or to increase for the increased in fixed assets, but in total this cannot exceed 10 percent of the taxable amount. Taxes are based on a sliding scale, not to exceed 60 percent. 

Subsoil users are also subject to corporate income tax, which is set at about 30 percent of the taxable income.  The legislation is very specific about the kinds of deductions which can be taken88. It also sets guidelines for the depreciation of assets.  In addition to corporate taxes, a subsoil user may also be subject to a branch profits tax.

PSA holders are also liable for payment of a “top-up”  tax to insure that the State’s take is no less than the statutory minimum.  Each PSA sets this based on the project, and it is usually in the range of 5 to 10 percent, and following the life of the PSA it can reach 40 percent.

All projects are subject to a variety of environmental fees, based on the nature of the activities of the project.  These fees are almost always paid to the localities in which the project is based. These include fees for land usage, fees for water usage, fees for the use of specially protected natural reserves, and fees for the pollution of the environment.Less commonly applied fees include those for use of a radio frequency and for use of navigable waterways.

Subsoil users must also pay a value-added tax on crude oil, natural gas and gas condensate sold in Kazakhstan, which in 2006 was 15 percent, but export sales do not have a VAT levied.  Geological prospecting is exempt from VAT levies.  Imported goods may be subject to customs duties of up to 30 percent, with exemptions provided for contracts negotiated before the new customs code (2003) was introduced. All goods may be subject to paying customs clearance fees. 

Crude oil and gas condensate is subject to excise tax from the time of sale or transfer to a refinery.  In 2006 this rate was set at zero. Subsoil users are also liable for property tax, land tax and vehicle tax.

KMG’s management believes that the value of the assets of KMG is seriously undervalued, and one way of rectifying this is to float shares in part of the company, the Exploration and Production unit, internationally.  This offering, designed to raise $1.9 billion, was offered on the London Stock Exchange in October 2006, the capital to be used to purchase the shares acquired by KMG in PetroKazakhstan and KazGerMunaygaz, both of which are in Kazakhstan’s Turgai Basin.  Prior to this offering over 97 percent of the shares of KMG E and P were held by NC KMG; the remaining shares having been bought by workers and management during the early stages of Kazakhstan’s national privatization process.  

KMG E and P shares are also being sold on the Kazakhstan Stock Exchange, but they are subject to a $50,000 threshold, effectively making purchase of shares impossible for ordinary Kazakh citizens.

In August 2006, KMG E and P approved a dividend payment of $2.90 per share, this compares to a dividend of $.55 per share in 2005, $.44 per share in 2004, and $.30 per share in 2003. KMG E and P are currently restricted to a total dividend payment of $3.9 million per year by the terms of the $800 million loan that Munayshy Finance, took with Esomet, of France. This 6.5 percent fixed rate loan is payable by September 2009, and is discharged through the sale of KMG E and P oil by Esomet. 

It is interesting to note that in KMG E and P’s IPO they note the accounting systems of the company as an area of financial risk for potential investors.  KMG E and P uses the International Financial Reporting Standards (IFRS) accounting system,but its personnel have limited experience with using it, and don’t understand how to properly use its applications.  As a result, the IPO notes, the company’s internal controls are weak, and management is not confident that mistakes in the preparation of its financial statements will be readily detected by those charged with preparing them. KMG E and P hopes to address this in part through the adoption of new software, the Enterprise Resource Planning software, which is scheduled to be introduced by the end of 2007. 

KMG E and P is subject to local and national tax regimes of the “model 1” type, described above.  It’s management, too, like foreign oil and gas companies operating in the country, have complained of the difficulties of understanding some of this legislation, which they maintain is the reason why they have been subject to a number of claims by the tax committee of the Kazakhstan Ministry of Finance, with regard to alleged underpayment of cash royalties and taxes. Penalties are quite high, up to 50 percent of the underpayment. 

One area that KMG E and P’s practices have caused raised eyebrows relates totheir alleged illegal transfer pricing practices.  Rumors of transfer pricing have surrounded many of the daughter companies of KMG, and cases of investigation by tax authorities have been infrequent.  The price oil sold to KMG Trade House AG, a Swiss subsidiary of KMG Trade House, is supposed to be set based on the mean quotations published in Platts Crude Oil Marketwire less a discount to cover the Swiss trading house’s transportation, insurance, financing and other expenses, plus a trader’s commission.

In November 2004, the tax committee, along with the Department of National Security (Deportment of Customs and Control and the Department of Economic Crimes) launched a joint audit of both UMG and EMG to verify the amount of the discount on export price sold to KMG Trade House AG, for the period 2001 through 2003 for UMG and 2003 for EMG, and in February 2005 the tax committee assessed KMG E and P $17.9 million for underpaid taxes and royalties, due because the discounts were said to have exceeded allowable amounts, and so were in violation of the country’s applicable transfer pricing laws and regulations.  But this decision was overthrown by the KazakhSupreme Court in February 2006.  But NC KMG and its daughter companies seem to be treated much like any other company; sometimes the courts find for them and other times they find against them, and it is highly unlikely that the KMG companies resort to bribing judges or local officials.

It is very possible that transfer pricing will become an area of growing future concern for the company, especially it the political environment in the country loosens up at all, and “independent minded” prosecutors seek to make a reputation for themselves. 

The management of KMG E and P is already deeply concerned about the ambiguities in the tax legislation which they believe leave them vulnerable to tax claims.  One of the ambiguities concerns what rate should be applied to the transfer of oil to Atyrau refinery, whether it is considered an out of contract activity and so liable for VAT charges.  With regard to this specific ambiguity KMG E and P has set aside a $17.9 million fund to cover their possible exposure from 2002-2005, but even they admit that they could easily be liable for another $59 million KZT for excess profits tax on the Uzen deposit, because they deducted EPT in the previous year and tax on dividends when figuring out how much EPT to pay. Finally, they admit to vulnerabilities with regard to the payment of social taxes on salaries in the service division, whether current or stabilized tax rates should apply. The management here believes that their tax liability could be an additional $5.6 million for 2001-2005. 

Again, these are potential liabilities that KMG E and P accountants have identified, and doesn’t mean that Ministry of Finance accountants wouldn’t offer many more.  Most importantly, though, this speaks to the lack of a fully comprehensible tax structure and the unpredictability of its application.

 

 

2. Financial analysis of “NC KAZMUNAYGAS”

Revenues of 797bn tenge (US$5,346m), which is 11% higher than 2011 mainly due to higher export volumes and higher domestic prices.

Net profit of 161bn tenge (US$1,079m) and earnings per share of 2,320 tenge (US$2.59 per GDR), a decrease of 23% and 21%, respectively, compared to 2011.

The average price of Brent in 2012 was US$112 per barrel, almost same as in 2011.

In 2012 KMG EP produced 12,191 thousand tonnes of crude oil (247 kbopd), including the Company’s stakes in KazgerMunay (KGM), CCEL (KarazhanbasMunay, CCEL) and PetroKazakhstan Inc. (PKI) which is 1% less than in 2011.

JSC UzenMunaygas (UMG) produced 4,950 thousand tonnes (100 kbopd), which is 132 thousand tonnes less than in 2011. JSC EmbaMunaygas (EMG) produced 2,816 thousand tonnes (57 kbopd), which is similar to the volume produced in 2011. The total volume of oil produced at UMG and EMG is 7,766 thousand tonnes (156 kbopd).

The Company’s share in the production from KGM, CCEL and PKI for 2012 amounted to 4,425 thousand tonnes of crude oil (91 kbopd), approximately equivalent to 2011.

In 2012 the Company’s export and domestic sales from UMG and EMG were 6,078 thousand tonnes (122 kbopd) and 1,637 thousand tonnes (33 kbopd) respectively.

The Company’s share of sales from KGM, CCEL and PKI was 4,412 thousand tonnes of crude oil (90 kbopd), including 3,430 thousand tonnes (70 kbopd) or 78% of total sales supplied to export markets.

Profit after tax (net income) in 2012 was 161bn tenge (US$1,079m), representing a 23% decrease compared to 2011, mainly due to impairment of assets, higher income taxes, higher employee costs and lower share of income from associates and joint ventures, partially offset by the benefits of higher export volumes and higher prices for domestic supply.

The Company’s revenues in 2012 amounted to 797bn tenge (US$5,346m), which is 11% higher than in 2011. This resulted from a 6% increase in export volumes and a 39% increase in domestic selling prices, compared to 2011.

Taxes, other than on income, in 2012 were 274bn tenge (US$1,839m), which is 3% lower compared to 2011, mainly due to non-repeated expense of 15bn tenge (US$105m) for export duty charge in 2011 and lower expenses from mineral extraction tax. This was almost fully offset by increased rent tax costs, which resulted from higher export volumes.

Production expenses in 2012 were 140bn tenge (US$941m), which is 19% higher than in 2011. A significant part of the production cost increase is due to higher expenses for employee costs, energy charges and a change in crude oil balance. These were partially offset by a reduction in repair and maintenance expenses due to a decrease in the number of repaired wells and of hydrofracturing in line with the production programme, as well as adverse weather conditions at the beginning of the year.

Selling, general and administrative expenses in 2012 were 93bn tenge (US$624m), which is 6% lower than in 2011. The decrease is mainly due to lower expenses for penalties and fines and lower management fees to National Company KazMunayGas from 8.3bn tenge (US$57m) to 4.0bn tenge (US$27m), partially offset by higher transportation expenses as a result of higher export volumes.