CASPIAN "BIG THREE" WITH "OIL SHIELD"

BAKU-TBILISI-CEYHAN IS THE MOST STRATEGY CASPIAN PIPELINE, THINK RUSSIAN INVESTMENTS COMPANIES

The Caspian basin and adjacent onshore fields (henceforth the "Caspian region" or "Caspian") hold some of the largest hydrocarbon fields in the world.

BP's 2002 Statistical Review of the World Energy credits Kazakhstan, Turkmenistan and Azerbaijan are three countries bordering of the Caspian Sea which have most of their reserves located in the Caspian basin - with just 16.5 bln. bbl. of proven oil and 28.4 bln. boe of gas reserves.

Yet, the five largest Caspian projects located in Kazakhstan and Azerbaijan hold an estimated 19.2 bln. bbl. of oil and 9.3 bln. boe of gas reserves, indicating the highly conservative nature of BP's figures.

BP's analysts are antagonist and conservative so a little and think that 16,5 bln. bbl. of oil reserves belong to "Three Largest but only five major project covers 192 bln. bbl. of oil". Schedule No. 1.

Reserve estimates under national classifications put the combined oil reserves of the three countries at 48 bbl. of oil and 45 bln. boe of gas. equal to around 5% of total global reserves in each commodity.

At current production rates the estimated oil reserves of Kazakhstan and Azerbaijan would last close to 100 years. Schedule No. 2.

Caspian oil production is set to grow rapidly in the future and will play an important role in meeting marginal energy demand for decades to come. In last decade, total oil production in the region doubled to the current level of around 1,5 mln. bpd; according to various estimates it is expected to double again to 3 mln. bpd by 2010. This would represent around 3% of the world's expected output at the time; however the Caspian region would account for about 10% of expected incremental global oil production growth.

According to June 2003 report by a leading of global investment bank titled "50 projects to change the world", the five largest Caspian projects accounted for 32% of the total new reserves the global oil industry plans to put on stream in coming years to replace the declining output at legacy fields.

Oil production doubled in last decade and expected to double again by 2010.

Caspian oil reserves are on average very productive; Caspian oil is of very good quality. Wells at mature fields yield 200-400 bpd, compared to the Russian average of around 65 bpd and 100-120 bpd for industry leaders Yukos and Sibneft. At new onshore fields well flow ranges from 900 to 6.000 bpd (Tengiz), while top offshore wells produce 9.000-18.000 bpd (Dragon, ACG). It doubled to current level and made 1,5 mln. bpd.

API gravity of 35-47, sulfur content of 0.1%-0.6%, compared to API of 38.5% and 0.4% sulfur content for Dated Brent and API of 31-36, sulfur content of 0.6% -1.3% for Russian crudes. This has important pricing implications as Tengiz/Azeri light crude usually sells at a $ 0.3/bbl-$1.2/bbl premium to Dated Brent, while Russian blends typically sell at a $ 0.5/bbl-$2.5/bbl discount.

Geology and geography of reserves present two key challenges.

Most reserves are situated at high debts of 4 km-5 km (and even more for offshore fields); in the west of Kazakhstan deep layers of salt lie between the ground and pay zones. This results in more complex and time-consuming (and hence more expensive) drilling to develop the reserves.

Associated gas at most fields (Tengiz, Kashagan, Karachaganak) has very high H2S content (around 10 %); the required gas utilization and sulfur disposal increase capital and operating costs. Finally, weather conditions are challenging, with wide temperature swings, while shallow waters off the Kazakh cast complicate the installation of drilling rigs.

Shipping oil out of the land locked Caspian region represents an even greater challenge than finding or producing it.

Despite challenging geology and operating conditions, production ("lifting") costs are very low at $ 1.5/bbl - $ 2.5/bbl due to the high productivity of the reserves. Including F&D cost of around $ 2/bbl, full cycle (finding, development and production) expense for the most producers in the region ranges between $ 3.5/bbl - $ 4.5/bbl per barrel, well below the $ 7/bbl - $ 12/bbl for developed and emerging market peers.

Since the development of Caspian reserves began in earnest in the mid-1990s, the issue of transportation has been the main operational challenge for producers in the region. As if to balance the hydrocarbon riches of the Caspian region, nature placed them in a land locked locations, thousands of kilometers from the end market.

This is why after almost a decade of jockeying for position between the various parties involved only one major pipeline, built by the Caspian Pipeline Consortium (CPC), has been completed and was given to exploitation in 2001, and in 2005 will be ready another major oil pipeline Baku-Tbilisi-Ceyhan (BTC).

On the base of analysts the export transport costs from most Caspian producers at around $ 4/bbl, compared to the $ 3.3/bbl - $ 3.6/bbl Russian producers pay to ship their crude out of Western Siberia to Baltic and Black Sea ports. Including further setbacks to Brent, Caspian producers sell their crude at $ 6/bbl - $ 8/bbl discount to Brent.

Thus, it is the pipeline capacity and not the cost of transporting oil that remains the biggest obstacle for most Caspian oil producers. And this is why we believe that successful completion of several new pipeline initiatives (BTC, Neka-Tehran expansion) could prove a critical catalyst for valuations re-rating of Caspian oil assets.

The expected introduction of the BTC in mid-2005 is going to add 1 mln. bpd of low-cost export capacity, an 83% increase on current installed capacity of around 1.2 mln. bpd. We estimate the region's pipeline capacity deficit at around 400 mbpd in 2003-04, so BTC's introduction will provide more than sufficient reserve capacity even if it does not operate at full capacity from the start. BTC whose construction started in late 2003 after decades of negotiations, is expected to have a tariff of around $ 3/bbl, making it the cheapest route out f the region although the tariff for non-BTC shareholders will likely be higher. Moreover, the pipeline will terminate in Turkey's port of Ceyhan, bypassing bottlenecks in Novorossiysk and the Bosphorus Straits and shortening the distance to the Mediterranean market.

Importantly, although the primary purpose of the BTC pipeline is to accommodate output from super-major Caspian shelf projects such as ACG and Kashagan, they are not expected to reach their peak production for many years to come, which suggests spare pipeline capacity for all Caspian producers until at least the end of this decade.

We note that BTC is the most significant, but not only, pipeline project aimed at solving the bottleneck problem. in the short term, expanding capacity for the $ 4/bbl Neka swaps from 170 mbpd to 500 mbpd (2005-2006) would facilitate greater exports out of the region.

Medium-term, the 200 mbpd Kazakhstan - China pipeline (due to come on stream in 2006-04) and CPC expansion (1.2 mln. bpd - 1.3 mln. bpd in 2008-2010 from 0.56 mln. bpd at present) would create substantial spare capacity reserve and provide an additional option to Caspian producers.

Kazakhstan is the largest oil producer in the region, shares a border with China - a country that will account for the overwhelming share of marginal demand. At present, sales of Kazakhstan oil to China are limited to rail deliveries of around 20 mln. bbl per year; however, the Kazakhstan government said it wants to start buildings a 10 mln. tons (200 mbpd) pipeline to China as soon as 2004. The 998 km. pipeline is expected to coast around $ 700 mln. to complete. In late of May 2004, Kazakhstan president Nursultan Nazarbayev will travel to China to sign the agreement on this pipeline. In result of this project should be the growth of oil and gas costs actives of Caspian region.

Overview of existing routes

At the present time the cheapest route for Kazakhstan oil exports via the Atyaru-Samara pipeline, which connects Kazakhstan's oil pipeline network (owned by state - owned KazTransOil) with Transneft, Russia's state- owned pipeline monopoly. The transit tariff is $ 0.73/tons/100 km, which translates into around $2-$3 per bbl, assuming a 2,000 - 3,000 km. average export distance and excluding the tariff through Kazakhstan. However both the capacity of the Atyaru-Samara pipeline and the Russia - Kazakhstan government agreements limit shipments through this route to 15-17.5 mln. tons (300-350 mbpd) a year, although recently discussion were held on expanding it further. This route is used primarily by government-owned or government-affiliated oil companies.

The second cheapest route is the CPC which carriers a tariff of $ 3.7/bbl (after a recent 3% increase). Use f CPC capacity, however, is restricted to CPC members; and while they may reassign their capacity to third parties, this requires the approval of all members of the consortium. Because of these restrictions and still insufficient production at the Tengiz field (the main intended customer of CPC), the pipeline's current capacity of 28 mln. tons (560 mbpd) was only 53% utilized in 2003, which is expected to rise to 71% in 2004

Another alternative is for Kazakh producers are to ship oil through the western Kazakhstan ports of Aktau and across the Caspian Sea to the eastern shore ports (Baku/Makhachkala) and onwards to the Russian port of Novorossiysk or the Georgian port of Batumi. Including tanker and offloading costs, the total expense amounts to $ 3/bbl - $ 4/bbl, excluding transport costs inside Kazakhstan.

Oil swaps with Iran represent another, increasingly popular, shipment option for Caspian basin producers. In a typical swap, seller deliveries oil to the port of Neka on Iran's Caspian shore and takes delivery of the same amount in the Persian Gulf port. These swaps make a lot of sense for the Iranian side considering that most of Iran's refineries and petrochemical complexes are located in the country's northern and central regions, while the key oil fields are in the south, swap deals enable them to supply these facilities at a much lower expense, while generating income for handling swap operations.

On average Iran swap costs around $ 4/bbl, including the swap fee of around $ 3/bbl, tanker shipments to Neka and offloading fee. Among companies covered in this report, Dragon Oil, Burren Energy and Petrokazakhstan all utilize these swaps. Moreover, LUKOIL recently announced plans to build a 3 mln tons (60 mbpd) export terminal in Astrakhan, located in the north of the Caspian Sea, with an eye to also utilizing the Neka route.

Neka is already connected to Tehran's oil refinery via an old pipeline with capacity of 40 mbpd and the new Neka - sari pipeline built by a Chinese consortium last year, which has capacity of 50 mbpd. Neka-Sari represented the first phase of the new three-phase Neka-Tehran pipeline (392 km). Following the recent further expansions, the current capacity on this route is 170 mbpd; according to NIOC, the total capacity of the Neka-Tehran pipeline will reach about 500 mbpd through the construction of additional pumping stations.

Finally, for Kazakh producers that do not have access to any of the above-mentioned routes, there is always the possibility of sending oil via rail through Russia to the Black Sea or Baltic ports. Although this is the most expensive route at $ 6/bbl - $ 7/bbl, at current oil prices this option also appears economical.

Petrkazakhstan is the most disadvantaged from the transport cost perspective since its fields are situated in central/Eastern Kazakhstan, far from the pipeline and po infrastructure in the west of the country. As a result, PKZ has to pay $ 6/bbl - $ 7/bbl to ship oil by rail t the ports of Aktau and Atyrau, from where it's another $ 4/bbl t go to Novorossiysk or for a Neka swap. Clearly, a total export cost of $ 10/bbl - $ 11/bbl makes PKZ very vulnerable in the event oil prices decline.

However, due to the location of its fields Petrkazakhstan is well-positioned to ship oil eastward to China over a shorter transport distance. As mentioned earlier, total Kazakhstan oil deliveries to China amount to around 20 mln. bbl annually. Although most of China's population and refineries are situated in the eastern part of the country, far away from tits western border with Kazakhstan, we note that there are three refineries - Dushanzi, Karamay and Urumgi, with combined capacity of around 220 mbpd - situated just across the border from Kazakhstan.

To summarize, the combined capacity of existing export routes is not sufficient to accommodate current, let alone future, oil production volumes. Thus, construction of the BTC pipeline coupled with the expansion of Iran swaps capacity, a Kazakhstan - China pipeline and CPC expansion are set to relieve the export capacity constraints on Caspian region producers. Thus, in turn, should accelerate the production growth and valuation re-rating of Caspian oil properties.

Terms

Caspian oil and gas reserves makes 4%-5% from world production but they have not been assimilated.

Economy of prospecting and oil production in region is very acceptable with comparison of the world analogues.

Is planned to eliminate the lack of means of transport that delay the increasing of production and negatively influence to repayable prices with will be worked of two new pipelines in 2005-2006.

Probably future oil prices will increase their historical analogues.

Caspian production companies represented by the strongest alternative that rise in price and absolutely impose duty by Russian companies.

Perspectives for Caspian oil producers

The obvious perspective of future production increasing.

The high level of incomes under the stable prices for oil; increasing of prices influence to the biggest companies.

Increasing of revenues, repayable prices will be improved that could bring to overestimation of oil actives.

Tendency of play onto the further oil prices in the future will be strengthened due to low expenses of full cycle of the obvious perspective of volume increasing.

Caspian production companies characterized by low operation charges and expenses to prospecting and development, acceptable tax regime, and favorably differs from Russian analogues of economy prospecting and production.