CBS Weekly Review: Kazakh debt fears; a big gas find in Turkmenistan

We address two Central Asian themes this week, one financial, the other geological.

Kazakh banking sector: Policy confusion is feeding fears (which are nonetheless overblown)

The share prices of the major independent Kazakh banks have been declining for months, but in the past month this decline has become a collapse. At present Halyk Bank, KKB, Alliance Bank and BTA are each trading at small multiples (as low as 2x) of already downgraded 2008 earnings, and at less than half of their book value.

In the current market environment it is difficult to impute any rationality or logic to prevailing valuations. But in this case evidence from the debt markets, as well as common sense, suggest that these declining valuations are being driven by fears about liquidity and solvency. Yields on Kazakh banking Eurobonds have exploded, increasing by more than 1500 basis points in the past six weeks. Most of the Eurobonds issued by these Kazakh banks are now trading (or not trading, as the case may be) at roughly 40 per cent of par value.

More worrying than bond yields – and thus better fodder for journalists – are the spreads being reported for Kazakhstan-related credit default swaps. We are very cautious about attributing a great deal of significance to these figures. The CDS market for Kazakh banks is highly illiquid, and in any case it is likely that this thin market is being driven by activity related to scenarios of potential technical default (related to loan covenants written in very different times) rather than by any real threat of insolvency.

However, simplistic media reporting of these CDS spreads has led to claims that Kazakhstan is at present the world’s riskiest emerging market (or perhaps number two after Pakistan) and that the weakness of its banks makes it a likely candidate to become "the next Iceland."

The government is trying to help, but not helping

In our view, which is unchanged, fears of default and insolvency in the Kazakh banking sector are overblown. The government of Kazakhstan is determined to prevent the failure or default of any major Kazakh banks; and unlike some of the other governments currently facing tough times, it has the means to do so thanks to its nearly US $50 billion in reserves (including the National Fund).

In the end we believe that the government will manage to do what is necessary. However, some of the current uncertainty can be attributed to the Kazakh government's response to the credit crisis, not only in recent weeks but over the course of the past year.

When the credit crunch first hit Kazakhstan in mid-2007, the government got two big things right: the successful defence of the tenge, and the effective provision of liquidity support to the banking system. But apart from those two successes the general approach has been to announce a large number of anti-crisis initiatives – generally without details – and then partially implement some of them while dropping others, often in such a way that observers have a hard time telling which measures are being implemented and which are not.

Until last month the negative impact of this policy incoherence was limited. But in the wake of the collapse of Lehman Brothers and everything that has followed – including the sharp decline in oil prices, which has hit market sentiment in oil-producing states – the confusion of Kazakh government policy now presents a more serious liability.

Of course, Kazakhstan is not the only government in the world that has exhibited an incoherent and confused response to the crisis in the global financial system. It is not hard to make the case that many other governments, starting with the United States, have performed far worse. But Kazakhstan is at the end of the day an emerging market, and it is perceived as such. The US or Germany get the benefit of the doubt even when they bungle major policies and exhibit high levels of political risk. But emerging markets are punished for far less.

Everything but the kitchen sink

The most recent series of anti-crisis measures announced by the Kazakh government is certainly broad in its scope. Within the course of several weeks the government has announced that it will back the creation of a fund to purchase bad loans; expand deposit guarantees; invest state funds in the equity market; stand ready to support banks with cash injections in return for equity; and several other things besides. Meanwhile major policy decisions unrelated to the current crisis are also being taken, most notably, the transfer of the state shares in mining companies ENRC, Kazakhmys and Kazatomprom to the new National Welfare Fund which has been created through the merger of state holding company Samruk and state investment fund Kazyna.

The right policy response to the present crisis certainly appears somewhere on this list. But not all of the measures being taken or consided now can be of equal importance and urgency; nor can they all be done effectively at the same time. To cite a generalization which certainly applies in this case, governments are more effective when they focus on one or two things rather than ten; to prioritize everything is to prioritize nothing. Thus it will be important in the weeks ahead that the government sort through the various measures on the table and then take the steps most appropriate to the situation.

Our guess now as before is that asset quality remains the most urgent problem. In our August review of Kazakh banking we argued that the problem of non-performing loans was worse than one would think from the figures being officially reported by the banks. Since that time this assessment seems to have become conventional wisdom.

If this guess is true, then particularly crucial will be the management of the so-called "distressed assets fund" announced in September – before the introduction of the Paulson Plan in the US, it should be noted – which would be set up to purchase bad debts from the Kazakh banks. Such a fund is probably more suitable for Kazakhstan than for the United States, since the authorities in Kazakhstan will be able to pay whatever prices they deem most appropriate for these loans without having to worry too much about a political backlash.

However, the current status of this program is deeply unclear. Initial comments from the Finance Minister spoke of a US $6 billion fund, with US $1 billion of state money being supplemented by another US $5 billion of "private investment." But more recently the amount of the state’s contribution to this fund has been revised downward to KZT 52 billion (US $434 million). Meanwhile the question of which private sources might provide the balance of the funding remains hazy. It was recently stated by a representative of the financial regulatory agency that the banks themselves would be expected to help fund the purchase of their own bad debts – a clarification that raises more questions than it answers.

Even if the fund ultimately reaches US $6 billion, it is not obvious that that will be comfortably sufficient for the task at hand. The total loan book of the Kazakh banking sector is approximately US $75 billion, of which roughly 40 per cent is related to the real estate, construction and mortgage sectors which are at the epicentre of Kazakhstan’s problems. Based on these numbers, US $6 billion is probably not enough.

Conclusion

The markets will be watching to see what comes next from Kazakhstan and its policymakers. In the short term more stumbling is possible, since clearly the policymaking process is not working as smoothly as it should, or as smoothly as it usually does in Kazakhstan. To engage in some speculation, one has the sense of enormous pressure from the top giving rise to too many ideas and initiaives – not all of them fully fleshed out – as technocrats vie to be the one who fires the magic bullet. The recently announced creation of the National Welfare Fund suggests an effort to streamline the policymaking process and put it in the hands of a few trusted people. Kairat Kelimbetov, the chairman of the new entity, was until his appointment President Nazarbayev’s chief of staff. Also of obvious significance is the appointment of Nazarbayev’s son-in-law Timur Kulibayev as the Fund’s deputy head, marking his return after a period of semi-exile from official posts.

Ultimately Kazakhstan is a well-functioning country run by a competent technocratic elite in a context of political stability. Its undemocratic politics and concentration of political power are negatives in other contexts, but in the current situation they are unquestioned advantages. One need only look at the comparison with Ukraine to see the value of having a stable political system during such a crisis.

Kazakhstan’s most important advantage, of course, is the US $50 billion at the government’s disposal – which is higher relative to GDP than what is available to Russia, where the scale and scope of the present economic and financial crisis is greater (not least because Kazakhstan’s crisis is already one year old). Assuming this money is used with some efficacy it will be enough to bring Kazakhstan through this crisis without economic catastrophe or bank defaults. The decline in the oil price means that this reserve will not rebuild itself as fast as it might have, and if prices decline further and stay low there will be other negative longer-term implications for the country. But lower oil prices do not represent a threat to the public finances of the sort that might prevent the state from doing what is needed to rescue the banks.

Turkmenistan’s South Yolotan field confirmed as a monster

For years the government of Turkmenistan has been telling the world that South Yolotan – a gas field in eastern Turkmenistan which was discovered in the mid-1990s – was a giant field, one of the world’s largest. There has been ongoing skepticism about this claim, for two reasons. First of all, the credibility of the Turkmen authorities on this and most other topics has been considered to be low. Second, grand claims about South Yolotan were suspiciously convenient from a geopolitical perspective, since they have allowed the Turkmen government to avoid tough decisions about future gas exports by adopting a line of "there’s enough gas for everyone."

It turns out that Turkmenistan was telling the truth. Indeed South Yolotan appears to be larger than almost anyone would have imagined. Gaffney Cline, the geological firm hired to perform an independent reserve audit, announced last week that it has estimated South Yolotan reserves at somewhere between 4 and 14 trillion cubic meters [Tcm], with a base-case figure of 6 Tcm. Even at the lower end of this range it would make South Yolotan one of the world’s largest gas discoveries – a field of the same magnitude as Yamburg and Urengoi, the West Siberian giants which have been the backbone of Russian gas production for a generation.

A field on this scale should be able to produce something on the order of 100 billion cubic meters [Bcm] per year, which would more than double the country’s production. (Turkmenistan this year will produce something between 73 and 75 Bcm.) Production at this level is at a minimum a decade away, but for the first time there is no longer any doubt as to Turkmenistan’s ability, geologically speaking, to meet (if not on schedule) its medium-term contractual export commitments, which total 124 Bcm per annum (of which 80 Bcm to Russia, 30 Bcm to China, and 14 Bcm to Iran, all on an annual basis).

One immediate impact of this news will be to take some of the edge off what had been a restrained but unavoidable competition between Russia and China for Turkmen gas. However, at least in the medium-term, this competition remains relevant. Given Russia’s approaching gas deficit, which was assessed by my colleagues in this report, Gazprom needs to increase its imports of Turkmen gas up to the contract plateau volume of 80 Bcm as soon as possible, and certainly by 2011 it would hope to be importing this level of Turkmen gas through an upgraded pipeline corridor. The Turkmenistan-China gas pipeline, now under construction, could plausibly be completed in that time frame. Even if the South Yolotan discovery suggests that Turkmenistan will be able to accomodate all comers in the much longer term, the medium-term outlook for upstream gas development in Turkmenistan, and thus the country’s production outlook for 2011, remain highly uncertain.

Will Turkmenistan seek upstream partners for South Yolotan?

This uncertainty is closely related to a question that has lingered for more than a decade without an answer – a question which has now become extremely trenchant once again given the news from South Yolotan: Will state company Turkmengaz seek equity partners to help it develop Turkmenistan’s largest gas fields?

For some years Turkmenistan has limited foreign direct investment in the oil and gas upstream to western Turkmenistan and the adjacent Turkmen sector of the Caspian Sea. In this region four companies are currently producing oil and gas on the basis of production-sharing contracts (PSCs), with several others holding or pursuing offshore exploration licenses. However the Amu Darya basin in eastern Turkmenistan – where the country’s largest gas fields (including South Yolotan), along with the potential for more, are located – has been closed to foreign investment. Bringing in a partner on a grand scale to further develop this region was considered during the late 1990s, with Shell as the main suitor, but in the end the isolationist tendencies of the late President Niyazov won out.

Niyazov’s death in December 2006 gave new hope to the international oil and gas industry that they might find an opening in Turkmenistan, and a handful of companies have made determined efforts to get into the country. This group includes several international majors (most notably Chevron and BP); some of the Russian majors (for instance, Lukoil and TNK-BP); and Turkey’s state-owned TPAO. Thus far the main focus of discussions seems to have been offshore licenses. But for most of these companies, the big gas of the Amu Darya basin is the real prize.

But there it is the state-owned Chinese company CNPC which has stolen a march. The Chinese of course come to the table with huge advanges: while other companies can only make proposals and promises, the Chinese have simply proceeded with construction of a perhaps US $10 billion export pipeline without any external financing or any committed thoughputs (or, to be precise, nothing that a Western lawyer would consider to be a binding ship-or-pay agreement).

With considerable justification, CNPC has sought some equity position in the Turkmen gas sector to go along with this massive pipeline commitment. Thus far, however, Turkmengaz has politely refused to give CNPC any direct stake in South Yolotan. In 2006, Turkmengaz signed a three-year drilling agreement with a CNPC subsidiary; this means that Chinese rigs and crews are working at the field, but it remains a simple service agreement which gives CNPC no equity position in South Yolotan or its gas. Then in July 2007 Turkmengaz took a major step by sigining its first PSC in the Amu Darya basin, an agreement with CNPC for a gas field called Bagtiarlyk. This is thought to be a sizeable field as well (although its reserves were not part of the Gaffney Cline audit), but it is not on the same scale as South Yolotan, and to some extent it was given to CNPC as a consolation prize.

Since South Yolotan will obviously be producing gas bound for Russia as well as China, and perhaps for other destinations over time, it is understandable that Turkmenistan would not want to hand part of it over to CNPC; or, for that matter, to Gazprom. The easiest choice would be simply to follow the current course by keeping South Yolotan fully in the hands of state-owned Turkmengaz. After all, this approach has seemed to work just fine with Turkmenistan’s existing giant gas fields such as Dauletabad.

But this choice – doing nothing, and hoping to fully develop South Yolotan with with cash flow, foreign borrowing, and contracts with foreign oil service companies – would in this case be far short of optimal. First of all, global credit rationing will substantially increase the costs of debt financing relative to equity, no small matter for a project as massive as this.

Even more important is the difficult character of the field itself, which stands in contrast to relatively simple fields like Dauletabad. According to an assessment carried out by the US Geological Survey on the basis of public data, fields in the relevant sub-basin are characterized by abnormally high reservoir pressures and moderate to high concentrations of hydrogen sulfide. Development of South Yolotan will therefore be much more complex and expensive than anything Turkmengaz has done in the past. Certainly most or all of the world’s major oil and gas companies will already be preparing their presentations explaining why their skills and experience make make them uniquely qualified to participate in the South Yolotan development.

One possible solution which could be attractive to the Turkmen government would be to break the development project into phases; this is the model that has been followed by Iran for the development of South Pars, the world’s largest gas field. Although this model has its drawbacks, it does allow the host government to diversify by choosing different partners for different phases.

But regardless of the model it chooses, working in full partnership with international companies would be a major step and a difficult challenge for a Turkmen government which in fact has not come so far from the isolation of the Niyazov era. It would be safe to predict that the development of this giant gas field will not be a quick or easy process.

Best regards,
Laurent Ruseckas
Director, Eurasia Research
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