CBS Weekly Review: Cadogan woes, KMG EP questions

The theme this week is oil and specifically two London-listed companies working in the CBS region. First is a view on the causes of this week’s sharp fall in the share price of Cadogan Petroleum (CAD LN), a small oil and gas company working in Ukraine. This case highlights how legal and general country risks in Ukraine are high even relative to the undemanding FSU peer group. Then I move on to raise some questions about the acquisition-driven growth strategy of KMG EP (KMG LI), the listed subsidiary of Kazakhstan’s state oil company Kazmunaygas.

Cadogan Petroleum falls victim to Ukrainian risk

Cadogan Petroleum is a small upstream oil and gas company operating exclusively in Ukraine which listed on the LSE main market on 21 June of this year. Trading in the company’s shares was temporarily suspended this week at Cadogan’s request, and upon the reopening of trading today its share price initially fell by more than half. All this follows news earlier in the week of a court decision in Ukraine’s Poltava region which seemed to invalidate two of the company’s key exploration licenses.

Cadogan issued a statement yesterday setting out their position, which is that their licenses are in fact unaffected by the Poltava court decision.

There are legal complexities here which I am in no position to address. What is clear, however, is that Cadogan is suffering from the fact that Ukraine remains a country where the court system – and indeed the rule of law more generally – remain very weak.

Natural resource companies are particularly vulnerable to the sort of legal uncertainty that prevails in Ukraine, because of their reliance on subsoil licenses. To cite language in Cadogan’s prospectus: "Ukrainian legislation in relation to the issue of licenses to explore and develop oil and gas reserves is in some cases unclear and subject to ambiguity." Indeed.

What this tends to mean in practice is that a holder of a subsoil license can usually be found to be in breach of its license commitments one way or another, or that a license can be invalidated for some other reason, if someone sufficiently powerful (in the context of the court making that particular decision) desires that it should be so.

This situation means that natural resource companies must put a premium on maintaining good relationships with government at the national and local levels, as well as any local partners or important stakeholders from the private sector.

Partner problems?

Based on admittedly limited evidence it seems that Cadogan’s current problems relate to their relationship with their main partner inside Ukraine, a state-owned company called NAK Nadra Ukrainy. In 2007 Nadra Ukrainy had cooperated closely with Cadogan to restructure their jointly held licenses in a way that reduced the Ukrainian company’s stake significantly but which gave these ventures the legal right to sell their gas production domestically for a market price (roughly US $220 per thousand cubic meter [mcm]) rather than the regulated price of US $65/mcm.

However this spirit of cooperation seems to no longer be present. The lawsuit which led to the Poltava court decision was brought by the Nadra Ukrainy subsidiary which is Cadogan’s partner in that region; and the press release available on the Nadra Ukrainy website states clearly the view of that company that the licenses in which Cadogan has an interest have been invalidated, and that the licenses now valid are those held solely by Nadra Ukrainy’s local subsidiary.

It is worth nothing that there has been a wholesale management change at Nadra Ukrainy since 30 January 2008, when the Tymoshenko-led government appointed Oleksandr Ponomarenko as the company’s new chairman. Ponomarenko is a businessman who had been elected to parliament in 2007 on Tymoshenko’s ticket. Although he resigned his parliamentary seat in May 2008 in connection with his appointment to the Nadra Ukrainy post, he is seen to remain a member of the Tymoshenko team.

I can offer no specific predictions about how this will play out; and certainly none as to what Cadogan shares should be worth. It is certainly possible to win, eventually, a legal battle in Ukraine. But it is not easy – and any success will likely be based less on the strength of one’s legal arguments than on the strength of one’s political support.

KMG EP: Will the flow of new assets continue?

The investment case for KMG EP has always been based on an expectation of an expanding asset base. The company’s core upstream assets at the time of its listing – nearly 200 kbd of oil production and at least 1.5 billion barrels of 2p reserves – were certainly nothing to sneeze at. But the ageing fields of the Uzen and Emba regions did not amount to a growth story.

KMG EP’s growth story was instead grounded in a general understanding about the character of Kazakhstan’s broad strategy in the upstream oil sector based on (1) a desire to enlarge the Kazakh presence in the upstream relative to foreign investors, and (2) a determination that KMG EP would be the vehicle for this expansion. To address any fears that this was a vision without substance, this strategy was backed by a legal agreement between KMG EP and its state-owned parent KMG which committed the parent company to offer any newly acquired onshore assets to its listed subsidiary. This agreement was of course subject to various caveats and exceptions, but it was a powerful promise of growth – particularly in its implication that KMG’s extremely strong preemption rights would be used to the benefit of KMG EP.

(These rights, accorded to KMG by legislation passed in 2005 and 2006, essentially allow it to preempt any transfer of ownership of oil licenses or assets on Kazakh territory.)

In two deals which closed in 2007, KMG EP acquired (via KMG) the 50 percent of the Kazgermunai venture that had been owned by a group of mainly German investors, as well as 50 percent of Karazhanbasmunai. Both of these are attractive assets, and even in those ancient days when the price of oil was still in double digits there was no suggestion that KMG EP had overpaid for them. Furthermore both of these transactions were facilitated by the parent KMG and its powerful preemption rights. So far, so good.

Time to raise questions?

However, in my view it is no longer obvious that we can expect a smooth flow of major assets from the parent to the child. This view relates primarily to the fate of the two major acquisition targets cited by KMG EP in recent presentations: KMG’s share in Petrokazakhstan (33 percent at present) and its prospective share in Mangystaumunaygas (estimated to be 51 percent although this is not fully clear). Because of the existence of the "Services Agreement" described in KMG EP’s IPO prospectus, which gives KMG EP certain legal rights in this area, I would not at this time go so far as to say that these acquisitions will not go ahead. But in my view the situation may be moving in that direction.

Changing of the guard

The main reason for this is the slow-motion changing of the guard in Kazakhstan’s oil sector which began in mid-2007, when Timur Kulibayev, President Nazarbayev’s son-in-law, resigned his position as Chairman of the Board of KMG and deputy CEO of KMG’s parent, Samruk (the holding which manages key state companies). Kulibayev had been the undisputed top decision maker in the Kazakh oil industry for several years, and he had been the driving force behind the creation and floatation of KMG EP.

By no means did Kulibayev´s influence disappear immediately upon his departure from these formal positions. The team of people he had in place running KMG, including its president Uzakbay Karabalin, remained in their jobs for some time, and major deals agreed during the Kulibayev era – including the KMG acquisition of Romanian refiner Rompetrol and the KMG EP acquisition of 50 percent of Karazhanbasmunai – went forward without any hitches.

But with the passage of time, this picture has changed. Samruk was put under new management last year, and in May 2008 Karabalin was replaced as president of KMG by Serik Burkitbayev, someone who had held several senior governmental positions but who is a new face in the oil sector. Most significant was the February 2008 appointment of Nurlan Balgimbayev as presidential advisor on Caspian energy issues. Balgimbayev is a former prime minister who had in some sense been Kulibayev’s predecessor as the key decision maker for the Kazakh oil sector.

The background to all this maneuvering is interesting, but not particularly relevant, so I won’t dwell on it here. To summarize my view briefly: after the fall of previously powerful Rakhat Aliyev – another son-in-law – President Nazarbayev felt that the field was now too much open for Kulibayev, who therefore needed to have his wings clipped.

KMG EP left outside the fray

As best I can tell the situation in the oil sector is now rather chaotic. Even though Kulibayev and his team remain active players, the previous informal hierarchy with Kulibayev at the top is gone, and nothing has yet risen in its place. Of course, in some sense Nazarbayev is and has always been the ultimate decision maker, but he has other things to worry about: this leads on the one hand to some sense of drift, and on the other hand, to an opening for various ambitious players to thrust themselves forward. To make an obvious but delicate point, some part of this jostling relates to the establishment of structures and the pursuit of deals that allow drips and drabs of cash flow to leak out in various directions.

Seen in this context, KMG EP looks a little bit like an orphan. As a company with foreign shareholders, UK disclosure requirements and independent board members, it cannot really participate in the sort of informal intrigues I have tried to describe above. What is clear, however, is that any asset which gets transferred to KMG EP is immediately extricated from these intrigues. From a certain perspective, therefore, there is reason for such transfers to be avoided completely.

It is also worth noting that KMG EP did not appear to have been given much of an opportunity to plead its case against the government’s imposition of an export duty in May which will erode KMG EP’s profitability.

Currently the company is citing the tax uncertainty as a reason for delaying discussions on its acquisition of KMG’s stake in PetroKazakhstan, and its prospective share in Mangystaumunaygas. But I do not believe that is the entire story. Although the export duty might necessitate changes to previous acquisition financing plans, it looks at least in part like it is being used as a cover story for more fundamental issues for KMG EP in nailing down targeted acquisitions.

Best regards,
Laurent Ruseckas
Director, Eurasia Research
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