Oil Exports as a Vehicle for Economic Transition and Development in Kazakhstan

Magzhan M. Auezov

Institute on East Central Europe

March, 1997

The dissolution of the USSR left its successor states with a complex task of carrying out transition from command to market economies. This process has been complicated by a sharp decline in production, a deterioration in living standards and the rapid stratification of society. Successor states of the USSR achieved various degrees of progress in their reform endeavors. Evidence suggests that despite sharing common recent historical experience, the former Soviet republics are adopting different strategies of economic transition and development, influenced by their resources, industrial and infrastructural "heritage" from the Soviet Union and pre-Soviet histories. Most current Western research on economic and political transition in the former USSR addresses Russia and the European republics, while little has been published on Central Asian and Caucasian states. In this essay, the author's intention is to broaden the discussion of the post-Soviet transition strategies by analyzing the case of Kazakhstan, focusing on oil export as a centerpiece of its transition strategy. This study will discuss Kazakhstan's acceptance of oil-export-driven development, analyze the government's efforts to stimulate investment in the oil and gas sector, and evaluate this strategy's benefits and weaknesses, using the experience of the Tengizchevroil (TCO) joint-venture as a case study.

Kazakhstan declared its independence on December 16, 1991, the last of the former Soviet Republics to do so. Since then it has maintained close economic ties with Russia and other republics within the framework of the Commonwealth of Independent States (CIS). President Nursultan Nazarbaev has been one of the strongest supporters of the CIS agree-ment, and has proposed greater economic integration in the form of a "Eurasian union." This pro-integration position was influenced by several factors; fear of severing economic ties of Kazakhstan's industry with enterprises in Russia and other CIS states, the need to address the concerns of a large ethnic Russian minority, caution towards the growing influence of China in Central Asia, and Uzbekistan's ambition to integrate Central Asia economically and politically under Uzbek leadership. Russia and most other CIS states, however, have been reluctant to maintain Soviet-era economic ties and to commit to integration policies. The CIS has so far been ineffective in coordinating a joint economic reform process. That left Kazakhstan with the task of elaborating its own economic recovery and development program. Large oil and gas potential allows the republic to accept a development strategy based on exports of hydrocarbons.

Reasons for Accepting the Energy Export-based Strategy

Kazakhstan is basing its economic recovery and development on exports of energy resources, at least in the short to medium term, because at present they possess the largest revenue earning potential for the nation. Neither industry nor agriculture are able in their current condition to serve as an engine for economic recovery and growth. Moreover, the transportation system is inadequate to support growth in these sectors, as shown below.

Industry

Industry accounted for about 40 percent of net material product in 1991 and is dominated by large, capital intensive enterprises geared to exploit the republic's natural resource base. The largest enterprises are: processing plants for ferrous and non-ferrous metals, refineries and petrochemical plants, and heavy machinery and tool producing fac-tories. Kazakhstan also has a variety of smaller agro-processing industries, including meat and fish canneries, wineries, and footwear and textile manufacture. Practically all of Kazakhstan's industrial enterprises were closely integrated within the Soviet economic system, receiving most of their supplies from and shipping most of their output to Russia and other republics. Thus, among three oil refining plants only one was processing crude that was extracted in the republic; the other two were working on Siberian crude. ₁

The economic collapse and disintegration of the Soviet Union left Kazakhstan with large, capital intensive, inefficient enterprises that were unable to compete on world markets due their to low quality output and high costs of production. The severing of economic ties between the CIS states left many enterprises without suppliers of inputs and consumers of output. Poor payment records between enterprises within the CIS further contributed to industrial depression. Gross domestic product and industrial production declined sharply through the 1990s with 1994 being the worst year. ₂

Source: Economist Intelligence Unit

To prevent massive layoffs of employees and the disruption of production processes the state continued to subsidize these enterprises and pay salaries to workers, thus creating significant inflationary pressure in the economy. Consumer price inflation peaked in 1994 at 1,498.3 percent. ₃

To maintain macro-balance in the economy, meet IMF deficit targets, and counter a lack of domestic savings, Kazakhstan's government began a daring privatization experiment in 1995. It began selling the largest state-owned enterprises to foreign investors, a move unparalleled in other CIS states, where fear of `selling off' national assets to foreigners often hinders direct foreign investment. Thus in 1995, 30 large enterprises were sold to foreign owners. Among these were several important oil producers, one of the three oil refineries, the largest steel smelter in Kazakhstan, copper smelters, coal mines and power plants. According to reports, most sales were characterized by both haste and low bids, reflecting the government's desire to dispose of budget draining enterprises and investors' reluctance to invest in large, capital intensive enterprises, most of which carry significant debt and require thorough restructuring. ₄

The current condition of Kazakhstan's industry prevents it from becoming the engine for economic recovery in the near future. Its large enterprises are characterized by low productivity and cannot contribute to employment creation nor revenue earning. Even if the `privatization by foreigners' strategy yields positive results in the form of greater efficiency and competitiveness, prior to that it is reasonable to expect significant layoffs of employees and low revenues, as enterprises restructure their economic ties and production methods.

Agriculture

Similar problems exist in food production. In 1991 agriculture was the second largest sector in the economy, contributing 36 percent to GDP. Despite being a net exporter of basic food products, Kazakhstan remains an inefficient agricultural producer. Crop yields are low compared with other countries with a similar climate, such as Canada. ₅ The severing of economic ties between the republics left state farms with large inventories of low quality agricultural equipment and a lack of spare parts and servicing. The wage differential between urban and rural sectors, as well as a deterioration of medical, social and educational facilities in the countryside lead to a significant migration of the rural labor force to urban centers. About 30 percent of the land cultivated during the Virgin Lands campaign is not suitable for cultivation and its use contributes to soil degradation. While Kazakhstan is able to export some of its agricultural production, it does not enjoy a compar-ative advantage in agriculture due to high costs, low efficiency, and dependence on unreli-able suppliers in Russia, Ukraine, and Belarus for most spare parts. ₆

In the long run, agriculture can stimulate the creation of backward linkages that may allow agricultutral supply industries to grow sufficiently to achieve their own economies of scale by drawing on existing industrial resources, particularly in chemical fertilizers, transportation equipment and farm machinery. Short run prospects for the development of such linkages, however, are bleak. Inefficiency and the need for thorough restructuring, as discussed above, should prevent these industries from developing or successfully adjusting to serve Kazakhstan's agriculture in the near future.

Transportation

To conclude our analysis, let us look briefly at transportation. Kazakhstan is a very large country with a widely dispersed population and resource base, therefore, transpor-tation is of crucial importance for the functioning of its economy. Railways form the backbone of the transportation system, carrying more than 90 percent of the freight in 1991. Railroads are experiencing problems similar to those in industry, and result from the severing of economic ties with the former Soviet republics. They suffer from a shortage of spare parts and materials: 95 percent of spare parts, workshop equipment, and rolling stock originates from outside Kazakhstan (mainly from Russia and Ukraine), ₇ as well as from the poor payments record of customers. Road maintenance and construction are lacking due to a shortage of road maintenance equipment. Therefore, in its present condition the transportation system is inadequate to support growth in industry and agriculture.

Energy export-based development

For the short to medium term outlook, Kazakhstan's major advantage over other former Soviet republics is its rich endowment of natural resources. The most important source of future revenues and development is seen in the exploration of vast reserves of oil and natural gas. As international experience indicates, exports of petroleum and its products can serve as an engine for growth. They can bring in revenues in the form of taxes and royalty payments and, by creating financial linkages in the economy, allow investment in infrastructure and industry development. More foreign investment, domestic saving, labor, and skilled manpower can complement the fixed factors of production, land and natural resources. Not only can such expansion allow Kazakhstan to move toward its production frontier, but it can also expand the frontier outward and enable the economy to produce more total goods. Growth in petroleum production may stimulate recovery and growth in chemicals manufacturing, oil wells, and refinery and processing equipment manufacturing. It can also bring improvement in infrastructure, in roads, training and medical facilities.

Further, current market outlooks for oil products are good. ₈ Attempts to move away from oil as prime energy source in the OECD countries have so far yielded only marginal results and have concentrated primarily on conservation. Many developing countries have limited energy options and remain dependent on oil as the lowest cost, most convenient energy source in their industrialization drives. The economic recoveries of former command economies are also expected to generate growth in demand for oil. Therefore, energy export-driven growth strategy can generate significant capital inflows into the republic. Before we proceed with the discussion of this strategy, let us first briefly discuss the structure and performance of Kazakhstan's oil industry and the governmental program of its development.

Existing production and governmental policies

The first oil was extracted in Kazakhstan in 1911, and it is presently the 26th largest oil producer in the world. Estimates of recoverable reserves vary widely depending on the source, ranging from 12 billion barrels and up. Most production is located in the Western part of the republic, while most of the population and the two largest refineries -- Pavlodar and Chimkent -- are in the East. The third refinery, at Atyrau, was built during World War II and needs to be reconstructed and modernized. Most production was traditionally exported for refining to Western Russia, while crude for domestic refineries was imported from Central Siberia. Severe recession in the industrial sectors both in Kazakhstan and Russia led to a decline in oil production from 1991 to 1995, as illustrated below:

As a result of the drop in demand from Kazakhstan's industrial sector, all three refineries operate significantly below their capacity:

Oil Refinery Output Relative to Capacity, Jan. 1996, barrels / day

Refinery	Capacity	Production	Percent of Capacity
Pavlodar	162,666	63,031	38.7
Shymkent	126,518	82,861	65.5
Atyrau	102,427	72,474	70.8
Total	391,611	218,366	55.8

Source: Interfax, Kazakhstanmunaigaz - as cited by EIU

The government places a high priority on exports of hydrocarbons for economic recovery and development. Illustrative in this respect is President Nazarbayev's address at the government meeting on foreign policy formulation held in Almaty on November 15, 1995, when he stated that the two most important tasks of Kazakhstan's foreign policy were the promotion of development and transportation of oil and gas to world markets and the signing of an agreement with other littoral states in economic zones in oil rich Caspian Sea. ₉ To stimulate the growth of oil and gas exports in 1994, the government released a short term hydrocarbons development program, continued privatization in this sector, and introduced several legislation packages.

The short term program was identified by the Ministry of Oil and Gas in 1994. ₁₀ It called for $6.6 billion worth of investment in the near term future. The program centered on several priority projects, among them: construction of a 60,000 barrels/day (b/d) oil refinery in Mangistau; rehabilitation of the Uzen oil field, the largest deposit under the Ministry of Oil and Gas; reconstruction and improvements at existing oil refineries to increase the production of light petroleum products; and construction of the western Kazakhstan-Kumkol pipeline that would decrease dependence on Siberian oil by allowing Kazakhstan to refine its own crude at Chimkent and Pavlodar refineries. The financing of the necessary development projects was set to come from both allocating larger part of governmental revenues to development of the sector and from foreign investment. The program does not address certain longer term issues of sustainable development, such as resource management or environmental protection.

Privatization in the oil sector

To stimulate growth in oil and gas sectors, Kazakhstan began privatizing its oil and gas producing enterprises. Beginning in early 1996, the Oil and Gas Ministry, working with

the country's State Property Committee, privatized 146 of its enterprises. ₁₁ Another 36 state enterprises were deemed unqualified to become privately owned, and 4 became the property of their working staffs. Of the 31 enterprises owned by the biggest state oil and gas company Kazakmunaigaz, 20 were transformed into joint-stock companies, and seven remained with the company. Several large enterprises were sold to foreign investors, among them the Yuzhneftegaz oil production association and the Chimkentnefteorgsintez refinery. Bids were invited from foreign investors for the Aktuibinskmunaigaz, Mangistaumunaigaz, Pavlodar production associations and the Atyrau refineries. ₁₂

Legal framework

There are several legal documents addressing oil sector development in Kazakhstan. among them: the Decree of the President of the Republic of Kazakhstan (RK) on Oil Operations of April 18, 1994, the Decree of the Cabinet of Ministers of the RK on the Regulation of Geological Research, Mining and Usage of Underground Resources of April ₁₃ , 1994, and the Law on the Underground and Processing of Mineral Resources of the RK of May 30, 1992. The most important is the June 28, 1995, Decree on Oil by the President of the Republic of Kazakhstan,13 issued to stimulate foreign investment by setting ground rules for the development of oil resources. It reserves ownership rights for Kazakhstan's onshore and offshore oil and gas for the central government but allows producers of hydrocarbons to dispose of their production as they see fit. According to the decree, the government can grant exploration rights by competitive tender or through independent direct negotiation. The forms of foreign participation are joint-ventures and service and production sharing agreements. The decree includes the requirement that foreign companies provide employment and training to Kazak nationals and give preference to Kazak subcon-tractors of equal skill and logistical capabilities vis-à-vis competing foreign subcontracting firms. This document, while reserving nominal ownership rights for oil and gas fields for the state, essentially leaves issues of taxation, export duties, bonuses, royalties, production sharing, resource management, and environmental protection to be set forth in agreements between foreign investors and the government. Further, the monitoring of environmental protection and resource management are left to oil producers, rather than to state agencies.

The policies outlined above reflect Kazakhstan's strong interest in stimulating growth in oil exports and foreign investment in the oil sector by privatization, restructuring and the establishment of a legal framework. Such long term development issues as environ-mental degradation, resource depletion, and revenue sharing, however, are not addressed.

Let us now turn to a discussion of the experience of the largest and most important oil project in Kazakhstan, the Tengizchevroil joint-venture, to identify the advantages and disadvantages of energy based development for Kazakhstan.

Case Study: Experience of the Tengizchevroil (TCO) Joint-venture

The Tengiz field is believed to hold nine billion barrels of recoverable oil and about 25 billion potentially recoverable barrels, as well as trillions of cubic feet of gas. ₁₄ Because the $20 billion joint-venture is the single largest U.S. investment project signed to date in the former USSR, Kazakhstan will be in a particularly unpleasant predicament vis-à-vis attracting foreign investment should this project fail. Attracting foreign investment is primary to the economic stability of Kazakhstan over the long term. A well-negotiated agreement with foreign companies created the possibility of generous tax and royalty pay-ments over the long run. It is in Kazakhstan's best interest to succeed in its Tengiz project, since it is indicative of Kazakhstan's willingness to cooperate with foreign investors. The experience of the TCO is illustrative of the benefits that Kazakhstan can expect from investment in its oil and gas sector and of the risks such large scale investment contain.

Chevron Overseas Petroleum Inc. considers Tengiz to be its biggest and most impor-tant project since the opening of Saudi Arabia to exploration and development about 50 years ago, as announced by its President Richard Matzke, in 1994. ₁₅ According to estimates, the Tengiz project could yield Kazakstan as much as $60 billion in taxes and royalties.15

In accordance with the joint-venture agreement, Chevron has adopted a five year, $50 million program for investing in the improvement of local infrastructure, training, and local business development. ₁₆ Thus, sanitary landfill and reduced water discharge systems have been installed as well as a recovery center for recycling. With an aim to increase safety at the production sites, preventive maintenance programs have been implemented and fire trucks and emergency response vehicles have been purchased. Upgraded medical and housing facilities and training are being provided to over 2500 employees on the site. The local community has been provided with donated medical equipment and pharmaceutical supplies, school equipment, and vehicles for police agencies. In 1994, 49 local businesses were employed by the joint-venture. To upgrade oil field operations, a central computer for financial and operational software and 800 personal computers on a fiber optic computer network linking Tengizchevroil with world networks has been installed. As of April 1995 Tengiz Chevron in cooperation with local oblast officials has spent over $21 million overall to upgrade medical, heating, drinking water and housing facilities.

Lack of export routes -- main impediment to the TCO operation

The main problem in the operation of joint-ventures stems from the lack of an adequate export pipeline. At the center of this issue is the existing Russian state-run pipeline monopoly, Transneft. During the existence of the USSR, Transneft was a branch of the Soviet Ministry of Oil and Gas and controlled 65 million kilometers of pipelines. The collapse of the Soviet Union has left 16 million kilometers of the old network outside of Russia. Transneft has since become a state-run joint stock company. Currently many of pipeline systems built under the old regime to supply oil to heavily industrialized regions in the European Soviet Union and Central and Eastern Europe are underused, due to a sharp decrease in the demand for oil in these areas that result from industrial depression. Today, most oil is exported to the West through systems in the Baltic and Black Seas.

The considerable importance of oil revenues to Russia means that the state-owned Transneft is unwilling to cut Russian oil exports in order to make room for Kazakhstan's oil. This is why in 1995 only 55,000 b/d of Tengiz oil was exported when the capacity was 130,000 b/d. ₁₇ This impediment has slowed Chevron's revenues considerably and can slow its investment in Kazakhstan. Aside from the existing transportation bottlenecks, another excuse for Transneft's limiting the flow of Kazak oil through its system of pipelines is purely technical: it claims that Tengiz's oil is contaminated with dangerous chemicals. Russia complains that it does not possess the technology to process mercaptan tainted crude from Tengiz. Russia argues that the pollutant contaminated the other Russian blend oil and caused problems with its existing pipeline. Consequently, most of Chevron's 1996 investment was not in the further exploration of wells but rather in the construction of large processing plants to reduce the pollutants at the field. ₁₈

The main factor negatively affecting oil exports from Kazakhstan is of an essentially political nature. Since the breakup of the Soviet Union, Russia has been using its control over the existing pipeline system as leverage in negotiating higher equity stakes in Kazakhstan's new oil and gas projects. Russia's interest in participating in the development of Kazakhstan's oil-exporting capacities has manifested itself in part in increasing equity investment by Russian oil companies in these projects. ₁₉ Since 1995 Lukoil, the Russian oil giant, has been negotiating for a portion of the equity in the TCO and in January 1997, sealed a deal for 5 percent of the venture, acquiring it from Chevron. ₂₀ This makes Lukoil, which is also one of the two largest corporate shareholders in the Caspian Pipeline Consortium, one of the biggest benefactors from TCO's success.

The Caspian Pipeline Consortium -- troubles with implementation

The most feasible project that may provide higher export capacity for Tengiz oil is taking shape in the plans of the Caspian Pipeline Consortium, Ltd. It proposes a 930-mile, $1.2 billion crude oil system from the Tengiz field to an export terminal on the Black Sea with an export capacity of up to two million b/d. ₂₁ Kazakhstan and Oman formed the Caspian Pipeline Consortium, Ltd. (CPC) in June 1992 and Russia joined the following month. Russia, Kazakhstan, and Oman became equal equity patrners in the CPC agreement, but 1992-1995 were characterized by a stalemate in the negotiation process over two issues.

First, Chevron and the CPC did not agree on the financial arrangements for the export pipeline. The Russian government has transferred assets to the CPC but has not guaranteed the vital volume of exports (180,000 b/d) that would make the project feasible. The government of Kazakhstan has neither transferred assets to the CPC, nor has it given a guarantee of the 90,000 b/d output throughout. ₂₂

Second, there is a strategic issue of Russian control over the oil exports of the former Soviet republics. At the volumes involved in the CPC, Kazakhstan's projected exports are not yet a problem to Russia. But in 20 years, Kazakhstan's potential to produce in excess of 1.5 million b/d could cost Russia market share. Therefore, Russia is interested in controlling the export volumes of Kazakhstani oil, or in being directly involved in the revenue sharing.

The gridlock was resolved in April 1996, when a new agreement that included the governments of Russia, Oman, and Kazakhstan and eight oil companies was signed. ₂₃ The agreement established principles for restructuring the Caspian Pipeline Consortium, under which Russia will have a ₂₄ percent stake; Kazakhstan will control 19 percent, and Oman will control 7 percent. The remaining 50 percent will be divided among eight companies. Chevron will hold the largest share, at 15 percent, followed by Lukoil with 12.5 percent, and Rosneft with 7.5 percent. This will give Russia and its two oil companies the largest bloc of shares. The other shareholders in the project are: Mobil, 7.5 percent; British Gas, 2 percent; Agip, 2 percent; Oryx Energy, 1.75 percent; and Kazakmunaigas, 1.75 percent. The resolution of the pipeline gridlock should provide the necessary financing for construction, ensure Russia's support, and thereby allow the TCO to increase its export capacity significantly to reach its projected goal of 700,000 b/d by 2010.

Some international aspects of TCO's implementation

Another impediment to TCO and the CPC projects lies in the possible negative response of Turkey. Once oil leaves Russian Black Sea ports, it will have to pass through the Bosphorus, a 28 kilometer long strait that is only 700 meters wide in places. A tanker accident in March 1994 increased Turkey's fears of possible environmental disasters for its largest city, Istanbul, if oil traffic through the Bosphorus increases. Also, as a nation with strong historical ties to the Central Asian states, Turkey is interested in increasing its influence in the region. Therefore, it may use its ability to limit the flow of oil traffic through the Bosphorus to support its political and economic interests in Central Asia.

The alternatives to building a pipeline through Russian territory include the construction of a pipeline through Iran and oil swap agreements with Iran. In October 1993, the presidents of Kazakhstan and Iran, Nazarbayev and Rafsanjani, signed a series of trade accords to boost economic ties between Kazakhstan and the Islamic Republic of Iran and discussed the possibility of oil swap agreements.24 Chevron is also considering the Iranian route. In September 1995, Hugh Dickey, a spokesperson for Chevron's CIS business unit, stated that Tengizchevroil is considering a deal with Iran as a short term arrangement until a longer term project is put in place. ₂₅ Under such an arrangement, Tengizchevroil would swap oil with Iran and collect Iranian crude at the Arabian Sea for export to world markets. The Iranian option suffers from several significant drawbacks. First, due to U.S. sanctions, U.S. companies cannot deal directly with Iran. Second, it is at present impossible to arrange financing for pipeline construction, as neither Iran nor Kazakhstan have the necessary funds, and as the United States has blocked Iranian access to multilateral financing. Finally, the Iranian government does not have the reputation of a reliable partner.

Risks of Oil Export-driven Development

As the experience of the TCO joint-venture indicates, an oil export-driven devel-opment strategy can be a viable source of significant short term revenues. There are, however, risks associated with such policy. Most importantly, Kazakhstan lacks viable alternatives in the shipment of oil to world markets. Russia is reluctant to allow major ship-ments of Kazak oil through its territory, unless it shares in the profits by including Russian companies in production sharing and transportation agreements. Kazakhstan has been unable to negotiate viable alternative export routes to avoid Russian territory, with the exception of several swap deals. Thus, in the short term-Russia maintains its control over oil exports from Kazakhstan, and has used this as leverage in negotiations that increased its participation in the CPC and the TCO, sometimes at the expense of other foreign partners. This Russian presence may decrease foreign investors' confidence in the stability of their long term investment in Kazakhstan. The Kazak government's lack of commitment to adhere to achieved agreements may further hinder the sector's development, as illustrated by the 1992-96 gridlock in the implementation of the CPC.

Potential exists for a conflict of objectives between foreign multinationals and Kazakhstan. It is in the interest of foreign investors to support political stability in the host country, while democratization and nation building, which might not contribute to short term political stability, are important for Kazakhstan as it enters the Twenty-First Century. Oil revenues can be used to finance the lack of real structural reform, and may be wasted on inefficient projects, such as continued subsidization of the domestic industrial sector.

In Kazakhstan, which inherited many environmental problems from the Soviet Union, environmental concerns are very important in the development of the oil industry. Yet standards of environment protection were negotiated with the TCO rather than being set by government agencies. Their implementation is left to the TCO as well. Important long-term issues for sustainable development, such as resource depletion, have also not been addressed.

Although oil export-led development has benefited most nations that have pursued this strategy, the experiences of several countries are worth mentioning in discussing its benefits and weaknesses. As history indicates, focusing solely on growth in one sector, combined with an ineffective and corrupt government, may in fact hinder economic growth. Thus, by 1929 Venezuela became the second largest oil producing country in the world (after the United States); oil provided 76 percent of Venezuelan export revenues and half of government revenues. It became a de facto oil country. Nevertheless, oil revenues did not lead to the modernization of the Venezuelan economy, and the country remained an underpopulated, impoverished, and agricultural nation. This was because linkages were not created in the economy; rather, most of the revenues went toward maintaining the power of the corrupt regime of General Gomez and his clients. ₂₆

Furthermore, Venezuela suffered severely from the economic phenomenon known as "Dutch disease." ₂₇ It derives its name from the experience of the Netherlands after 1960, when major reserves of natural gas were found. The ensuing export boom and balance-of-payments surplus promised new prosperity. Instead, during the 1970s the Dutch economy suffered from rising inflation, declining exports of manufactures, lower rates of income growth, and rising unemployment. The oil boom of the 1970s and early 1980s produced similar paradoxes in other countries, including Venezuela, Nigeria, Mexico, and Saudi Arabia. An increase in primary exports causes the real exchange rate to appreciate, rendering other exports less competitive and hence less profitable. Producers of tradables, both exporters and import competitors, face rising prices for non-tradable goods and ser-vices, including wages for employees. They cannot, however, charge higher prices because they compete with foreign producers, either as exporters or as import competitors. These farmers and manufacturers face a profit squeeze that causes some to reduce production and employment. The growth in primary exports is offset partly by a depression in tradables.

This negative phenomenon can be avoided by creating an effective monetary control system. One possible cure for Dutch disease is to prevent or reverse real appreciation of the currency. This might require a devaluation of the currency, perhaps through a series of smaller devaluations (crawling peg) by the central bank. Devaluations must be accompanied by stringent controls over budget expenditures by the government and by strong restraints over money creation by the central bank, both actions aimed at curbing the inflation.

Finally, Kazakhstan is a very large and multiethnic state with regions varying widely in terms of demographics and economic composition. As oil rich regions develop, conflicts of interests may emerge between different regional, industrial, and ethnic lobbies. Thus, for example, the oil industry and the manufacturing sector may have conflicting views on a foreign trade regime. The largely Russian-speaking and heavily industrialized northern provinces may opt for a closer integration with Russia than may be comfortable for Almaty if they feel excluded from the revenue sharing. These risks, nevertheless, are outweighed by the significant advantages of energy export-driven development in Kazakhstan.

Advantages of Energy Export-driven Development

As the experience of the TCO indicates, a development strategy driven by oil exports and focusing on inviting foreign investment into the sector can create significant benefits for Kazakhstan. Large scale direct foreign investment that incorporates equity capital, management, technology, and marketing skills does more for Kazakhstan than just finance the development of its natural resource base. It also creates a large tax and royalty potential that could stimulate development of fiscal linkages in the economy as the revenues are reinvested in other sectors. Revenues can be channeled for reinvestment in the development of new promising sectors, such as finance or telecommunications, thereby diversifying the economy. Moreover, rapid growth in the oil sector may lead to the creation of linkages to other sectors, such as chemicals, exploration, processing, and drilling equipment manufacturing, drawing on existing industrial capacities and technical expertise.

Oil revenues can be used to finance the creation of a social safety net and retraining programs for workers as industrial restructuring takes place. This is a measure opposite to the above, in which oil revenues are used to subsidize inefficient production so as to prevent massive layoffs.

The transfer of technology, production, and managerial skills takes place in the process of project implementation. Given the relatively high educational level in the former Soviet republics, particularly in engineering, it is possible to argue that the capacity for such skills transfer exists in Kazakhstan. National cadres of oil engineers, economists, and managers can be created. As the TCO experience indicates, significant development of local infrastructure also follows. Communications, roads, and utilities are upgraded to meet world standards. Finally, foreign multinational corporate investors provide the oil sector with access to world markets. Vertically integrated multinationals investing in Kazakhstan have developed preferential access to customers by adhering to long-term contracts. It may take years for Kazakhstan to penetrate world petroleum markets on its own.

Avoiding Negative Developments

The above discussion allows us to posit a worst-case scenario of development and suggest policies to avoid it. In this scenario, Kazakhstan's government is unable to cope efficiently with the inflows of revenues from oil exports. The interests of different pressure groups prevail. The revenues are not reinvested but rather are used to subsidize favored sectors or enterprises. Uneven, one-sector development makes the country increasingly vulnerable to outside shocks, such as oil price fluctuations, like those suffered by Mexico and several other Latin American countries in 1982. Unable to negotiate alternative export routes, Kazakhstan's ability to ship oil remains at the mercy of Russia, making the country even more vulnerable to outside events. Oil revenues support lack of any real structural economic and political reform and are used to maintain the status quo. To avoid such development, the government needs to adopt a long-term development policy, in which the oil sector is viewed as a means to development, rather than its end.

What Can the Government Do?

At present, oil exports are probably Kazakhstan's main route to economic recovery and prosperity. The achievement of these goals, however, depends on the complex tasks of creating viable export routes; establishing an investor-friendly climate; stimulating the creation of (particularly financial) linkages in the economy; privatizing inefficient state-run enterprises; and balancing the interests of foreign multinationals with considerations of domestic development and nation building, as well as the interests of different domestic groups. To these ends, a coherent, governmental long-term strategic development program needs to be developed and implemented through effective and transparent legislation. Such a program must be based on available geological data and estimates, assessment of the current domestic and regional economic and political situation, and the experiences of other oil producing states. The following issues need to be addressed.

Transportation routes other than the Russian pipeline systems need to be developed in order to decrease Russia's ability to limit oil exports from Kazakhstan and use its control over pipelines as a means to further its political and economic interests in the region. In the long-term, such routes can be built through Turkey, Iran, Afghanistan, China, and Pakistan. Although too costly or otherwise unfeasible at present, they might become real alternatives as the regional situation improves. In the meantime, it is important to establish and maintain a stable working relationship with Russia as it becomes more interested in the success of Kazak oil projects.

It is important to ensure the efficient reinvestment of revenues from energy exports resources to other sectors. A sound financial system that could stimulate the development of financial linkages in the economy and prevent negative effects of real appreciation of Kazak currency needs to be created and maintained. The role of the independent central bank in this project cannot be overemphasized.

The long-term program also needs to focus on the creation of linkages to chemical and oil exploration and development equipment manufacturing, drawing on existing industries and expertise. Developing the oil sector should be viewed not as an end in itself, but as a stepping stone that could enable the currently depressed industrial sector to revive. In addition, the social safety net, including unemployment compensation and retraining programs, needs to be introduced and financed from revenues, so as to allow the restructuring in the industrial sector to take place without a rapid deterioration in living standards of workers.

A more comprehensive legal framework governing the oil industry that sets environmental and resource depletion standards and addresses other long term tasks of sustainable development needs to be introduced. Writing good laws, however, is insufficient. Mechanisms to ensure the enforcement of regulations and laws by both Kazak and foreign oil producers operating in Kazakhstan, and to minimize corruption and procrastination by bureaucrats, need to be set and enforced.

Oil exports cannot serve as an engine of growth indefinitely, but can enable Kazakhstan to achieve economic transition and recovery. The caveat is, however, that these policies can be introduced and maintained only by a highly capable and commited government. The question remains whether Kazakhstan is up to this task.

Summary

At present, Kazakhstan's industry, agriculture, and transportation are in need of deep restructuring. The country's rich natural resource base, in particular its significant hydro-carbons potential, are the primary, if not only, viable route to prosperity. The advantages of a development strategy based on exports of hydrocarbons outweigh the risks. The government of Kazakhstan has taken steps to stimulate growth in oil exports by privatizing oil producing and processing enterprises and creating a legal climate favorable to foreign investment. These measures, however, are mostly short-term and do not address long-term issues of a sustainable development program fueled by oil exports. The experience of the TCO allows us to identify some of the issues that need to be addressed by a strategic long term program of oil sector development. Successfully developing and implementing such program, however, will require a highly capable government and state bureaucracy.

Overall, recent economic performance data suggests that the oil sector is already becoming the fastest growing part of Kazakhstan's economy. After two years of falling oil and gas production, there was a strong recovery in oil production in 1996. In the first quarter of 1996, production increased by 20.7 percent over the corresponding period of 1995 to 426,700 b/d. ₂₈ The output by refineries in the first quarter of 1996 rose 40.2 percent over the same period in 1995. ₂₉ The resolution of the CPC gridlock and the recent signing of agreement on economic zones in the Caspian Sea create good prospects for continued significant growth in oil output in the coming years.

Footnotes

Note 1: "Facilitating Kazakhstan's Natural Resource Development," U.S.-Kazakhstan Monitor, January 1995, 3. Back.

Note 2: Economist Intelligence Unit, Kazakhstan Country Report (London: Economist Intelligence Unit, 1st quarter 1996), 9. Back.

Note 3: Ibid., 24. Back.

Note 4: "Kazakhstan's Sale of the Century," Financial Times, October 25, 1996, 4. Back.

Note 5: Kazakhstan: The Transition to a Market Economy: A World Bank Country Study (Washington: World Bank, 1993), 130. Back.

Note 6: . Ibid. Back.

Note 7: Ibid., 140. See also Sodruzhestvo Nezavisimykh Gosudarstv v 1994 godu. Kratkii spravochnik predvaritelnykh statisticheskikh itogov (Moscow: Statisticheskii Komitet SNG, 1995), 126. Back.

Note 8: "Oil and Gas Journal's 3-Year Forecast," Oil and Gas Journal, April 22, 1996, 40-60. Back.

Note 9: "The Speech by the President of the Republic of Kazakhstan, N. A. Nazarbaev, at the Meeting on Foreign Policy Issues. Almaty, 15/2/1995," in Vneshnyaya politika Kazakhstana. (Almaty: Ministry of Foreign Affairs of the Republic of Kazakhstan, 1995), 5-17. Back.

Note 10: "The Balgimbaev Agenda," U.S.-Kazakhstan Monitor, January 1995, 6. Back.

Note 11: Economist Intelligence Unit, Country Report, 9. Back.

Note 12: New Europe, Jan. 19-25, 1997, 42. Back.

Note 13: "Decree on Oil," U.S.-Kazakhstan Monitor, September-October 1995, 37-43. Back.

Note 14: Economist Intelligence Unit, Kazakhstan: Country Profile 1996-1997 (London: Economist Intelligence Unit, 1997). Back.

Note 15: "Challenges of Tengiz Oil Field and Other FSU Joint Ventures," Oil and Gas Journal, July 4, 1994, 62. Back.

Note 16: "Facilitating Kazakhstan's Natural Resource Development," U.S.-Kazakhstan Monitor. January 1995, 3. Back.

Note 17: "Tengiz Field Operation Marks Second Anniversary," Oil and Gas Journal, April 17, 1995, 28. Back.

Note 18: Economist Intelligence Unit, Country Report, 15. Back.

Note 19: "It's in the Pipeline," U.S.-Kazakhstan Monitor, July-August 1995, 25. Back.

Note 20: With reports from Interfax and Reuters; printed in New Europe, January 26-February 1, 1997, 41. Back.

Note 21: "Mobil Joins in Deal for Asian Pipeline," The Washington Post, April 28, 1996, A20. Back.

Note 22: "Oil's Deal of the Century Still in the Pipeline," The Washington Post, March 12, 1995, H1. See also: "Pipeline Diplomacy," The Washington Post, September 19, 1995, A12. Back.

Note 23: "Mobil Joins in Deal for Asian Pipeline," The Washington Post, April 28, 1996, A20. Back.

Note 24: "Kazakhstan, Iran Expand Economic Ties," Agence France Press, October 25, 1993. Back.

Note 25: "Chevron Group Seeks to Arrange Iranian Oil Swap," The Wall Street Journal, September 12, 1994, A4. Back.

Note 26: Excellent historical perspective on oil-driven development is provided in: Daniel Yergin, The Prize (New York: Simon and Schuster, 1992). Back.

Note 27: Malcolm Gillis and Dwight Perkins, Economics of Development (New York: W.W. Norton, 1993), 434-439. Back.

Note 28: Economist Intelligence Unit, Kazakhstan Country Report. Back.

Note 29: Ibid. Back.