Банки Казахстана в июле 2016 года Приложение 1. Кредит экономике, депозиты в депозитных организациях. Oil and gas sector in the economy of Kazakhstan

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1 Банки Казахстана в июле 216 года Приложение 1. Кредит экономике, депозиты в депозитных организациях Summary Elmira Arnabekova Murat Temirkhanov +7 (727) Atlynay Ibraimova Kazakhstan holds one of the leading places in the world with its oil reserves (12th in the world, 1.8% of world reserves). In CIS region, the country is also one of the leaders by the volume of oil reserves and production level, ranked second only after Russia. BP estimates that at current oil production levels, reserves are adequate for around 49 years. According to BP's report, natural gas reserves amount to 1 trillion cubic meters,.5% of the world's reserves, while at the current gas production level, reserves will last for 75 years. Possessing significant hydrocarbon development potential, the country attracts foreign investors and is one of the major players in the world market. Oil sector of Kazakhstan is represented by more than 2 fields, concentrated mainly in the west of the country. The country annually produces about 78-8 million tons of oil (~ million barrels per day), with the completion of expansion projects, the maximum production level by 225 is projected to reach 11 million tons (at this volume, daily production will exceed 2 million barrels per day). Oil and gas industry is one of the main drivers of the country's GDP growth, reflecting significant dependence of the economy on the industry's revenues. The decline in world oil prices (from $98 in 214 to $53 in 215 and $44 in 216) and a considerably small decline in its production contributed to a slowdown in economic growth from 4.1% in 214 to 1.2% and 1% in 215 and 216. In general, the dynamics of GDP growth in Kazakhstan can be divided into three separate periods: from 199 to 1999, characterized by practically zero growth; the period from 2 to 214, when positive dynamics of oil prices, investment inflows and production growth contributed to an annual increase in Kazakhstan's GDP on average by 7-8% (except for the period of the global crisis in 27-29); and the period of , when a steady and sharp drop in oil prices, a decline in production and investment in the sector are observed. It should be noted that from 2 to 24, despite relatively low oil prices, the inflow of foreign investment into the oil and gas industry (in 4 years gross direct investments in the sector grew more than twice) ensured a rapid increase in oil production in the country and a rise in export revenues, and, as a result, GDP growth reached double-digit values. The inflow of foreign direct investments in the following years increased (especially in geological exploration), and the growth in oil production and the economy stabilized. Following the dynamics of oil prices in 28-29, the country's economy slowed sharply, then in , again rebounded to a level of 5% in annual terms, when the price of oil reached its maximum values, exceeding $1 per barrel. Thus, during the entire period of Kazakhstan's independence, the main catalyst for an active economic growth was the oil and gas sector. In turn, the main factors of the sector's progress were oil price, foreign direct investments and oil production increase. Other sectors of the economy could not provide such a strong and sustainable growth in GDP. The rapid development of the country's oil and gas industry over the course of the decade led to a significant dependence of the economy on oil exports and oil prices. Exports of oil and gas in 213 and 214 accounted for 7% of the country's total exports. The share of oil and gas sector in GDP reached 3% in 211. Taking into account additional financing of state budget expenditures from the National Fund (NF), the contribution of the oil and gas sector to GDP was even greater. In the past few years, on average, the share of direct investment in oil and gas industry has taken just over half of the gross inflow of foreign investment into the country, falling from record levels of the earlier periods. The current period (from 215) has revealed the weakness of the commodity-oriented economy, which caused the deterioration of macroeconomic indicators. After a decrease in oil prices and in volumes of oil production, GDP growth sharply fell and fiscal imbalances arose that depleted the NF's currency assets - a decrease from the peak of $73.2 billion in 214 to $61.2 billion by the end of 216 (a decrease of $12 billion). Due to unfavorable external environment, the consolidated state budget moved from a surplus to a deficit and the non-oil deficit grew even more. As the result of a net export decline more than threefold since 214, the current account balance turned from a surplus of 2.8% in 214 to a deficit of 6.3% of GDP in 216. At the same time, record inflow of direct investments in the financial account of $14 billion in 216 offset negative consequences of the decline in export revenues, covering the current account deficit (51% of the gross inflow of investments in 216 was directed to the oil and gas sector).

2 The National Fund (in line with a countercyclical policy of using the National Fund) had to play an important role in absorbing the negative consequences of dependence of the economy on commodity sector. In the period of high oil prices, in order to prevent overheating of the economy, the National Fund was supposed to perform the functions of sterilization and accumulation of petrodollars (with an aim to reduce the volatility and dependence of budget expenditures on the oil and gas sector). In the period of falling prices for oil, NF assets were to serve a stabilization function for directing the funds to stimulate and sustain economic growth. In our opinion, the use of funds from NF did not correspond to countercyclical policies and was of a certain procyclical nature. So that in years of fairly high oil prices (21-214) NF assets expenditure continued and remained practically at the level of spending during the crisis Thus, petrodollars surplus revenues, received in years of a favorable price environment, did not have time to accumulate sufficiently, while the dependence of state expenditures on the use of the National Fund resources grew. After the crisis of 27-29, the non-oil deficit of the state budget remained at an unacceptably high level. Also, in the past few years the state has been actively attracting funds from the NF not to directly support the economy, but to ensure the financial stability of certain institutions. For example, in 29, the NF provided a purchase of Samruk-Kazyna bonds (comparable in size to 3.7% of GDP), which in turn were mainly used to support the nationalization of banks. In 215, the NF finds were used for Samruk-Kazyna bond purchase (comparable to 1.8% of GDP), which provided coverage for external liabilities of NC KMG. In 217, the NF's funds are planned to be spent at the banking sector improvement (comparable to 4% of GDP). Currently, there are signs of a process for a more rational use of funds from the NF. Measures to reduce the level of transfers and reduce the dependence of the economy on oil revenues are reflected in the new concept of NF, agreed last year. However, the document is far from the best world practice on the accumulation and use of sovereign funds of the country. According to our calculations, the oil price at which the consolidated budget of the country will be neutral should be $55 in 217 (not taking into account the one-time use of funds for the improvement of the banking sector this year), which roughly coincides with our forecasted oil prices in 217. In these conditions, one can expect the construction of an acceptable fiscal balance of the country. In the first half of this year, an unexpectedly high GDP growth (4.2%) is noted. The main growth driver was again the oil and gas sector, as well as the mining sector (metal production). Compared to the first half of 216, the average price of oil increased by 3% to $52, and due to Kashagan, oil production increased by 1%. Price turbulence in the oil market has led to the fact that oil production is now barely on the verge of profitability. According to our calculations, the operating cost of producing one barrel of oil in Kazakhstan's fields, with the exception of Kashagan, fluctuates between $7- $48/bbl. Such a wide range is explained by different stages of maturity of deposits. The field of exploration and development of new deposits in recent years is characterized by the departure of investors from projects and the direction of the main part of the investment in the extraction of existing deposits. Therefore, the hopes of the industry are mainly associated with the increase in production at the three giant deposits of Karachaganak, Kashagan and Tengiz. In general, the commodity-dependence of the economy and the volatility of the price of oil are one of the key risk factors for Kazakhstan's economic stability. Negative shocks of fluctuations in prices for oil adversely affect the main components of the gross domestic product: consumption, investment, and state expenditures decrease. Moreover, positive shocks also have negative consequences for the country's economy: the structure of the economy is being rebuilt into the sector of non-tradable goods (construction, services, etc.), while the traded goods sector is stagnating (manufacturing industry, agriculture). Also, improperly pursued countercyclical policies are the reason of growing consumer and investment imports. Thus, local production cannot compete with cheaper imports during high oil prices, but at the same time, production is also experiencing difficulties in the period of low prices due to a general decline in business activity and lack of financing. Among other disadvantages of the commodity-oriented economy, we note an increase of public investment in business in the period of high oil prices, which leads to the predominance of the public sector over the private sector. A small share of the private sector in the economy is one of the main reasons for the weak development of market relations and the weak competitiveness of local businesses. In Kazakhstan, large proportion of the employed population works in state structures and receives income financed by volatile oil revenues. In the long term, stable employment in this sector is unsustainable, it is necessary to reduce this share for more efficient use of oil revenues. We should also note that the oil sector is characterized as quite capital-intensive, so it is not a sector that actively creates jobs. All these facts speak of the urgent need to diversify the economy to reduce the dependence of the country's revenues on fluctuations in oil prices and improve the policy on the use of the National Fund. From the point of view of diversification, the early implementation of structural reforms, the denationalization of the economy, the development of market relations and the private sector will be the main drivers of this process. 2

3 mln tonnes $/bbl Figure 1. Oil output Source: CS MNE, Bloomberg Oil output Brent price ($/bbl, right sc.) Brent price consensus forecast ($/bbl, right sc.) Production and Reserves Oil Kazakhstan holds one of the leading places in the world with its oil reserves (12th in the world, 1.8% of world reserves). Proved oil reserves of Kazakhstan, according to BP's report, increased almost 6-fold from 5.3 billion barrels in 1995 to 3 billion barrels by the end of 216 (3.9 billion tons). The government estimates the reserves of the country a little higher - at a level of 4.8 billion tons. BP estimates that oil reserves are adequate for 49 years. The largest oil fields are concentrated in the west of the country, among them: Tengiz, Kashagan, Karachaganak, Uzen, Zhetibai, Zhanazhol, Kenyak, Karazhanbas, Kumkol, North Buzachi, Alibekmola, North and East Prorva, Kenbai and Korolevskoye. At the same time, the oil reserves of these 15 large deposits account for 9% of the country's total reserves. Taking into account the depletion of the oldest deposits (Uzen, Emba), it is necessary to search for new oil fields to maintain the country's commodity base. The search for deposits is mainly concentrated in the offshore areas of the Caspian Sea, which require more expensive investments. Oil production in Kazakhstan reached its peak in 213, and during the last 3 years after a consistent increase on average by 4% is reduced due to a physical decline in oil production at existing fields. At the end of 216, the volume of production was 78 million tons, down by more than 1 million tons per year (Fig.1). According to government forecasts, the volume of oil production in 217 will be 81 million tons. At the same time, during the first half of this year, Kazakhstan increased production by 1% compared to the same period last year to 42.5 million tons. Thus, the daily production was about 236 thousand tons, or 1.72 million barrels (barrel conversion coefficient 7.3). Last December, Kazakhstan pledged to reduce oil production by 2, barrels per day in the first half of 217 from November, thereby promising to freeze production at 1.7 million barrels per day. However, due to the start of production at Kashagan (which reached 17 thousand barrels/day in 5 months after launch), as well as growth in volumes at Tengiz, Kazakhstan, on the contrary, exceeded the agreed figure, according to the International Energy Agency. So, according to the agency's report, daily oil production in February amounted to 1.8 million barrels. In March-April, daily production exceeded 1.7 million barrels, while the Minister of Energy noted that in May-August, the volume of oil production is expected to decline due to climatic conditions. So, in June, according to the Statistics Committee, production fell by 2% mom. Kazakhstan supported OPEC's May decision to extend the agreement for another 9 months, while the Minister of Energy spoke about the gradual withdrawal of the country from the agreements within 2-3 months after the expiration of the agreement. The Ministry also noted that the decline in production will affect the developed fields in Aktobe and Kyzylorda regions, and the volume of oil production at Kashagan, Tengiz and Karachaganak is not planned to be reduced. 3

4 Т trln % mln tonnes mln cub m Figure 2. Natural gas production Gas % 1.8% 8.6% 25% 2% 15% 1% 5.7% 5.2% 5.4% 5% 5.% 1.9% 1.8% 2.4% % Natural gas production Growth dynamics, % (right sc.) According to BP's report, natural gas reserves amount to 1 trillion cubic meters,.5% of the world's reserves, while at the current gas production level, reserves will last for 75 years. Among the largest deposits are: Kashagan (reserves of 1 trillion cubic meters), Tengiz (1.8 trillion cubic meters), Karachaganak (1.35 trillion cubic meters). Gas production in the country in 216 amounted to 46.6 billion cubic meters, an increase of almost 1 million cubic meters per year. The production of natural gas is growing every year, but there has been a significant slowdown in the growth rate from 12% in 28 to 3.5% on average over the past two years (Fig. 2). Almost all natural gas is exported (86% of the produced gas is exported abroad). Prospects for oil and gas production Figure 3. Output perspectives Other TCO KPO KMG EP (incl. KGM, KBM, PKI) Mangistaumunaygaz Aktobemunaygaz KazakhOilAktobe Kashagan This year, oil production, as projected by the Government, is about to reach 81 million tons. Due to the physical decline in oil production in the old fields, we expect that production at existing fields will drop to 76 million tons (-3% yoy), and taking into account the planned 5 million tons at Kashagan, the production growth may be about at 4% in 217. In the future, we expect a continued decline in production at the developed fields by an average of 1% yoy, while this decrease can be compensated by the growth of production at Kashagan to 13 million tons per year by Thus, according to our expectations, production can reach 87-9 million tons (Fig. 3). With the implementation of the further development of Kashagan, the production level can reach 16 million tons by 225, and production at Tengiz is expected to increase by 12 million tons per year to 39 million tons (the expected completion date is 222). While maintaining production volumes in Karachaganak (12-15 million tons) and other fields (about 4 million tons), this will increase production to 11 million tons by 225 (with a daily output of more than 2 million barrels per day). Figure 4. Share of oil&gas sector in GDP % % % GDP Oil output Share in GDP (right sc.) Source: CS MNE 4% 35% 3% 25% 2% 15% 1% Prospects for further increase in gas production and its exports are associated with a decrease in the use of extracted commodity for re-injection in oil fields. At the same time, the insufficient capacity of existing gas pipelines is also a factor limiting supplies abroad. Effect of the industry on GDP The oil and gas industry is one of the main drivers of the country's GDP growth, reflecting the significant dependence of the economy on the industry's income. The decline in world oil prices (from $98 in 214 to $53 in 215 and $44 in 216) contributed to a slowdown in economic growth from 4.1% in 214 to 1.2% and 1% in 215 and 216, respectively. Along with the fall in the price level, the decrease in oil and natural gas production in 216 caused the sector's share in the country's GDP to drop to 18% from almost a quarter in 214 (24%) (Fig. 4). Despite the fact that the share of production of the oil sector in GDP is relatively small, many sources of financing for nonoil GDP in the country are dependent on this sector. Taking into account that the state expenditures of the country make up about 25% of GDP, while on average about 4% of revenues of the consolidated budget are contributions from oil and gas 4

5 mln tonnes $ bn $ bn % Figure 5. Oil output and GDP dynamics % 9.8% 29 Source: CS MNE, World Bank 13.5% % Oil output, mln tonnes Brent price GDP growth Figure 6. Oil output and investments in the industry Source: CS MNE, World Bank Figure 7. Export revenues in dollar terms Oil output, mln tonnes Brent price Investments in oil and gas sector (right sc.) % 1% 5% % -5% -1% -15% companies, this indirectly gives 1% to GDP. It is necessary to note the inflow of investments related to the industry, which is used for spending in other sectors of the economy, in consumption, which also form the non-oil GDP of the country. Therefore, when considering the dynamics of GDP indicators, the country's budget, we observe a significant deterioration with oil prices fall. Also, based on empirical data, according to our estimates, there is a long-term relationship between GDP dynamics and the variables of the physical volume of exports and the price of oil. The sensitivity of GDP to the price of oil in the long-term period is.13, and to the export index of.14. That is, a 1% rise in oil prices contributes to long-term GDP growth of.13pp, a 1% change in the physical volume of oil exports shifts GDP growth by.14pp. At the same time, 11% of the deviation of GDP from its equilibrium value as a result of the shock of independent variables (export volume and oil price) occurs within 1 year (.11 - cointegration equation residual coefficient). Earlier, we also estimated the direct impact of the launch of the Kashagan field on the country's GDP. According to our calculations, the contribution of the growth in production at the new field to GDP growth in may amount to.7pp. In general, the dynamics of GDP growth in Kazakhstan can be divided into three separate periods: from 199 to 1999, practically zero growth, the period from 2 to 214, when the positive dynamics of oil prices, investment inflows and production growth contributed to an annual increase in Kazakhstan's GDP on average 7-8% (except for the period of the global crisis in 27-29), and the period , characterized by a steady and sharp drop in oil prices, a decline in production and investment in the sector % 62% 57% 59% 61% 61% 65% 68% 68% 7% 7% 62% 56% 8% 7% 6% 5% 4% 3% 2% 1% It should be noted that a fairly active economic growth in 2-26 occurred against the backdrop of low oil prices, and the country annually increased oil production, which almost doubled over the period. The increase in production and development of new oil and gas fields became possible due to the inflow of foreign investments (Fig. 6). Effect of the industry on the balance of payments % Export Total export Oil&Gas export Share of oil&gas (right sc.) Source: CS MNE, WITS Figure 8. Export volumes 9 8 Output Export 2 Consumption 1 Source: CS MNE, World Bank The share of revenues from the export of oil, natural gas and oil products in the total volume of exports tends to decline for the last 3 years, and in 216 it took a significant 56% (62% in 215) (Fig.7). This decrease in export revenues has a negative impact on the trade balance. As the result of a net export decrease more than threefold since 214, the current account turned from the surplus of 2.8% in 214 to a deficit of 6.3% of GDP in 216. About 8% of the oil produced is annually exported from the country. The remaining volumes of oil are sold on the domestic market for further processing at the refinery (Fig.8). In the past two years, there has been a dynamics of a decline in exports and growth in consumption on the domestic market. At the same time, we note that the country profits more with exporting oil rather than selling it on the domestic market. The sale of oil on the domestic market is executed at understated prices and is compulsory. 5

6 $ bn Therefore, with declining volumes of oil production in country, we expected an increase in supplying more oil abroad (which brings more tax inflows to the budget). However, possibly, with the growing demand for petroleum products in the country, deliveries (on average 3% of the produced oil of companies) to the domestic market have grown. Noting the high share of oil in the country's exports, fluctuations in world oil prices directly affect exports. At the same time, the effect of oil price increase on improving the current account is not fully manifested - due to a simultaneous increase in the primary incomes of foreign investors paid. So, according to the calculations of the NBK, a 1% rise in prices for black gold increases payments to foreign investors by.89%. Thus, the rapid restoration of the balance of payments is limited by the growth in investors claims. Direct investments Every year, the volume of direct investment in the oil and gas industry occupies almost half of the gross inflow of foreign investment into the country and is an important factor in economic development. So, the negative consequences of the decline in export revenues in 216 compensated a record inflow of direct investments to the financial account of $14.4 billion (net FDI inflow), covering the current account deficit. Earlier, the highest level of gross net inflow of $13.1 billion was achieved in 28. Figure 9. Gross FDI inflow % Other Trade Metals&Mining Geology Share of oil&gas sector investm. (right sc.) Source: NBK 42% Fin.services Construction Oil&gas production Oil&gas sector 56% 51% 1% 8% 6% 4% 2% % In terms of gross inflow of direct investments into the country, a record indicator was fixed in 212, reaching $28 billion. Of these, 42% was directed to the oil sector. In the period of relatively high oil prices in , the gross inflow of direct investment in exploration and the search for new deposits significantly exceeded the investment in production. However, in 212, direct investment in exploration activities considerably decreased (-25% yoy). Investors' interest has turned in the direction of increasing production at existing fields, in connection with which there is an accelerated growth of investments in this sector (Fig. 9). Thus, starting in 213 (with the exception of 215, when the total inflow of investments fell sharply), there was a tendency for the prevalence of investment in production and development of old projects, as the geological exploration is not attractive enough for investors due to high risks. In 215, in view of a drop in world oil prices, direct investment fell significantly, including in the oil and gas sector (-62% yoy in production, while geological exploration declined slightly). But already in 216, net gross inflow of direct investments into the oil and gas industry recovered, having increased by almost a third, and was mainly concentrated in extraction. Apparently, due to unfavorable prices for commodities, investments in geological exploration and exploration fell again in a year. However, we note a negative dynamics in geological exploration threatens depletion of reserves. Export revenues reflected in the current account of the balance of payments are an important source of currency in the country. Also, the inflow of capital into the financial account through direct investment provides an acceptable balance on the country's external accounts. At the same time, the bulk of these foreign investments are directed to the hydrocarbon sector, which for foreign companies is subject to long-term 6

7 investment. Therefore, the dynamics of oil prices is the determining factor in the investment activity in the country. Deposits of large oil and gas enterprises also occupy a significant share in the obligations of the banking system and are a source of foreign exchange funding. Thus, short-term foreign currency deposits of NC KMG in banks at the end of 216 were $3.5 billion (~5% of liabilities of the banking sector). Prospects for direct investment Currently, the prospects for foreign investment in the country are almost entirely depend on the expansion and development of existing large oil and gas fields: Tengiz and Kashagan. Further development prospects for Tengiz assume the maintenance of the existing capacities and production capacity. The consortium last year announced the decision to direct from 217 $37 billion for new projects: the future growth project (FGP) and the project of wellhead pressure management (WPM). Based on the scale of investment this is the second biggest investment project since independence after the Kashagan project was developed. With the FGP implementation, the total volume of oil production will increase by 12 million tons to 39 million tons per year (85, barrels per day). Initially, the cost of the project was estimated at at least $16-2 billion, of which $7-8 billion was to be spent on the construction of an oil stabilization plant, and almost the same at the WPM. The project was planned to be completed in 219. However, in 216, the deadline was postponed until 222, with the project cost already estimated at $37 billion. According to the Minister of Energy, the project will bring $12 billion from 222 to 233 in the form of tax revenues. The minister also believes that Phase 1 of the development of the Kashagan field is designed for decades, which gives grounds for expecting a possible extension of the PSA. The second stage of the expansion project involves the construction of the Center of Compression (CC-1), intended for pumping gas back into the reservoir. According to the project implementation plan, investments of about $5 billion are required, while commissioning will be carried out in 224. Completion of the 1st stage of the project will allow an increase in daily oil production to 45 thousand barrels, i.е. 16 million tons of oil since 225. It should be noted that according to the forecast of the Ministry of National Economy, oil production will reach 81 million tons in 217, of which 5-8 million tons are Kashagan oil. Since the conclusion of the production sharing agreement, $2.6 billion has been invested in the development of the Karachaganak field. Prospects for the development of the field include an increase in the production of liquid hydrocarbons to 15 million tons per year, gas - up to 38 billion cubic meters per year. The first stage of the expansion envisages the drilling of new and major repairs of existing wells, the construction of facilities for gas preparation and for increasing the volumes of gas re-injection. The second phase of the expansion involves investing $12 billion to build a gas processing plant. However, due to the disputes with Kazakhstan, the project was postponed several times. Now the decision on expansion is put 7

8 $ bn $ bn off to the end of 217, the commissioning of new facilities and installations - to 222. National Fund The first sovereign funds were created in the 197s to absorb surplus revenues from the trade balance and preserve the funds received. Following the world practice (copper fund in Chile, oil fund in Norway), in 2 a National Fund was established in Kazakhstan. In the period of high oil prices in order to prevent overheating of the economy, the National Fund performed the functions of sterilizing petrodollars and accumulating them to reduce the volatility and dependence of budget revenues on the sector. In the period of falling prices for oil, NF's assets serve as a stabilization pillow, funds are directed to stimulate and support economic growth. Figure 1. NF assets % % 22.9% 28.1% 52.8% 6% 5% 4% 3% 2% 1% % The funds are accumulated on the Government's account of the National Bank of RK and are divided into stabilization and savings portfolios. The stabilization portfolio is considerably liquid, with its share in total assets being less than 25% (at the end of 216). The savings portfolio occupies most of the NF's funds, representing investments in long-term financial instruments. In addition to assets denominated in foreign exchange (97% of the total portfolio), it also includes tenge bonds of Samruk- Kazyna, KazAgro and Baiterek, which are practically impaired assets, due to the fact that loans were issued with interest rates significantly lower than the market ones (their value in dollar equivalent is about $2 billion). Source: NBK NF assets Share in GDP (right sc.) The revenues of NF are mainly formed from the inflows of direct taxes from the oil sector. At the same time there is a high concentration of funds - about a third of the taxes received from oil sector are taxes of "Tengizchevroil". Guaranteed and targeted transfers and purchase of bonds of quasi-public companies are the main directions of the use of funds. Figure 11. NF inflows from oil&gas sector and expenditure (5) (1) (15) (2) Oil&gas sector taxes Source: MinFin (average USDKZT fx rate used) Excess inflows over expenditure (NF savings) Expenditure (transfers+bonds) The share of transfers in official budget expenditures (unconsolidated) increased from 22% in 211 to 3% in 216, which also indicates the increasing dependence of the state on the oil sector. Since the times when the Fund was established to 27, its assets have been consistently growing. The share of assets in the country's GDP in less than 1 years has doubled from 14.1% in 25 to 33.6% in 215 (Fig. 1). In 28-29, due to worsening of the global economic situation, the use of funds from the NF increased at once 3 times compared to 27. The funds were used to support the fiscal and economic balance, including the provision of funding for large quasi-public entities (allocation of T75 billion in 29 for the purchase of Samruk-Kazyna and KazAgro bonds). In the period from 21 to 214, the NF performed a savings function, the average share of savings was 48% of inflows. The accumulation of savings was made possible by record oil prices, while the use of funds was practically not reduced (Fig. 11). In due to the fall in world oil prices, the use of funds was more than double the inflows. Thus, the NF's currency assets fell from a peak of $73.2 billion in 214 to $63.4 billion in 215 and $61.2 billion by the end of 216. Since the 8

9 Oil revenues in consolidated budget*, % % $ bn % Figure 12. NF funds expenditure beginning of this year, foreign exchange assets have been at a fairly stable level, but due to the allocation of transfers to ensure the stability of the banking system, in July, the assets of the NF fell by $4.3 billion. In 217, we do not expect further significant decline in NF assets (considering level of transfers at $9 billion, and the level of tax revenues at $5-6 billion in 217). In years of economic downturn, the state is actively drawing funds from NF to support the economy. Countercyclical measures are often allocated not to a direct support of the economy, but at ensuring financial stability of certain institutions. For example, in 29, the NF purchased Samruk- Kazyna bonds (comparable to 3.7% of GDP), which in turn were used to support the nationalization of banks, in 215 the NF purchased Samruk-Kazyna bonds (comparable to 1.8% of GDP), from which the coverage of external obligations of KMG were delivered, in 217, the NF assets are used for the improvement of the banking sector (comparable to 4% of GDP) (Fig. 12). Source: MinFin NF transfers Purchase of bonds NF expenditure (% GDP, right sc.) Figure 13. Consolidated budget expenses and GDP Source: MinFin In 29 - SK bonds purchase (3.7% of GDP) Consol.budget expenses GDP (yoy, %). In imrpovement of banking sector, 4% of GDP In SK bonds purchase (1.8% of GDP) Since the beginning of 2, without taking into account 4 years, when the consolidated budget expenditures were actively increasing, the average ratio of budget expenditures to GDP was 22%. Given the fact that the global trend of economic slowdown persisted, despite the allocation of the funds from NF and state budget, one can note that the effectiveness of state support for the economy was poor (Fig. 13). In our opinion, the use of NF funds is more pro-cyclical. So that, in years of sufficiently high oil prices, in , the spending of NF assets remained virtually at the level during the crisis in (Fig. 11). Thus, petrodollar surpluses, received in the years of favorable prices, do not accumulate sufficiently. Measures to reduce the level of transfers and reduce the dependence of the economy on oil revenues were reflected in the new concept of NF, agreed last year. The concept assumes a reduction in the guaranteed transfer to T2 trillion ($6 billion) by 22 (previously the annual size was $8 billion +/-$1.2 billion, depending on the demand cycle). At the same time, the minimum level of NFRK assets was increased from 2% to 3% of GDP, and the target of the non-oil deficit should be 7% by 22, 6% - by 225. The impact of the industry on fiscal policy Figure 14. Oil reserves horizon and oil revenues in consolid. budget Mexico 2 Norway 15 Azerbaijan Russia *Average estimate for Source: IMF, BP statistical review Kazakhstan Reserves horizon, years Iran Fiscal policy of the country can be dually interpreted due to differences in the composition of the balance of public finances by official bodies and the methodology of budget formation developed by the staff of the IMF. The official budget of the country does not fully reflect the dynamics of inflows and expenditures of public finances. Proceeds from the oil sector are accumulated in NF and fall into the official budget in the form of transfers, and often the funds are spent for the purchase of bonds and allocation of loans to quasi-government entities and not indicated in the official budget as expenditures. The consolidated budget, formed using the IMF methodology, more fully reflects the movement of public funds and more accurately assesses the state of the fiscal balance, in view of the fact that tax proceeds from the oil sector are directly reflected in revenues, and budgetary lending in the form of assistance to quasi-structures is reflected in state expenditures. 9

10 Т trln Figure 15. Oil and gas revenues in consolid.budget expenditures Source: MinFin 21% 3% Consolid.bufget expenditures Taxes from oil&gas sector Net expenditure/savings (excess of inflows from oil&gas sector over expenses) Share of transfers in official budget expenditures (noncons., right sc.) Figure 16. Non-oil deficit of consol.budget 1.% 5.%.% -5.% -1.% -15.% Source: MinFin Non-oil deficit (% of GDP) Overall deficit 35% 3% 25% 2% 15% 1% 5% % Comparative analysis of oil-exporting countries demonstrates sufficient dependence of the consolidated budget of Kazakhstan on oil revenues, explaining the volatility of macroeconomic and budgetary conditions of the country, which follow the cycle of the industry (Fig. 14). This indicator allows us to determine the further outlook for the macroeconomic and fiscal balance of the country, the stock horizon gives an idea of the duration of oil flows (short-term/long-term). Kazakhstan, which has a significant hydrocarbon reserves horizon, is quite dependent on the revenues of the oil sector in comparison with Norway. It should be noted that as the country approaches its natural resources depletion, the share of revenues from oil and gas sector in budget is declining. In general, the indicators of the country's fiscal balance better than GDP can assess the economic and political stability in the country, as they are a source of financing for socially important sectors (health, infrastructure), and also react more quickly to unfavorable external conditions. So, in the last two years, in view of falling earnings and a decline in economic activity, tax payments, replenishing the budget and the National Fund, are significantly lower than previous years. In 216, the share of oil revenues in the revenues of the consolidated budget of the country fell to 23% (28% in 215, 47% in 214) (Fig. 15). The deficit of the consolidated budget is mostly higher than the official one. So that, during the crisis period in 28-29, the active use of funds to support the economy widened the deficit of the consolidated budget to 5%, while the official amounted to only 3% of GDP. Another problem of the fiscal budget is the growth of the nonoil deficit against the background of a decrease in revenues from the oil and gas sector. Despite the fact that the overall deficit of the consolidated budget improved from 6.3% to 5.6% last year, the non-oil deficit remains at a high level of 9% (Fig. 16). According to our calculations, the share of the non-oil deficit of the consolidated budget in GDP in the last three years increased sharply from 7.4% in 213 to 12% in 215. Last year, the deficit was 9%, while, according to World Bank, maintaining such a high level of non-oil deficit will lead to the NF's currency assets fast depletion and by 22 it will be equal to the total Government debt. Therefore, it is necessary to take measures to stimulate the non-oil sector and increase its incomes, as well as to reduce government spending. With the planned for 217 state expenditures at T1 trillion, at the current oil price of $55 per barrel, according to our calculations, the overall deficit of the consolidated budget will remain at 6%, while the non-oil sector will expand to 11%. According to our calculations, the oil price at which the consolidated budget of the country will be neutral should be $55 in 217 (not taking into account the one-time use of funds for improving the banking sector this year), which almost coincides with the forecast prices for oil this year. Under these conditions, one can expect the formation of an acceptable fiscal balance of the country. Thus, the price of oil is the determining factor in the formation of a balanced budget, and in the period of low commodity prices is the reason for the growth of the deficit and the reduction of state revenues. 1

11 Figure 17. Total cost of oil production by countries, $/bbl Brazil Canada USA Norway Angola Columbia Nigeria China Mexico Kazakhstan Libya Venezuela Algeria Russia Iran UAE Iraq Saudi Arabia Kuweit Source: Rystad Energy Figure 18. Average opertaional cost of oil, $/bbl* Karazhanbas Uzen, Emba Akshabulak, Nuraly, Aksay Alibekmola, Kozhasay Kumkol Tengiz Zhanazhol, Kenkiyak Kalamkas, Zhetibay Karachaganak *Lifting costs, MET, export and rent taxes, transportation costs Source: HF estimates, finstatements of the companies The cost of oil in Kazakhstan's fields Price turbulence in the oil market has led to the fact that oil production is now barely on the verge of profitability. More recent sources show that the countries of the Persian Gulf experience the least discomfort in this matter. So, according to Rystad Energy, the cheapest oil production is in Kuwait ($8.5/bbl), Saudi Arabia ($9.9/bbl) and Iraq ($1/bbl), while the most expensive in Great Britain ($52.5/bbl). In Kazakhstan, according to the above source, the average production cost is $27.8/bbl. According to our estimates, the operating cost of producing one barrel of oil in Kazakhstan's fields, with the exception of Kashagan, fluctuates between $7- $48/bbl. Such a wide range is explained by the different stage of maturity of the deposits (see Appendix 1.). At the same time, it should be noted that taking into account the invested capital in the most largescaled projects that have not yet been completed, the cost should increase tremendously. However, the lack of public data on such projects raises certain difficulties in estimating the actual cost price, and therefore our calculations take into account only net (cash) operating costs for oil production. For a more indicative comparison with other countries, we include in costs the expenditures on exports, which include the export customs duty and the rental tax. Calculations show that the most expensive (except Kashagan) oil production is in Karazhanbas, where the operating cost in 216 is $31/bbl, and in it reached $68 and $48/bbl, respectively. The next costly projects are the Uzen and Emba fields with costs of about $27/bbl in 216. Relatively high costs in the above fields, we associate with the depletion of deposits and hard-to-recover reserves. The lowest extraction costs are observed in Karachaganak, where the operating cost is below $1/bbl. It should be noted that labor productivity (estimated as the ratio of production volume to the number of employees) in the largest national oil and gas company of NC KMG is significantly lower than in Russian and other foreign companies. Calculations (according to annual reports of companies) show that oil production per 1 employee in NC KMG (252 tons per employee) is 3.5 times less than Lukoil (872 tons per year, according to the annual report), as well as in 6 times less than Chevron (154 t/r). Such a low productivity is apparently associated with a weak development of new technologies and the efficiency of a state-owned company. A more detailed description of oil and gas projects is given in Appendix 1. 11

12 mln tonnes Appendix 1 Figure 1. Oil output in 216, mln tonnes Source: Company data TCO KPO KMG EP (incl. KGM, KBM, PKI) Mangistaumunaygaz Aktobemunaygaz KazakhOilAktobe Other Table 1. Tengizchevroil (Tengiz and Korolevskoe) NC KMG (2%), Chevron (5%), ExxonMobil (25%), Participants LucArko (5%) Reserves volume bln tonnes (6-9 bln barrels) Annual oil output ~27 mln tonnes (22 mln barrels) per year (6 ths volume barels per day) Figure 2. TCO output Source: Company data Large oil and gas projects In this appendix we have tried to highlight the main points concerning the key oil and gas projects. Based on the available information, we tried to calculate the average operating cost of oil production at the top-1 fields of Kazakhstan. The main information base in the calculations was data from financial statements of companies. It is important to note that in the calculations below the operating cost is understood as the specific expenditure on oil production, which includes lifting costs, MET, and also rent tax and export customs duty. It is equally important to clarify that, due to the lack of public data, the calculation of the operating cost is made without taking into account the invested capital and gives an overall picture of the costs of each field relative to each other, but in no way is the benchmark for calculating the payback and profitability of the fields. Tengiz is one of the largest and deepest oil and gas fields The development of the deposit began in 1993 with Chevron. Four companies currently are partners: Chevron (5%), ExxonMobil (25%), KazMunaiGaz (2%), LukArco (5%). Total explored oil reserves amount to 3.3 billion tons (27.5 billion barrels), of which billion tons (6-9 billion barrels) are recoverable. Since the beginning of the development, the consortium produced about 363 million tons of oil. The volume of extracted crude oil in the field averages one third of the total volume in the country, so in 216, The production amounted to million tons (22 million barrels, 35% of the total volume of the previous year). With the current volume of oil production, the field will last for 4 years. All oil produced in Tengiz is exported through the Tengiz- Novorossiysk pipeline (CPC). In addition to oil, TCO produces gas, propane, butane and sulfur. From 1993 to the first quarter of 217, TCO's direct financial payments to the country amounted to $119 billion, including staff salaries, purchases of goods and services of domestic producers, payments to state enterprises, payment of dividends to a Kazakh side, and also in the form of taxes and royalties transferred to budget. Total investment in the country since 1993 amounted to more than $2 billion. Of these, $7.2 billion were spent on the implementation of modernization projects, due to which the daily oil production reached 7 thousand tons (6 thousand barrels) and 22 million cubic meters of natural gas. Further development prospects for Tengiz assume the maintenance of the existing capacities and production capacity. The consortium last year announced the decision to direct starting from 217 $37 billion for new projects: the future growth project (FGP) and the wellhead pressure management project (WPM). Based on the scale of investment, this is the second investment project since independence after the Kashagan project was developed. With the FGP launch, the total volume of oil production will increase by 12 million tons to 39 million tons per year (85, barrels per day). Initially, the value of FGP was estimated at at least $16-2 billion, of which $7-8 billion were to be spent on the construction of an oil stabilization plant, and almost the same at the WPM. The project was planned to be completed in

13 mln tonnes Table 2. Karachaganak Petroleum Operating (KPO) NC KMG (1%), Eni и Shell (29.25% each), Chevron Participants (18%), Lukoil (13.5%) Reserves volume 9 bln barels of condensate и 1.35 trln cub m of gas Annual oil output ~11 mln tonnes per year (average barrelization coefficient volume 7.3: 22 ths barels per day) However, in 216, the deadline was postponed until 222, with the project cost is already estimated at $37 billion. According to the Minister of Energy, the project will bring $12 billion from 222 to 233 in the form of tax revenues. The average cost of oil production in Tengiz, taking into account basic and additional royalties, according to our estimates, is $16.65/bbl in 215. The net operating cost was rather low - $4.47/bbl. According to Chevron's annual accounts, operating costs for the production of one barrel of oil in Tengiz in amounted to $4.32- $3.67/bbl, respectively. Karachaganak is a gas condensate field in the northwest of Kazakhstan, launched in Figure 3. Oil output at Karachaganak Source: Company data In Soviet years, the commodity was sent to the Orenburg gas processing plant. However, after independence, the cooperation with Russia was halted. Then, following the completion of the search for foreign investors, in 1997 an international consortium was established. It is regulated by the Production Sharing Agreement, which is in force until 238. Currently, the operator of the field is Karachaganak Petroleum Operating BV. (KPO). Through NC KMG Kazakhstan holds 1% share of consortium (Eni and Shell %, Chevron - 18%, Lukoil %). The estimated reserves of the field are 9 billion barrels of condensate and oil and 1.35 trillion cubic meters of gas. According to NC KMG, annual oil production is about 11 million tons (14% of the total volume in the country) and 18 billion cubic meters of gas (39% of the total volume). The production plan in 217, according to the Minister of Energy, is 11.8 million tons of oil and 18 billion cubic meters of gas. In 216, the volume of production in KPO amounted to million boe (141.7 million boe in 215). The field has the lowest cost of oil production among the large deposits of Kazakhstan. Since the production sharing agreement was concluded, $2.6 billion was invested in the development of the field. Prospects for the development of Karachaganak include the project of an increase in production of liquid hydrocarbons to 15 million tons per year, gas - up to 38 billion cubic meters per year. At the first stage of the expansion, there were plans of drilling new and major repairs of existing wells, the construction of facilities for gas preparation and increase of its output. At the second phase of the expansion, the construction of gas processing plant includes investing of $12 billion. However, due to disputes with Kazakhstan, the project was postponed several times. Now the decision on expansion has been postponed to 217, commissioning of new facilities and installations - for 222. In October last year, the Minister of Energy stressed that the plan to expand Karachaganak is at the stage of coordination and optimization. Together with Shell, the Ministry of Energy began to study the prospects for the development of petrochemical and gas processing facilities at the field. 13