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A decade later, the shine has worn off for investors in KMG EP, who are locked in an increasingly bitter stand-off with its parent, the Kazakh state oil company NC KMG, which owns a controlling stake.
This week, minority shareholders will vote on a plan by NC KMG to tighten its control over the KMG EP by rewriting the “relationship agreement” between it and its subsidiary that, if approved, could lead to a buyout worth up to $1.3bn. Independent directors have decried the proposals as an attempt to “severely undermine” corporate governance, and a growing number of investors look likely to vote against them.
However, the story of how KMG EP went from a flagship for Kazakhstan’s state oil company to a thorn in its side shines a light on the inefficiencies that plague the Kazakh company and the challenges of reforming the oil industry in the former Soviet Union.
It is also a tale of a power struggle between two warring units of the same company — and, in particular, between two sets of independent directors, the westerners hired to burnish corporate governance credentials who are sometimes written off as uncritical “Noddies”.
“It’s a very promising asset. To say that it has been underutilised is a gross understatement,” says Ivan Mazalov, director at Prosperity Capital.
When KMG EP listed in 2006, the Kazakh government’s intention was “to create a blue-chip oil company,” says a long-time adviser to the company who worked on the initial public offering. “The level of transparency and corporate governance is unparalleled for the country.”
The oil boom lifted the global depositary receipts from an IPO price of $14.64 to a high of more than $34. But as prices fell, the inefficiency of KMG EP’s Soviet-era fields became more apparent. In 2015, the company reported a $288m operating loss.
“At the moment there is no value in the assets: it’s going to be a major struggle to get our auditors not to write off all our assets,” says Chris Hopkinson, a former Royal Dutch Shell executive hired by NC KMG to lead a turnround of its and KMG EP’s assets.
KMG EP says it is returning to profitability. But efficiency remains poor. For example, KMG EP employs 2.5 people in its production division per well, more than twice the level of comparable Russian companies, according to an analysis last year by Sberbank CIB.
Mr Hopkinson and people close to KMG EP say that resistance from local contractors and politically connected businesspeople in the regions of western Kazakhstan where the company operates has made it hard to push through change. The company has exclusive relationships with some contractors, whose share of KMG EP’s operating costs has risen from 12 per cent in 2014 to 23 per cent this year, according to a company circular.
Replacing KMG EP’s old-fashioned “nodding donkey” wells with electrical submersible pumps could improve efficiency and lift production by as much as 60 per cent, Mr Hopkinson says.
“EP is very close to the communities, who naturally have a huge apprehension with regards to changing away from a system which their whole societies and towns are based on supporting, to something which is unknown,” he says.
Mr Hopkinson casts the drive for efficiency as the main reason NC KMG is proposing to rewrite the relationship agreement with KMG EP. The changes would give KMG EP’s board, of which he is the NC KMG-appointed chairman, greater power, he says.
But many shareholders and people close to KMG EP question whether these changes are necessary or sufficient to push through the efficiency plan. “It will only be implemented if the Kazakhs want it to be implemented. Unless you bring vested interests on side, you won’t succeed,” says one person close to the company.
What’s more, the proposals are the latest in a longstanding tussle for control between the parent company and its subsidiary. They also come as NC KMG prepares for its own listing — something that bankers and investors say would be difficult to achieve while KMG EP is still listed.
It did not take long following KMG EP’s 2006 IPO for the new company’s independence to chafe with its parent. The tensions were exacerbated by the companies’ differing financial positions. KMG EP built up several billion dollars its balance sheet while NC KMG has been weighed down by hefty debts and the need to finance its stakes in Kazakhstan’s major projects.
In 2010, NC KMG went to its subsidiary to borrow $1.5bn, a humiliation that “enraged” the parent company, according to a person who advised on the deal.
In 2014, NC KMG attempted to end its troubled relationship with its subsidiary, offering to buy out minorities at a price of $18.50 per global depository receipt. But after six months of discussions between the independent directors of the parent company and its subsidiary, the offer was withdrawn amid tumbling global oil prices.
Since then, NC KMG has placed growing financial and operational pressure on its subsidiary, shareholders and people close to KMG EP say. For much of 2015, NC KMG’s trading unit, the sole buyer of KMG EP’s oil on the Kazakh market, refused to pay the rates set out in the relationship agreement between the two companies — only agreeing to a settlement after protracted negotiations. Then this year, when that provision of the agreement expired, NC KMG unilaterally slashed the price it paid KMG EP to just $7 a barrel.
The deterioration in relations between the two companies has been exacerbated by personal animosity between the three western independent directors of NC KMG and their three counterparts at EP KMG, say people close to both companies.
NC KMG has overruled the independent directors of KMG EP for two years now over the company’s dividend payments, which were slashed to zero this year.
Ivan Mazalov, director of Prosperity Capital, one of the largest minority shareholders in KMG EP, says the proposal from NC KMG “looks to me like constructive dismissal” of the subsidiary’s independent directors. “There’s a civilised way to end it: make a competitive offer and people will sell. Don’t fumble it like this,” he says.
