Commercially viable discoveries lay the groundwork for the domestic oil and gas industry

Along with Tanzania and Uganda, Kenya is emerging as a new destination for oil and gas explorers after several hydrocarbons deposits in commercially viable quantities were found in the East Africa region. A series of onshore and offshore oil and gas finds in Kenya suggest that the country has the potential to become a hydrocarbons exporter, as well as a regional energy transit hub as producers in Sudan and Uganda look for port facilities. Kenya is also developing its mining sector, which currently contributes less than 1% to GDP, but has significant potential to grow. Coal and rare earth prospects are of interest, while a landmark titanium minerals project made its first shipment in 2014.

Kenya is working to review and improve its regulatory environment for natural resources. Also critical to the success of the sector will be key infrastructural developments, including a major pipeline that is planned to carry crude oil to the Kenyan coast. Both areas must be managed carefully by the Kenyan authorities to promote appeal and minimise risk for investors.

Energy Needs

Kenya’s main sources of energy are wood fuel, other biomass and hydropower, while fossil fuel use as a percentage of total consumption was 19.7% in 2011. This balance is likely to change as the economy grows and the middle class expands.

Petroleum products imported into the country declined in 2013, down to 4m tonnes from 4.14m tonnes. The import bill fell 3.5% with this drop to KSh315.5bn ($3.6bn). Meanwhile, the total value of petroleum products exported decreased by 11.2% with one possible reason for this drop being increased competition in the export market, according to the “2014 Economic Survey” from the Kenya National Bureau of Statistics (KNBS). At the same time, domestic demand for petroleum products increased, with net domestic sales rising from 3.63m tonnes to 3.7m tonnes. “We will see an increase in the import of refined products as the economy grows, especially following the effective shutdown of the Mombasa refinery,” Oscar Kang’oro, head of oil and gas for East Africa at Standard Bank of South Africa/Stanbic Bank, told OBG. “The rise in imports will come in line with economic growth.”

The import of crude oil ceased altogether in the second half of 2013 – having already declined substantially – after the Kenya Petroleum Refineries Limited (KPRL) plant in Mombasa closed. Light diesel oil is the main type of fuel sold in the country, representing 42.8% of total domestic demand in 2013. Demand increased by 7.7% over 2012, while demand for motor petrol and aviation spirit also rose. However, declines in demand were recorded for liquefied petroleum gas (LPG), jet/turbo fuel, illuminating kerosene, heavy diesel and fuel oil. The largest user of petroleum products in Kenya is the transport sector, followed by the industrial and commercial sectors.

Hydrocarbons Finds

The extent of Kenya’s oil and gas reserves is still being determined and estimates vary widely, but some government projections suggest that its reserves could exceed Uganda’s expected reserves by as much as threefold and rank the country as one of Africa’s most resource-rich nations (see analysis).

The country’s exploration acreage is largely divided into four sedimentary basins – Lamu, Anza, Mandera and the Tertiary Rift – that straddle the country, covering some 485,000 sq km, according to the Ministry of Energy and Petroleum. They are believed to be extensions of, or have similar characteristics to, geological formations in neighbouring countries where significant hydrocarbons reserves have been found.

Of a total of 46 gazetted blocks, Kenya has licensed 43 to at least 23 different exploration companies, while one has been licensed to the state-owned National Oil Corporation of Kenya (NOCK). Another seven blocks are expected to be offered in the country’s first competitive licensing round – once a new energy law has been enacted – in a move away from the traditional first-come, first-served allocation of rights.

Despite disappointing exploration results in previous decades, Kenya has drilled 16 wells since the country’s first crude oil discovery in March 2012, of which 11 are discovery wells. London-listed Tullow Oil has been one of the more prominent players in the East African exploration space, having announced eight onshore oil discoveries in Kenya since March 2012 as of September 2014, including the country’s first. Tullow, which partners with Canada’s Africa Oil in Kenya, confirmed in mid-2013 that it had exceeded the commercial threshold. In early 2014 it doubled its resource estimates to some 600m barrels, with overall potential in the South Lokichar Basin of more than 1bn barrels.

In September 2012 Australia-based Pancontinental Oil and Gas and US-based firm Apache – which has since ceded its stake in the block – said they had struck 50 metres of net gas pay in offshore Mombasa, while Africa Oil and its partner Marathon made an onshore natural gas discovery in the Anza trough. UK-headquartered BG Group announced that it had found both crude oil and natural gas deposits in its block offshore Lamu.

Tullow has announced plans to ramp up its exploration activities through 2014, while a number of other firms currently present in the country – including Afren, Ophir Energy and Anadarko – are expected to increase activities. According to local press reports, Kenya could become an oil-producing country by 2020 and as early as 2017. “We’re starting to see more companies entering the market,” William Lay, director of KK Security’s oil and gas division, told OBG. “The government is working hard to provide the infrastructure and the regulatory environment. But the timeline to recover investment does need to shorten.”

Estimates vary as to when Kenya might first see oil. The government has expressed hopes that production could begin as soon as 2016, but fast-tracking of necessary infrastructure, such as an exporting pipeline, is vital if estimated timelines are to be met. Obtaining the needed financing and reaching the necessary decisions on these projects could take years on their own.

Government Strategy

Energy is a key priority for the Kenyan government and is described as an infrastructural “enabler” in Vision 2030, the nation’s long-term strategic development plan. As discoveries and investment interest have picked up, the country is in the midst of a full regulatory review to suit its nascent status as a producer. A final Draft National Energy and Petroleum Policy was published in June 2014, updating the 2004 policy, while a broad-ranging new energy bill has already gone through multiple drafts.

The draft bill, due to supersede the Energy Act of 2006, would set a regulatory framework for oil and gas activity (midstream and downstream). The government intends to adopt and implement the Extractive Industries Transparency Initiative, which in addition to oil covers gas and all mineral resources, as well as create a sovereign wealth fund. The new legislation will reflect the principles of Kenya’s 2010 constitution, which devolved significant powers to 47 counties and promotes revenue sharing. It includes a proposed sharing of some royalties between the community, the county and the central government. Tackling this issue is one of the reasons for the bill’s delays. Upstream activities in Turkana, for example, have faced challenges from local communities over land, resources and opportunities. In line with the roll-out of local content clauses elsewhere on the continent, the new draft laws are also set to update provisions for the preferential use of national goods and services, including skilled staff. Competitive licensing rounds for acreage – against direct negotiation – will become the norm. Tax, royalties and duties will be revised, as will the conditions of acreage surrender to the government. Environmental protection provisions will be strengthened.

The Draft National Energy and Petroleum Policy introduces new forms of petroleum agreements which may include production-sharing contracts (PSCs), concessions, royalties, service contracts or any other forms of agreements. It also plans to establish a regulatory agency for upstream petroleum operations. Among the other changes, benefit-sharing percentages and as well as the 30% local equity participation requirement in the previous draft were both deleted.

According to the draft policy, the government will also develop and implement local content policy and regulations to spearhead participation of Kenyans in the development of the sector.

“The energy policy and energy bill are supposed to go hand-in-hand,” Sonal Sejpal, the director of Anjarwalla & Khanna law firm, told OBG. “The energy policy but not the energy bill refers to a requirement of a 30% local shareholding for all investments in the energy sector. The new regime will ensure that the dishing out of contracts is a thing of the past.”

Other Regulatory Revisions

The Petroleum Exploration and Production Act – which governs the upstream sector – is also under review and draft amendments are expected. The regulation of natural gas will be better defined, while the creation of a sovereign wealth fund will be allowed and regulations for upstream operations will be outlined.

Revisions to the model PSC will also be critical for current and future investors. The PSC model replaced an earlier royalties tax-based system. The version of the current model PSC outlines the acceptable duration of exploration and development, the division of profits, expected taxes and levies, and preference for local material and supplies. According KNBS data, a total of 45 PSCs have been signed.

Explorers must also cede part of their licensed acreage at the end of each exploration period. In August 2014 Kenya’s president, Uhuru Kenyatta, also revealed plans to impose windfall and capital gains taxes on oil, gas and mining companies.

The government, with the support of the World Bank, is also developing a Petroleum Master Plan. Consultancy PwC is advising on the plan, which is expected to outline a roadmap for investments and extend to 2040. NOCK, incorporated in 1981, is responsible for crafting the master plan. The state-owned company has been the vehicle for government participation in PSCs and appears set to retain a role in policy, exploration and retailing of petroleum products. NOCK has had its own exploration acreage, Block 14T, since November 2010. In addition to participating in exploration activities, it is also tasked with the marketing of the country’s exploration acreage.

State Actors

In addition to NOCK, the Kenya Oil & Gas Association (KOGA) was set up in April 2014 to represent the sector. Members include up to 25 explorers, as well as oil and gas services firms, which are increasing in number in the country. The Energy Regulatory Commission (ERC) is tasked with regulating the sector, including pump prices, licensing, planning for future energy development and assisting with disputes.

Infrastructure Needs

As interest in Kenya’s hydrocarbons potential has deepened, the need for urgent infrastructural development to support possible future oil and gas production in the country has been underscored. As a coastal country, Kenya is well placed to export both crude hydrocarbons and refined products, but it currently lacks the necessary infrastructure. “Infrastructure does remain the biggest hurdle,” said Lay. The Lamu Port and South Sudan-Ethiopia Transport Corridor (LAPSSET) – part of Vision 2030 and a mega-project in its infancy – could change that (see analysis).

Kenya’s only refinery, run by KPRL, stopped operations during 2013 following the withdrawal of Indian joint venture partner Essar. In 2013 the Mombasa plant produced 627,300 tonnes of petroleum products, compared to 992,100 tonnes in 2012, all derived from crude oil supplied by the Abu Dhabi National Oil Corporation. The plant is reverting to full government ownership but was indebted and remains in need of major upgrades. There were initial plans to spend $1.2bn on modernising the refinery, although a study by Essar found that the refinery was not economically viable in its current state, and local media reports suggest it may yet be converted to a storage facility.

Kenya has indicated it would consider a stake, along with other East African countries, in a proposed refinery in Uganda. The Lake Albertine Rift refinery project would target capacity of 60,000 barrels per day (bpd) and is set to cost $2.5bn. But Kenya is also seeking to build its own new refinery, as part of LAPSSET. The proposed 120,000-bpd refinery would be situated at Lamu, on Kenya’s northern coast, although Isiolo, a junction on the corridor and closer to the finds in Turkana, has also reportedly been considered as a location.

The LAPSSET project is also seeking to develop a 2240-km oil pipeline from Lamu to Isiolo, and from Isiolo to the South Sudanese and Ethiopian borders. Some 1260 km of the pipeline would be dedicated to crude, while another 980 km would be dedicated to refined product. Tullow and Africa Oil’s Turkana discoveries alone are believed to make such a pipeline viable, without counting the 3.5bn barrels found in Uganda.

Petroleum Products

In addition to its upstream responsibilities, the Ministry of Energy oversees the downstream service delivery of state companies, such as the Kenya Pipeline Company (KPC) and KPRL. The ERC licenses downstream operators, retailers and their facilities, and also monitors fuel. The Petroleum Master Plan, under development, includes a review of domestic markets. The KPC is one of several parastatals slated for privatisation.

Domestic sales of petroleum fuels totalled 3.7m tonnes in 2013, up from 3.6m tonnes in 2012. Light diesel accounted for 43.2% of demand. While the Ministry of Energy reports over 30 companies are licensed to market petroleum products, four players dominate the downstream sector: Total Kenya, OiLibya, Vivo Kenya and KenolKobil. The state-owned NOCK is also a domestic supplier. Currently marketing companies need at least five filling stations to get access to the KPC network. With nearly 180 facilities, Total Kenya has the largest network of service stations. In 2013 it had a market share in the domestic retail market of 21.4%, overtaking KenolKobil on 20.8%. Vivo Energy – which took over Shell’s assets and still trades as Shell – came in third at 17.1%. OiLibya’s share stood at 7.7%, while NOCK’s was 4.9%. LPG demand is set to rise, and increasingly replace biomass as a source of domestic energy supply. LPG usage currently is estimated to be only 7% of total energy consumption. The government forecasts that the country’s annual LPG usage could rise to 735,217 tonnes by 2035 if supply improves. Demand in 2012 was 93,600 tonnes. Current storage capacity is 15,400 tonnes, with the KPC set to build a storage facility of 2200 tonnes near Nairobi. Government officials have raised the possibility of increasing tax on kerosene relative to LPG. The intention to increase LPG usage has been dampened by the 2013 imposition of value-added tax at a rate of 16% and the closure of the country’s only refinery, although price regulations aim to promote the use of the gas. “Price regulation has been a boon,” said Kang’oro. “There is now a guaranteed margin for every link in the distribution chain. Retailer margins are decent – around KSh5 ($0.06) per litre. It has taken the price risk out of the game.”

According to a report issued by Old Mutual Securities, a Kenyan securities trading company, Vivo Energy (under the Afrigas brand) maintained market leadership in terms of LPG with a 28.5% share, followed by Total Kenya at 22.3%, OiLibya at 18.3%, KenolKobil at 11.5% and National Oil at 1.4%. The Draft 2014 National Energy and Petroleum Policy includes an aim to diversify the downstream segment and encourage more nationally owned marketing firms. However, at least nine smaller LPG refilling operators are challenging the ERC’s decision to shut them down on regulatory grounds. “We have worked to bring an independent inspector on board for the LPG sector due to ongoing malpractice and illegal refilling,” Edward Kinyua, technical officer in the ERC’s petroleum department, told OBG. “Awareness raising has been a priority since 2013.”

Product Storage & Pipeline

Storage and pipeline capacity for petroleum products are under pressure, but expansions to both are planned. The KPC’s total storage capacity is 612,233 cu metres distributed across at least seven depots, including facilities in Nairobi, Mombasa and Kisumu. The total pipeline network stretches for 896 km, encompassing a primary pipeline from Mombasa to Nairobi, as well as a western Kenya extension, with a total of 12 pumping stations. However, new regulations require suppliers to maintain 15 days’ worth of stocks, and the country lacks a strategic reserve. In 2013 the KPC network had throughput of 5.1m cu metres, up from 3.8m cu metres in 2008.

In anticipation of increasing demand both domestically as well as across the region, a new 450-km Mombasa-Nairobi (Line 5) pipeline has been planned by the KPC to replace the existing Line 1. Loans of at least $400m will be needed to finance the work. The KPC awarded the Line 5 construction contract to Lebanon’s Zakhem International Construction Company for a total bid of KSh42.1bn ($480.2m). A 14-inch spur pipeline from Eldoret in western Kenya to Kampala has also been planned to complement the existing 6-inch, multi-product pipeline, while an additional multi-product pipeline running from Eldoret to Isiolo has been mooted to serve central Kenya. Authorities are also planning to increase storage capacity by 22% over the next two years, particularly in Nairobi and Mombasa. Plans in Mombasa include relocating and expanding the main Kipevu facility – with its capacity of 326,333 cu metres – to allow for the import of refined products using larger tankers. Rotterdam-based energy and commodities firm Vitol Group has entered the East African market through its Vitol Tank Terminals International (VTTI) logistics wing, launching a $60m storage terminal with 111,000-cu-metre capacity also located in Kipevu. The facility is one of the largest in the region and is connected by pipeline to the KPC mainline to Nairobi.

Regonal Expertise

Kenya has a limited pool of trained individuals who have the necessary skills to service the growing oil and gas sector. Skilled labour is thus in high demand. Operators are currently flying in the necessary expertise from abroad, but a number of companies are setting up training centres in the hope of capitalising on rising demand for accredited workers, both in Kenya and elsewhere in the region. The emphasis on local content should also help to expedite the training of East African nationals.

The School of Petroleum Studies, operational since 2007, has been offering training for both upstream and downstream oil and gas. A wholly owned subsidiary of the Petroleum Institute of East Africa (PIEA) – which is the main industry body – the school offers diploma courses as well as specialised short courses that target the industry. “Big oil is anxious to generate employment, so passing on specialist skills is one way of doing that,” Noel Grier, the general manager of Energy Resources Group (ERG) Africa, told OBG. “Up to 15,000 people could potentially be employed in Uganda’s proposed refinery. It’s going to take time, but training locals is the start of a process.”

Industry actors estimate that the oil and gas sector in Kenya could need up to 20,000 skilled workers within four years, while some 45,000 could be required to staff the sector’s workforce across East Africa.

“There are companies working to help meet human resources needs, as well as environmental and health and safety standards,” said Lay of African security firm KK Security. “We, for example, are investing $2m in a training centre. There are definitely opportunities for training and oilfield services.” The oil and gas potential offshore Kenya opens up additional training possibilities, given the highly specialised skills that are needed in the offshore segment. ERG Africa has built a training facility in central Nairobi where specialist skills can be taught, with a view to also target some of the needs elsewhere in the Indian Ocean offshore Africa. “We draw on the industry as a resource as well, and we are in the process of partnering with a university,” Mathias Muindi, executive officer of the PIEA, told OBG. “There seems to be a lot of interest in upstream courses, especially from the Turkana region.”

Mining Sector Potential

Kenya is also working to develop its nascent mining sector. Currently representing just a small fraction of GDP at 0.6%, the industry has potential to grow given the various deposits of minerals and precious metals.

More than 300 firms are estimated to be prospecting or in small-scale production. Soda ash and gold are the strongest foreign exchange earners in the sector: soda ash production grew by 4.2% to 468,215 tonnes in 2013. The sector’s output increased by 4.7%, rising from 1.45m tonnes in 2012 to 1.52m tonnes in 2013, although the total value of output declined. This was in part due to a decrease in gold production that followed price uncertainties. Gemstone production jumped on the back of high demand from Sri Lanka, Thailand and India for low-grade sapphire, ruby and opals, although values remain low. Production of fluorspar, diatomite and gold all registered declines.

Large-scale viable coal and iron deposits have attracted interest, as have deposits of titanium minerals such as ilmenite and rutile. In an important development, Australian mining company Base Titanium exported its first batch of minerals from the Kwale Mineral Sands project south of Mombasa. Some 25,000 tonnes of ilmenite were exported to China in early 2014, following delays related to discussions over royalties. The company plans to ship more than 450,000 tonnes of titanium minerals from the site annually.

After the 2013 elections, the government created a dedicated Ministry of Mining in April of that year to regulate the sector and to encourage its growth. As a priority area for the government, the sector’s regulatory environment is also under review. In an abrupt decision, the ministry suspended over 40 prospecting and mining licences that had been issued between January and May 2013 on the grounds that they had been improperly awarded by the previous administration. A task force has reviewed over 250 mining licences issued between January 2003 and December 2012, with 78 of these reported to have failed to meet all of the requirements of the existing Mining Act.

A new mining bill, replacing the Mining Act of 1940, is expected to bring some changes to the system, including developing an online licensing system designed to remove irregularities in licence issuance. The parliamentary committee on natural resources has made certain changes to be reflected in the bill as it goes for its third reading. The committee agreed on a revenue-sharing formula of 70% to the national government, 20% to the county government and 10% to the community. Mining prospectors will also be able to apply for licences online and get feedback within 90 days, while the Mining Advisory Board will oversee the licensing process and not the Cabinet secretary.

The bill is also set to create a state-owned mining company that will act a custodian for a proposed 10% free-carry stake of each mining licence awarded that will go to the government. It is expected to set deadlines for firms to begin mining and conditions for retention licences, and will not grant licences for raw ore.

Royalties

An increase in royalties on minerals – announced when the licences were revoked in 2013 – as well as a local ownership requirement have come as a shock to the sector. Royalties on minerals are set to rise to 5% of gross sales for gold, up from 2.5-3%; 10% of gross sales for rare earths, niobium and titanium, up from 3%; and between 1% and 12% of gross sale value on other minerals. With corporate and withholding tax, the burden of extra royalties is high and could discourage some investors. According to the proposed mining bill, foreign companies will cede a 10% stake to local owners in some cases. The same capital gains and windfall taxes that President Kenyatta said will be imposed on oil and gas firms are also set to be applied to mining companies. “There is a lot of activity in the sector,” Stephen Mwakesi, policy and research manager of the Kenya Chamber of Mines, which represents the industry, told OBG. “There have been attempts to review legislation but some of the approaches have had negative impacts on the potential for future exploration. We are working to reduce uncertainties and make sure that any decisions are subject to consultation. While the government is seeking to increase revenue from the sector, we do need some level of confidence that the rules will not shift too much.”

Outlook

Kenya’s natural resource potential is promising, particularly in the oil and gas arena, with many in the industry hoping that East Africa will prove to be among the next frontiers for hydrocarbons exploration. As the industry develops, clarity on the regulatory framework would help to reassure international investors in both the oil and gas and mining sectors.

An appealing regulatory environment will help to convince the industry that Kenya is serious about promoting investment in extracting its natural resources. In addition, a commitment to infrastructure development by the authorities should also help to attract the necessary funding and expertise to the country.