Global Economics

Energy: Caspian Treasure


Zeyno Baran of the Hudson Institute says the U.S. and EU are not taking enough advantage of non-OPEC oil from the Caspian Sea region

[The following is an excerpt of testimony delivered 12 June before the U.S. Senate Foreign Relations Committee. It was presented by Zeyno Baran, director of the Center for Eurasian Policy at the Hudson Institute, a Washington-based public policy institute.]

Since Russia cut off gas supplies to Ukraine on 1 January 2006 — the same day it took over the presidency of the Group of Eight (G8) — there has been increased awareness in Europe of their dependence on Russian gas supplies. There is talk about formulating a united external energy policy within the European Union to diversify supply sources and routes, but the 27 countries have been unable to reach consensus because of conflicting priorities.

The EU has so far failed to come together as a single voice partly because the issue has not been framed correctly. The unity they need is in negotiations with Russia, and specifically its giant gas monopoly Gazprom, which serves as the Kremlin's leading foreign policy arm. There is simply no other county that poses the same political and economic challenge to the EU.

WANTED: U.S. STRATEGIC ENGAGEMENT

European energy security and supply diversification as a concept is important, but this is not an area where direct U.S. involvement is necessary or appropriate. U.S. leadership is needed, however, to enable Caspian producers (mainly Azerbaijan, Kazakhstan and Turkmenistan) non-Russian controlled export options to Western markets. Europe's independent access to Caspian hydrocarbons would prevent further Russian control over their energy infrastructure, and thereby their foreign policy.

There is an excellent precedent: the Baku-Tbilisi-Ceyhan (BTC) and Baku-Tbilisi-Erzurum (BTE) pipeline projects. Even though the governments of Azerbaijan, Georgia, and Turkey backed these projects, the United States government's unequivocal support allowed these countries to proceed without fear of Russian repercussions. Similarly, it gave companies the confidence to invest in a major project like BTC or BTE that might have faltered in light of strong opposition from Moscow. In fact, even though the consortia for the BTC and BTE pipelines consisted mostly of European companies, European governments relied on U.S. diplomacy to shield their companies from Russia.

Thanks to these two pipeline projects, Azerbaijan and Georgia are now free to develop their future policy without undue foreign pressure. Extending the energy corridor further east to Turkmenistan, Kazakhstan, and Uzbekistan would provide these Central Asian countries with such freedom as well. Surrounded by Russia, China, and Iran, all three have made clear their desire for a direct Western outlet in order to maximize their negotiation power and also to solidify their independence from Russian influence. As long as almost all their revenues come from Russia, they cannot feel completely independent.

Unlike in the 1990s, we have a strong and united Kremlin, currently occupied by a man who used to be the head of Gazprom. In some ways the switch from Gazprom to the Kremlin was not a major change for [President Dmitry] Medvedev because the policies of Gazprom and the Russian government have been inexorably intertwined. Gazprom is the state's largest source of revenue and the engine that has driven Russia's economic recovery. The company is primarily state-owned and many of Gazprom's corporate leadership currently hold — or previously held — high-ranking positions in the Russian government. In addition to the president himself, there is his assistant Konstantin Chuychenko, executive director of RosUkrEnergo and head of Gazprom's legal department; and the new Gazprom chairman, former Prime Minister Viktor Zubkov.

[Then-President Vladimir] Putin has personally visited each of the relevant European and Eurasian countries, and met repeatedly with their top leaderships in order to [lure] them to join his energy projects. The most notable of these gas projects is the Nord Stream gas pipeline that will connect Russia and Germany. This politically divisive project is headed by Gerhard Schroeder, who extended [a] $1.2 billion credit guarantee to this pipeline just prior to stepping down as German chancellor.

Clearly, it is not realistic to expect the U.S. president to micromanage these issues. Yet, it is important to make clear our strong and bipartisan commitment to the Caspian-Europe energy corridor.

BRINGING NON-OPEC CASPIAN OIL TO WESTERN MARKETS

On oil, there is the BTC, as well as the Baku-Supsa pipeline ending [on] Georgia's Black Sea coast to transport Caspian (mainly Azerbaijani) oil to Western markets via non-Russian controlled routes. [The] Baku-Novorossiysk and CPC pipelines also bring Caspian oil westwards, but with Russian involvement. Russia has used its shareholder position in CPC to delay the expansion of this pipeline bringing Kazakh oil to the Black Sea, thereby hindering production.

Moreover, Moscow has conditioned the expansion to the commitment of necessary volumes of oil for its planned Burgas-Alexandroupolis (B-A) oil pipeline. The B-A pipeline will transport oil from the Black Sea via Bulgaria and Greece. In principle, the U.S. should be supportive of such a pipeline, but Russia has 51 percent ownership and the Kremlin is using its position to urge Russian companies to invest in it. This may not be the best route for Kazakhstan or for private companies (mainly Chevron and Exxon) that may not want to submit to further control by the Russian government. The U.S. should inquire further about the ownership and structure of this pipeline, which would be the first Russian-managed oil pipeline in the EU.

Diversification from Russian control in the western direction is a key reason for Kazakhstan to commit its oil to BTC. The Kazakh-Azeri connection is critically important to enlarge the east-west energy corridor and to reliably bring significant [amounts] of new, non-OPEC oil to world markets.

Additional Kazakh oil will go westwards to Georgian Black Sea ports (Kulevi and Supsa). Some will reach markets via tankers crossing the Turkish Straits and some via Straits bypass routes. A portion of that oil, along with Azerbaijani oil, [could] be sent to European markets via the existing oil pipeline starting in Ukraine's Black Sea port Odessa and continuing onwards to Brody. Odessa-Brody was actually built for that purpose but failed to secure supply commitments from oil producers. As such, it has been operating in [the] reverse direction ever since, transporting Russian crude from Brody to Odessa. In May, at the Kyiv conference, Azerbaijan, Georgia, Ukraine, Poland, and Lithuania not only reached consensus to switching Odessa-Brody back to its intended direction, but also to support extending the pipeline to the Polish city of Plock. From there, it would connect to the existing Polish network, enabling oil to continue to the Baltic Sea oil terminal of Gdansk.

The U.S. needs to ensure that Azerbaijan, Kazakhstan, and private oil companies would not once again be subverted as this project would connect Ukraine to the east-west corridor and strengthen its pro-Western orientation. Now that Ukraine has been officially promised NATO membership, it should be firmly anchored in the broad Caspian-Europe energy corridor.

GEOPOLITICS OF GAS: NABUCCO VS. SOUTH STREAM

On gas, the challenge is bigger due to the nature of natural gas as a tradable commodity — there is no global market, and the construction of costly pipelines effectively locks consumers into a prolonged contract with producers. This means that Moscow can more easily manipulate dependence into political and economic leverage. Natural gas is vital to the economies of many European nations — and the fuel's primacy is growing. The prospect of being forced to pay a higher price for that gas, or even having the supply of that gas curtailed, can exert a powerful influence on a country's domestic and foreign policies.

Thanks to U.S. support for [a] Caspian-Europe direct gas connection, BTE has already been [built], and its extension to Greece began operation in November 2007. The Turkey-Greece pipeline has enabled gas from Azerbaijan to flow all the way to the EU free from Russian control. Construction will soon begin on an extension of the Turkey-Greece connection to Italy, named the TGI pipeline.

Meanwhile, the Nabucco pipeline has become a litmus test for the ability of the EU and the U.S. to complete a project that is a stated priority. Nabucco (named after Giuseppe Verdi's opera) is intended to have a capacity of 31 billion cubic meters that will enter Europe through Turkey. The pipeline will traverse Bulgaria, Romania and Hungary, terminating in Austria at that country's Baumgarten gas storage and distribution hub. It was originally introduced by Austria to bring mostly Iranian gas to European markets; now it is backed by the U.S. to transport Caspian and Iraqi gas to European markets.

After recognizing that Nabucco and TGI would break their monopoly of transporting Caspian gas to Europe, the Russian leadership took several steps to undermine them. At first, the Kremlin wanted Gazprom to be included as a partner to have Russian gas transported via these pipelines. However, it faced opposition since the move would have annulled the raison d'etre of these projects. Putin was also eager for a second gas pipeline connection to be built from Russia to Turkey, called Blue Stream II, in order to reach the Turkish market first and keep Caspian gas out.

In other words, there was a race for the Turkish market. Having learned from its experience with Blue Stream I Turkey did not want to — once again — undermine the Central Asia-Europe gas vision by reaching another major agreement with Russia. Turkey thus made clear its continued commitment to the work with the U.S., EU and its Central Asian partners.

When it became clear that Nabucco could not be derailed in Turkey, Russia moved to bypass it by piping into Bulgaria directly, and from there Greece. So, in June 2007, Gazprom came up with a massive subsea pipeline project, the South Stream pipeline. Although the details of this venture are yet to be solidified, it is clear that South Stream, with a planned capacity of 30 bcm, will be one of the world's largest and most expensive pipelines ever built. Estimates of cost vary, but most analysts predict it would cost twice as much as Nabucco.

The signing of the South Stream pipeline project took place in Moscow between Greek Prime Minister Kostas Karamanlis and...Putin on 29 April...

South Stream targets the same markets and utilizes almost identical routes to Nabucco. In fact, three of the five countries along Nabucco's route are also part of South Stream's intended route. The pipeline would cross the Black Sea to Varna, Bulgaria. From there, South Stream will split into two smaller spurs: one heading west through Greece, beneath the Ionian Sea and into southern Italy; and the second heading north through Serbia and Hungary, terminating at Austria's Baumgarten storage facility. There may also be additional lines constructed to northern Italy via Austria and/or Slovenia.

Baumgarten is critically important in Russian strategy. Austria is involved in both Nabucco and South Stream, and both pipelines will bring gas to Baumgarten. In January, Austria's partially state-owned energy company OMV signed a deal giving Gazprom 50 percent ownership in Baumgarten. As we know by now from other such partnerships Gazprom has formed over the years, the 50 percent would not mean equal partnership — Gazprom, and thus the Russian state, would in reality have a much bigger say. The growing OMV-Gazprom partnership is important, especially in light of OMV's desire to take over Hungarian MOL, which is the only privately owned company in the Nabucco consortium.

Austria will thus become a Russian partner in Europe and serve as the clearinghouse for gas coming to Europe. Furthermore, Gazprom just last week announced that Austria and OMV would be joining South Stream and that an intergovernmental agreement will soon be signed to appoint OMV as South Stream coordinator for Austria.

Putin had previously offered Hungary the chance to become such a "hub," but the government refused — in part because of strong U.S. opposition. Similarly, when Putin offered [German] Chancellor [Angela ] Merkel such a "privileged partnership," she made clear her position to side with her EU allies.

Gazprom is making sure it has maximum flexibility in extracting the best deal for itself by having several options to get to its key markets. For example, even with strong Austrian partnership, it will construct a South Stream spur to Slovenia, and thus negate the possibility of Austrian leverage over the gas route. If problems were to emerge in Austrian-Russian relations, Gazprom could then re-route exports to northern Italy via Slovenia.

No Western company has the kind of partnership with its state as Gazprom has with the Kremlin. No Western country or company would build pipelines with such political calculations. None would undertake commercially unviable projects. We are dealing with a situation where normal competitive market principles simply do not work. It is imperative the Europeans recognize it and start taking steps accordingly; we are invariably dealing with a state-sponsored organization that has turned gas pipelines into a geopolitical tool.

OTHER RISKS OF SOUTH STREAM

Gazprom may not have enough gas to fill Nord Stream, South Stream, and its two preexisting pipeline networks through Ukraine and Belarus. The International Energy Agency has already warned that Gazprom may be unable to meet its supply contracts by 2010. Yet from Gazprom's perspective, this surplus capacity will have no negative effects. If both Nord Stream and South Stream are constructed in the proposed time frame, Nabucco will likely disappear. Russia's dominant market position will be enhanced. Thus, European consumers will be left competing against each other for scarce Russian resources, driving up prices and granting Russia ever-greater leverage. Energy prices would escalate and Moscow would be able to extract political concessions from consumer countries in exchange for greater gas supplies. This leverage is typically not exercised through dramatic supply cut-offs, but instead through subtle and protracted pressure.

If South Stream (and its sister Nord Stream) is constructed, Gazprom will actually enjoy a surplus of export capacity while Europe will face a deficit of supply options. This is potentially very troubling. Having a strong monopoly on transit routes into Europe, even if underutilized, still gives Russia significant influence vis-à-vis its ability to grant other producers access to these routes. Moscow may be anticipating the formation of a cartel-type organization for natural gas — with Russia assuming the leadership role — that will coordinate European supply. Reportedly, there is a plan in the works to create an international platform for elaborating a universal gas pricing formula and for discussing new gas [pipeline] routes and swap arrangements. From there, it will be an easy step for members to agree to divide up markets, forming monopolies, and gaining absolute control over prices.

South Stream also poses a very real threat to Ukraine, as it would give Moscow the option to decouple the country from its gas supply exports to the EU. This would leave Ukraine exceedingly vulnerable to Russian political pressure. Ukraine's position as the transit route for around 80 percent of Russia's gas exports to Europe currently gives it a degree of leverage over Moscow. Were these supplies rerouted via South Stream, Ukraine would lose this leverage. It is no secret that Moscow does not want to see Ukraine align itself with the West, and has strongly opposed the country's efforts to do so. Ukraine is in a precarious position between East and West. There are many in its government that wish to abandon Ukraine's current political orientation and turn towards Russia — and to its corresponding political and social values. Whether or not Ukraine continues its progress towards Western values has much to do with its energy security, with South Stream as the cornerstone of the issue.

WHAT SHOULD THE U.S. DO?

The most important next step is to make credible, unequivocal, and bipartisan commitment to the Caspian-Europe energy corridor. First, the [U.S.] president needs to reinforce this vision by traveling to the region, namely Azerbaijan, Kazakhstan and Turkmenistan. Second, the secretary of state needs to be engaged [in] the Caspian-Europe energy corridor. Third, a bipartisan congressional delegation needs to show its commitment as well. A Senate delegation led by Senator [Richard] Lugar, who is highly regarded in the Caspian region, would have the best chance to make a positive impact.

If the U.S. wants non-Russian pipelines such as Nabucco and TGI to become pipelines for Caspian gas transport to Europe, then Washington needs to provide political support to encourage exploration and development. It is important to recognize that [the] U.S. vision for these two pipelines, especially Nabucco, is not the same as that of Brussels — hence the lack of political backing from the EU. In September 2007 the European Commission appointed former Dutch Foreign Minister Jozias van Aartsen as "EU Coordinator for the Caspian Sea-Middle East-European Union Gas Route," including Nabucco, which it considers a "priority project." Yet Mr. Van Aartsen has not yet visited Azerbaijan or Turkmenistan. As of May, he began serving as mayor of The Hague and spends only minimal time on this project. The EU cannot be taken seriously in its commitment to Nabucco (at least not in obtaining Caspian gas for it) if they leave the coordination of this project to an occasional presence because the whole Kremlin machinery is working to undermine it.

Now is not the time for hesitation but for immediate action. Russia and Russian-influenced groups argue there is not enough gas in Azerbaijan, Kazakhstan or Turkmenistan to make Nabucco viable. This is the same argument used to sow doubt in the investors' and countries' commitment to BTC: there was not enough oil in Azerbaijan, it was not commercial, and it was merely an American political project.

Of course, if there were indeed no large gas volumes in these countries, Mr. Medvedev would not have chosen Kazakhstan as his first foreign visit and would not be courting his counterparts in Azerbaijan and Turkmenistan, which he plans to visit in early July. In addition to maintaining [Russia's] monopoly over Kazakh and Turkmen gas export, he hopes to also begin exporting Azeri gas as well.

All three nations are able to provide more than enough gas for Nabucco and several other projects — provided action is taken now. Each nation has shown they want to send large volumes of energy resources westward, but they are increasingly under Russian pressure. They managed to resist thus far, but now they need to see political will from the West. If the U.S. would not risk the ire of Russia, how can they be expected to do so?

Azerbaijan has already shown its strategic vision by promising gas to Nabucco. In November 2007, the Azerbaijani government and the Western producers operating in its Shah Deniz offshore gas fields announced that there were significantly more reserves than initially thought — more than enough to supply the first phase of the Nabucco project. More recently, at the Caspian Oil and Gas-2008 [conference] in early June, Azerbaijan's Minister of Industry and Energy Natiq Aliyev announced that the reserves exceed 1.2 trillion cubic meters, and production could soon reach 30 bcm. Some of this gas will be consumed in Azerbaijan, Georgia and Turkey; about 15 bcm could be sent to EU markets. For that, the stage-2 of the Shah Deniz field develop


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