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Caspian Energy At The Crossroads

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FUEL FOR THOUGHT

In response to recent oil and gas price hikes, recurring blackouts in California, and other symptoms of a U.S. energy "crisis," both the Bush administration and the Senate have made national energy security a top priority. Whereas the Bush team has advocated increased domestic energy production, the Senate -- now under Democratic control -- has emphasized conservation. Neither side, however, has given adequate attention to international energy policy, particularly U.S. policy toward the Caspian region.

The countries surrounding the Caspian Sea -- Russia to the north, Kazakhstan and Turkmenistan to the east, Iran to the south, and Azerbaijan to the west -- hold some of the largest oil and gas reserves in the world. And together with neighboring Armenia, Georgia, Turkey, Ukraine, and Uzbekistan, they represent important economic, political, and strategic interests for the United States. To advance those interests, Washington should strengthen its policy toward the Caspian by giving the highest level of support to the cooperative development of regional energy reserves and pipelines. In particular, it should encourage the construction of multiple pipelines to ensure diverse and reliable transportation of Caspian energy to regional and international markets.

Although the Organization of Petroleum Exporting Countries will continue to dominate the global energy market for decades to come, oil and gas development in the Caspian basin could help diversify, secure, and stabilize world energy supplies in the future, as resources from the North Sea have done in the past. The proven and possible energy reserves in or adjacent to the Caspian region -- including at least 115 billion barrels of oil -- are in fact many times greater than those of the North Sea and should increase significantly with continuing exploration.

Such plentiful resources could generate huge returns for U.S. companies and their shareholders. American firms have already acquired 75 percent of Kazakhstan's mammoth Tengiz oil field, which is now valued at more than $10 billion. Over time, as the capital generated from Caspian energy development spreads to other sectors, U.S. firms in other industries -- from infrastructure to telecommunications to transportation and other services -- could also benefit.

In addition to these energy-related and commercial interests, the United States has important political and strategic stakes in the Caspian region -- including a NATO ally in Turkey, a former adversary in Russia, a currently turbulent regime in Iran, and several fragile new states. Located at the crossroads of western Europe, eastern Asia, and the Middle East, the Caspian serves as a trafficking area for weapons of mass destruction, terrorists, and narcotics -- a role enhanced by the weakness of the region's governments. With few exceptions, the fledgling Caspian republics are plagued with pervasive corruption, political repression, and the virtual absence of the rule of law. Even if they can muster the political will to attempt reform themselves, the attempt will fail so long as they lack the resources to build strong economic and political institutions. And until they build close, substantive relations with the West, they will remain vulnerable to Russia's hegemonic impulses. The cooperative development of regional energy reserves and pipelines -- independent of their huge neighbors to the north and the south -- thus represents not only a boon for the United States and the world at large, but also the surest way to provide for the Caspian nations' own security and prosperity.

PIPE DREAMS

Cooperative ventures in Caspian oil production and pipeline development have already reaped considerable benefits. Chevron, for example, has led a consortium of investors (including ExxonMobil, the state-owned Kazakhoil, and LukArco, a joint venture between Russia's Lukoil and Arco, now owned by BP) in developing the Tengiz field, which holds more than 10 billion barrels of oil. Agip, meanwhile, a subsidiary of Italy's ENI, is now leading the OKIOC consortium (which includes British Gas, ExxonMobil, France's TotalFinaElf, and Royal Dutch Shell) in developing the Kashagan field off the coast of Kazakhstan, which could well rival Tengiz in oil volume. Each project is expected to cost $20 billion over 20 years, bringing valuable capital and jobs into Kazakhstan and reinforcing its ties with the West.

The potential for state and corporate cooperation is best illustrated by the success story of the Caspian Pipeline Consortium (CPC), which is owned half by governments (Russia, Kazakhstan, and Oman) and half by companies (eight in total, including Chevron, ExxonMobil, and LukArco). Its pipeline, which loaded its first tanker in August, transports oil from Tengiz through Russia to the Black Sea for export to Europe and the United States. When it reaches its planned capacity of 1.3 million barrels per day or more, it will contribute the biggest single addition to the world oil market since reserves from Alaska and the North Sea became available in the 1970s.

Meanwhile, in the western Caspian, the BP-led Azerbaijan International Operating Company (AIOC) is working with the Turkish state-owned pipeline company BOTAS on a multimillion-dollar study of the Baku-Tbilisi-Ceyhan pipeline. The BTC line -- strongly endorsed by the U.S. and Turkish governments -- would carry one million barrels of oil per day from Baku in Azerbaijan to Tbilisi in Georgia and from there to Ceyhan on Turkey's Mediterranean coast for export to Europe and the United States. Most of that oil would come from the Azeri-Chirag-Guneshli fields off the coast of Azerbaijan, which are expected to produce up to 480,000 barrels of oil per day by the time the BTC pipeline is completed in 2005, and up to 1.2 million barrels per day by 2010. In addition, oil producers in Kazakhstan could ship into the BTC pipeline 200,000 barrels per day from Kashagan and another 200,000 barrels per day from onshore fields other than Tengiz.

For now, however, the Caspian nations, particularly Kazakhstan, still depend heavily on Russia for oil transportation. Most of their oil exports go through Russian pipelines, including the new CPC line, to Russian ports on the Black Sea, where they are then shipped through the Bosporus to international markets. In fact, until the AIOC recently constructed a pipeline that carries some 115,000 barrels of "early oil" per day from Baku to Supsa on Georgia's Black Sea coast, Russia held an effective monopoly on Caspian oil transportation.

Continued dependence on Russian pipelines would be dangerous because it would allow Moscow to unilaterally raise tariffs and constrain Caspian exports, or threaten these actions to win political or economic concessions from its neighbors. Both Kazakhstan (an energy exporter) and Georgia (an energy importer) have been particularly vulnerable to such pressure, and their future political autonomy will rest on their ability to secure independent access to international energy markets.

As an alternative to the Russian pipeline system, the Kazakh government has recently agreed with TotalFinaElf to study the feasibility of a pipeline from the Kazakh oil fields to Iran, where it would be "swapped" with exports from the Persian Gulf -- a route that advocates say would be shorter and thus cheaper than both the BTC and the CPC routes. Nevertheless, it would be difficult to develop and construct such a pipeline before the BTC line's completion in 2005. And besides, Kazakhstan would be ill-advised to entrust its energy security to Iran, a large strategic competitor in the international energy market. Tehran could give priority to its own exports or seek other leverage from its control over exports to the south. Bulgaria and Ukraine have both offered their own plans for pipelines that may prove viable in the future, but the former faces continued conflict and turmoil in the transit countries (Albania and Macedonia), whereas the latter confronts limited demand for oil in central and eastern Europe. And both risk the environmental dangers that come with emptying tankers midroute.

The BTC pipeline thus remains the best alternative to the Russian lines. Compared to other routes, it offers a more secure investment environment, a potentially lower tariff (currently projected at less than $3 per barrel), direct linkage to large carriers in the Mediterranean, and access to the substantial Turkish and western European energy markets. The BTC line will also divert traffic from the Bosporus, reducing Turkish resistance to Russian plans for increased shipping there. Most important, the cooperative development of the BTC line will not only provide a reliable alternative to Russian pipelines but also solidify ties between the Caspian nations and the West. The United States should therefore fully support it, even if the project does not offer as high a return as initially expected.

OIL SLICK

Turkey, Azerbaijan, and Georgia, with strong encouragement from the United States, have already formally agreed to support the BTC pipeline's passage through their territories. These countries are now negotiating with Kazakhstan on the transportation of oil across the Caspian into the BTC pipeline. On March 1, Kazakhstan joined them and the United States in signing a preliminary memorandum of understanding to this effect. At the same time, however, Kazakhstan has faced intense pressure from both Russia and Iran to transport its oil through their respective pipelines instead. To satisfy Moscow, Kazakh President Nursultan Nazarbayev has consistently given top priority to the construction of the CPC pipeline, which runs through Russia. But despite occasional gestures to Iran, he has committed to the BTC pipeline as his second priority and will be free to step up his consideration of non-Russian alternatives when the CPC line becomes operational in August.

For its part, Russia is continuing to develop its own oil fields and expand its existing pipeline system. Lukoil, for example, has begun to develop the Severniy oil field in the Caspian, which could eventually offer opportunities for Western investment. Meanwhile, in an effort to maintain Russian dominance over Caspian energy transportation, the state-owned Transneft has built additional stretches of pipeline in a bypass around Chechnya, as well as a line from the Dagestani port of Makhachkala. Last April, Russia's Caspian negotiator and former energy minister, Viktor Kalyuzhniy, suggested that Russian pipeline tariffs should be reduced so as to divert oil from the BTC route, revealing Moscow's persistent interest in undermining alternatives to its pipeline system.

Russia has also continued to ship large volumes of oil through the Bosporus. It already transports one million barrels per day across the Black Sea, from Russian and Kazakh fields through its existing pipeline system and from Azerbaijan through the newly built bypass around Chechnya. In the next decade, however, these shipments may well be surpassed by those coming from Kazakhstan through the CPC pipeline as well as across the Caspian and through Dagestan. Thus Moscow urgently needs to secure Ankara's acquiescence to increased Russian shipping through the Bosporus, which may be a problem because vessels traversing the long and narrow strait have already experienced numerous accidents, some resulting in serious oil spills and injuries. Although in the past Russia has unilaterally asserted its shipping rights by relying on the 1936 Montreux Convention's declaration of the Bosporus as an international waterway, it now appears interested in a more cooperative approach with Turkey, especially given the importance of the Turkish market for Russian energy exports.

Iran, like Russia, has proceeded to develop its own oil fields and to invest in those located off the coasts of Azerbaijan and Turkmenistan. It has been upgrading its oil-processing facilities in Neka on the southeastern Caspian coast, and it is now building an oil pipeline from Neka to Tehran. At the same time, it has been constructing pipeline links and electricity grids with Turkey and the countries of Central Asia and the Caucasus. And it has pursued energy deals with the other Caspian states, including profitable "oil swaps" with Turkmenistan in which Iran exports oil from its southern fields through the Persian Gulf in exchange for imports from its northern neighbor.

Iran has also actively courted foreign investment in its energy sector -- an opportunity that European and Japanese companies have already seized. The Iran and Libya Sanctions Act (ILSA) threatens U.S. sanctions against foreign companies that invest more than $20 million in Iran, but those measures have yet to be enforced. The two U.S. executive orders that accompany ILSA, on the other hand, have precluded American firms from investing in Iran altogether. In 1995, for example, Conoco was forced to yield development of the Sirri fields in Iran's Persian Gulf waters to France's Total (now TotalFinaElf). And last March, the Japanese firms Japex and Inpex acquired preferential negotiating rights for the lucrative Azadegan field near Iraq -- a deal that U.S. firms were prohibited to pursue.

With the scheduled expiration of ILSA in August and the anticipated termination of the executive orders at the same time, U.S. firms had hoped that they too could start investing in Iran. But despite Iran's landslide reelection of moderate President Mohammad Khatami in June, Congress is likely to insist that sanctions be renewed, given Iran's continued nuclear and missile development, hostility toward Israel, and alleged links to the 1996 bombing of U.S. troops in Saudi Arabia. Thus, the best that U.S. companies can realistically hope for is that the White House will revise the executive orders so that domestic and foreign sanctions are aligned. At the very least, the executive orders should allow U.S. firms to invest up to $20 million a year in Iran, the same amount permitted foreign companies by ILSA. Even this limited step could shore up the market position of U.S. firms and help reduce Iran's hostility toward the United States, especially if ILSA and the executive orders are eventually phased out.

COLD TURKEY

The geopolitical considerations that dominate the debate over transporting Caspian oil also apply to the region's natural gas. But whereas the oil debate centers on bringing Caspian oil to international markets in general, the most pressing concern with gas is the growing Turkish demand. Assuming that it recovers from its current economic crisis, Turkey expects its annual gas consumption to more than triple over the next decade, to 55 billion cubic meters. Having already experienced serious gas shortages during its cold winters, Turkey is eager to import more gas from its neighbors -- it currently produces only five percent of what it needs.

The question is whether Turkey will continue to depend heavily on Russian imports or whether it will successfully diversify its supply. Today, Russia controls 70 percent of the Turkish gas market, transporting about 10 billion cubic meters per year through the Balkans. It plans to ship another 16 billion cubic meters per year by 2007 through the Blue Stream pipeline, currently under construction by Russia's Gazprom and Italy's ENI. The pipeline will run underwater across the Black Sea at unprecedented depths, making it somewhat susceptible to breakage, and the project's technical complexities, along with serious allegations of corruption, are leading many Turks to question their country's reliance on Russia -- or any single country -- for so much of its energy needs.

One alternative gas supplier is Iran, which concluded a modest contract with Turkey in 1996 and is now completing a pipeline from Qazvin in northern Iran to Bazargan on the Turkish border. (Turkey avoids seeking supplies from neighboring Iraq out of deference to United Nations sanctions.) Iran expects to export 3 billion cubic meters of gas per year through this pipeline starting later this year, and up to 10 billion cubic meters per year starting in 2007. This contract has prompted considerable friction between Turkey and the United States, but it is unlikely to cause further confrontation so long as it remains relatively small.

More important, Turkey has promised to buy gas from Azerbaijan and, when it is ready, Turkmenistan. (Kazakhstan, with its potential gas reserves of more than 3 trillion cubic meters, could also become a supplier in the future.) Azerbaijan has actively pursued the Turkish gas market, securing a contract in March to export 2 billion cubic meters of gas per year starting in 2004 and more than 6 billion cubic meters per year starting in 2007. This contract will directly benefit BP and other investors in Azerbaijan's offshore Shah Deniz gas field; these investors also plan to build a gas pipeline from Shah Deniz to Turkey along the same route as that of the BTC oil pipeline -- a land route that will not face the same risk of costly damages that the technically challenging Blue Stream pipeline poses.

Turkmenistan, on the other hand, has failed to take advantage of the opportunity to ship its gas to Turkey directly through an underwater pipeline across the Caspian Sea. Proposed by the Pipeline Solutions Group (a joint venture between Bechtel and GE Capital) and Royal Dutch Shell, this line would link to the planned pipeline from Azerbaijan to Turkey. Although both the United States and Turkey have strongly encouraged Turkmenistan to support this plan, Turkmen President Saparmurad Niyazov has disregarded the chance to diversify his country's energy transportation, continuing to propose instead a Russian or Iranian route, something Ankara has rejected. In the meantime, Turkmenistan continues to depend on Russian and Iranian demand for its gas sales, thereby solidifying its political alignment with those two countries and flying in the face of Niyazov's declared stance of independence.

Heavy reliance on Russian gas transportation is particularly dangerous for the former Soviet republics in light of Moscow's recent coercive behavior. For example, it has sold gas to Georgia at exorbitant rates and then interrupted the supply on several occasions, in apparent attempts to press that country to cooperate on various issues such as military action against Chechen insurgents and supplying electricity to Turkey. These actions discredit Russian reliability and only reinforce the need for alternate energy supplies and transportation. Given Turkey's recent troubles, however -- including disputes between President Ahmet Necdet Sezer and Prime Minister Bulent Ecevit, a sharp currency depreciation, turbulence in Turkish financial markets, and a corruption scandal involving government energy tenders -- the United States will have to step up its diplomatic efforts in the region if it wants to ensure diverse and stable energy development there.

HIGH STAKES

Ongoing energy projects in the Caspian have demonstrated that active U.S. leadership and commercial cooperation can reap both economic and political benefits. During the Clinton administration, the United States strongly endorsed joint investments by American and Russian companies in the development of energy resources and transportation networks both within Russia and throughout the Caspian region. This approach has provided economic incentives for Russian cooperation while giving the other former Soviet republics access to unprecedented wealth -- up to $100 billion over the next two or three decades -- that could grant them a degree of independence not experienced since the time of Tamerlane. At the same time, it has secured a major role for American companies in the region while consolidating U.S. relations with Turkey and the other Caspian states. Finally, it contained Iran's regional influence at a time when that country's policies were particularly anti-American.

But these accomplishments are now at risk of unraveling due to inadequate attention from the Bush administration and restrictive U.S. policies. In contrast to the Clinton administration's vigorous support of Caspian energy initiatives, the Bush team seems to have placed those issues on the back burner. It has eliminated, for example, the position of special adviser to the president and secretary of state for Caspian energy diplomacy, replacing it instead with a "senior adviser" on Caspian energy issues in the State Department. And it has excused from serious Caspian energy policy development the high-level interagency groups encompassing the White House; the Commerce, Energy, and Treasury Departments; and the trade finance agencies that contributed to this policy during the Clinton administration.

In the absence of such attention, coordination, and oversight, the success and leadership of U.S. firms in the Caspian region may well be stunted by restrictive U.S. policies. In addition to the unilateral sanctions against Iran that prevent U.S. firms from enjoying the same investment opportunities as their European counterparts, Section 907 of the Freedom Support Act -- supported by the powerful Armenian lobby and adopted in the wake of the conflict between Armenia and Azerbaijan -- prohibits direct U.S. assistance to Azerbaijan that is crucial for creating the economic and political institutions necessary for stable long-term investment there.

To protect U.S. interests in the Caspian, Washington must articulate a new, robust strategy comprising both commercial and political initiatives. First, the United States must do all that it can to promote reliable, diverse regional energy transportation -- and in particular, strongly support the development of the BTC oil pipeline. This means not only finalizing agreements with the relevant governments to secure political support for the project, but also encouraging U.S. and other Western companies to sponsor it.

To attract support from both firms and governments, the BTC pipeline must remain commercially competitive. Although studies indicate that the project will likely be profitable eventually, two contingencies could threaten its viability: the pipeline's construction costs could exceed the projected budget of $2.4 billion to $2.7 billion, and Russia or Iran could try to lower the tariffs on their pipelines to undercut the BTC pipeline's competitiveness.

Although increased tariffs or decreased investment returns could cover moderate cost overruns, both the United States and Turkey should be prepared to subsidize any excess costs that would be commercially unsustainable. Already, Ankara has guaranteed to cover construction costs in Turkey that exceed $1.4 billion. Washington could make a similar guarantee by agreeing to subsidize construction and other risk insurance for the pipeline's corporate sponsors to be issued by the Overseas Private Investment Corporation. Although it would be far better to base pipeline development on purely commercial terms, the strategic importance of alternative, independent transportation routes for Caspian energy is great enough to justify government intervention as a last resort.

In addition, Ankara should make clear to Moscow and Tehran that any politically driven attempts to undercut BTC tariffs would be met by countervailing measures (consistent with World Trade Organization rules) against Russian and Iranian energy sales to Turkey. The Turkish government could instruct BOTAS, for example, to buy less energy from Russia and Iran and more from Caspian suppliers that use the BTC route, which would increase that pipeline's usage and thereby reduce its tariffs.

Aside from wielding trade threats, however, both Washington and Ankara must persuade Moscow that greater Russian cooperation and participation in Caspian energy development is economically beneficial. Absent a rupture in U.S.-Russian relations over NATO expansion, arms control, or other sensitive issues, both countries should reaffirm the joint statement they made at the September 1998 summit in Moscow supporting cooperation between U.S. and Russian companies in both bilateral and regional energy development. Russia could consider, for example, the Georgian proposal of supporting a pipeline link that would carry as much as 600,000 barrels per day from the Russian port of Novorossiysk through Supsa to Ceyhan, thus reducing the amount of oil destined for the Bosporus and sharing in the economic and political benefits of the BTC line. Lukoil already invests in Kazakh and Azerbaijani oil fields and has recently acquired the majority share of the U.S. firm Getty Oil. U.S. companies sponsoring the BTC pipeline could establish or expand partnerships with Lukoil not only in Russia and the Caspian but also in other markets.

Moreover, the United States should review its economic relations with Iran, even if Congress decides to renew ILSA. Denying American companies the opportunity to invest in Iran's civilian economy serves no purpose -- especially when their European competitors are free to do so. U.S. companies should be allowed to invest in Iran as part of a broad, long-term effort to normalize relations with that country. At a minimum, they should be granted the same investment opportunities as their European competitors before becoming subject to U.S. sanctions.

The United States should make an important distinction, moreover, between U.S. energy investment in Iran, which Washington should permit, and Caspian energy transportation through Iran, which investors should avoid until a viable alternative (such as the BTC line) is in place. After all, it will hardly benefit the Caspian states to become dependent on Iran as well as Russia, since both countries are major competitors for exporting energy to international markets.

A commercial strategy focused on supporting pipeline development across Russia and Turkey for export to Europe and the United States, as well as allowing U.S. investment in Iran, could have broader political benefits as well. It could help dispel support in Russia and Iran for an anti-Western coalition that is reflected, for example, in the growing arms trade between those two countries. It could help the international community refocus on immediate threats such as Iraq. It could prompt the European Union to broaden its current Russia-focused energy policy to give greater regard to the Caspian. And it could facilitate stronger relations among the EU, Turkey, and the Caspian states.

Ultimately, commercial success in the Caspian will require a stable political environment. Therefore, in addition to promoting financial investment in Caspian energy projects, the United States must also commit greater technical and political resources to the region. To start, Congress should repeal Section 907 of the Freedom Support Act and provide Azerbaijan with the necessary technical aid for developing the fiscal, regulatory, and judicial institutions needed for attracting foreign investment and fostering long-term economic development. In concert with the EU, the United States should also provide incentives for the Caspian governments to root out corruption, increase transparency, and allow their citizens increased economic and political freedoms. For their part, U.S. and other foreign companies should insist that their Caspian partners follow the same business standards that prevail in their home countries. One encouraging step has been the creation of oil funds in Azerbaijan and Kazakhstan out of the government's share of energy revenues; these funds are to be used solely for the long-term development needs of those countries.

Through its Partnership for Peace, NATO could sponsor more exercises between Western and Caspian military forces to enhance border security in the region. And the Bush administration could encourage regional conflict resolution through the Organization for Security and Cooperation in Europe, as well as security cooperation through the GUAAM regional group comprising Georgia, Ukraine, Uzbekistan, Azerbaijan, and Moldova. Such moves could help create a more stable environment for developing and transporting regional energy resources (which could lead in turn to further security cooperation).

Over the next few months, governments and companies in the Caspian will watch closely as the Bush administration indicates the extent of its commitment to the region. President George W. Bush took a positive step in March when he wrote to Nazarbayev urging Kazakhstan to participate in the BTC pipeline project. He gave another encouraging sign in April when he met Azerbaijani President Heydar Aliyev and Armenian President Robert Kocharian to encourage the resolution of their countries' territorial dispute over Nagorno-Karabakh. These steps should be followed by much more proactive Caspian energy diplomacy, including the restoration of not only the Caspian envoy's special status but also the interagency engagement and the consultations between the public and private sectors that have played such a vital role in Caspian policy development in recent years. A strong, coherent U.S. policy toward the Caspian region could bolster world energy security as well as regional stability and independence. For the United States to squander its past success and future potential in the region through complacency and inattention would be a serious mistake.

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