Picture Energy magazine  "Oil & Capital"  ¹10 / 2000                  

‘The pipeline that is one too many’
Andrei Konoplyanik and Anton Lobzhanidze question the need for the Baku-Ceyhan oil pipeline

Andrei Konoplyanik, Doctor of Economics, Professor, Ordzhonikidze State Management University, President, Fund for Promoting the Development of Energy and Investment Policies and Project Financing, Advisor, RF Ministry of Energy, RF Ministry of Industrial Development and Trade
Anton Lobzhanidze, postgraduate, Ordzhonikidze State Management University

A year ago the framework agreements for the Baku-Ceyhan oil pipeline were signed during an OSCE summit in Istanbul but 12 months later it is time to admit that the project has stalled.
Foreign participants in Azeri oil projects are saying, increasingly often, that the pipeline to Ceyhan is not really needed, particularly by the leaders of BP, one of the largest investors in the Azeri economy.
Last month the project lost another major potential donor — ExxonMobil. Its top executives said, during a Washington conference for investors in Azerbaijan, that the Baku-Ceyhan project runs counter to their interests.

It again confirmed analysts’ doubts about the project’s economic efficiency. In fact, the project, so energetically lobbied by the West, may be the main impediment in the way to the Azeri shelf’s development.
The Caspian region’s geographic location, unfavourable for oil and gas companies by being far away from the main markets, with no access to major sea routes and the need for transit across third countries, the many interstate and inter-ethnic conflicts and high risks involved, especially in the field of transport, pose tougher requirements in what concerns substantiating the need for the laying of export pipelines.

Such a transport system should meet at least three major requirements:
a) guarantee long-term stable supplies;
b) take account of the situation in the oil market;
c) be economically efficient.

Stable supplies can be guaranteed by the availability of several alternative routes, which rules out any nation’s diktat in Caspian energy resources’ transport. Especially so as virtually all potential transit nations are involved in certain inter-ethnic conflicts such as Russia’s Chechnya problem, the Kurds in Turkey or Georgia’s breakaway Abkhazia.
In principle, all interested parties share the view. The problem is striking a balance between pipeline projects’ economic efficiency and minimising the risks involved in supplying oil to the world market.
The combined potential throughput capacity of export pipelines (existing, under construction and planned) by far exceeds the region’s output in the near future. As a result, only one or two new transport projects will be realised.

The market situation is determined by supply and demand in the main potential markets for Caspian oil. According to forecasts for the coming decade or two, demand will grow rapidly in Asia, while Caspian oil, if brought to Western Europe or the Mediterranean market in substantial amounts, can ruin the existing balance. To avoid this, at least part of the Kazakh or Azeri oil should be directed to alternative markets to Western Europe, such as China, the Asia-Pacific nations, Eastern Europe and the Black Sea region.
As for economic efficiency, an export pipeline system should ensure, first, maximum throughput capacity with minimum capital investment and, second, oil transport tariffs acceptable for companies operating in the region. In other words, the overall level of all Caspian oil costs should correspond to the existing and, which is particularly important, predicted level of world prices.

We want to look at prospects for the export of Caspian oil on the basis of two main scenarios — with a Baku-Ceyhan pipeline and without it.
The scenario involving Ceyhan should also be considered in two versions — with and without upgrading and increasing the capacity of existing routes (such as the Baku-Novorossiisk, Baku-Supsa and CPC pipelines, Transneft’s vacant capacity on the Atyrau-Samara section and swap schemes with Iran).
The current throughput capacity of existing export pipelines is insufficient even for Azerbaijan’s first consortium, AIOC — its peak output will be somewhere between 35m and 40m tonnes a year.

The problem is whether there are real alternatives to the Baku-Ceyhan project today.
In our opinion, there are such alternatives: the realisation of the Caspian Pipeline Consortium (CPC) project, along with modernisation of existing pipelines, will meet Azerbaijan’s and Kazakhstan’s demand for export infrastructure for at least five to seven years.
Rapid implementation of the Baku-Ceyhan project with a throughput capacity of 50m tonnes a year, will result in there being too much spare capacity (see the chart).

The widest gap between production and available throughput capacity would then be in 2005, when production in the Caspian may reach around 70m tonnes of oil (throughout this article, we are speaking of export volumes, with no account of domestic consumption), while export pipelines’ throughput capacity would be 140m tonnes. In Azerbaijan, the gap will be wider than the region’s average: production, 32m tonnes, and throughput capacity, 87m tonnes.
By 2010, the gap would narrow down from 70m to 20m tonnes for the Caspian as a whole (production, 130m tonnes, and throughput capacity, 150m tonnes) and from 55m to 32m tonnes for Azerbaijan (production, 55m, and throughput capacity, 87m tonnes).

If the Baku-Ceyhan pipeline is laid while other assets are not upgraded, the situation will be more balanced: by 2010 Azerbaijan’s oil output and its transport capacity will be almost equal. But this variant is inefficient in economic terms.
If a line to Ceyhan is not laid, by 2005 the Caspian’s production volumes will be more or less equal to the pipelines’ throughput capacity (70m and 90m tonnes respectively), and by 2010 shortages of transport capacities might be registered (130m and 100m tonnes respectively). The situation will be similar for Azerbaijan: 32m tonnes and 37m tonnes by 2005, 55m tonnes and 37m tonnes by 2010.

Obviously, this rivalry between various transport routes for Caspian oil is, in effect, a game of who comes first wins, because the commissioning of one or two pipelines with throughout capacities optimal for their economy makes the laying of yet another pipeline senseless.
It is obvious that Baku-Ceyhan is today the pipeline that is one too many.
The line bypassing Chechnya has been working since the spring and, according to Transneft leaders, its throughput capacity may be increased rapidly to 17m tonnes a year, when required. As for the Baku-Supsa pipeline, if necessary, it can be easily upgraded in 2004 or 2005.
Therefore, it is very unlikely that the Baku-Ceyhan project can fit harmoniously in the emerging system for Caspian oil supplies to the world market.

On the contrary, the advantages of the scenario without Ceyhan are clear, the main one being that Caspian export flows are divided up between two different markets. From Novorossiisk or Supsa oil can be carried to the Mediterranean and it can also be shipped to Ukraine (then to Western and Northern Europe) and Eastern Europe (by tankers up the Danube).
So, the Baku-Ceyhan project can only be implemented if its economy is better than that of its rivals and if it involves less risks.
Two major parameters determining a project’s economic efficiency also need to be looked at: throughput tariffs and capital investment. Estimates show that in both respects Baku-Ceyhan is lagging far behind its rivals.
According to the Istanbul accords, the pipeline will cost $2.4bn (if its annual throughput capacity is 50m tonnes), and planned tariffs will range from $16 to $17.5 a tonne ($2.2-$2.4 a barrel).

In our opinion, the figures are overly optimistic. In 1997 and 1998 Transneft specialists conducted their own research for various throughput capacities for all potential transport routes, including Ceyhan. They found that investment in the laying of a pipeline to Ceyhan would be more than $3.8bn, and tariffs would be around $33 a tonne.
Even if a maximum throughput capacity is chosen, throughput tariffs on the route would be $5-$7 higher, than on the western (to Supsa) or northern (to Novorossiisk) routes (see Oil transport tariffs for main alternative routes). On the contrary, both the northern and western routes are effective even at a minimum throughput capacity of five million tonnes a year.

Oil transport tariffs for main alternative routes, $ a tonne
Capacity  Baku-Ceyhan  Baku-Supsa  Baku-
5m tonnes  110+3*=113  34+8*=42  31+5*=36
10m tonnes  74+3=77  24+8=32  28+5=33
30m tonnes  46+3=49  21+8=29  26+5=31
50m tonnes  33**+3=36  —  — 
* cost of tanker shipments to Genoa
** extrapolated on the basis of Transneft estimates
Source: Transneft, estimates made by the authors

High tariffs on the Turkey route could be justified if risks were lower. But Baku-Ceyhan is far from perfect — the Kurdish problem is still high on the agenda in Turkey. Besides, as the situation in Chechnya improves, oil transport risks on the northern route will be lower, further worsening the Ceyhan pipe’s chances.
As for the required investment volumes in pipelines, they range from $5.35bn to $7.05bn for the whole of the Caspian, including:

• laying of the Baku-Ceyhan pipeline — $2.4bn-$3.8bn;
• upgrade of the Baku-Supsa route — $0.7bn-$1.0bn;
• the Chechnya by-pass line — $150m;
• CPC Phase One — $2.1bn.

With no account of the Turkey route, combined investment will range from $2.95bn to $3.25bn.
Respective figures for Azerbaijan are $3.25bn-$4.95bn and $0.85bn-$1.1bn.
If we compare the share of total investment in each pipeline project and each pipeline’s share in the region’s throughput capacity, Baku-Ceyhan is again the loser. While accounting for slightly over one-third of combined throughput capacity, it will require half to two-thirds of combined investment (see Relative weight).

Relative weight of the Baku-Ceyhan pipeline in combined throughput capacity and
 investment in Caspian oil transport

Combined throughput capacity, m tonnes  150  130
Share of Baku-Ceyhan in combined throughput capacity, %  32  37
Total investment, $m  5,350-7,050  4,500-5,900
Share of Baku-Ceyhan in total investment, %  44-57  53-64
1 if Baku-Novorossiisk and Baku-Supsa are upgraded
2 with no upgrade

The accords signed during the OSCE summit in Istanbul in November 1999 created a legal framework of the project’s implementation but they failed to resolve the pipeline project’s financing problems. 
The financing problems have not been tackled so far, as the project’s profitability is open to question.
In theory, there are four sources of investment in the project:

• the world capital market — private investment, primarily funds of oil companies operating in Azerbaijan;
• the budgets of countries across whose territory the pipeline would run;
• international financial institutions (IBRD, EBRD etc); 
• various government agencies formed to encourage investment (such as US Eximbank, OPIC etc).

None of those could be used in the foreseeable future for the Baku-Ceyhan project.
Attracting financial resources from the world capital market is the least politicised way, but it poses very tough requirements to borrowers.
Azerbaijan can hardly be considered a first class borrower as estimates of its oil reserves have been reduced. Besides, investors cannot be guaranteed that by 2004 — when the pipeline’s construction is to be completed, even though it has not begun so far, that there will be enough oil for the pipeline to work at full capacity. But even if Azerbaijan finds the required oil amounts somewhere, the Turkey route should be able to compete with the western and northern routes.

Unfortunately for Azerbaijan, as we showed above, there is no scenario under which the Baku-Ceyhan pipeline’s economy and tariffs could compete with rival pipelines: if tariffs are high, the pipeline cannot get enough oil, if they are low, the project’s economy sharply worsens.
It should be added that the commissioning of the Baku-Ceyhan pipeline could wreck the oil market in Western Europe. Annual supplies of 50m tonnes of Azeri oil, combined with supplies by the CPC and a potential increase in Russian exports from the Caspian would mean extra 100m tonnes a year. This is more than 2.5 per cent of the world’s oil demand and around 13 per cent of Western Europe’s consumption.

By way of comparison, let us recall that the 1998 price crisis broke out in the wake of OPEC’s decision to increase production by three per cent.
In turn, a decrease in oil prices will make the project’s pay back period much longer, making it unacceptable in economic terms.
Obviously, this large-scale project cannot be financed from budgets of nations across whose territory the pipeline would run. Neither Azerbaijan nor Georgia have enough funds for the project, and Turkey cannot finance it alone, especially in its current complex financial state.

As for international financial institutions, such as the World Bank or the EBRD, practice shows that they prefer not to get involved in low-profit, risky projects.
Getting investment from specialised government agencies, primarily US agencies, seems more realistic. They might be tied loans or guarantees for tied loans issued by US governmental financial institutions.
But numerous problems defying solution emerge again. Positive effects for part of the US economy are obvious — US contractors and subcontractors are guaranteed involvement in projects to amounts usually reaching 85 per cent of the value of tied loans. But another part of the US economy loses.

If a project proves unprofitable, either US oil companies will have to pay exorbitant tariffs, or the US government will have to shift the burden on its taxpayers. Will the US administration be prepared to explain the need for such spending, even though the US economy has been growing steadily? Unlikely.
There is a further factor — changes in forecasts concerning Caspian oil production, which may have a serious effect on the choice of route for oil exports from the region.
On the one hand the outlook on Azerbaijan’s oil reserves is now less optimistic. On the other, major reserves in the Russian sector have been confirmed.

If the trend persists, a pipeline running to Novorossiisk will be needed to carry Russian, not Azeri oil. On the whole, reserves in the Russian and Kazakhstan sectors can cover an increase in Western Europe’s demand for oil at least until 2010. Those Caspian littoral states which are the first to lay export routes for themselves, will be able to cut off their rivals from the Western European market.
Russia’s chances to succeed in this competition have substantially grown during the past two years. Even though both the AIOC and LUKOIL in the northern Caspian are expected to reach peak production in 2007, Russia is better provided with export infrastructure.

But there is an alternative for big Azeri oil to the European market — the far more capacious and rapidly growing Asian market. The shortest distance to that market is via Iran. The idea is not new, but until recently it had been blocked by ‘irreconcilable’ US politicians.
Had the Baku-Ceyhan project been even slightly more attractive for US companies operating in the Caspian, no one would have mentioned Iran.
But in this case the economy has a chance to show its dominance over politics. The first signs have manifested themselves.

George W Bush, the presidential candidate, expressing the interests of US major oil capital, said recently that if he is elected president, he will not support the Baku-Ceyhan project, he will lobby for the Iran route instead, which is more beneficial in economic terms.
This is an optimal variant for Caspian oil. 
Oil from Kazakhstan and Russia via Novorossiisk plus small amounts of Azeri oil via Supsa would be supplied to Europe, while the bulk of Azeri oil would go — via Iran — to the Asia-Pacific region, China and the Far East. This will ensure real diversification of export routes for Caspian hydrocarbons — besides, the Iran route is also preferable to the Turkey route in security terms.

The use of the southern route would make the situation unusual.
On the one hand, Iran, being an OPEC member, would have to obey the organisation’s decisions and limit supplies if prices go down. On the other, as a transit nation, it would have to ensure uninterrupted supplies from countries that are its rivals. One possible solution would be, for example, Azerbaijan’s joining OPEC or, if the world oil market situation is unfavourable, some mechanisms could be worked up to limits exports from Azerbaijan.