EU seeks energy security in stronger supplier ties

The European Union (EU) is increasingly dependent on foreign supplies to meet its growing demand for energy, especially for fossel fuels. This situation has not changed since 2000, when the European Commission (EC) adopted its Green Paper. However, Europe is intensifying efforts to ensure its energy security.

The EC adopted the “Green Paper: Towards a European Strategy for the Security of Energy Supply” on Nov. 29, 2000. The main goal of this important document was to create a dialogue for possible solutions to the energy question and to reach a consensus on the necessary strategies to ensure Europe’s energy security.

The thrust of the problem is that Europe’s indigenous energy production is declining while its demand is rising. Foreign supplies increasingly have been filling this growing gap, and as a result, the EU’s energy import dependence is projected to rise to 68% by 2030 from 50% in 2000.1

In 2000, oil constituted about 41% of the EU’s energy consumption, natural gas 22%, coal 16%, nuclear power 15%, and renewables 6%.2 This heavy dependence on fossil fuels is part of a global trend. According to the International Energy Agency (IEA), fossil fuels will continue to dominate global energy use.

Crude oil will remain the single most-used fuel in the primary energy mix, even though its percentage share will fall marginally. Meanwhile, demand for natural gas will grow most rapidly, mainly due to strong demand for electric power generation.3 By 2030, the EU is projected to be 90% dependent on imported oil and 80% dependent on imported natural gas.4 Most of the oil comes from the Middle East, while most of the gas originates in Russia.

The underlying reason for this large and growing dependence on foreign supplies is Europe’s limited indigenous energy production capacity. EU members possess only 0.6% of the world’s proved oil reserves and 2% of proved natural gas reserves.5 These limited reserves are largely concentrated in the North Sea. Restrained by this combination of limited indigenous hydrocarbon resources and rising demand, most European policymakers have reached the conclusion that energy self-sufficiency is not a realistic option.

In response to the expected growth of reliance upon imported oil and gas, the EU has tried to strengthen energy partnerships with major oil and gas exporters in Russia, the Caspian Sea region, and the Middle East. Its efforts reinforce the observation that stability and predictability in energy markets are shared goals between producing regions and major consumers.

Dialogues with Russia

Given the growing gap between Europe’s domestic energy production and its large and growing demand, it is quite natural that the EU would seek cooperation with its large neighbor, Russia, the world’s largest exporter of natural gas and the second largest exporter (after Saudi Arabia) of oil.

This cooperation was documented and institutionalized in the Energy Charter Treaty, the roots of which date back to a political initiative launched in Europe in the early 1990s, when the end of the Cold War offered an unprecedented opportunity to overcome previous ideological, political, and economic divisions. The two sides of the Cold War share interests in promoting cooperation in the energy sector. Russia and many of its neighbors are rich in energy resources but needed major investments for exploration and development.

West European governments and private companies have the financial resources and economic and strategic needs to diversify their energy supplies. Based on these mutual interests, the Energy Charter Treaty and the Energy Charter Protocol on Energy Efficiency and Related Environmental Aspects were signed in December 1994 and entered into legal force in April 1998.

The treaty’s provisions focus on five broad areas: the protection and promotion of foreign energy investments; free trade in energy materials based on the World Trade Organization rules; freedom of energy transit through pipelines and grids; reduction of the energy cycle’s negative environmental impact through improving energy efficiency; and mechanisms for the resolution of state-to-state or investor-to-state disputes.6

The EU-Russia energy dialogue has already produced some significant results, including the setting up of a center for energy technology in Moscow in 2004, negotiations to improve safety levels for transportation of oil by sea, and negotiations to build a gas pipeline system in northern Europe (see maps, OGJ, Nov. 8, 2004, p. 62).

In short, the EU-Russia dialogue is based on a simple bargain-Europe’s investment in return for Russia’s oil and gas. According to a recent IEA study, Russia’s oil industry during 2001-30 will require a total investment of $328 billion, or $11 billion/year, while the gas sector will need $330 billion, or $11 billion/year.7 Since the mid-1990s, major European oil companies have invested substantial financial resources in Russia’s energy sector. In fact, during the early 2000s, Britain has been the single largest foreign investor in Russia.

Pipelines necessary

Russia has proposed and negotiated several pipeline schemes to export its oil and natural gas to Europe. The export of Russia’s crude oil via pipeline falls under the exclusive jurisdiction of Russia’s state-owned pipeline monopoly Transneft. In recent years, Russia’s pipeline export capacity has not kept pace with the country’s fast-growing production. Furthermore, during the Soviet era, most of the Soviet pipelines were aimed at providing oil to former Soviet republics and allies in Eastern Europe. Since the collapse of the Soviet Union there has been a growing interest to redirect Russia’s oil exports towards Western Europe (see maps, OGJ, Apr. 5, 2004, p. 60). The Druzhba (friendship) pipeline, the Baltic Pipeline System, and the Adria pipeline underscore this new orientation.

Europe is more dependent on natural gas supplies from Russia than on oil supplies. Russia’s state-run natural gas monopoly Gazprom holds nearly one third of the world’s natural gas reserves, produces nearly 90% of Russia’s natural gas, and operates the country’s natural gas pipeline grid. Like oil, most of Russia’s natural gas was exported to nations in Eastern Europe during the Soviet era. In recent years, increasing supplies have been shipped to EU members and to Turkey, Japan, and other Asian consumers.

All of Russia’s gas is exported via pipelines. The Yamal-Europe system carries natural gas from Russia to Poland and Germany via Belarus. The Blue Stream line connects the Russian system to Turkey through pipelines that extend underneath the Black Sea. And Russia and several European countries have negotiated and signed several agreements regarding the construction of a Northern European gas pipeline. The line would run under the Baltic Sea from St. Petersburg to northern Germany and then across the Netherlands and the English Channel to the UK.8 A possible spur to Sweden has also been considered.

Several developments are likely to shape the future of the EU-Russia energy dialogue:

• Russia’s ability to maintain its high level of oil production and to expand its export capacity (i.e., the construction of new pipelines) for both oil and natural gas.

• The future of economic reform in Russia. Developments in recent years have raised doubts about the reconstruction of the country’s energy sector. Russia’s vast gas industry remains substantially unreformed.

• The challenge to EU members of being too dependent on Russia to meet their growing hydrocarbon demands. They have been actively seeking cooperation with other producing regions. The EU also is demanding an end to Gazprom’s export monopoly.

Caspian Sea cooperation

The US Energy Information Administration (EIA) and BP PLC estimate that the Caspian region holds 16.9-32.2 billion bbl of oil and 167 tcf of natural gas.9 The close cooperation among Western governments and oil companies on one side and Azerbaijan, Kazakhstan, and Turkmenistan, which were part of the Soviet Union until 1991, on the other side has contributed to the growing interest in the region.

Europe’s interest in energy cooperation with the Caspian and Central Asian states has been institutionalized since 1995 in what is known as the Interstate Oil and Gas Transport to Europe (Inogate) program. This arrangement is, to a great extent, similar to the EU-Russia Energy Dialogue. It aims to promote European investment in Caspian Sea and Central Asia states in return for their energy cooperation with the EU member states.

Another important step in the same direction was taken in February 2001 when the Inogate umbrella agreement officially came into force. The agreement sets out an institutional and legal system designed to rationalize and facilitate the development of interstate oil and gas transportation systems and to attract the investments necessary for their construction and operation (see map, OGJ, July 11, 2005, p. 55). This European enthusiasm to strengthen energy cooperation with the Caspian region faces many hurdles, however, particularly the lack of consensus on how to divide the Caspian and disagreements over the most cost-effective pipeline routes (see maps, OGJ, May 28, 2001, p. 66).

Caspian legal status

In the 19th Century, ships of the Russian and Persian empires sailed the Caspian Sea unchallenged, but their captains were interested primarily in establishing trade routes and exploiting the sea as a source of food, not for the wealth of minerals beneath it.

In the 20th Century, the two sides negotiated and signed several agreements to govern their relationship with respect to the Caspian, most notably the Friendship Treaty of 1921 and the Treaty of Commerce and Navigation of 1940. Moscow and Tehran agreed that the Caspian was open only to their own vessels and was closed to the rest of the world. They also reserved a 12-mile zone along their respective coasts for exclusive fishing rights. However, no attempt was made to delineate any official sea boundary between them, and the treaties said nothing about the development of mineral deposits under the seabed. Thus, many analysts and policymakers have questioned the applicability of these two documents to the new, post-Soviet situation in the Caspian. Indeed, Russia, Iran, and the three former Soviet Republics have intensely disagreed on how to define the Caspian as a body of water.

Despite this lack of consensus, a de facto regime is emerging. Several international oil and gas companies have decided not to wait for an agreement and have commenced development of Caspian offshore fields. These ambitious and very expensive deals between international companies and littoral governments, however, face another serious obstacle-the lack of adequate pipeline systems to ship the region’s oil and gas to global markets.

Pipeline diplomacy

Given that Azerbaijan, Kazakhstan, and Turkmenistan are landlocked, they must ship their oil and natural gas by pipelines, which cross multiple international boundaries. The issue of potential routes through neighboring countries has become a priority for both regional and international powers, as well as for oil companies.

The construction of a pipeline would provide the transit states with several financial and political benefits, including access to oil or natural gas for their domestic needs, foreign investment and jobs, substantial transit fees, and political leverage over the flow of oil and gas.

Thus, the process of choosing and constructing pipeline routes is complicated and requires delicate negotiations with many parties. Until recently, the existing pipelines in the Caspian region were designed to link the former Soviet Union internally and were routed through Russia. Most of the Caspian’s oil and gas shipments terminated in the Russian Black Sea port of Novorosiisk.

Upon independence, there arose political and security concerns as to whether these Caspian states should remain so dependent on Russia as their sole export outlet. Furthermore, the Russian network is aimed at the Mediterranean market; it does not target the vast Asian states.

For several years a number of proposed routes have been under consideration. These include a pipeline to the north to Novorosiisk that was completed in 2000; a second one to the east, from Kazakhstan to China; a third one to the southwest, through Afghanistan to Pakistan; a fourth one to the south, across Iran; and finally, a pipeline to the west from Baku in Azerbaijan to the Georgian port of Supsa on the Black Sea-which became operational in April 1999-or to the Turkish port of Ceyhan on the Mediterranean, which was completed this year.

For several years international companies and the concerned governments have been engaged in serious negotiations to determine the priority of each pipeline. Both strategic considerations and financial interests have shaped the outcome of these negotiations.

Three conclusions can be drawn from this discussion of pipeline diplomacy in the Caspian Sea:

• Given the domestic, regional, and international rivalries surrounding oil and gas fields in the Caspian, there is no doubt that multiple export routes would increase the energy security for consumers, producers, and the global energy markets by making deliveries less vulnerable to technical or political disruptions on any individual route. Still, energy security will have to be balanced by economic feasibility because a larger number of pipelines would mean smaller economies of scale.

• In many cases, particularly US efforts to deny Iran a role in transporting Caspian oil and gas, the decision to choose the most appropriate route reflects a competition between strategic concerns and economic interests. Companies, not governments, build most pipelines. Ultimately, projects must stand on their own commercial merit, and the economics of a project will dictate its success. In the long term, pipelines that make economic sense are more likely to be built than those that do not.

• Pipelines’ capacity and availability will, to a large extent, influence the timing of oil and gas development in the Caspian region.

The Caspian region is an important source of incremental production. It will contribute to the diversification of oil and natural gas supplies and therefore to Europe’s energy security. The Caspian region, however, does not have the resources or production capability of the Middle East.

Middle East partners

The Middle East has many geological advantages. It holds the largest proved oil and natural gas reserves in the world and is the world’s largest energy-producing region. In addition, the cost of producing hydrocarbon resources in the region is the cheapest in the world, and the region is well connected to major consuming markets in Europe, the US, and Asia-Pacific.

In addition, the EU enjoys a special relationship with most Middle East countries. Geographical proximity and long historical ties have shaped the relations between the two regions. Not surprisingly, the EU is the main trade partner for several Middle East states, with oil and increasingly natural gas representing a large and growing proportion of the trade volume between the EU and Middle East states.

In recent years, the EU has sought to institutionalize its relations with its neighbors to the south and east, specifically on the Mediterranean coast, in the Persian Gulf, and more recently with members of the Organization of Petroleum Exporting Countries.

The Euro-Mediterranean Energy Partnership between EU members and the North African and Mediterranean countries-Algeria, Cyprus, Egypt, Israel, Jordan, Lebanon, Libya, Malta, Morocco, the Palestinian Authority, Syria, Tunisia, and Turkey-is an action plan to develop a free trade area by 2010 with particular attention to energy markets.

The partnership was launched in Barcelona in November 1995. The Barcelona Declaration defined three main objectives of the Euro-Mediterranean Partnership based on the pattern of the Helsinki Declaration of 1975:

1. The creation of a common area of peace and stability.

2. The construction of a zone of shared prosperity through an economic and financial partnership.

3. The development of human resources, the promotion of understanding, and the rapprochement and exchange of peoples.

The process is based on the mutual interests of both parties. The EU members expect to create a stable climate for energy investment and supply security. The Mediterranean countries see the partnership as a privileged channel for investment and technical assistance. Algeria, Libya, and to a less degree Egypt embody this energy cooperation between the two sides.

Several dynamics shape the EU-GCC Dialogue-the energy ties between Europe and the Gulf Cooperation Council (GCC) states of Bahrain, Kuwait, Oman, Qatar, Saudi Arabia, and the UAE:

• The GCC members and Iran, combined, hold the world’s largest proved oil and natural gas reserves.

• The world’s spare oil capacity since the early 2000s is almost exclusively concentrated in Saudi Arabia. The country can use and indeed has used its spare capacity to protect global markets from temporary supply interruptions, which helps to maintain stable prices.

• The EU is the preferred destination for oil from Russia, the Caspian Sea area, and North Africa, primarily because of logistics considerations, while Persian Gulf oil typically is directed toward the East and the US.10

Although most gulf oil and gas is not exported to Europe, the EU has a special interest in the GCC producers. Their massive production volumes and exports shape global markets regardless of the destination of these supplies. For the last several years the two sides have negotiated economic and trade agreements with broad energy implications. In addition, European companies play a leading role in developing oil and gas deposits in the gulf.

In parallel with the GCC dialogues, the EU initiated talks with OPEC in June when delegations from the two sides met in Brussels. This important new initiative is seen by the EU as part of a broader approach to strengthen energy dialogues with the main oil and gas suppliers and by OPEC as a significant step in its continued efforts to encourage cooperation among oil producers and consumers.

Policy implications

The analysis of Europe’s efforts to ensure its energy security by diversifying energy sources suggests four major conclusions:

The potential for energy self-sufficiency within the EU is limited. Simply stated, Europe does not have the necessary energy resources to sustain its well-developed economies and high standard of living. Consequently, in the foreseeable future Europe will continue to be dependent on foreign supplies.

Despite attempts by the EU and individual members to liberalize the energy sector, governments still have an important role to play. Europe’s active policy in Russia, the Caspian area, Iran, and the rest of the Middle East opens the door for European oil companies to do business in these countries. It was European governments and the EU that initiated dialogues with the producing regions.

The Middle East will always be a critical player in energy policy. Although strong and growing relations with Russia and Caspian Sea areas are important and diversification of sources has greatly enhanced Europe’s energy security, these two regions will not replace the Middle East, given its geological advantages.

Oil and to a less extent natural gas markets are global and well integrated. The source of a barrel of oil matters less than its availability. No country or region can alone protect itself from oil price swings or from the consequences of interruptions in oil production wherever they occur.11

Greater predictability in energy markets is increasingly seen as a shared goal between producers and consumers. It can facilitate global economic prosperity and political stability in a win-win opportunity.✦

References

1. European Commission (EC), “European Energy and Transport Trends to 2030,” p.15; online January 2003 at http://Europa.eu.int/comm/energy/index_en.html.

2. EC, “Green Paper: Towards a European Strategy for the Security of Energy Supply,” November 2000, p. 4; online at http://Europea.edu.int/comm/energy/index_en.html.

3. International Energy Agency (IEA), “World Energy Outlook,” Paris, 2004, p. 31.

4. Commission of the European Communities, “Green Paper on Energy Efficiency or Doing More with Less,” June 2005, p. 5; online at http://Europa.eu.int/comm/energy/indes_en.html.

5. Energy Information Administration (EIA), “Regional Indicators: European Union,” January 2005; online at www.eia.doe.gov.

6. Energy Charter Secretariat, “What Is The Energy Charter? An Introductory Guide,” September 2002, p. 2; online at www.encharter.org.

7. IEA, “World Energy Investment Outlook,” Paris, 2003, p. 25.

8. Roberts, John, “What Role Can Eurasian Gas Play in Europe?” Energy Economist, No. 266, December 2003, pp. 7-11.

9. EIA, “Caspian Sea Region: Key Oil and Gas Statistics,” August 2003; online at www.eia.doe.gov; and BP PLC, “BP Statistical Review of World Energy,” London, June 2005, pp. 4 and 20.

10. Luciani, Giacomo, “EuroGulf: An EU-GCC Dialogue for Energy Stability and Sustainability,” 2005, p. 5; online at http://europa.eu.int/comm/energy/index_en.html.

11. Gault, John, “Energy as a Security Challenge for the EU,” Middle East Economic Survey, Vol. 47, No. 46, Nov. 15, 2004; online at www.mees.com.

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