Caspian oil export choices clouded by geopolitics, project economics

Bhamy V. Shenoy
Hagler Bailly Services

S. Gürcan Gülen, Michelle Michot Foss
Energy Institute
University of Houston
College of Business Administration

• Projected Caspian oil exports [71,722 bytes]
• Caspian oil reserves estimates, 1996 [86,047 bytes]
• Projected Caspian oil production [81,631 bytes]
• Caspian oil export route capacity [76,048 bytes]
• Caspian excess oil pipeline and export route capacity [112,745 bytes]
• Who benfits form Caspian pipeline options [99,472 bytes]

The Caspian region has received considerable attention because of the potential of its hydrocarbon resources.

The debates among companies operating in the region, local governments, and outside forces such as the U.S. and the European Union concerning Caspian export pipeline options have been capturing analysts' attention.

This article provides a concise overview of the hydrocarbon potential and geopolitics of the region, a forecast of the region's export options, and projections of export revenues set against an oil price scenario analysis.

We concluded that the first pipeline to be built may remain the main option for a considerable period of time.

Furthermore, if the operators can increase the capacity of the Baku-Supsa pipeline that is being built for "early oil" purposes from 100,000-200,000 b/d to 400,000 b/d as speculated, this may be the primary option.

Finally, even under the most optimistic price scenario, oil export revenues for companies may not be sufficient to cover capital expenditures necessary to develop resources.

Caspian hydrocarbon potential

Currently identified oil and gas reserves of the Caspian region have been compared with oil reserves of the North Sea and gas reserves of North America.

Many believe, however, that postulated oil resources of the region are comparable to those in Saudi Arabia and that potential gas resources are on a par with those in Iran.

The estimated combined postulated resources for Azerbaijan, Kazakhstan, Turkmenistan, and Uzbekistan (hereafter, "Caspian Four") cover ranges of 15-200 billion bbl of oil and 230-650 tcf of gas. These estimates correspond to 2-17% of world oil reserves and 5-12% of world gas reserves. When considering these shares, we need to remember that larger estimates include unproved (probable and possible) reserves as well and that they may be tainted by "optimism" of officials in producing countries. Also, if one includes unproved reserves in other parts of the world, the share of the Caspian Four will be significantly lower than the 17% and 12% calculated here.

Despite all of the speculation about the oil and gas potential and geopolitical intricacies of the region, the consensus is that the potential resources of the Caspian outweigh the risks-at certain price scenarios. This explains why international energy companies entered the region in search of opportunities, even before the collapse of the Soviet Union and establishment of independent states. It also explains why they braved the region's highly uncertain investment environment, characterized by inadequate petroleum legislation and poor conceptual understanding of market economics, capital markets, and western business practices. Despite all these obstacles, foreign exploration and production investments were launched in the region in the early 1990s. Now, the producing companies and the region's governments face the more serious problem of transporting their oil and gas from this landlocked region to hard-currency markets.

The region's pipeline system was built during the Soviet era and mostly serves Russia. Pipelines in or near the Caspian region are dilapidated and inadequate to meet the export needs of the Caspian Four. Moreover, Russia's Transneft controls the oil pipeline grid and has so far been unwilling to allow higher export quotas in its transportation network to former Soviet states. Turkmenistan had an even more difficult time sending its gas through Russia because of Gazprom's control of the gas pipeline network. Gazprom exports its own gas to hard-currency markets in Western Europe while sending Turkmen gas to Ukraine and Georgia, both of which owe billions in unpaid gas receipts. In April 1997, Turkmen gas shipments ceased because of disagreement between Gazprom and Turkmenistan regarding the price: Turkmenistan was asking $42/1,000 cu m ($1.20/Mcf) vs. Gazprom's offer of $32/1,000 cu m ($0.90/Mcf) to be paid part in cash and part in barter trade. However, under the European Energy Charter Treaty, Turkmenistan may get better access to Gazprom's pipeline system.

Major issues

Realizing the problems associated with access to the Russian pipeline system, operators of Caspian fields started exploring alternative pipeline routes outside of Russia in the early 1990s. Although there are several feasible projects, so far, no significant development towards finalizing major pipeline routes has been recorded because of the complexity of the geopolitical panorama.

There are significant political disputes and potential for armed conflict in the region.

The Armenia-Azerbaijan friction over Nagorno-Karabakh is probably one of the most conspicuous conflicts. Armenia continues to occupy Azerbaijan territory, and shooting between Armenian and Azeri border guards continues.

Abkhazia and South Ossetia are two regions that caused significant instability in Georgia in the early 1990s. Although there have been positive developments since then, these two regions, as well as some others in Georgia, can cause further instability in the Caucasus. For example, the Javakheti region, which is mostly populated by ethnic Armenians, has long been a cause for dispute between Georgia and Armenia.

The Chechnya and Dagestan conflicts in Russia appear to be under control currently, but the future is at best uncertain.

Turkey has made significant progress against Kurdish terrorists, but as long as some of Turkey's neighbors continue to support these groups, Southeast Turkey cannot be proclaimed totally safe.

Also calling for caution are other less tangible but equally pertinent historical rivalries among some neighbors that may not have received enough attention or that may not have surfaced yet.

Turkey's concern about increased tanker traffic through the Bosporus Strait is now also shared by some analysts and exporters who are more concerned about potential stoppage of tanker traffic due to an accident than the environmental impact of such an accident. On occasion, the strait has been closed to traffic for several days because of accidents. The inability to send 2-3 million b/d of oil to markets for several days is not an appealing prospect. In addition, environmental groups have clogged the strait with hundreds of small boats to protest tanker traffic.

Afghanistan's political uncertainty and protracted civil war and tensions between Pakistan and India render the option of a southward pipeline through these countries unrealistic. Most recently, nuclear tests carried out by these two rivals may also hurt prospects for such a pipeline. The current military build-up on the Iran-Afghanistan border increases the odds against this pipeline option.

Because of the U.S. sanctions against Iran, pipelines through Iran are not being considered seriously. There is doubt about Iran's willingness to allow continuous flow of Caspian oil and gas through its land once the country increases its own export capacity within the next decade.

Eastward pipelines from western Kazakhstan to China do not appear to face any major political problems (except for the potential restiveness among Muslim minorities in China's Xinjiang Uygur autonomous region). The distance from lucrative markets in southeastern China, South Korea, and Japan makes potential investors think twice before financing these projects, although China appears to be determined to pursue these options.

In addition, the collapse of oil prices in 1998 and the long-term implications of changing oil industry fundamentals (including resumption of oil demand growth in Asia) are a new source of tension. Remember that "proved" reserves constitute commercially attainable liquids given price assumptions.

Projections on Caspian oil

With regard to Caspian oil production, export, and transportation options, one must first look at the Caspian Four's potential oil reserves (see table, p. 30). Although Oil & Gas Journal's estimate for the region's proved oil reserves is 7.7 billion bbl, Washington, D.C., consultant LPI Consulting Inc. cited "industry estimates" of ultimately recoverable oil in the region that had a low-end of 25 billion bbl (OGJ, June 15, 1998, p. 39). According to the Energy Information Administration's April 1998 International Energy Outook, current proved reserves of these four countries are estimated at 32.1 billion bbl, and "potential" reserves are estimated at around 164 billion bbl. These numbers are obtained from Petroconsultants' Destiny International Energy Forecast Software and represent an upward revision on the EIA numbers reported in the table on p. 30. British Petroleum Co. plc, in its annual review of petroleum statistics, kept its yearend 1997 reserve estimates for the region unchanged from its yearend 1996 estimates. The most striking observation from this table is the wide range of proved and possible reserves estimates, 7.7-40 billion bbl and 70-150 billion bbl, respectively. For both proved and possible reserves, our estimates, based on conversations with industry sources, are closer to the optimistic end of this range.

There is also a fairly wide range of estimates for Caspian oil production. According to OGJ, total oil production of the Caspian Four was around 800,000 b/d in 1996, while EIA puts that year's output at about 1 million b/d. All other estimates lie between these two extremes. While our 2010 predictions are somewhat optimistic, Kazakoil estimates Kazakhstan oil production will reach 2.40-3.20 million b/d by 2004, as compared with our estimate of 2.20 million b/d (see inset table and chart, p. 30). Total production for the Caspian Four is expected to increase more than five-fold to more than 5 million b/d in 2010 from just under 1 million b/d in 1997, with the largest increases realized in Kazakhstan and Azerbaijan. Although production in Turkmenistan is expected to rise six-fold, to 600,000 b/d in 2010 from 100,000 b/d in 1997, in terms of absolute volume, this increase is dwarfed by the expected increase in Kazakhstan and Azerbaijan. Kazakhstan's output will more than quadruple from 0.5 million b/d in 1997 to 2.20 million b/d in 2010. More impressively, Azerbaijan's production will increase ten-fold to 2 million b/d over the same period. Production in Uzbekistan will reach 240,000 b/d in 2010 vs. 140,000 b/d in 1997.

Oil demand, export projections

Domestic demand and implied export potential during 1997-2010 for the Caspian Four together, and for each individual country, are shown in the chart on p. 29.

Caspian exports are calculated as production less domestic consumption. The average annual growth rate for demand is assumed to be 5% for Azerbaijan and Kazakhstan, 4% for Uzbekistan, and 3% for Turkmenistan.

In Azerbaijan, domestic consumption is expected to nearly double, to 320,000 b/d in 2010, from 170,000 b/d in 1997. Given expected production levels, this implies that exports will increase to 1.68 million b/d from 30,000 b/d over the same period.

Demand for oil in Kazakhstan is expected to increase by about 200,000 b/d during 1997-2010, which, in turn, implies that the country will be able to export 1.77 million b/d of oil in 2010 vs. 270,000 b/d in 1997.

In Turkmenistan, domestic demand for oil will increase to 60,000 b/d in 2010 from 40,000 b/d in 1997. Accordingly, the country will be able to export 540,000 b/d in 2010.

Uzbekistan will continue to be barely self-sufficient in oil. Almost all of its 240,000 b/d domestic production in 2010 will be consumed internally.

Although our predictions for 2010 export levels are significantly more optimistic than either EIA's (2.8-3.2 million b/d) or the International Energy Agency's (1.54-2.34 million b/d), we are not as optimistic as Kazakhstan's Ministry of Energy, Industry, and Trade, which announced that country's plans to export 2.6 million b/d by 2015. Similarly, officials from other countries may have more optimistic predictions or plans about their respective countries' export potential.

Transportation options

Clearly, Azerbaijan and Kazakhstan are the countries that will desperately need additional export route capacity. Currently, pipeline capacity allowed by Russia to the Caspian Four is limited mainly to 160,000 b/d of Tengiz oil sent to the Baltic Sea through the Druzhba pipeline and 20,000 b/d of Azeri oil sent to Novorossiisk.

Alternative transportation via trains and barges or swaps with Iran are cumbersome but provide a short-run, albeit costly, solution to the problem. Currently, about 140,000 b/d of oil is exported through non-pipeline options. These alternative arrangements, however, cannot handle the 4 million b/d of crude oil the region is projected to export by 2010.

Although Turkmenistan's exports will remain a fraction of those by Azerbaijan and Kazakhstan, the country will still need to find an export route for its oil. Currently, the country uses swaps with Iran for about 20,000 b/d, but this option is not practical for the 540,000 b/d the country is expected to have available for export by 2010. In terms of access to markets, Turkmenistan is probably in the worst shape. Most pipeline routes will have to go through several potential competitors' territory. The most direct route through Iran, as earlier noted, is politically untenable.

In order to meet the export potential of the region, international energy companies operating in the region and host governments have been exploring and promoting alternative pipeline routes. As discussed earlier, some options are politically motivated, but their economics are shaky. Options that are more desirable to energy companies are politically infeasible. Major pipeline proposals and an alternative arrangement of oil swaps with Iran are listed in the table on p. 31.

Export route capacity, utilization

In the chart on p. 31, we present a possible profile for total capacity of export alternatives combining current export capacity and that under consideration through 2010. We also include three railway options that currently account for about one-third of exports from the region. Neither the southern pipelines nor trans-Caspian connections are included.

By 2010, Caspian export capacity reaches almost 5 million b/d. This represents about 1 million b/d in excess capacity over the anticipated 4 million b/d export level.

The Baku-Ceyhan pipeline for Azerbaijan, and the Caspian Pipeline Consortium (CPC) pipeline for Kazakhstan will be the primary options under this scenario. Later, the Baku-Supsa route will also become important, especially for Azerbaijan and Turkmenistan.

Obviously, there are no guarantees that all of the pipeline routes cited will eventually be built; there may be other combinations than those shown here. But the interesting observation is that, if all of the pipelines under consideration are developed, the result would be excess transportation capacity. In the chart at upper left on this page, we show that even if only the pipelines we cite are built, there will still be excess pipeline capacity of 200,000-400,000 b/d. If we further consider other alternatives, excess export route capacity will be almost 1 million b/d by 2010.

Price scenarios

Perhaps, under better market conditions, the potential for building excess pipeline capacity may not be considered a major risk. However, with oil prices currently low and with little optimism about future prices because of weakened demand stemming from the Asian economic collapse, every dollar to be invested in the Caspian region carries additional risks.

To demonstrate this situation, we entertain several price scenarios and calculate the revenues from Caspian oil production under these scenarios. We assume (based on estimates from industry sources) that an investment of $100 billion will be necessary through 2010 in order to bring oil production up to the optimistic levels we projected and to develop transportation options.

We consider four different price scenarios for 1998-2010. Under the depressed price scenario, the Organization of Petroleum Exporting Countries is not able to control production, and prices fall to $10/bbl. If, despite low prices, Caspian region projects can be completed, and our export profile can be realized, at a 10% discount rate, the present value (PV) of oil revenues to the Caspian Four during 1998-2010 will be about $9 billion. We also calculated PVs for each scenario with a 15% discount rate. Naturally, the higher discount rate leads to significantly lower values. It is also very important to note that we maintain production levels the same in each scenario. Under depressed and low price scenarios, production will most likely be less than our optimistic projections and, accordingly, resulting PVs will be much lower.

Assuming OPEC (perhaps with non-OPEC cooperation) achieves some level of success in maintaining the price of oil at around $15/bbl for the next few years, with a gradual increase to $20/bbl by 2010, the PV for Caspian oil revenues would be about $50 billion. If OPEC is more successful, and the price of oil remains about $18/bbl for a few years and reaches $25 by 2010, the PV would be about $70 billion. Finally, we consider the possibility of a price shock similar to those experienced during the 1970s. This scenario would require an extreme disruption (principally on the supply side) in order to be borne out. In this case, the price of oil jumps up to $30/bbl and stays at that level for 3 years before settling at $25. Naturally, this is the scenario with the highest average price and therefore yields the largest PV at about $94 billion.

As can be seen from the analysis of these scenarios, oil companies do not stand to reap huge returns from their $100 billion investment over the next 10 years. In addition, if oil production turns out to be less than our forecast, then exports of oil from the Caspian region may be as low as 1.54 million b/d. In this case, there will be no need for two major export pipelines such as CPC and Baku-Ceyhan, with a combined capacity of 2.34 million b/d. Just one of them in combination with other existing infrastructure (two "early oil" pipelines, the Russian pipeline, rail shipments, and swapping with Iran) may be more than adequate. Perhaps it is this type of scenario that is preventing oil companies from pursuing export pipelines more aggressively. Of course, the political pressure from various governments is not making the decision process any easier.

Another look at these fairly disheartening prospects is provided by calculating how revenues from oil production are allocated among operating and maintenance (O&M) and transportation costs, and by company and government shares. Based on information from industry sources, we make the following simplifying assumptions: O&M costs are assumed to be $4/bbl, and transportation costs are set at $4/bbl for pipelines and $7/bbl for other alternatives, such as railways. We assume a 35-65 split of net revenues (i.e., after costs) between operating companies and local governments.

Total revenues for the four scenarios cited earlier are estimated, respectively, at $124 billion, $141 billion, $283 billion, and $335 billion. Because the total cost remains fairly constant regardless of the price of oil (about $106 billion), the shares of companies and governments are low when revenues are low, and increase disproportionately when revenues rise. Under the depressed price scenario, companies receive only 5% of total revenues, about $6.4 billion. Transportation costs account for 37% of the total, while 48% of revenues is used to meet O&M costs. Company take improves to 19% under the low-price scenario-about $44 billion. Companies fare better with OPEC success and price shock scenarios, taking in $62 billion (22%) and $80 billion (24%), respectively. However, even then, revenues are not sufficient to finance the investment needs that are speculated to reach $100 billion over the next decade. The levels of government take and transportation costs appear to be the most significant reasons for this situation. Transportation costs claim at least 14% of total revenues at the minimum, and at least one third of revenues are used to cover all costs.

Caspian pipeline game

Our preceding analysis suggests that one of the most important factors that would keep multinationals interested in the Caspian region is the availability of a reasonably priced, accessible pipeline system to move hydrocarbons out of this landlocked region to hard-currency markets.

As discussed earlier, building this system is not a trivial matter not only because of large capital requirements but also because of the region's complex geopolitics. One of the implications of our analysis is that the first pipeline to be built may remain the primary export route for a considerable period of time. This adds significantly to the complexity of the region. The winners and losers in various scenarios among interested parties regarding the specifics of the pipeline system are shown in the table at the tope of this page.

Note that OPEC loses whichever pipeline is built. Given the organization's current struggle with low oil prices, additional oil from the Caspian region that would put further downward pressure on the world oil markets is not welcome news. (For this reason, it is entirely possible that Saudi Arabia will indeed take steps that facilitate a return of multinationals to their oil sector. This action would, of course, alter Caspian prospects completely.)

Basically for the same reason, the European Union is always a winner, as is any oil-importing region or country. It does not matter where the oil is sent, because of the oil market's global nature. Even if oil is sent to the Asian markets through China or the Persian Gulf, oil prices worldwide would diminish, given current conditions and foreseeable market dynamics. Note that Iran, as a member of OPEC, shares this bad fortune, but if a pipeline were to go through Iran, the benefits from tariffs and economic development may compensate, at least to a certain extent, for the losses Iran would suffer due to lower oil prices. That is why Iran is a winner in the case of the Kazakhstan-Turkmenistan-Iran (KTI)-Persian Gulf pipeline. The U.S. shares the good fortune of any major importer of oil when Caspian oil reaches world markets. The only exception is the Iranian pipeline, which the U.S. opposes for political reasons. If the current "warming" of U.S.-Iran relations continues, the U.S. stance may change. Turkey appears to be a loser unless the pipeline is built on its land. However, access to Caspian oil via any other pipeline ending at the Black Sea can still offer benefits for Turkey.

Any time Kazakhstan finds an alternative route (especially westward), China loses because it will have to compete with European markets in terms of netbacks. In this case, any oil China receives from Kazakhstan will be more expensive than if the Chinese pipeline were Kazakhstan's primary option. Kazakhstan loses only when the Baku-Novorossiisk pipeline is built. This pipeline will bring Azeri oil to Novorossiisk, forcing head-to-head competition in European and Mediterranean markets. Depending on port capacity in Novorossiisk, the need to share facilities with exporters of Azeri oil may present a problem for Kazakh stan.

The remaining three countries in our analysis benefit from any pipeline alternative. Turkmenistan is a winner no matter which pipeline is built, because this will give them spare capacity to move their crude using either swaps or pipelines. Uzbekistan is not likely to be a major exporter of crude oil; but, in case of surplus, the country is a winner when any pipeline is built to move crude oil from east of the Caspian. This gives Uzbekistan a chance to exchange its crude oil with Kazakhstan and Turkmenistan based on geographic advantages. Pipelines west of the Caspian do not have much impact on Uzbekistan's balance. But, to the extent Kazakhstan and Turkmenistan can gain access to these western pipelines, Uzbekistan will have a slight advantage competing in eastern or southern markets.

Conclusions

Based on all of the assumptions and analyses we have presented here, we can draw the following conclusions:

• There will be excess transportation capacity if more than one pipeline is built. Therefore, the first pipeline to be built may remain the primary option for some time. The Caspian pipeline game has become a "winner takes all" game.
• Even under the most optimistic price scenario, revenues from Caspian oil exports may not be sufficient to cover costs of developing reserves and pipelines.
• Transportation cost will play a significant role in deciding the viability of the region's oil development.
• A delicate geopolitical balance in the region remains crucial for projects to be successful.

The collapse of oil prices and the delay in recovery of Asian demand present new complications that affect the development of Caspian reserves.

Thus, there seems to be a need for a brokered solution with incentives to keep Caspian development going in light of world oil market reality.

The Authors