Caspian Oil Transportation: Insights from a Commercial Perspective

by Laurent Ruseckas

Laurent Ruseckas is a Research Associate with Cambridge Energy Research Associates

In the past year or two, governments, foreign policy specialists, and the media have been paying an increasing amount of attention to the southern tier of the former Soviet Union and specifically to the geopolitical issues surrounding the development and transportation of Caspian oil.  Caspian oil is indeed at the center of the region’s evolving international relations, and the future of hydrocarbon developments in the area certainly cannot be understood except through the lens of geopolitics.
However, from the perspective of some of the key actors in the Caspian region such as the oil companies, geopolitics are a sideshow. Their interest is rooted in their strong commercial interest in participating in the development of Caspian oil. The commercial realities of Caspian oil are often ignored or misunderstood in the face of more exciting geopolitical aspects, but they are no less important to a complete understanding of the region. There are few of the ways in which non-political factors not only commercial factors but also technical and geographical factors can interact with politics to affect the emerging situation in this region.

Transportation, meaning primarily pipelines but also including tanker transport issues, sits right at the intersection of politics and economics. Oil transportation is obviously very political.  All of the proposed export routes from the Caspian region transit several countries, and the governments in the area have very strong interests as they should in where those pipelines run because their routes will give certain countries a great deal of leverage. All the same, the commercial realities of these pipelines are also very important because projects that are not commercially viable simply cannot happen. We do have at the same time acknowledge that in some instances factors other than commercial considerations may play a part in pipeline construction. However, for the moment let the premise that commercial interests are of paramount importance stand. This issue will be elaborated on towards the end of this essay.

There are four separate issues related to transportation and how their commercial aspects relate to the Caspian oil game:  first, the Bosphorus; second, the existing Russian pipeline system; third, local and nearby markets for Caspian oil; and fourth, Asian markets.
 

Commercial Aspects of the Bosphorus Issue

First, the Bosphorus: the general situation is that it is hazardous to ship oil on tankers through the Bosphorus. This is clear to everyone in Turkey, and they’ve put forth their position very strongly to the other relevant parties:  transit through the straits is dangerous, thus the Turkish government opposes new volumes of oil passing through the Bosphorus. Meanwhile there are plans being acted upon to ship oil from the Caspian area which would appear to do exactly what Turkey opposes, by shipping new volumes of oil from both a Russian port and a Georgian port.

The Bosphorus is obviously a political issue today, and it has in fact long been a political bone of contention between Russia and Turkey. And, of course, one of the political questions to be resolved is to what extent is Turkey constrained from regulating passage through the straits by the 1936 Montreux Convention.  And it’s an environmental question as well; certainly the environmental issues are very real.  But are there also some commercial issues that bare consideration?  How do the oil companies look at this problem?

There are several points to be made here.  First, the imminent flood of oil tankers from the Black Sea is actually more a more complicated issue than it seems, and more complicated than it’s often presented to be.  The question is usually conceived of in this fashion: take the current volumes of Russian oil flowing through the Black Sea, add to that new Caspian oil, and you have too much oil for the Bosphorus.  But in fact there are a few variables here which must be considered, uncertainties which can affect that picture.  One of them is Russian supply.  It’s not obvious that Russian oil production will be maintained at its current levels, and if Russian oil production declines enough, so will Russian exports through the Bosphorus. We at CERA have done a lot of work on different scenarios for Russian oil production and some of them have Russian oil production falling quite dramatically in the next decade—to the point where you don’t have any Russian oil exports at all.  Secondly, developments in other parts of Russia can affect flows through the Bosphorus.  So if a new Baltic export pipeline were built, as Russia has proposed, that would pull some volumes of West Siberian oil away from the Black Sea. So you could have a situation where Caspian exports on the Black Sea are rising but Russian exports are falling, thus canceling each other out.
Another uncertainty is Black Sea demand.  Obviously oil that gets shipped from Georgia or Russia and then imported and consumed in Romania, Bulgaria, Ukraine or even the Black Sea coast of Turkey does not have to go through the Bosphorus.  One can imagine a scenario where Ukraine proceeds with some of its plans to build import capacity on the Black Sea, where Bulgaria and Romania continue to be growing economies with growing oil demand, and where Turkey itself takes some steps to import some of its crude from the Black Sea rather than the Sea of Marmara or the Mediterranean as it does today.  In fact, Romania and Bulgaria today are both importing significant volumes of Persian Gulf crude oil the wrong way  through the Bosphorus.  If and when these wrong-way imports are ceased, it will go some distance toward easing the strain on the Bosphorus.  So this is a complicated issue with a many commercial angles, and certainly one that is subject to a great deal of uncertainty.  There is nothing predetermined about the balance of oil supply and demand on the Black Sea, and therefore we cannot draw a straight line between new Caspian supply on the Black Sea and greater flows through the Bosphorus.

One final point figures prominently in the perspective taken on the Bosphorus issue by the companies which will be producing oil in the Caspian.  Let us assume that these mitigating factors which I have mentioned do not, in fact, come to pass: thus, Russian oil production remains high, as it certainly could, and Black Sea demand is limited, as it certainly could be.  Then there will unquestionably be a Bosphorus problem.  In this case, who is going to pay for a pipeline to bypass the Bosphorus, or who will pay the added price for longer pipelines which avoid the Bosphorus completely, such as Baku-Ceyhan?  Most assume it will be the new Caspian producers.  But from the perspective of these producers (or their host states), it is not clear why the Russian crude that’s currently being shipped through the Bosphorus should continue to have this privilege simply because it was there first, while the Caspian producers must pay for the burden and the added cost of building a bypass or Baku-Ceyhan.  So this is one of the questions that’s tricky and that’s going to have to be resolved.
 

The Existing Russian Pipeline Network

The second point I would like to address is Russia, and the question of the existing Russian pipeline system. In the Caspian oil derby, Russia has a major built-in advantage:  its’ pipelines are already there.  We’ve seen this in Azerbaijan.  The reason why the Azerbaijan International Operating Company (AIOC) went forward and negotiated with Russia and pursued the early-oil export route through Russia—despite the fact that it seemed to be unlikely in 1995 that you were ever going to be able to ship oil through Chechnya—was that commercially it was such an obvious thing to do.  The pipeline was already there, and it didn’t cost very much at all compared to other options, such as the Georgian one, to get that pipeline into working order and start using it for oil exports.  There is an entire pipeline system in Russia which is already there.

There are two arguments that are usually raised at this point.  First of all, who wants to deal with Russia, and specifically who wants to deal with Transneft, the Russian pipeline monopoly? Second of all, there’s a space constraint in Russian oil exports; Russian producers themselves cannot export all the oil which they would like to export, so why would Russia let this scarce capacity be used by the Caspian states?  In fact, there is a big secret here.  The secret is that the constraints on exports through the Russian system are not primarily physical.  Certainly, there are bottlenecks in certain places, but I think it’s fairer to say that the constraints are commercial and they’re a function of the way Transneft operates.  Many Russian oil companies have become very sophisticated in their understanding of Western business, and are today light years beyond where they were in 1991.  Transneft is not one of these Russian companies on the cutting edge.  It is still behaving as a Soviet-style state agency for the most part, and it is certainly not being driven by anything resembling commercial concerns.

However, if this changes, a lot of things could change.  If Transneft began to behave on a more commercially rational basis, a lot more oil could be exported through its system, both by  Caspian and Russian producers.  And today Transneft is finally now starting to change.  First of all, it is being privatized: 25 percent has been sold and another 24% is scheduled to be sold.  That of course, gets the management of Transneft to start to think like owners rather than state bureaucrats.  And the World Bank has been working very closely with Transneft to try to encourage it to reform; we have worked on some studies with the World Bank that have been part of this process.

In general, this is more important for Kazakstan rather than Azerbaijan, because Kazakstan does have a pipeline leading into the Russian system which right now is not being used for exports to full-value markets at anything like full capacity.  Some changes in Russia, and some changes in Transneft in particular, would open up a door for significant quantities of Kazak oil—which most people assume will require a new pipeline—to flow through the Russian system to export markets in Europe.  Politically, of course, there are other questions; certainly there would be political implications to this that might be of some concern in Almaty.  But the commercial reality is that some reform in Transneft would change the game, making it possible for more oil—especially Kazak oil but also some from Azerbaijan beyond the early-oil volumes—to be exported through Russia in a way that would make commercial sense for the oil companies and their host governments.
 

Local and Nearby Markets

The third issue I would like to touch on is the question of local and nearby markets for Caspian crude.  Let us start here with the Russian market.  Russian Federation prices for crude oil—what you get when you deliver oil to a refinery in Russia—are not up to world levels. They’ve hovered at a level which is around 60 to 70 percent of world levels for the past couple of years.  It has been much higher than that at certain points, but that’s the average. But this is not because the prices are state controlled; they float freely.  But they are being held down by two factors. One is that most of the Russian refineries are old and decrepit. They are not adding a lot of value to the crude when they process it, so they are also not willing to pay very high prices for that crude. Basically, they are not producing the light products that people in the new Russian economy need: gasoline and diesel fuel. Instead they are producing a lot of heavy fuel oil of which there is a tremendous glut and which is often not worth a great deal more than crude oil.

The other problem is that Transneft, by causing the artificial constraint on exports from Russia which I  mentioned before due to its non-commercial approach toward running the pipeline system, holds the domestic price down.  If Transneft reformed and all companies producing oil in Russia could freely export their oil, in theory at least, and probably in practice, you would see an equalization of the world oil price to the Russian oil price.  A situation might even develop where Russian markets turn out to be the highest netback markets for Caspian crude, meaning that it would be more profitable for Caspian producers to deliver to Russian refineries than to the export markets which everyone is focusing on today.

I should point out that no one is betting their company on this.  You are not going to see any companies investing in major projects in Azerbaijan and Kazakstan and not worrying about export routes because they assume that pretty soon they will be able to get full value from Russian refineries.  That would not be a wise strategy at this point in time, and no one is pursuing it.  However, I think that the chances are decent over the next few years that at some point these factors I’ve mentioned will begin to change, and Russian domestic prices will begin to rise, and then what you’ve opened up is an entire set of new markets, an entire set of new possibilities for commercializing and selling this oil at prices that make sense for an oil project in Azerbaijan, Kazakstan, and perhaps Turkmenistan. To draw this out, if you add in Northern Iran then there are a variety of things you can do without out even building a major new pipeline through Iran; a lot of oil could in theory be supplied to some of the refineries in the north of Iran (at Tabriz and Teheran) in exchange for equivalent volumes of oil at the Persian Gulf.  If you combine this possibility with a very optimistic scenario for the markets in the Caspian states themselves, plus in Russia and Ukraine, you can you imagine by 2010, even with an optimistic projection of Caspian-area oil production, about half of the oil production of the Caspian region being consumed locally or nearby, including Russia, Ukraine, and Northern Iran.  This changes the picture substantially.  This is not the conventional wisdom right now; but if in fact half of the oil produced in the Caspian can stay more or less at home that really decreases the need to build several major new pipelines as is assumed to be necessary today.
 

Asian Markets

The fourth point and final point I would like to make is about Asian markets. China specifically and Asia more broadly are the main growth areas for oil demand in the world.  If you look at this fact from the perspective of the Caspian producer, this has some implications.  One underlying reality of the oil market is that it is regionally segmented to some extent. Oil can have different values at different sea terminals; the price one can get depends on the character of the oil market at any particular location.  Today, for instance, studies CERA has done suggest that you would rather have a barrel of oil on the east side of the Suez canal—with easier access to Asian markets—than on the west side of it in the Mediterranean Sea. If Asia continues to have the most rapid demand growth in the world, as is expected, then this differential will grow, and the premium one gains for bringing Caspian oil to a terminal east of Suez will grow.  Of course oil prices are changeable, and the market is unpredictable, so this is not guaranteed, but it is considered to be a very likely dynamic going forward.

Starting from this understanding, it is useful to think of Caspian oil production coming in two waves. The first wave is going on right now, and it consists of the Tengiz project in Kazakstan, the AIOC project in Azerbaijan, and then a few other projects in these two countries and in Turkmenistan that will move forward more or less in the same time frame.  The portion of that oil that is exported out of the region is probably going to end up, one way or another, flowing to the West, whether through Russia, Georgia, Turkey or some combination of those.

 This oil will go west of Suez, and be delivered to the Mediterranean market.  But for the next wave, however, probably after 2005, it’s pretty clear that the differential between putting even more oil on the Mediterranean or bringing it closer to Asia is going to increase.  So what we see is after 2005 when this next wave of Caspian oil is coming on line—much of it probably from Kazakstan’s offshore—is that the commercial driver to send this east of Suez to be closer to Asia is going to be overwhelming.  The possible routes are either south, through Iran, Afghanistan, or Pakistan, or possibly east to China.

What does this mean?  First of all, it gives Iran a very powerful card.  Any route through Iran is a southern route leading closer to Asian markets, and that’s something that is not going to go away. So, regardless of politics, this factor is a powerful driver which will always keep Iran in the game from the perspective of the oil companies.  Second, the pull of Asian markets is the main justification for the proposed pipeline from Central Asia through Afghanistan to Pakistan to the port of Gwadar. On the face of it, this project doesn’t appear to make sense:  it looks strange; it goes a long distance; and these are tricky countries to work in.  Without understanding the power of the Asian market over the long term, that project does not make sense.  But if you factor that in, it does make sense under a lot of scenarios. Third, obviously this Asian market issue is related to the Chinese pipeline proposal that we’ve already heard a little bit about.

Chinese pipeline proposal has a very large problem from a commercial perspective. On the face of it, it doesn’t make any sense commercially.  It is being billed as a $3.5 billion project.  It is difficult to say what $3.5 billion is supposed to represent, but that appears to be the estimated cost of building a pipeline from western Kazakstan to the Chinese border.  But it’s going to cost much more than that to bring oil from these oil producing regions of Kazakstan in the west all the way to parts of China where the markets are—which lie all the way on the other side of China, for the most part.  This project is almost certainly too expensive to make any sense commercially.  But economics is not driving the project; it is quite clearly something that’s being driven 100 percent by strategic concerns, by Chinese geopolitical strategies rather than by any commercially driven concerns. This project is important to Beijing because of China’s need for new oil supplies and a concern with energy security.  The security aspect is clearly crucial, because if supplies were the only issues, it would make a whole lot more sense for China to send oil produced in Kazakstan south to Iran or Pakistan, and then have China import that oil from the sea. But politically, China feels that these sea borne exports represent a vulnerability, and it makes China more secure to have a direct land route for oil imports.

Can this project work?  In the beginning of the article it was said, that projects which are not commercially viable are not going to happen. This is a project that’s not commercially viable; therefore,  it seems that is not going to happen. But in conclusion, I would like to amend that statement.  In the end, politics can overcome commercial realities if countries really want a project to go forward badly enough, for strategic or geopolitical reasons. And the fact is, if China wants to go out and finance a pipeline costing $6 billion or whatever from its state budget, to just pay for it the same way it would pay for an aircraft carrier or a tank, then it could quite clearly work. They can simply pick up the tab, and subsidize the pipeline tariffs. The pipeline project can have what Western companies would consider to be a negative rate of return—and yet China might be perfectly happy with that because it meets their strategic needs.  So this is something to watch.  Right now, there’s not a lot of substance behind this proposal; the proposal has quite clearly started from the top and now it will have to work its way down to the the details: who is going to build it, when are things going to happen, what contractors are going to work on it, etc.?  This will be an interesting  process.

Can other countries pursue this same model, and support or subsidize a pipeline which they see to be in their strategic interest?  Turkey is the another obvious case where this model might apply. This is quite different: unlike the Chinese pipeline, a pipeline to Ceyhan could make commercial sense on its own merits.  On the other hand, it might be commercially viable but not quite the optimal choice for the Caspian oil producers. In this case, if Turkey wants to step up and finance it out of their state budget and provide subsidizes tariffs, then the Baku-Ceyhan pipeline would certainly become much more attractive.

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