Azerbaijan’s Shah Deniz-2 and Southern Corridor: Potential Risks

MEHMET ÖGÜTÇÜ

Now that the Trans-Adriatic Pipeline (TAP) project has been selected over the ‘light” Nabucco as a transporter of the natural gas from Azerbaijan, the attention turns to the final investment decision regarding the development of the Shah Deniz-2, expected to be taken before the end of this year.

Let’s not forget that Shah Deniz development, TANAP and TAP are only the initial steps for what’s to come, namely a Southern Corridor energy highway that will eventually carry Central Asian, Caspian, Iranian, Iraqi and East Mediterranean gas flows via Turkey to the high value international markets. It is a bigger game, coupled with huge opportunities and risks, both geopolitical and economic alike, that Turkey has to keep playing with utmost prudence and effective multi-stakeholder alignment.

The recent selection of TAP as outlet of gas towards the Southern Gas Corridor all the way from Azerbaijan, Georgia and Turkey to Europe is a strategic one in many ways.

- First, it signifies the defeat of the Nabucco concept, which caused waste of time and resources for almost a decade, initially from the well to the Baumgarten gas hub, and then in its “light” form from the Turkish border to South East Europe. It could not achieve a convergence of all stakeholders along the value chain but managed to create an intergovernmental legal structure to secure and free flow of gas.

- Second, the upstream country, namely Azerbaijan, has succeeded in acquiring significant asset and leverage in Turkey through TANAP and then in Greece through the 66 percent purchase of its natural gas grid operator DESFA. This deal has contributed to the TAP winning its bid for Azeri gas, against its competitor west Nabucco.

- Third, Azerbaijan has consolidated its position not only in Turkey but also in South East Europe including Italy at a time when there are so many competing gas projects, i.e. Russia’s South Stream, KRG, east Mediterranean, Iran and Turkmenistan’s Trans-Caspian pipeline project.

There will also be an increase in gas production from other fields in Azerbaijan in the future, which will cause a need for new interconnectors and new infrastructure. The decision on the choice of a route for the Azerbaijani gas supplies to Europe has become the first one in the way of entering the new market including Bulgaria, Romania and other Balkan states. Italy is not the final destination for gas deliveries given that there are plans to access Austria and other countries through Italy.

Now, the next big challenge is to work hard with the Shah Deniz Consortium to ensure that they are able to take a successful final investment decision as scheduled.

The estimated overall investment, which includes the construction of the new gas pipelines, is in excess of $50 billion. This represents one of the largest investments globally in the natural gas industry. A final investment decision has already been delayed by half a year to the end of 2013 and cost estimates have once again risen by between 15 and 20 percent. Revised phase two investment is now estimated at between $28 billion and $30 billion.

New challenges surface as the dynamics in the international gas industry are changing. The shale gas revolution, the EU gas glut due to the Eurozone debt crisis, and the determination of Russia to construct the South Stream pipeline, are among the new primary challenges that Shah Deniz consortium is facing. Furthermore, the delays to reach the FID are creating internal disagreements.

What are the key risks?

- Shale gas to bring in fuel-to-fuel competition
 
A serious challenge relating to the Shah Deniz gas and the opening of the Southern Corridor is the “shale gas revolution”. Shale gas, in less than five years, is transforming the US from a net importer of natural gas to a net exporter. The shale gas production has led to an international over-supply of gas, and consequently to the decline of natural gas prices. Moreover, the US is investing in new LNG terminals for exporting purposes, mainly to the European markets.

For Azerbaijan the EU and Turkey represent the primary market for the Shah Deniz gas (and further supply from Absheron and Umit). So, any extra supply of gas from other sources, which means lower prices, is not good news for Azerbaijan. As a result, it will not be surprise if Shah Deniz consortium may consider a postponement of the FID this year in order to better assess the impact of the shale gas phenomenon on its commercial viability.
 
- New competing gas provinces
 
It is not only the US, which is likely to take over from Russia the title of the world’s largest gas producer in the next decade or so. There are also other new gas suppliers that will target the European markets and compete with Shah Deniz supply. Gazprom has been forced to change its domestic strategy, including abandoning its flagship Shtokman project in the Arctic, and it has had to contend with plummeting market value and a new EU anti-trust investigation.

Russia is unlikely to loosen its grip over Europe very easily. These trends give the non-Russian suppliers an unprecedented opportunity to advance broad natural gas diversification and break Russia’s control over European gas markets. The European market is also among ‘natural’ options for new gas supplies from Iran and Turkmenistan (one day), Kurdistan Region of Iraq and Eastern Mediterranean.

With LNG export projects from major new gas discoveries – notably those in the Eastern Mediterranean and Mozambique/Tanzania, as well as Australia’s plethora of gas export facilities (not mentioning North African producers) – there are plenty of options. It remains to be seen how competitive the price of gas transported through the Southern Corridor projects will be, but as the EU sees it, Europe needs secure supply of gas from non-Russian sources to protect it from geopolitical concerns about Gazprom’s role in Eastern Europe.

- Reduced gas demand in Europe and Turkey

The volumes of Azerbaijani gas (16-20 billion cubic meters annually) are not enough for the growing gas appetite of the EU. Actually the point is in decrease of gas dependence from Russia. There are three opportunities for a solution of this problem: using gas from Turkmenistan, Iran, and Iraq’s Kurdistan Region. Iran, considering the sanction policy of the EU and the US, is not considered as an acceptable variant – at least for the foreseeable future. In Iraq there is a serious dispute about distribution of (oil and) gas export revenues between regional Kurdish authorities and official Baghdad.

Brussels rely on Ashkhabad, considering construction of the Trans-Caspian gas pipeline to be the easiest for implementation. However, Moscow and Tehran following their economic and political interests are blocking construction of the pipeline on the bottom of the Caspian Sea. Russia and Iran are not ready to let such a major player as Turkmenistan come to European markets directly and will do their best to thwart efforts from the Caspian to send additional volumes to Turkey and beyond.

Furthermore, the overall economic recession in Europe and Turkey’s goal to reduce the share of gas in power generation mix from the current 50 percent to 30 percent by 2030 will not be good news for the Caspian gas exports.

- Russia’s leverage over IOCs
 
Should Moscow conclude that fresh supplies from Shah Deniz-2 and other Caspian resource holders could seriously erode its market dominance in Turkey and Europe, the Russian leaders will likely step up their pressure on the consortium members, which have sizeable stakes (and vulnerabilities) in Russia.

For instance, after recycling $4.9 billion of cash from the TNK-BP deal into Rosneft stock, BP has become the second-largest shareholder after the Russian state and CEO Bob Dudley sits on its board. BP’s tie-up with Rosneft allows it to continue to explore and exploit the country’s vast energy resources, including in the Arctic region. BP got 12.8 percent of Rosneft and bought an additional 5.7 percent from state holding Rosneftegaz in the deal, on top of a 1.25 percent stake it already owned.

Hence, with a history in Russia of over 20 years and with activities spanning across exploration, the refining of lubricants, marine products and trading operations, BP will find it difficult to resist pressure if Moscow decides to thwart further development of Shah Deniz 2. However, with so much invested in Azerbaijan, BP remains strongly committed to its projects in this country and it remains to be seen how Russians and BP will manage this complex relationship.

It would be naïve to think that Moscow will not leverage its influence over Statoil and Total as well. Statoil (present in Azerbaijan since 1992, with more than $5 billion of investment in Azeri-Chirag-Gunashli and Shah Deniz) has been operational in Russia since the late 1980s. It has a 24 percent ownership interest in Shtokman Development AG. It also has a 30 percent ownership interest in the Kharyaga oilfield. Total is the main international partner on the Yamal LNG project holding a 20 percent share and took a 12.08 percent shareholding in Novatek with the intent of both parties to increase the share to 19.40 percent within 36 months.

Another consortium member is Iran’s Nico – no need to say more on how Moscow and Tehran could collaborate for pursuing their “grand game” in natural gas markets.
 
- Financial constraints
 
The international energy investments are on a declining trajectory due to the financial crisis, business climate issues, and resource nationalism. Whether the consortium will be able to secure the huge funding needs for the Shah Deniz-2 and TANAP raises some question marks.

The value of BP remains 30 percent below its level before the Gulf of Mexico oil spill three years ago, which forced Dudley’s predecessor out. In the US, there is still a risk that BP could be found grossly negligent for the 2010 spill. Selling more than $50 billion in assets and becoming a shareholder in Rosneft has yet to revive the share price and the company is embroiled in a US trial that could saddle BP with billions of dollars in fines. BP is looking to divest $38 billion in assets during the next 18 months. Selling its assets is one way for the company to raise the money needed to cover its expected liabilities.

BP has already sold off half its upstream installations such as oil platforms, a third of its wells and half of its pipelines. Still, the sales shed just 9 percent of the company’s production and 10 percent of its reserves. But those sales are moving right into the teeth of a new round of M&A deals that were already taking place in the oil-and-gas sector, due to rising volatility there and the inability of some to withstand the uncertainty. As a result of all this wheeling and dealing, the big will get bigger - and BP will get smaller. Indeed, the BP that emerges from the mess that it created should be smaller, leaner and smarter.

Money problems - not the relief wells - could prove to be the undoing of BP. And that means the company’s fate is most closely tied to its ongoing efforts to raise money by selling key assets from around the world. This situation will no doubt affect adversely its ability to invest in Shah Deniz-2 and TANAP.

- Russia’s South Stream

Russia is moving rapidly towards signing the necessary inter-governmental agreements and solidifying its geopolitical alliances, in order to reach, before the end of this year, the FID for the South Stream pipeline. Although South Stream does not provide the EU with new gas it does affect the Southern Gas Corridor, since it reaches the South Eastern European markets, which are intended for the Azeri gas.

Next steps

Azerbaijan has seized the opportunity to tie its gas production to Turkey, a fast-growing gas market, and beyond to Europe. Any delay in the Shah Deniz-2 FID could wipe out this advantageous position as shale gas, LNG, and competitor suppliers in the region (particularly Kurdistan Region of Iraq and East Mediterranean) could move into the already tight market. Hence, the risks in slowing down FID are too high and need to be mitigated effectively.

Yet, nobody has got any clue how expensive the field will be to develop. The break-even price remains anyone’s guess to go ahead with any kind of final investment decision expected by end-2013. Let alone who’ll be happy signing up for expensive oil indexed gas in European end-markets. Start lumping pipeline construction costs across Azerbaijan, Turkey and Europe into the mix, then Shah Deniz becomes not an inexpensive project.

The Shah Deniz consortium is currently spending almost $2 bn for the project and so much political and financial capital have been invested in TANAP and TAP infrastructure. Everyone involved in this project has vital interest in completing it.

There could also be new players such as ExxonMobil entering the gas play in Azerbaijan. Look at the map, and Azeri gas production clearly has ‘synergies’ for ExxonMobil’s recent gas plays over in Kurdistan. When it comes to the pipeline politics the Europeans have been a categorical failure to date. Get the US State Department involved and things actually start to happen as we saw in the case of BTC pipeline. Further north, ExxonMobil is involved in Kazakhstan with Kashagan and has even been camping in Turkmenistan for the big prize.

Taking a core role in Azerbaijan could offer ExxonMobil the perfect double hedge over to Moscow not to turn the contractual tables on them. But who will sell to ExxonMobil a respectable stake: Statoil or BP? Both are unlikely to do so under the current circumstances. If there are unexpected major problems emerging, then such a possibility could be considered.

If ExxonMobil comes into Azerbaijan, this would be the biggest shake up in Eurasian energy relations over the past twenty years. Symbolically it would be a bitter blow for BP and this does not seem to be the likely scenario. There are many “ifs” for ExxonMobil to consider an entry into Azerbaijan. First and foremost, it will look for scale and market dominance. That could well mean a far larger, blockbuster pipeline drawing all the Caspian, Middle East and perhaps even Eastern Mediterranean pieces together.

Turkey should be commended for its patient and wise energy diplomacy performed from the outset which made it an equity investor in Azerbaijan’s upstream sector (no matter how modest its share is), a game-maker in TANAP alongside Azerbaijan and a crucial influencer in TAP. But the game is not over yet – it requires an integrated management of energy, geopolitics, finance, investment and human capital.

*Mehmet Öğütçü is currently chairman of the UK-based Global Resources Corporation