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The Caspian Pipeline: Will the $3.6 Billion Be REALLY Worth It?
Raymond James' Energy "Stat of the Week"
February 17, 2004
EQUITY RESEARCH
Industry Brief
By Wayne Andrews
Independence from foreign oil is a perennially favorite topic for our
politicians. It is also, as we have often stated, a totally
unrealistic goal, as impractical in theory as it is elusive in
practice. As Washington gradually comes to realize that imports must
continue to represent an ever-rising percentage of America's oil
demand, it turns its attention to an idea that is only slightly more
feasible - reducing reliance on oil from OPEC, and especially its
Middle Eastern members. For strategic reasons, this concept has broad
bipartisan support. As U.S. security policy overlaps more and more
with energy policy, the objective is simple: increase oil supply from
non-OPEC countries as much as possible. Russia, West Africa and South
America are all considered key areas for this, but no part of the
world is arguably regarded as more vital than the Caspian Sea region.
Located at the crossroads of Europe and Asia, the Caucasus is where
the 19th century `Great Game' for territory was played by the British
and Russian empires. Today, the main competitors are the U.S. and
Russia, and the game is not about land, but rather who will develop
the reserves, build the pipelines, and obtain the oil from this
emerging export area. Politically, the stakes may be high, but from a
pure energy supply standpoint, the region is only a minnow in the vast
ocean of Middle Eastern oil. For all the attention and money that
Moscow and Washington are lavishing on their client states in the
region, the oil they will get does not seem to be, in and of itself, a
worthwhile return on their investment. How much oil are we talking
about? Even under an optimistic scenario, not much at all.
Two weeks ago, the final financing terms were approved for a $3.6
billion Baku-Tbilisi-Ceyhan pipeline, the core of a massive project
designed to bring oil from offshore Caspian fields to Turkey, from
where it will be re-exported to the international market. Reflecting
the staunch support of the U.S. government, the 1,100- mile pipeline
obtained favorable terms from the World Bank and other major
lenders. While we see no inherent problem in the construction of the
pipeline itself, everyone should be clear that the amount of oil in
question is so modest, as to be almost immaterial for the market.
Here's the situation. There are three major fields in the Caspian:
Azeri, Chirag and Guneshli, dubbed ACG. All three combined currently
produce less than 150,000 barrels per day, about half as much as
Ecuador or Syria, and five times less than Qatar, the smallest OPEC
producer. Certainly, given the modest level of foreign investment in
the area so far, there are tangible long-term growth prospects. As ACG
is being developed by a British Petroleum-led consortium, production
is expected to ramp up to one million barrels per day (bpd) by 2008,
in three phases. The consortium's extremely ambitious goal is to reach
350,000 bpd in 2005 (when the pipeline is to be commissioned), 700,000
in 2006, and the one million mark in 2008. This is depicted as the
`optimistic' scenario in the adjacent chart.
Let's suppose for the moment that production does increase seven-fold
over the next four years. In percentage terms, that would certainly be
quite impressive - an annual growth rate of over 60%. In absolute
terms, however, the growth only represents an extra 850,000 bpd. To
put this in context, we project that global oil demand in 2004 will
average 80.5 million bpd. Even assuming a very conservative 1.2%
annual demand growth for the next four years, 2008 demand would reach
84.4 million bpd, 3.9 million higher than currently. This means that
the much-vaunted Caspian projects will provide less than 22% of the
world's incremental oil demand over this time period. Or, to put it in
a different way, the Caspian projects will satisfy a little over 1% of
global demand in 2008, as shown in the chart on the prior page. We
have to wonder - is this 1% worth all the media attention and
political fuss over the Caspian pipeline?
There are serious obstacles to Caspian oil development. Even under
the project sponsors' highly optimistic scenario, therefore, the
Caspian will not come even remotely close to replacing the West's
dependence on Persian Gulf oil. And, is it realistic to expect
production to ramp up as rapidly as the sponsors believe? We think
not. In fact, there are several significant obstacles that may serve
to slow down development of the Caspian fields over the intermediate
term. While it is difficult to quantify their impact, it seems clear
to us that their overall influence will be negative.
- Endemic corruption
The Baku-Tbilisi-Ceyhan pipeline will run through three countries:
Azerbaijan, Georgia and Turkey. In the two former Soviet republics,
corruption has reached enormous proportions after 1991. Just how bad
is it? - Very bad. The leading global anti-corruption organization,
Transparency International, ranks both Georgia and Azerbaijan 124th on
its country list, with 133rd being the worst possible ranking. Even
Turkey is ranked 77th, in the bottom half. Despite the institutional
safeguards insisted upon by the multilateral lenders who provided
project finance for the pipeline, it is probable that at least some of
the funds will not be spent according to western `best practices.'
This has the potential to materially slow the pace of construction.
- Political instability
The governments of Georgia and Azerbaijan have undergone dramatic
changes in recent months. In Georgia, President Shevardnadze left
office after massive street protests demanding his resignation. The
new administration faces extensive challenges, including a
nearbankrupt government and separatist movements defying his
authority. In Azerbaijan, the death of authoritarian leader Heydar
Aliyev led to violence, with opposition parties protesting his son's
succession to the presidency. Although none of this directly impacted
the petroleum industry, it clearly creates a volatile climate that may
discourage foreign investment, which is essential for production to
grow. It also means that political attention will be diverted from
economic development, at least for the short term, as new leaders
consolidate their power.
- Threat of violence
Once the pipeline is built, it will face the potential threat of
terrorist attacks from Kurdish separatists in Turkey. On top of that,
the simmering conflict between Armenia and Azerbaijan has not been
permanently resolved. While there is a durable cease-fire in place, it
is important to recall that this conflict had escalated into nearly
full-scale war in the early 1990s. Other ethnic tensions in the
Caucasus may lead to strikes on the pipeline and other oil
infrastructure. Just as the ongoing insurgency is slowing down the
reconstruction of Iraq's oil industry, the same may happen in the
Caspian region, albeit to a lesser extent.
The above factors, along with the obvious problems of operating in
remote terrain under tough conditions, could easily halve the
project's output growth rate from the 60% envisioned by the
sponsors. In addition, the highly sour nature of Caspian crude
represents another technical challenge. Under this `mid-range
scenario,' the Caspian would satisfy only about 0.5% of global oil
demand by 2008.
Conclusion
Developing Caspian oil reserves is important for creating a market
economy and relieving poverty in Georgia and Azerbaijan. From a local
standpoint, therefore, it is a worthwhile project. From a political
standpoint, it may help build the `East-West Corridor' through the
Caucasus - a central goal of U.S. policy after the Cold War - which
would limit the sphere of influence of Russia and Iran, the region's
leading powers.
As far as oil supply is concerned, though, the Caspian will not free
the U.S. from its dependence on OPEC. Even under the optimistic
scenario discussed above - which itself is a very big `if' - the
Caspian will satisfy only 1% of global demand by 2008, compared to
35-45% for OPEC. While oil projects in nearby Kazakhstan and other
Central Asian countries may be more fruitful in the long run, they do
not enjoy the worldwide attention or the capital inflows that are
being lavished on the Caspian area. In short, the Caspian's output
potential is simply too low to be of any real significance for the oil
market, so there is every reason to believe that OPEC will be at least
as firmly in control of the market in 2008 as it is today.
Contacts:
Wayne Andrews, (713) 789-3551
[email protected]
Pavel Molchanov, Research Associate (713) 278-5270
The Raymond James Financial Center
880 Carillon Parkway
St. Petersburg, FL 33716
Institutional clients may call for additional information:
Research 800-237-5643 - Trading 800-237-8426
The views expressed in this report accurately reflect the personal views
of the analyst(s) covering the subject securities. No part of said
person's compensation was, is, or will be directly or indirectly related
to the specific recommendations or views contained in this research report.
Investors should consider this report as only a single factor in making
their investment decision.
Raymond James' Energy "Stat of the Week"
February 17, 2004
EQUITY RESEARCH
Industry Brief
By Wayne Andrews
Independence from foreign oil is a perennially favorite topic for our
politicians. It is also, as we have often stated, a totally
unrealistic goal, as impractical in theory as it is elusive in
practice. As Washington gradually comes to realize that imports must
continue to represent an ever-rising percentage of America's oil
demand, it turns its attention to an idea that is only slightly more
feasible - reducing reliance on oil from OPEC, and especially its
Middle Eastern members. For strategic reasons, this concept has broad
bipartisan support. As U.S. security policy overlaps more and more
with energy policy, the objective is simple: increase oil supply from
non-OPEC countries as much as possible. Russia, West Africa and South
America are all considered key areas for this, but no part of the
world is arguably regarded as more vital than the Caspian Sea region.
Located at the crossroads of Europe and Asia, the Caucasus is where
the 19th century `Great Game' for territory was played by the British
and Russian empires. Today, the main competitors are the U.S. and
Russia, and the game is not about land, but rather who will develop
the reserves, build the pipelines, and obtain the oil from this
emerging export area. Politically, the stakes may be high, but from a
pure energy supply standpoint, the region is only a minnow in the vast
ocean of Middle Eastern oil. For all the attention and money that
Moscow and Washington are lavishing on their client states in the
region, the oil they will get does not seem to be, in and of itself, a
worthwhile return on their investment. How much oil are we talking
about? Even under an optimistic scenario, not much at all.
Two weeks ago, the final financing terms were approved for a $3.6
billion Baku-Tbilisi-Ceyhan pipeline, the core of a massive project
designed to bring oil from offshore Caspian fields to Turkey, from
where it will be re-exported to the international market. Reflecting
the staunch support of the U.S. government, the 1,100- mile pipeline
obtained favorable terms from the World Bank and other major
lenders. While we see no inherent problem in the construction of the
pipeline itself, everyone should be clear that the amount of oil in
question is so modest, as to be almost immaterial for the market.
Here's the situation. There are three major fields in the Caspian:
Azeri, Chirag and Guneshli, dubbed ACG. All three combined currently
produce less than 150,000 barrels per day, about half as much as
Ecuador or Syria, and five times less than Qatar, the smallest OPEC
producer. Certainly, given the modest level of foreign investment in
the area so far, there are tangible long-term growth prospects. As ACG
is being developed by a British Petroleum-led consortium, production
is expected to ramp up to one million barrels per day (bpd) by 2008,
in three phases. The consortium's extremely ambitious goal is to reach
350,000 bpd in 2005 (when the pipeline is to be commissioned), 700,000
in 2006, and the one million mark in 2008. This is depicted as the
`optimistic' scenario in the adjacent chart.
Let's suppose for the moment that production does increase seven-fold
over the next four years. In percentage terms, that would certainly be
quite impressive - an annual growth rate of over 60%. In absolute
terms, however, the growth only represents an extra 850,000 bpd. To
put this in context, we project that global oil demand in 2004 will
average 80.5 million bpd. Even assuming a very conservative 1.2%
annual demand growth for the next four years, 2008 demand would reach
84.4 million bpd, 3.9 million higher than currently. This means that
the much-vaunted Caspian projects will provide less than 22% of the
world's incremental oil demand over this time period. Or, to put it in
a different way, the Caspian projects will satisfy a little over 1% of
global demand in 2008, as shown in the chart on the prior page. We
have to wonder - is this 1% worth all the media attention and
political fuss over the Caspian pipeline?
There are serious obstacles to Caspian oil development. Even under
the project sponsors' highly optimistic scenario, therefore, the
Caspian will not come even remotely close to replacing the West's
dependence on Persian Gulf oil. And, is it realistic to expect
production to ramp up as rapidly as the sponsors believe? We think
not. In fact, there are several significant obstacles that may serve
to slow down development of the Caspian fields over the intermediate
term. While it is difficult to quantify their impact, it seems clear
to us that their overall influence will be negative.
- Endemic corruption
The Baku-Tbilisi-Ceyhan pipeline will run through three countries:
Azerbaijan, Georgia and Turkey. In the two former Soviet republics,
corruption has reached enormous proportions after 1991. Just how bad
is it? - Very bad. The leading global anti-corruption organization,
Transparency International, ranks both Georgia and Azerbaijan 124th on
its country list, with 133rd being the worst possible ranking. Even
Turkey is ranked 77th, in the bottom half. Despite the institutional
safeguards insisted upon by the multilateral lenders who provided
project finance for the pipeline, it is probable that at least some of
the funds will not be spent according to western `best practices.'
This has the potential to materially slow the pace of construction.
- Political instability
The governments of Georgia and Azerbaijan have undergone dramatic
changes in recent months. In Georgia, President Shevardnadze left
office after massive street protests demanding his resignation. The
new administration faces extensive challenges, including a
nearbankrupt government and separatist movements defying his
authority. In Azerbaijan, the death of authoritarian leader Heydar
Aliyev led to violence, with opposition parties protesting his son's
succession to the presidency. Although none of this directly impacted
the petroleum industry, it clearly creates a volatile climate that may
discourage foreign investment, which is essential for production to
grow. It also means that political attention will be diverted from
economic development, at least for the short term, as new leaders
consolidate their power.
- Threat of violence
Once the pipeline is built, it will face the potential threat of
terrorist attacks from Kurdish separatists in Turkey. On top of that,
the simmering conflict between Armenia and Azerbaijan has not been
permanently resolved. While there is a durable cease-fire in place, it
is important to recall that this conflict had escalated into nearly
full-scale war in the early 1990s. Other ethnic tensions in the
Caucasus may lead to strikes on the pipeline and other oil
infrastructure. Just as the ongoing insurgency is slowing down the
reconstruction of Iraq's oil industry, the same may happen in the
Caspian region, albeit to a lesser extent.
The above factors, along with the obvious problems of operating in
remote terrain under tough conditions, could easily halve the
project's output growth rate from the 60% envisioned by the
sponsors. In addition, the highly sour nature of Caspian crude
represents another technical challenge. Under this `mid-range
scenario,' the Caspian would satisfy only about 0.5% of global oil
demand by 2008.
Conclusion
Developing Caspian oil reserves is important for creating a market
economy and relieving poverty in Georgia and Azerbaijan. From a local
standpoint, therefore, it is a worthwhile project. From a political
standpoint, it may help build the `East-West Corridor' through the
Caucasus - a central goal of U.S. policy after the Cold War - which
would limit the sphere of influence of Russia and Iran, the region's
leading powers.
As far as oil supply is concerned, though, the Caspian will not free
the U.S. from its dependence on OPEC. Even under the optimistic
scenario discussed above - which itself is a very big `if' - the
Caspian will satisfy only 1% of global demand by 2008, compared to
35-45% for OPEC. While oil projects in nearby Kazakhstan and other
Central Asian countries may be more fruitful in the long run, they do
not enjoy the worldwide attention or the capital inflows that are
being lavished on the Caspian area. In short, the Caspian's output
potential is simply too low to be of any real significance for the oil
market, so there is every reason to believe that OPEC will be at least
as firmly in control of the market in 2008 as it is today.
Contacts:
Wayne Andrews, (713) 789-3551
[email protected]
Pavel Molchanov, Research Associate (713) 278-5270
The Raymond James Financial Center
880 Carillon Parkway
St. Petersburg, FL 33716
Institutional clients may call for additional information:
Research 800-237-5643 - Trading 800-237-8426
The views expressed in this report accurately reflect the personal views
of the analyst(s) covering the subject securities. No part of said
person's compensation was, is, or will be directly or indirectly related
to the specific recommendations or views contained in this research report.
Investors should consider this report as only a single factor in making
their investment decision.