Wednesday, June 5, 2013

Possible Political Implications of Russian decision to cancel Baku-Novorossiysk pipeline agreement

Russia is terminating the Northern Route Export Pipeline, running from Baku, Azerbaijan to Novorossiysk, Russia.  This oil pipeline, which stretches 1,330 kilometers (830 miles) at one time was considered an important national interest for both countries.  Today, it is considered a pipeline to be filled only if the economic conditions warrant it.

In 1994, when the government of Azerbaijan signed the "Contract of the Century" with Western oil companies to exploit offshore energy deposits, the United States opposed any proposal that would give Russia control over the export route.  But in February 1995, at a confidential meeting with the heads of the State Oil Company of the Azerbaijan Republic (SOCAR) and the Azerbaijan International Operating Company (AIOC, a BP-led consortium), President Heydar Aliyev directed early oil to be exported via the northern route.  According to the former President of the AIOC, "There were to be no situations created by Baku that would actively alienate President Aliyev's political allies in Moscow...Preparatory work could also start on WER (Baku to Ceyhan), but not brought into full effect until such time as Russian contracts had been signed.  For President Aliyev it was in Azerbaijani national interests to be aligned with but not subordinate to a cooperative Russia."  (Adams, Terry D.  "Baku Oil Diplomacy and 'Early Oil,' 1994-1998: an external perspective," in Azerbaijan in Global Politics:  Crafting Foreign Policy.  Baku:  Azerbaijan Diplomatic Academy, 2009, 242-243).

One reason that this pipeline route was important was the same reason that the original consortium included the Russian oil company Lukoil; namely, to avoid a Russian challenge to Azerbaijan's right to take oil from the contested waters of the Caspian.  The strategy worked:  in May 1995 Russian Energy Minister Yuri Shafranik proposed that the flow be reversed in the pipeline which had previously brought Russian crude to Azerbaijan to be refined.  In February 1996 the intergovernmental agreement was approved.  AIOC would ship oil across the border into Russia, from where the Russian pipeline company Transneft would take it to the Black Sea port of Novorossiysk.  There, it would be mixed with Russian "Ural light"-blend oil for sale on the international market.

The original agreement called for 5 million tons (approximately 35 million bbls) of oil to go through the pipeline annually.  The pipeline could carry up to 10 million tons, so the agreement only called for the pipeline to be 50% full.  In fact, however, the quantities shipped were far less than that.  Azerbaijan averaged 2.5 million tons per year, with the quantity decreasing in recent years:  2.2 million tons in 2010, 2.06 million tons in 2011, 1.99 million tons in 2012.

Because of these decreased flows, discussion about discontinuing the export through this line has been around for at least a decade, according to Azerbaijan's Ambassador to Russia Polad Bulbuloglu.  In 2007, SOCAR took over from AIOC as the operator of the Azerbaijani side of the pipeline.  Almost immediately, SOCAR President Rovnag Abdullayev announced a continuation of the use of the pipeline, but at reduced levels.  SOCAR cited the loss of revenues from the mixing with Ural light as the reason (Ural light sells for approximately $4 per barrel less than the higher quality Azerbaijani crude).

In August 2008, possibly as a signal of their unhappiness, Transneft notified SOCAR of a temporary suspension of the transportation of Azerbaijan's oil, supposedly because of repair work on the pipeline. This was followed in May 2009 by a Russian proposal to alter the original transit agreement.  According to Russian Minister of Industry and Energy Sergey Shmatko, the agreement had become "old."  Shmatko wanted to see the quantity increased from the average 2.5 million tons per year to the originally conceived 5 million tons.  "It is necessary to make changes in the agreement and the draft of the revised agreement was sent to Azerbaijan.  We expect a response," said the minister.  Apparently, they did not get one as the oil volumes continued to drift downward.

In September 2012, SOCAR announced they were holding negotiations with the Russians as to how much oil would be transported through the pipeline.  SOCAR estimated the volume would be 1.6 million tons, a 20% drop from the already low level of 1.99 million.  The decrease was soon confirmed:  in January-March 2013, SOCAL exported 411,339 tons through the pipeline, a drop of 85,548 tons from the same time a year ago.  The volume decreased an additional 2.8% in April.

Faced with the declining volumes, and with Transneft already losing an estimated $50 million annually on pipeline maintenance, Russian Prime Minister Dmitri Medvedev signed a decree on May 5, 2013 terminating the arrangement.  The Russians did not give any advance notice of the action, although the termination was legal.  The original intergovernmental agreement stated either side could cancel the arrangement with six months notice, and Russia agreed to honor the current agreement until the beginning of 2014.  Transneft spokesman Igor Demin stated the agreement was being cancelled because Azerbaijan had not honored the terms as to the quantity being shipped. He added that the shipments could be resumed in 2014 if a new agreement were negotiated.  "From January (2014) we will calculate the tariff based on real rates," he said.

Azerbaijan also chose to look at the issue from an economic viewpoint.  "There will be no problem with oil exports," said SOCAR's leader Abdullayev.  "We have the Baku-Tiblisi-Ceyhan route, Baku-Supsa and a railway."  Abdullayev said he was ready to enter into negotiations with Transneft.  "The company will continue oil deliveries in case of economic suitability of new (contract) conditions for SOCAR.  In case of economic unsuitability, deliveries won't be implemented."  A separate report quotes Abdullayev saying, "This is a commercial decision and the matter has moved from the political perspective to the economic.  The State Oil Company understands the decision of the Russian side."

Both sides have gone out of their way to make the decision appear divorced from politics.  Russian Foreign Minister Sergei Lavrov announced the talks had already begun.  "Our respective energy agencies and companies are working on preparing a new intergovernmental agreement which will reflect current realities."  Similarly, the deputy chief of Azerbaijan's presidential administration, Novruz Mammadov, concurred that "the transportation of oil at the moment is simply not profitable to both parties in terms of economic and commercial viability..we accept the decision of the Russian Federation as perfectly normal."

SOCAR's Abdullayev is reviewing all options for the pipeline including the establishment of an oil quality bank in Novorossiysk, using the pipeline to transport oil from a third party, or even reversing the pipeline to its original orientation.  "Economic efficiency of all possible options may be considered," he said.  "There is enough time."

While economic considerations must play into the decision making, one is forced to ask:  Why now?  After all, the mixing with Ural light was included in 1995 in the original draft of the intergovernmental agreement.  And Azerbaijan has never sent more than 3 million tons through the pipeline since they began the northerly flow in 1996.  The conclusion, despite protests from both sides, is that Russia continues to ratchet up the pressure on Azerbaijan.

Russia has long tried to force Azerbaijan into a customs union or security treaty.  It has opposed Azerbaijan's claims to its territory in the Caspian (pending an all-party conference), supported Armenia against Azerbaijan over Nagorno Karabakh, and announced construction of the South Stream pipeline to choke any attempt for Azerbaijan to ship its gas to Europe independently.  When the Russian lease ended on the Gabala radar station in Azerbaijan and Azerbaijan demanded an increase in rent, Russia refused to renew the lease.  Instead, it announced it was increasing its troop presence in Armenia.  The cancellation of the Baku-Novorossiysk intergovernmental agreement appears to be yet another move to bring Baku back under Moscow's control.