10.2 Hub For The 21st Century - Azerbaijan's Future Role in the Caspian Basin

Summer 2002 (10.2)
Pages 66-71

Hub For The 21st Century
Azerbaijan's Future Role in the Caspian Basin

by Stanley Escudero

With government service in Pakistan, Iran, India, Egypt, as political advisor to the general commanding American forces in the Middle East, Persian Gulf and East Africa, and as ambassador to Tajikistan, Uzbekistan and Azerbaijan, Escudero has spent most of his adult life in Central, South and Southwest Asia. After retirement from Foreign Service in the fall of 2000 and the prompt discovery that he loathed the inactivity of retirement, he opened a small consulting firm and quickly discovered an extensive demand for his expertise. Within a few months, he found himself spending more time in Azerbaijan than in the United States and, by late summer of 2001, three of his clients had persuaded him and his wife, Jaye, to move back to Baku permanently. Now, as a member of the Boards of Moncrief Oil International and the U.S.-Azerbaijan Chamber of Commerce (USACC), First Vice President of the American Chamber of Commerce (AmCham) in Baku and with a range of clients that includes several of the most active foreign investors in Azerbaijan's non-energy sector, Escudero is back in the thick of things, relishing his second career.

Here he poses an interesting question: given that two nearby countries, Kazakhstan and Turkmenistan, have a great deal of oil and gas to get out to the world market, how can Azerbaijan get involved and facilitate the larger development of the region? He argues that Azerbaijan is uniquely poised to serve as a major hub for regional transportation, business services, light manufacturing, warehouse storage and agriculture. But for this to happen, Escudero says, Azerbaijan must first take major steps to encourage serious foreign investment.

Below: Clockwise, from top: Baku's bustling Fountain Square serves as a reminder that the city is back on its feet and thoroughly modern.

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Baku has every prospect of developing into the same kind of regional support center that Dubai has become in the Persian Gulf.This development is absolutely inevitable, provided that the conditions are there to make it attractive for investment to jumpstart the process.

-Stanley Escudero

What are the possibilities for the future of the Caspian basin? I think they are quite extraordinary, due to the vast energy reserves that exist in and around the Caspian. Azerbaijan is sure to profit not only from its own oil and gas resources, but also from the activities of some of the other countries that border the Caspian.

For instance, huge amounts of oil have already been discovered and are continuing to be discovered in Kazakhstan.

Above, Right: Baku's new airport will see even more activity if the city becomes a regional transportation hub for the Caspian region.

There is the giant Tengiz onshore field, which is typically described as a 10-billion-barrel field, although my understanding is that they haven't yet plumbed the depths of this field.

Add to that the Kashagan field, the largest offshore field in the Caspian, located in waters that belong to Kazakhstan. This is the largest single oil find of the last 30 or 40 years. Kazakhstan has large gas fields as well. In short, the western part of the country has a very large amount of oil and gas. Turkmenistan, too, has enormous gas reserves. But even though these two Eastern countries have a great deal of oil and gas, they have not yet figured out how to get all of it out to the world market.

Turkmenistan in particular has experienced some difficulties in developing marketing arrangements for all of its gas. Personally, I think that this country made a big mistake in not going along with the United States' proposal for a Trans-Caspian Pipeline. This proposal would have enabled Turkmenistan to move its gas directly to the Turkish market at a higher price than it receives from Russia. But the Turkmens were never able to reach an agreement. Perhaps they thought that they could rely on other export routes for their gas and didn't realize that for them, as for the other countries in this part of the world, multiple pipelines is the best insurance of access to future markets.

Left: Baku's Television and Radio Tower.

Another possibility would be to resurrect the old gas pipeline project that was supposed to go from Turkmenistan to Afghanistan, to Pakistan and Western India. This idea was discussed some years ago in association with Unocal, but was later abandoned because it was not possible to construct and maintain a pipeline through Afghanistan while the Taliban was in power. Now that the political situation has changed, this pipeline may once again become a possibility.

Northwestern India has a substantial industrial base but is chronically short of gas because it doesn't produce its own. This area would benefit from Turkmen gas if it could be brought down through Pakistan. And, of course, the intervening states - Afghanistan and Pakistan - would benefit from transit fees. Additionally, and despite recent discoveries of more gas in Pakistan beyond its depleted Suigas fields, Pakistan would also be able to make use of some of the gas carried in such a pipeline.

It would be a very good regional development project to resurrect, given the political changes in the region, the problems between India and Pakistan notwithstanding. But it will not happen tomorrow, regrettably. Like any other international project in the oil and gas business, it would require extensive preparationnot just to deal with technical issues of construction and performance, but to ensure financing and resolve the tricky issues posed by the need to construct and operate the pipeline across the territories of four nations. I would guess that it would take five to 10 years, at least.
Export Routes
So how will the oil and gas from Kazakhstan and Turkmenistan get out? The production of Kazakhstan's Tengiz field is already committed to the Caspian Petroleum Consortium (CPC) line, which is an enormous line that's already begun to move oil. The CPC line goes around the northern coast of the Caspian from Kazakhstan into Russia and then over to the Black Sea coast at Novorossiysk. There the oil is loaded onto tankers and sent off to market, either to Black Sea ports or via the Bosphorus.

Below, right: ISR Plaza is one of Baku's most prestigious office buildings.

However, this CPC line is not large enough to handle the total production of Tengiz, Kashagan and the other fields in Kazakhstan. The CPC line's planned maximum capacity is only about 1.3 million barrels per day. But the anticipated production of the Kashagan field alone could conceivably reach 6 million barrels a day. Either the CPC pipeline will have to be expanded, or Kazakhstan will have to find additional ways to move this large volume of oil to market.

One problem with expanding the CPC pipeline is that large volumes of oil are already passing through the narrow Bosphorus Straits at Istanbul. More congested tanker traffic would mean an increase in the risk of an environmental catastrophe and closure of the Straits. In light of the opposition of the government of Turkey to the possibility that Caspian oil could pass through the Bosphorus in large amounts, I predict that Ankara will pose similar objections to any proposal for substantial increases in CPC or any other oil if it is to exit the Black Sea via the Bosphorus.

I believe that Kazakhstan sees the necessity for alternate export routes. It could export a certain amount of oil to the south into Iran and probably should, from Kazakhstan's point of view. The crude oil would go through Turkmenistan and then come down in a pipeline or by tanker to the Iranian Caspian Sea port of Nekaa, and then through a pipeline that the Iranians are building from Nekaa to Tehran. From Tehran, it would go to the Northern Iranian refineries at Rey (near Tehran), Arak, Tabriz and possibly Isfahan. But this possible export route would still only move 400,000 barrels a day.

Baku - Ceyhan Pipeline
You then have to ask yourself, "What are the Kazakhs going to do with the rest of their oil?" This is where Azerbaijan fits in. Tankers could move the oil from Kazakhstan to Azerbaijan. Then it would be placed either in pipelines, if there is sufficient capacity, or moved by rail eventually to Turkey's Mediterranean port of Ceyhan [pronounced Jeyhan] via the Baku-Tbilisi-Ceyhan (BTC) pipeline.

Below: Azerbaijan was a huge agricultural supplier during the Soviet era, so today products like these cherries could easily be exported to nearby countries.

This idea has already been discussed but not yet approved. Azerbaijani oil will start moving through the BTC line in late 2005 or early 2006. By then, the ACG fields [Azeri-Chirag-Gunashli, being developed by the Azerbaijan International Operating Company] will be producing enough oil to fill that line. With the eventual addition of oil from Kazakhstan or Turkmenistan, not to mention additional Azerbaijani production, this pipeline will need to be enlarged.

One way to do this would be to add pumping stations and slicking agents. Crude oil exerts friction on a pipeline as it moves through it, slowing down the progress of the oil. Pumping stations increase the pressure and keep the oil moving along faster. Slicking agents reduce the friction of the crude oil in the pipeline, also increasing the speed. That way, you can move greater volumes through the pipeline, provided the line is strong enough to withstand the pressure.

But the capacity of the Baku-Ceyhan pipeline can only be expanded by so much. Another system will have to be developed to move the additional oil produced in the Caspian Basin to market. The most intelligent thing to do would be to build a parallel line, right alongside the BTC line.

There are obvious economic advantages to using this same route. Most of the land has already been acquired. Plus, the basic negotiations have already been undertaken and completed to construct and operate an oil pipeline along this particular route through the countries involved. So the entire process would be much simpler and quicker the second time around. The second pipeline would cost much less, simply because a number of related costs aren't there. Of course, it would take some time to renegotiate the transit fees.

Trans-Caspian Pipeline
A certain amount of oil already crosses the Caspian by tanker and is moved by rail via Azerbaijan to Batumi, Georgia, a port on the Black Sea. What I anticipate would happen is that there would be greater tanker traffic moving oil to Baku and then from there initially to Batumi, until the BTC pipeline is constructed. However, the amount of oil produced in the eastern Caspian will soon exceed the capacity of Caspian tankers and approach the point at which the construction of a trans-Caspian oil pipeline will become necessary.

Once the companies in Kazakhstan are sure that they are going to reach 500,000 barrels a day, they will begin, I believe, preparations for the construction of a Trans-Caspian pipeline. This would move oil across the Caspian to the region of Baku and then join into an enlarged BTC pipeline. But eventually, a parallel BTC pipeline will be needed to move this eastern Caspian oil.

Will that happen? Yes, it almost certainly will. How soon? That's not clear. It takes a long time to develop an oil field, even one that is known to be massive, like Kashagan. It's not so easy to develop oil in the Northern Caspian. It freezes in the wintertime. The oil is heavy in the sense that it has sulfides and other things that have to be taken out before it's moved. Too much paraffin, sulfides and heavy metals in the oil would foul the pipeline. It's cheaper to get that stuff out at the front end of the pipeline.

Another difficulty is that these vast reservoirs of oil and gas in the Eastern Caspian are found along undeveloped coastal areas. Kazakhstan's developed areas are much farther to the east, around Almaty and the new capital, Astana. In Turkmenistan, Ashgabat is about the only place that has any development.

So the areas of the Eastern Caspian where oil and gas are found do not have sufficient infrastructure to serve as a support base for the oil and gas activities. The little infrastructure that does exist, other than what has recently been constructed by the oil companies, is in an old and somewhat decrepit state.

Support Services
The development of any region like the Caspian Basin requires certain types of support, not only of its oil and gas activities, but all kinds of other related activities. First of all, the area will need regional transportation - a regional airline, for example, that moves not only people, but more importantly, cargo, in grasshopper jumps all around the Caspian.

Compared to the small, primitive towns along the Eastern Caspian, Baku is in an ideal position to provide these types of support services. If this were a horse race, Baku would already be half a track ahead.

Every one of those large oil companies is going to need a regional office. In Baku, that kind of support infrastructure already exists. There is modern office space available, easy access to transportation routes, functioning water and electrical systems and new construction going on all around the city. Baku could put itself into a position to provide telecommunications, broadband connections and fiber optics links, including dedicated satellite links for the region.

And most importantly, all of these companies will need to be tied to the international banking structure. We're talking about companies that are worth more than most countries. Azerbaijani banks have the capacity to provide international commercial banking services, provided that they can partner with foreign banks that already have a presence here. But in order for Baku to become a regional banking center, Azerbaijan will have to make changes in its banking laws and practices. The absence of such reforms is already running counter to Azerbaijani and regional interests and has led at least two foreign banks to pull up stakes.

Cultural Dimension
Another reason companies would be interested in locating their regional headquarters here is that, unlike other cities to the east, Baku is not a primitive oil town. Baku is an ancient, cultured city with a great deal to offer. In addition to the tourist sites that one visits here - like Gobustan or the Shirvanshah Palace - there are cultural offerings like opera, ballet and jazz.

Plus, everyone here is learning to speak English. When I first came here only four years ago, it was difficult to find people who spoke English. Now it's quite common. Today when you hire office staff, you assume that the applicants know English in addition to Azeri and Russian, and that they have basic computer skills.

A number of Azerbaijanis are coming back from Western universities with MBAs [Master in Business Administration]. So the area is beginning to get trained people who can assume responsibility, not just in the office as executive secretaries, but also in the upper levels of management.

Oil Equipment
In terms of light manufacturing, Azerbaijan has the potential to produce a considerable amount of dependable oil production equipment. In Soviet times, Azerbaijan produced 70-80 percent of all the support equipment for the Soviet Union's oil industry. And in those days, the Soviets were producing 12.5 million barrels of oil a day.

During the Soviet era, this equipment was being produced according to Soviet standards, not the more stringent American Petroleum Institute (API) standards. But with minimum retraining, Azerbaijani workers could be taught to produce equipment according to the API standards followed around the world. The old factories that have deteriorated and become decrepit could be rehabilitated or rebuilt.

Here in Azerbaijan, it would be possible to produce relatively simple items, like sucker rods, to supply the entire Caspian basin oil industry. Otherwise, these items would have to be imported from Europe or the United States at substantially higher prices. In other words, it is possible to resurrect much of the old Soviet-era industry, initially on the low-tech end, at a cost that is profitable to both Azerbaijan and the oil companies.

Warehouse Storage
Azerbaijan has access to major transportation routes, which enables Westerners to come and go more easily here than they can in places farther east. With this in mind, bonded warehouse storage is another area in which Azerbaijan could be helpful and supportive in the development of the rest of the region. Items could be moved here cheaply and stored in a large system of bonded warehouses for protection against theft, loss or misappropriation in one form or another.

In this way, companies could delay paying taxes and customs duties on items that they keep in these bonded warehouses. Let's say I want to import 10,000 tables but only have an immediate market for 1,000. I could save the cost of moving smaller volumes of my tables by bringing in 10,000 at a time and putting them in my bonded warehouse. I could also save on the initial outlay of paying customs and taxes on 9,000 of those tables until I am actually ready to sell them.

There are also certain savings of scale. Let's say that 20 different companies all use gloves or boots in the course of their operations, which might involve construction, oil development or any number of things. Each one of those companies could import the boots and gloves separately. But if they own or share a single warehousing operation, they could realize substantial economies of scale. Or, they could contract separately to bring in what they need, store it in the warehouse and have it available as they need it.

Agriculture
During the Soviet era, Azerbaijan was a huge supplier of early spring vegetables, flowers and other fruits and vegetables to the rest of the Soviet Union. With its broad range of climatic zones, it is equipped to do that again for the Caspian basin.

But first, Azerbaijan's agricultural system needs to be redeveloped. The government needs to focus on the development of food products that can be produced, canned and exported - not just to Turkey, but also to the east. There is a rapidly developing commercial supply industry for food. In the Kazakh ports of Aktau and Atyrau, for instance, lots of things are being flown in from Dubai and being sold in grocery stores.

Why shouldn't such agricultural products be produced to an international standard here in Azerbaijan? They could easily be shipped via tanker or ferry across the Caspian to these same stores in Aktau and Atyrau. The price would be cheaper, and the quality would be just as good.

So why hasn't it happened? Primarily because the sufficient conditions for attracting and supporting the foreign investment needed to make these things happen have not been fully developed.

Attracting Investment
Azerbaijan must create an attractive environment for international investment. The government needs to take every conceivable step it can to guarantee success. Attract the investors, get them in here, let them work, help them to make a success and then use them as showcases to attract other investors.

For this to happen, the Azerbaijani government needs to make decisions in close coordination with foreign companies, addressing questions like privatization, the cost of acquiring a given company and the right to produce a given thing. If an old Soviet-era company has past debts, assuming them could be ruinous for a new investor. If the old company incurred environmental liabilities, the new investor cannot be expected to take on the responsibility for them.

Likewise, new investors cannot be expected to hire all of an old company's former employees. In Soviet times, companies employed many, many more people than they actually needed because the object was to have 100 percent employment. It didn't really matter what the cost was because the market influences were irrelevant. That's one of the main reasons why the Soviet Union fell apart. New investor companies cannot be expected to maintain thousands of workers more than necessary. Some reasonable arrangement has to be made so that some of the old workers can be pensioned off while the others are kept and retrained.

The government also needs to grant tax holidays, meaning that if you come in and make an investment, you don't start paying taxes until a certain number of years have passed or you have amortized your initial investment and made some degree of profit. Based on the past track record of the region, firms that invest in Azerbaijan are taking a considerable risk. That risk must be reduced or they won't be interested in coming.

There's also the question of financing. It's conceivable that Azerbaijan might want to use some portion of its Oil Fund to assist reputable companies with good investment and development plans. The Oil Fund could buy shares in a project but not actually try to control the project. After a number of years, if the company has succeeded, these shares would be worth much more than they were initially and could be resold at a profit to the Fund.

If the project fails, however, the company is off the hook for the amount that the Oil Fund has invested. This gives the Oil Fund, and therefore the government of Azerbaijan, an additional interest in seeing that the project survives and is successful, while at the same time reducing risk to the foreign investors.

All of these things can be done and ought to be done if the investment that Azerbaijan so desperately needs is to take place. Potential investors need to feel very comfortable about exploring the region's opportunities; there has to be a degree of predictability for them.

Neighboring States
I see Azerbaijan as a future hub, not just for the South Caucasus, but for the entire Caspian basin. The other two countries of the South Caucasus [Georgia and Armenia] lack Azerbaijan's resource base and must share its geographic location on the East-West transport route. Therefore, these two nations will only benefit to the degree that Azerbaijan benefits first.

As Azerbaijan develops and becomes a major hub for transportation, banking activities, administrative support, light manufacturing, warehouse storage and almost anything you'd care to mention, initially Georgia and, perhaps - if there is peace in Nagorno-Karabakh-Armenia, will benefit. If Azerbaijan does not serve as the development engine for these other two South Caucasus nations, they have very little prospect of taking part in the broader development and prosperity of the Caspian basin.

Azerbaijan is on the cusp of a very rapid development on the basis of its own energy resources, which will become more substantial as exploration continues. Plus, Baku has every prospect of developing into the same kind of regional support center that Dubai has become in the Persian Gulf, or Beirut once was before the wars and may become again. This development is absolutely inevitable, provided that the conditions are there to make it attractive for investment to jumpstart the process. It may take 10 to 15 years. But 10 to 15 years pass in the blink of an eye.

Stan Escudero, former U.S. Ambassador to Azerbaijan, was interviewed for this article by Azerbaijan International's Editor, Betty Blair. For previous articles by Escudero, see "Hands Tied: Denying Aid to Baku - Section 907" in AI 8.4 (Winter 2000) and "Visions of Baku: Future Hub of the Caspian" in AI 9.3 (Autumn 2001). SEARCH at AZER.com.

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