July 2, 2013

A Tale of Two Pipelines: Why TAP has Won the Day

For several years, one of the most intriguing and strategically significant questions for those who are interested in European energy security has been, what route will be selected for the Southern Corridor, the network of pipelines that will help Europe diversify its supplies of natural gas with a connection to s fields in Azerbaijan and beyond. The decision has been expected in the past, only to be postponed as the companies developing the massive Shah Deniz natural gas field in Azerbaijan’s sector of the Caspian Sea recalibrated their investment plans. Now, the waiting is finally over. The Shah Deniz Consortium, (which includes the State Oil Company of the Azerbaijan Republic or SOCAR, BP, Statoil, Total, Lukoil, the National Iranian Oil Company and TPAO. The contest was close up until the last minute. TAP’s victory was a function of several confluent commercial and political factors that ultimately tipped the balance and eliminated Nabucco West. Below we attempt to recap the strategic importance of the Corridor, summarize these factors and outline the way forward.

02.07.2013, Ambassador Matthew Bryza, David Koranyi (Atlantic Council)
Natural Gas Europe
For several years, one of the most intriguing and strategically significant questions for those who are interested in European energy security has been, what route will be selected for the Southern Corridor, the network of pipelines that will help Europe diversify its supplies of natural gas with a connection to s fields in Azerbaijan and beyond.  The decision has been expected in the past, only to be postponed as the companies developing the massive Shah Deniz natural gas field in Azerbaijan’s sector of the Caspian Sea recalibrated their investment plans.  Now, the waiting is finally over. The Shah Deniz Consortium, (which includes the State Oil Company of the Azerbaijan Republic or SOCAR, BP, Statoil, Total, Lukoil, the National Iranian Oil Company and TPAO. The contest was close up until the last minute. TAP’s victory was a function of several confluent commercial and political factors that ultimately tipped the balance and eliminated Nabucco West. Below we attempt to recap the strategic importance of the Corridor, summarize these factors and outline the way forward.
The Strategic Rationale of the Southern Gas Corridor
At first glimpse it may seem hard to understand all the hype around the Southern Gas Corridor. After all, the 10 bcm it will initially carry to Europe represents only around 2 percent of the EU’s gas consumption, hardly a silver bullet in supply diversification. But, the Southern Corridor will provide Europe with a new route to secure natural gas supplies from the Caspian Sea Basin, the region on which Russia’s giant state natural gas company, Gazprom, had planned to rely to sustain its monopolistic leverage in Europe for decades.  Now, with the Southern Corridor, Azerbaijan’s gas will reach lucrative European markets independently of Gazprom and at prices set more by the market principles of supply and demand than the monopolistic machinations of Gazprom.  Moreover, the Southern Corridor is designed to be expanded as additional natural gas becomes available in Azerbaijan, and future supplies in Turkmenistan seek access to European markets.  The Southern Corridor could expand further, to include natural gas from Israel and Cyprus in the Eastern Mediterranean, as well as Iraq and perhaps some day, Iran.
An expanded Southern Corridor will take several years to achieve.  The original idea for a Southern Gas Corridor (the ‘Grand Nabucco’ concept with a capacity of 31 bcm) was first conceived more than twelve years ago to bring Iranian gas to Europe. That is a non-starter today for obvious political reasons, and also because of commercial challenges in reaching energy deals with Tehran. Turkmen gas will not be available for the foreseeable future due to political and legal disputes over the Caspian Sea, as well as Russian pressure on Turkmenistan to forego a European export route, all of which are likely to be resolved only after the Southern Corridor is coming to physical fruition; at that point, Turkmenistan’s leaders will be able to calculate that the risk of aggravating Russia will be outweighed by the geopolitical and commercial benefits of exporting Turkmen gas westward. Moreover, future Azeri offshore gas will require at least a decade more to develop.
Yet the importance of the Southern Gas Corridor cannot be overstated. Opening up a fourth major natural gas corridor (the first three being the ones from Norway/North Sea, North Africa, and Russia) is of strategic significance not only for Europe but for the transatlantic alliance as a whole. The rationale behind the concept is more valid – and more worrisome to Gazprom — than ever.
First, as discussed above, the Southern Corridor opens a new and competitive route for Europe to import natural gas from producers that Gazprom does not control.  This competition comes at a time when Gazprom is seeing its monopoly leverage weakened by the emergence of natural gas trading hubs in Northern Europe, by the increasing availability of liquid natural gas, and by vigorous European Commission efforts to establish a unified European energy market in which market rather than monopoly forces determine energy prices. Taken together, these factors are making it increasingly difficult for Gazprom to demand higher natural gas prices based on long-term contracts that are indexed to the price of oil, which is currently nearly twice as expensive per unit of energy than is natural gas.
Second, Europe will likely need more gas in the long run. While natural gas usage is forecast to be flat in the coming years in the European Union, it will pick up again in the next decade, as coal and in some cases nuclear are phased out from the energy mix and gas is ideal to serve as back-up generation to steady the uneven performance of renewables. As conventional reserves deplete, Europe’s dependence on gas imports is expected to grow further from the current 64 percent in the coming decades to above 80 percent. Even a significant – and at present distant – uptick in unconventional gas production in Europe, complementing the U.S.’s shale gas revolution, it will likely only offset the decline in indigenous conventional production and keep import rates steadily around 60-65 percent. In comparison: the United States has imported less than 5 percent of its natural gas consumption in 2012 and is widely predicted to become a net liquefied natural gas exporter by 2016. Energy prices in general and natural gas prices in particular are increasingly a headache for European leaders as an issue of competitiveness as well preserving social peace.
Finally, the Southern Corridor will be essential to stabilizing the volatile region South Caucasus by anchoring Azerbaijan to the Euro-Atlantic community.  Just as the Baku-Tbilisi-Ceyhan pipeline solidified Azerbaijan’s and Georgia’s Western links, the Southern Gas Corridor will expectantly contribute to cementing their Euroatlantic orientation.  And, hopefully, in the not-too-distant future, it will be possible for Azerbaijan to offer natural gas supplies to Armenia as suggested on June 7 by SOCAR President Rovnaq Abudllayev, as a way to help the two countries overcome their animosity that is rooted in the unresolved Nagorno Karabakh conflict. It will also bring new supplies to Turkey, the fastest growing gas market in Europe, to decrease its dependence on Iran and Russia and lay foundation for a gas trading hub that will lower gas prices for Turkey and its European neighbors. Turkey’s energy bill makes up the bulk of the current account deficit that endangers its economic growth.
Why TAP?
TAP’s selection has disappointed many who rooted for Nabucco as the main pipeline to bring gas to the Central European region still overly dependent on Russia, even though what ultimately matters from a geopolitical perspective is that the Southern Corridor materializes in one form or another. Many Nabucco supporters argued that while the Italian and Western European markets are oversupplied and well diversified, gas through Nabucco West would reach most of the countries exposed to the 2006 and 2009 Russo-Ukrainian gas crises, including countries in Southeast Europe and that by Nabucco would increase the liquidity of the Central European Gas Hub at Baumgarten, Austria, the terminus of the Nabucco pipeline.
Nabucco West’s strategic advantage over TAP has been slowly but surely chipped away due primarily to commercial concerns, with political factors making a push in the end. Most fundamentally, Nabucco West was unable to assuage anxieties around its financial firepower to cover what is a significantly longer and more expensive route, with the TAP consortium able to demonstrate it would provide Shah Deniz consortium members a higher gas sales price minus transportation costs (or “netback”) than would Nabucco West. Meanwhile, the late entry of GDF Suez into the Nabucco consortium (after the departure of German RWE) failed to dispel concerns that the Nabucco consortium consists of smaller entities some of which are exposed to the whims of unpredictable government policy either through politics, ownership structure or regulatory environment. In addition, Nabucco West was unsuccessful in organizing itself sufficiently to mount as strong a commercial bid as TAP, as evidenced by Nabucco West’s failure to attract sufficient non-binding bids for its initial 10 bcm capacity in the crucial months before the decision, signaling uncertain market prospects in Central Europe in the medium-term.
A second key set of issues that helped seal the Shah Deniz consortium’s selection of TAP was the commercial and political factors surrounding the privatization of Greece’s natural gas distribution company, DESFA. Sintez, a Russian company that appears to be indirectly controlled by Gazprom, originally seemed to have locked in its acquisition of DESFA’s domestic gas pipelines with a $1.9 billion bid that was nearly five times as high as independent financial experts’ analysis of the network’s value.  Coupled with Gazprom’s lone bid for privatization of DEPA, the Greek government’s natural gas contracting company, Gazprom and its ally appeared poised to seize control of Greece’s entire natural gas trading system.  Though the TAP consortium will build an entirely new pipeline across Greece and into Albania and under the Adriatic Sea, DESFA’s internal Greek pipelines were critical to the Shah Deniz consortium’s plans to market gas from TAP to Greece’s Balkan neighbors.  Then, just a little over week before the Shah Deniz consortium’s scheduled decision on TAP versus Nabucco West, the European Commission made clear it would insist on applying the market liberalization directives of its Third Energy Package in Greece and prevent Gazprom from operating Greece’s national gas grid as a monopoly.  At this point, both Gazprom and Sintez bowed out, leaving DESFA to be acquired by the lone remaining bidder, Azerbaijan’s and Shah Deniz’s SOCAR.  These developments also reflect how TAP has skillfully transformed itself from a project primarily destined to supply the saturated Italian market to one that will supply the Balkans though the Ionian-Adriatic Pipeline (IAP) as well as the major markets in Western Europe. Signals from Fluxys – a pipeline operator with access to mature markets in Germany, France, Belgium, the Netherlands and even the UK – to enter into the TAP consortium further underpins that strategy.
Completing the Corridor
The process is far from over. The Shah Deniz Consortium now moves on to finalize negotiations on both the ownership and financing of TANAP and TAP. The final investment decision will take place sometime during the fall (likely October). There are many open questions left that must be addressed.
Financing challenges remain for both TAP and the the two pipelines that will carry gas from Azerbaijan to the Turkey-Greece border:  expansion of the South Caucasus Gas Pipeline (SCP-X) that already connects Azerbaijan with Georgia and Turkey; and construction of the Trans-Anatolian Pipeline (TANAP), 80% of which will be owned and financed by Azerbaijan and Shah Deniz consortium partners SOCAR, BP, and Statoil. Financing these large projects is complicated by the tight economics of natural gas production at the Shah Deniz field.  The complex geology of that field means that net profit from natural gas production and exports barely exceed the break-even point, with investors relying on gas condensate to boost returns.  Moreover, SOCAR faces extreme demands for capital investments due not only to TANAP and SCP-X, but to huge investments in Turkey at the Star Refinery and Petkim petrochemicals factory in Izmir, Turkey, along with two large-scale petrochemical parks in Azerbaijan.
It is also important to note that the TAP choice over Nabucco West might eventually be more about sequence than exclusivity. The Southern Gas Corridor’s initial 10 bcm capacity is likely only the beginning. Both pipeline projects were designed to be scalable and by the middle of the next decade additional supplies will be more than enough to provide up to 30-35 bcm of gas from Azerbaijan alone that in theory could fill both a larger TAP and pipelines that carry gas towards Central Europe. Further fields from the Kurdistan Region of Iraq and the Eastern Mediterranean could be shipped through the Corridor to Europe, shall the underlying and complex geopolitical issues be resolved – big ifs indeed.
Nabucco West as a project may be dead (save for significant quantities of gas coming online from the Black Sea or Romanian shale, both distinct possibilities as of now), but gas might still flow towards Central Europe as well. Building the Greece-Bulgaria Interconnector, the rights to which are owned 25% by Greek DEPA, 25% by private Italian company Edison, 50% by the Bulgarian state energy holding company EAD, could  provide gas from TAP into Bulgaria. By building a long stalled Bulgaria-Romania interconnector, gas could be moved onwards to Hungary through an already existing Hungarian-Romanian interconnector (that must be upgraded to be able to handle bidirectional flows). That was the original idea of SEEP, a BP led project based not on a grand construct such as Nabucco, but linking up the existing networks. Azeri (or swapped) gas might also be shipped from Italy to Austria’s Baumgarten Hub, the original destination of Nabucco West through the TAG pipeline.
The remaining political and commercial uncertainties around the project should not be underestimated. TAP’s victory only heralds a new, but equally challenging chapter in this long journey. The implementation will be complex, possibly fraught with further delays. But a major piece of the puzzle was finally put in place that would unlock the real prospect of opening up a fourth major natural gas supply route to Europe. That in any case is a welcome development of strategic nature.  And, Greek Prime Minister Antonis Samaras has won an important victory, helping Greece  emerge as a natural gas transit hub that will elevate the country’s strategic significance and generate jobs and revenue at a moment when Greek voters’ spirits urgently needed some good news.
Ambassador Matthew Bryza is a Senior Fellow with the Atlantic Council’s Dinu Patriciu Eurasia Center and Director of the International Centre for Defence Studies in Tallinn. David Koranyi is the Deputy Director of the Atlantic Council’s Dinu Patriciu Eurasia Center.

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