"Energy Supplies in Eurasia and Implications for U.S. Energy…

      "Energy Supplies in Eurasia and Implications for U.S. Energy Security"

             The United States Senate Foreign Relations Committee
   Subcommittee on International Economic Policy, Export and Trade Promotion

                                    September 27, 2005

                                     Zeyno Baran
                Director, International Security and Energy Programs
                                  The Nixon Center

Thank you, Mr. Chairman, for the opportunity to appear before you to share with you my
views on Eurasian energy dynamics and implications for U.S. energy security. I have
closely followed Eurasian energy developments and U.S. policy towards the Caspian Sea
Basin since the mid 1990s, and I am delighted to be part of this hearing today.

With its significant oil and gas reserves, especially in Russia and Kazakhstan, the
Eurasian region is vitally important to the U.S. strategic effort to diversify energy
supplies away from sources in the Middle East. The U.S. has a clear need to ensure that
these supplies reach world markets cheaply and safely; however, it has an equal need to
ensure internal reforms in the countries of the region. If it fails to do so, its effort to end
its energy dependence on oil and gas from Saudi Arabia and the Persian Gulf will only
result in the creation of a "second Middle East," with equally damaging consequences for
U.S. interests.

A Review of U.S. Caspian Energy Strategy
In the 1990s, the U.S. developed a multiple pipeline policy to the oil and gas reserves of
the Caspian Sea. The intention of this policy was to allow the production of the region's
newly independent countries to reach Western markets without having to rely solely on
Russia's transportation infrastructure. The U.S. strategy was founded on four major
objectives. The first was to strengthen the independence and prosperity of the Caspian
states through the revenues obtained from energy production. The second was to bolster
the security of worldwide energy markets by ensuring the free flow of supplies unfettered
by the policies of regional competitors and by geographic chokepoints such as the
Bosporus. Third was to reestablish close economic linkages among the new states of the
region in order to prevent or mitigate regional conflicts, while the final goal was to
enhance overall business opportunities.

The U.S. extended its support to five major pipeline projects intended to achieve the
above-mentioned goals. The most significant projects backed by the United States were
the two pipelines along the so-called East-West Energy Corridor. First was the Baku-
Tbilisi-Ceyhan (BTC) oil pipeline, which later this year will begin transporting
Azerbaijani (and, in the future, Kazakhstani) oil through Georgia to Turkey's
Mediterranean port of Ceyhan, and second was the South Caspian Gas Pipeline, which




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after its completion next year will transport Azerbaijani gas via Georgia into Turkey and
onward to Western Europe.

U.S. support for these two projects did not reflect any anti-Russian agenda; it was instead
intended to break the Russian monopoly on economic and political relations with
Azerbaijan and Georgia so that these newly emerging states could freely develop their
economic and foreign policies without fear of reprisal. The breaking of the Russian
monopoly over the region's transportation system also helped Western companies
operating in Azerbaijan and Kazakhstan. Once they were able to use the east-west
pipelines and railroads to get their oil to markets, the companies were in a much stronger
negotiating position vis-à-vis Russian corporations, who had become accustomed to
charging high transport tariffs and gave preferential treatment to Russian companies. The
availability of alternative routes provided security for Western companies operating in
this region.

Despite the strong support of the U.S. government, the east-west pipelines would never
have materialized were it not for their commercial attractiveness. American involvement
was certainly important to the oil companies and other investors, as it substantially
reduced the political risk of these projects. However, U.S. support was not sufficient by
itself to make the projects a reality; the international consortium responsible for the
development of Azerbaijani oil and gas did not make the final decision on either pipeline
until each state signed the internationally-binding agreements offering the investors the
right incentives and the necessary legal protection.

Ultimately, U.S. Caspian policy envisioned these pipeline projects acting as engines of
economic growth, providing an impetus for political and economic reform in both the
producing and transit states. Indeed, to avoid the so-called "resource curse" experienced
by many energy-rich countries in the developing world, Azerbaijan and Kazakhstan have
created Oil Funds that are transparently managed and monitored by international
financial institutions and NGOs. While the governments have used part of the money to
improve the living conditions of the countries' poorest citizens, the bulk of the energy
revenues have been set aside in investments for the future. Although the implementation
of democratic and political reforms have been slow, both countries are heading toward
critically important elections this fall, and both leaderships seem committed to
conducting elections that would meet international standards.

Putin as the CEO of Russian Oil and Gas
The U.S. vision in its Caspian energy strategy was the correct one, and many of its policy
goals are still valid objectives. However, important developments require a new
framework for the broader Eurasian region. Today the biggest policy challenge for the
U.S. is Russia, which may well become a second Saudi Arabia in more than one sense.
Indeed, Russia is already the world's largest gas exporter, and is the second-largest oil
producer after Saudi Arabia. According to the Department of Energy, Russia has more
than twice the gas reserves of the next country on the list--Iran. The report further states
that the Russian gas monopoly Gazprom "holds nearly one-third of the world's natural
gas reserves, produces nearly 90% of Russia's natural gas, and operates the country's



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natural gas pipeline network....Because exported Russian natural gas accounts for
approximately 25% of Europe's demand for natural gas, Gazprom is also one of
Moscow's main foreign policy tools." This is the key point I would like to focus on in
the remainder of my testimony.

As you know, Presidents Bush and Putin concluded a Strategic Energy Partnership in
2002. While it is not clear at all what the U.S. and American companies got out of this
partnership, it has been a rather lucrative one for the Russians. With little interference
from the United States, Russia has constructed monopolistic oil and gas networks that
now threaten the energy security of the entire region. Over the past several years we
have seen Putin dismantle Yukos, once the largest Russian oil company, and through the
state firm Rosneft gradually consolidate its assets under the Kremlin's control.
Yuganskneftegas, the main production unit of Yukos, was effectively nationalized in
December 2004; through the acquisition of other assets, Rosneft plans to overtake Lukoil
as Russia's leading petroleum firm by 2008. Gazprom is also planning to enter the oil
sector and will soon by the privately held Sibneft, Russia's fifth-largest oil producer.
Soon Putin will be in direct control of the world's largest integrated oil and gas
enterprise.

It is not as if their intention to do so had been kept secret; in September 2003, Anatoly
Chubais declared that "Russian business ought to be allowed to expand...with the aim of
creating a liberal empire" in the former Soviet sphere. This sentiment was echoed at the
highest levels of government; in 2004, then-energy minister (and later prime minister)
Viktor Khristenko declared that Russia would act "more confident in pursuing its
interests, while relying on [the] common resources" of the former Soviet states.

Adding to the strength of its monopolistic base at home and in its "near abroad" has been
the increase in world oil prices. As I mentioned earlier, Russia is the world's second
largest oil exporter after Saudi Arabia, and earned $34 billion from oil exports in the first
half of 2005--almost 50% more than the same time last year. Over the last five years,
Russian economic growth has been primarily fueled by energy exports, and the economy
has become dangerously dependent on the energy sector. And as long as oil prices
remain high, there is little incentive for the Russian government to improve the
investment climate and attract the billions of dollars worth capital necessary to increase
oil and gas production.

Instead, Russia can afford to focus on its long-term interests in the energy sector:
strengthening Gazprom, both as a gas monopoly and soon as an oil giant; building up
Rosneft through former Yukos assets; and maintaining the monopoly power of the state-
owned pipeline operator Transneft. All these long-term goals dovetail perfectly with
Russia's long-term geopolitical interests.

But it is in America's and world energy security's interest for Russia to produce more oil
and gas, and it is important to act fast. Easy oil is running out and huge investment and
new technologies are needed to exploit the more remote and difficult fields such as those
in the West and East Siberia. Therefore now is a good time to discuss a set of new



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initiatives and conditions, especially as Russia moves to head the G-8. Russia has already
stated that energy security will be its major theme; the U.S. needs to have its own energy
security strategy as well.

Given that Russia wants to accede to the World Trade Organization (WTO) by the end of
the year, the U.S. has some leverage over Russia, but it is limited, especially given that
there are other pressing issues in the bilateral agenda ranging from North Korea to Iran.
Moreover, the U.S. needs to engage with Russia on energy and ensure that it can
purchase Russian oil and gas, including liquidified natural gas (LNG) on a commercial
basis. For such purchases to be on a commercial basis, the U.S. and Russia need to work
together to channel Gazprom and other oil and gas firms away from monopolistic
operations. The U.S. and the EU share similar interests in this area; in fact, they should
adopt a common position against the oil, natural gas and electricity monopolies across
Europe and Eurasia. These monopolies are clearly bad for consumers, since they charge
higher prices than firms would in a more competitive situation; they also offer geo-
strategists in the Russian Government an irresistible temptation to use energy supplies as
leverage over the country's neighbors.

Russia will require a lot of investment to build the new infrastructure needed to develop
its major oil and gas fields. Together with the EU, the U.S. could put together a large
funding package--with the involvement of international financial and lending
institutions, as well as the private sector in both Russia and the West. But such a package
must be made conditional on improvements in the investment climate, particularly
reforms in the areas of governance, transparency and the rule of law. Without these
reforms, no major investment can be made.

The Russians have responded to competition, especially from the Caspian, and the U.S.
therefore needs to maintain its focus on the Caspian. Transneft's monopoly control over
the oil pipelines is creating a major hindrance to Russian oil exports, since it does not let
any other company to construct pipelines. However, Russia granted improved terms to
the Baku-Novorossiysk pipeline, after a competing pipeline was built from Baku to the
Georgian Black Sea port of Supsa. Similarly, only after the Baku-Tbilisi-Ceyhan oil
pipeline from the Caspian Sea to Turkish Mediterranean port of Ceyhan became a reality,
did Russia adopt a more constructive approach to the Caspian Pipeline Consortium's
transportation of oil to Novorossiysk from Kazakhstan. And most recently, after
Kazakhstan and China began work on their oil pipeline, Russia announced it would be
building an East Siberian line with a spur to the Pacific.

Transatlantic Initiative Needed on Gas Diversification
The U.S. can maximize its leverage by working with the Europeans. First, Europe must
understand that increasing oil and gas supplies from Russia does not necessarily increase
their energy security. What the Europeans need to do, given that they are the principal
market for Russian gas, is to require that Russia sign on to the Energy Charter Treaty,
conduct competitive business, and offer the same terms to Central Asian oil and gas
transiting Russian infrastructure.




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The U.S. therefore needs to hold a transatlantic discussion to urge the Europeans not to
cut any long term deals with Russian monopoly companies without any pressure to
change--otherwise, they will be hurting Russian energy development and Europe's own
long-term security. For example, the unchecked growth of Gazprom is damaging to
Europe's long term security; in this context, the pipeline agreement between Germany
and Russia that would bypass Poland and Ukraine is not a positive development, as these
two transit countries would not be able to pressure Gazprom to behave in a commercial
manner.

Western and Central European countries are dependent on the Russian gas monopoly
Gazprom as their sole or primary supplier of natural gas. Consequently, European energy
utilities have vested commercial interests in maintaining cordial relations with Gazprom.
For example, Germany's Ruhrgas is a major investor in Gazprom. Such relationships
create a disincentive for European countries to take a firm line with Russia, even as
Russia's policies undercut democracy at home and undermine the sovereignty and
independence of its neighbors.

Gazprom has over the last years systematically increased its leverage over European
energy markets by bolstering its monopolistic control of regional pipelines. Last
December the International Energy Agency already expressed concern that the EU as a
whole was becoming too reliant on Gazprom, which could use its power as a monopoly
supplier to push up gas prices. Russia in the past withheld oil and gas supplies to
pressure the Baltic States and has done the same in the South Caucasus. The fact that
Russia has in the past been a reliable gas supplier to Western Europe is meaningless;
Russia has never had the kind of power it has recently acquired and we simply have no
precedent to help us determine how it will use this power

Gazprom is not without vulnerability. It is burdened with its obligation to supply Russian
consumers with gas at below-market prices. Gazprom needs to undertake significant
corporate restructuring and reinvest into technology to increase its domestic production.
Otherwise, to meet its supply demand, it will continue to try to acquire as much cheap gas
in Central Asia as possible, and sell that gas to Western markets at higher prices. In other
words, Gazprom will need to rely on its monopoly control of regional pipelines to compel
Turkmenistan, Uzbekistan, and Kazakhstan to continue to sell their gas at below-world
prices. This has already made gas into a major geopolitical issue.

Gazprom's diplomacy is intended to press the countries around the Black and Caspian
Seas to agree to gas supply and transit arrangements which satisfy the company's goals:
keeping Central Asian gas prices at below-world-market rates, channeling Central Asian
gas to lower-paying Russian customers, and protecting its lucrative European markets by
freezing out Central Asian suppliers. In short, Gazprom is trying to strengthen its
monopoly power, which in turn will strengthen its leverage (and that of the Russian
government) over European gas consumers.

The Central Asian states must therefore settle for barter deals with lower-paying Russian
customers, as Gazprom reserves for itself more lucrative deals with Western European



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consumers. The West's challenge then is to prevent Gazprom from further strengthening
its leverage over European markets by reducing its monopoly power and channeling it
toward more market-based behavior.

The Bosporus Chokepoint and New Cooperation Possibility
The bulk of Russian oil is transported to the Black Sea and from there via tankers to
world markets. The increasing amount of oil being transported to the Black Sea has
caused the dangerously narrow and overcrowded Bosporus to become a chokepoint,
stalling traffic in and out of this closed body of water. In severe weather conditions,
delays can be up to 30 days, which imposes a huge cost on oil companies. Once Russian
oil companies reach their production targets, and once the Caspian Pipeline Consortium
(CPC) begins to transport oil from Kazakhstan to the Black Sea at full capacity, traffic
through the Straits will simply become paralyzed. Any incident that caused delays above
and beyond those caused by traffic and weather would shut down the passageway for a
considerable period, with devastating effects for the countries of the region, all of which
rely on the Bosporus for transportation of imported goods and exported commodities.

The occurrence of such an incident, whether it is a major oil spill or a terrorist attack, is a
serious possibility; the consequences of the latter are nearly unimaginable. If an LGP
tanker is attacked while traversing the narrow Bosporus through a city of 14 million, over
a million people could be killed. After all, Istanbul was already hit twice by terrorists in
November 2003 and is a front-line state in the war against terror.

One way to make the Straits safer is to divert some of the oil traffic to bypass pipelines.
Once the BTC pipeline opens later in the year, the bulk of Azerbaijani oil will reach
world markets via Ceyhan. Other Caspian countries could also use this pipeline, but
there still will be significant amount of Russian oil transported via tankers. Given the
importance of uninterrupted oil exports to its economy, Russians are now actively
looking for a second Bosporus bypass pipeline.

A win-win project on which the U.S. can work with Russia and Turkey is to encourage
Turkey to provide incentives for companies to construct a new oil pipeline across Turkey.
This pipeline would connect the Black Sea to Ceyhan and have a capacity of 1 million
barrels per day, and would also increase Russian government tax revenues by $5 billion
to $6billion per year. The U.S. could then focus oil exports into the Mediterranean at
Ceyhan, and thereby create a sort of oil "supermarket" where traders could buy oil from
Azerbaijan, Iraq, or the Urals.

Implications of Russian-Chinese Energy Partnership
Ending months of speculation, President Putin has confirmed earlier this month that
Russia will build a multi-billion dollar oil pipeline across Siberia that will first reach the
Chinese oil terminal of Daqing before being extended to the Pacific port of Nakhodka.
From there, oil can be shipped to Japan and onward to the United States. In addition,
Gazprom is in talks with CNPC to lay two pipelines to China. One would carry Russian
gas west to join China's internal West-East pipeline, while the other would reach the
country's northwest; for each pipeline, the figures are 20-30 bcm per year.



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The Russian-Chinese energy cooperation is extremely significant in light of the
developments in and around Central Asia over the last several years. While it is difficult
to fathom a long-lasting Russian-Chinese strategic partnership, at least for now both seem
to have decided to cooperate to reduce the U.S. influence and presence in Central Asia.
Benefiting from the growing concern over perceived American support for the
revolutions in Georgia, Ukraine and Kyrgyzstan, Russia and China used the July summit
of the Shanghai Cooperation Organization (SCO) to make the first declaration against the
presence of the U.S. military bases in the region. The SCO has been a weak regional
alliance consisting of co-chairs Russia and China, and the Central Asian countries of
Kazakhstan, Kyrgyzstan, Tajikistan and Uzbekistan; Mongolia also participates as an
observer. In July, India, Iran and Pakistan joined as observers as well.

Last month Russia and China held a joint military exercise, Russia and India will hold
their first ever joint army drill next month, and in 2006 all of the SCO members and
observers are expected to participate in such military exercises. While Russia, China and
India have expressed interest in "maintaining stability in Central Asia and ensuring the
stability of oil supplies" it makes one wonder if an anti-American alliance is in the
making. Given the participation of Iran, and its new president's preparedness for
confrontation with the U.S., it would be prudent for the U.S. to play close attention to
these developments in Central Asia.

Moreover, a realist approach to the region's hydrocarbon-rich but democracy-poor
countries, such as Turkmenistan and Uzbekistan, is needed in order for the West to make
full use of the alternative sources and transport routes in the region. The United States
needs to develop new policies that better address the new challenges, so that U.S. energy
security can be strengthened and influence maintained and deepened across Eurasia.

Conclusions and Recommendations
I hope I was able to draw a picture in which the Kremlin knows that control over the
Eurasian energy infrastructure, especially its gas pipelines, is its most effective foreign
policy tool today. Given that Gazprom will for the foreseeable future be the leading gas
supply provider to the EU, the U.S. needs to urge the European gas consumers, as well as
transit states, to form a transparent, market-based, commercial relationship with
Gazprom. Forging such a relationship requires all these states to strive for increased
competition in gas supply and transit arrangements, and to circumscribe Gazprom's
monopoly power.

The U.S. can also work with the countries of the former Soviet Union to enable them to
pay upfront for the gas they take from Gazprom and charge Russia for transit services,
thus bringing full transparency to the gas relationship. These countries also need to
ensure that they avoid incurring further debt to Russian companies that could force them
to each debt-for-equity deals. The South Caucasus countries can already work with the
EU and the Energy Charter to adopt European standards in these dealings; Russia needs
to join the Energy Charter as well.




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The U.S. needs to recognize that there is a new alliance taking place that brings countries
of the SCO closer in cooperating on political, military and economic areas. Russia,
China, Iran and India have also been increasing their energy cooperation--given that all
have state-owned and monopoly companies, their business practices are different than
those of the West. In addition, they are able to offer government backing and non-
transparent incentives Western companies are not able to offer. These developments are
neither in the interest of American companies nor in line with U.S. stated Caspian Sea
region policies I discussed earlier.

Moreover, U.S. democracy and freedom agenda is in direct opposition to what the major
SCO countries are preaching today. While the U.S. may be limited in its ability to
influence the region's developments, it nonetheless needs to be consistent in its
promotion of internal reform and democratic change. While criticizing Uzbekistan or
Turkmenistan for their democratic short-falls, the U.S. and the EU cannot turn a blind eye
to developments in Russia in the name of "energy security". At the same time, it is
important to be realistic about the implications of pushing the freedom and democracy
agenda in a region where other major powers are vying for influence by promising
stability instead.

In this context, I would like to express my strong disagreement with the State Department's
reported decision to move Central Asia out of the European Bureau and into the South
Asian Bureau. The U.S. has been able to help the Caspian Sea region's energy projects
and internal reform process by offering the region an East-West perspective. If the
Central Asian countries are put together with Afghanistan, Pakistan and India, the
chances of them coming under the SCO's influence will be significantly increased.

If this decision is not reversible, then it would be important to assess the signals the U.S.
would be sending to the leaderships and the people of Central Asia. Such major
reorganization would also require a new Eurasian energy strategy, as the strategy of the
1990s looking East-West would effectively come to an end. A new Central Asian energy
strategy would then be devised to integrate the infrastructures of Central Asia and
countries like Afghanistan, Pakistan and India. For example the U.S. would then need to
strongly support the proposal to get Central Asian gas to India to block Iranian gas. On
the negative side, Kazakhstan, which has long made clear its long-term vision to be
closely engaged with Euro-Atlantic institutions, will be left with little option but to
increase cooperation with its giant neighbors Russia and China, and such cooperation
may come at the expense of energy cooperation with the U.S. I therefore would like to
conclude my presentation by urging you Mr. Chairman and Members of the Committee
to carefully consider this pending reorganization of the U.S. government as you
deliberate on ways to increase U.S. energy security.




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