The Nabucco Pipeline: A

Sober Assessment

November 2008

F. Wallace Hays The Nabucco Pipeline: A Sober Assessment

A publication by the Center for European Policy Analysis (CEPA)

November 2008

By F. Wallace Hays

F. Wallace Hays is a Senior Adjunct Fellow at the Center for European Policy Analysis focusing on energy security policy. Hays concurrently leads FWH and Associates LLC, a non-partisan consulting firm specializing in international energy issues. He has more than sixteen years of experience in foreign policy, international relations and political and economic risk assessments, and has provided intelligence analysis and political risk assessments on American foreign policy issues to a variety of clients, including foreign governments in Europe and the Middle East, as well as several major energy companies.

Center for European Policy Analysis 1155 15th Street, NW Suite 550 Washington, DC 20005 Tel: (202) 551-9200 Fax: (202) 296-3880 E-mail: [email protected] www.cepa.org

© 2008 by the Center for European Policy Analysis, Washington, D.C. All rights reserved. No part of this publication may be used or reproduced in any manner whatsoever without permission in writing from the Center for European Policy Analysis, except in the case of brief quotations embodied in news articles, critical articles, or reviews. The views expressed in the publication are those of the author(s) and do not necessarily reflect the views of the staff, officers or board members of CEPA.

ISBN: 978-0-9797433-6-8

1 Table of Contents

Introduction ……………………………………………………………………..……….. 4 1. Lessons of BTC and Odessa-Brody.…………………………………….……...... 6

1.1 BTC and Elements of Success .……………………………..…………..……….7

1.2 Odessa-Brody …………………………………………………...………………. 10

1.3 Lessons…………………………………………………….……………………...12

2. Applying the Lessons of BTC and Odessa-Brody to Nabucco ..…………...... 13

3. The Political Environment for Nabucco……………………………………………. 15

3.1 Current Political Conditions …………………………………………………... 15

3.2 Russia’s Energy Dominance ………………………………………………….... 16

4. Challenges Ahead for Nabucco……………………………………………………... 16

4.1 Finding the Gas …………………………………………………………………. 17

4.2 Tariff Structure and Economic Viability…………………………...... 20

4.3 Competition from Other Pipelines ……………………………………………. 20

4.4 Financing……………………………………………………………...…………...21

5. Impact of Nabucco …………………………………………………………………… 21

5.1 Nabucco’s Impact on Total European Gas Supply…………………………... 22

5.2 Nabucco’s Impact on Incremental European Gas Supply…………………... 23

6. Scenarios for the Future …………………………………………………...... 23

7. Conclusions ……………………………………………………………...... 26

2 List of Acronyms

AIOC Azerbaijan International Operating Company BCM Billion Cubic Meters BCM/A Billion Cubic Meters Annually BTC Baku-Tbilisi-Ceyhan pipeline CPC Caspian Pipeline Consortium ECA Export Credit Agency EBRD European Bank for Reconstruction and Development EIA Energy Information Administration (a unit of the U.S. Department of Energy) ENI Italian state-owned gas company EU European Union FSU Former Soviet Union HGA Host Government Agreement IEA International Energy Agency IFC International Finance Corporation (a branch of the World Bank) IGA Intergovernmental Agreement LNG Liquid Natural Gas NATO North Atlantic Treaty Organization NSC National Security Council (U.S. policy coordination entity in the White House) OMV Austrian state-controlled energy company OPIC Overseas Private Investment Corporation SOCAR State Oil Company of Azerbaijan SCGP/SCP South Caucuses Gas Pipeline TGI Turkey-Greece-Italy natural gas pipeline

Executive Summary

The Nabucco natural gas pipeline is a multi-national project designed to bring Caspian and Middle East gas to Central Europe. It enjoys broad support among western politicians but faces many external challenges. While Nabucco is not destined to fail, policymakers in the United States and Europe should review whether a commitment to this specific pipeline is a sound policy. They should embrace a broader agenda for energy diversification for Central and Eastern Europe – one that includes support for multiple import options and pipeline routes, alternatives such as Liquefied Natural Gas (LNG), recognition of Russia’s importance as a supplier and market incentives to promote reforms within the Russian energy sector.

Introduction

In the past few years, a new era in global energy markets has arrived. Global demand has soared, supplies have struggled to keep pace and national governments are positioning themselves to secure additional energy resources to meet future consumption. In Europe, the recent Russian incursion into Georgia, which many claim was at least partially about control over energy routes, has further encouraged debate on energy security policy.

Whereas debates about energy security in the United States focus on perceived dependence on foreign oil, dependence on Russian natural gas is the issue du jour in many European capitals. Today, Europe consumes more than 500 billion cubic meters of gas annually (bcm/a). Of that total, about 145 bcm, or about 25 to 28 percent, comes from Russia. But Europe has a two-fold problem looking forward. Its projected demand for gas is expected to increase to 700 to 800 bcm/a by 2020.1 At the same time, Europe’s largest gas fields are facing declining production levels. As a result, Europe will almost certainly have to significantly increase its natural gas imports in a relatively short time-frame.

Russia has the natural gas reserves to meet the rising demand to supply Europe. However, Russia’s major gas fields are experiencing a drop in output levels. Russia needs to make substantial investments today in order to meet Europe’s projected demand ten years from now. If Russia makes these investments, the country can substantially increase the amount of gas it supplies to Europe – meeting European increases in demand. For Europe, this means a possible increase in its dependence on Russia as a major supplier of energy. Some Western politicians, including many in the United States, do not want Europe to become overly dependent on Russian gas.

Though Europe’s energy security is primarily a policy dilemma for the European Union (EU), Washington has taken an interest in shoring up its allies’ energy security. Specifically, the United States wants to ensure that as Europe develops its near- and long-term energy security policy, Russian influence does not impact issues unrelated to energy. In other words, the United States is fearful that Russia will use its dominant gas supply position in Europe, not to argue for higher prices, but to influence European policies in other areas, like NATO enlargement or U.S. missile defense plans.

1 Sources: “Supply Capacities For Europe 2010-2020 (IEA/OME)” in Eurogas’ Brochure “Natural gas - the energy for a sustainable future” – June 2005, plus CERA’s Special Report “Long-term Outlook for European Gas” (July 2005) plus Michael Townshend, CEO of BTC Corporation, presentation to CSIS on May 8, 2006.

Many in the United States view the planned Nabucco pipeline as Europe’s answer to both its gas supply problems and the problem of checking Russia's influence in Europe. The Nabucco project is a planned natural gas conduit that would transport natural gas from Erzurum, Turkey to Baumgarten, Austria, through Bulgaria, Romania and Hungary. The project hopes to deliver as much as 30 bcm/a of gas to Europe from the Caspian, Central Asia and possibly the Middle East.2

Source: The Wall Street Journal3

But the proposed pipeline is plagued by immense commercial weaknesses and political impracticalities. The foremost problems are basic: the project lacks binding commitments on gas supplies and transit agreements as well as immense security concerns. Moreover, it faces competition from the proposed South Stream pipeline – Gazprom’s joint venture with Italy’s Eni. The Russian-backed pipeline will travel on a similar route to that of Nabucco (see above). In effect, both pipelines will compete for many of the same customers.

Because of concerns about Russia’s influence in Europe, Western politicians (primarily American and European) increasingly support accelerating the Nabucco project. For example, Senator Richard Lugar, one of the most respected voices in Washington on foreign affairs, recently noted that “European governments must be convinced that their long-term security interests are served by the Nabucco pipeline.”4

2 Nabucco website, . 3 Guy Chazan, “Russia Outflanks EU's Pipeline,” The Wall Street Journal, June 16, 2008. 4 Senator Lugar, Statement to the Senate Foreign Relations Committee, June 12, 2008.

On the other hand, the private sector is generally pessimistic about Nabucco’s prospects. Major energy companies generally agree that Nabucco is “a political pipeline for which there is no gas,”5 and are therefore skeptical of its ability to succeed. At the same time, they acknowledge that there is a clear demand for additional routes into Europe. They question whether or not Russia will be able to meet Europe’s rising demand “in a coordinated way and in sufficient scale” because Gazprom’s track record of developing new fields is spotty.6 Industry representatives generally agree that Nabucco will remain in the planning stages for some time even though it has little commercial basis at this stage.

To illustrate the divide between the political support for the project and the viability of the project based on facts on the ground, it is useful to examine the successes and failures of two other pipelines designed for oil transport: the Baku-Tbilisi-Ceyhan pipeline (BTC), which runs from Baku, Azerbaijan through Georgia to the Mediterranean Sea in Ceyhan, Turkey, and the Odessa-Brody pipeline, which connects Ukraine’s Black Sea port at Odessa to the inland Ukrainian city of Brody. Both were constructed at about the same time. One project has been viewed as a success, while the other has generally been seen as a failure. By examining multiple factors that led to their respective successes and failures a more realistic assessment of the Nabucco project emerges.

Whether and when Nabucco is realized, the main issue driving the support and development of the pipeline – how to provide energy security to Western and Central Europe – needs more attention. Specifically, politicians need to step back and answer some questions. Is Nabucco the only option for advancing European energy security or one of many? Is it a viable project, both commercially and politically? Only when thoughtful and practical answers to these questions have been reached can the United States and Europe develop and implement a sophisticated, commercially sound policy that achieves mutually beneficial energy security goals for Europe.

1. Lessons of BTC and Odessa Brody

Oil and gas pipelines are generally built to serve the basic commercial purpose of moving an upstream resource to a downstream market. This was the case for the BTC pipeline, shown below, which was built to monetize oil fields in Azerbaijan. In contrast, the Odessa-Brody pipeline was built under a political set of assumptions and without certain basic commercial underpinnings. Specific aspects of each of these deals can explain why these projects worked, or did not work, as intended.

5 Interview with industry representative, August 12, 2008. 6 Interview with industry representative, August 12, 2008.

The Baku-Tbilisi-Ceyhan pipeline (BTC)

1.1 Elements of Success for BTC

The BTC pipeline was completed in 2006. It now carries about 1 million barrels of oil per day from offshore Azerbaijan to the Turkish port of Ceyhan on the Mediterranean Sea. Michael Townshend, the former CEO of BTC Corporation, addressed some of the key elements laying the groundwork for BTC’s triumph during a visit to Washington, DC in May 2006. He explained why the project succeeded, even though many industry experts questioned the commercial viability and overall feasibility of the pipeline. Townshend noted the following points:

1. The project was headed by a commercial champion (BP) that possessed significant resources and leadership skills; 2. The project developed a regional alignment both politically and economically among the transit countries; 3. The project acquired strong international support at the political level; 4. The project successfully developed a facilitation and dispute resolution mechanism which placed the U.S. government in the role of “referee”; 5. The project used a phased approach to development; and 6. The political environment during the time of the project favored western ideals and power structures.7

Commercial Champion. Following BP’s acquisition of Amoco in 1998, BP controlled 34 percent of the Azerbaijan International Operating Company (AIOC), the joint company that was awarded the contract to develop the offshore Azerbaijan oil fields of Azeri Charig and Ganashili. Together with the State Oil Company of Azerbaijan (SOCAR), who held a 25 percent stake in the oil fields, the two partners held a majority stake and were able to drive the consortium’s internal decision making process. BP played the role of the lead company.

7 Michael Townshend, CEO of BTC Corporation, presentation to CSIS May 8, 2006.

The commercial and leadership strength of BP was important for three reasons. First, it meant that BP had a strong interest in the project’s success because it had upstream resources it was looking to get to market. Second, as the primary operator of the project, BP (one party) had the authority and support to negotiate on behalf of the consortium; the consortium therefore presented a single position during negotiations. Third, BP made sure that industry best corporate practices were applied to the project. With this commitment to corporate social responsibility, BP was able to attract international financing at reasonable rates. Lenders seek good commercial deals but public lenders like the European Bank for Reconstruction and Development (EBRD), the International Finance Corporation (IFC) and export credit agencies (ECAs) are also sensitive to corporate social responsibility issues that can affect public opinion.

Regional Alignment. In addition to strong historical ties, the governments of Azerbaijan, Georgia and Turkey shared the common objective, prevalent in the 1990s, of wanting to work with the United States in establishing a new East-West energy corridor. The purpose of this corridor was to build economic links to help the newly independent states of the former Soviet Union establish a solid economic base that would help the transition to more market- based economies and democratic societies. At the same time, Georgia was seeking to diversify its oil and gas purchases (so as not to rely exclusively on Russia), and Turkey was seeking more energy for its own consumption as well as an expanded role as a key energy transit country.

For these reasons, Azerbaijan, Georgia and Turkey wanted the pipeline to traverse their territories. They proposed a number of incentives to make the route attractive to BP and other key players. For example, Turkey provided a government guarantee against cost overruns. All of the different offers from interested countries helped make the project more viable. This alignment was confirmed in a series of agreements: the Intergovernmental Agreement between Azerbaijan, Georgia and Turkey (witnessed by the United States), the Istanbul Agreement in 1998 and the Ankara Agreement in 2000.

International Support. The BTC pipeline consortium was made up of companies from the United Kingdom, the United States, Japan and several other major industrialized nations. This international consortium, which was strategically selected by the late President Aliyev of Azerbaijan, gave the project the ability to draw on substantial international support. This support was made clear in two major ways: in the international declarations noted above and in the substantial international financing that the project obtained. BTC obtained financing from six ECAs from Japan, Germany, Italy, France, Britain and the United States.8 Additionally, the project obtained financing from the EBRD and the IFC. BP’s size, strong commercial track record and commitment to utilizing industry best practices all favorably factored into the ability of the project to obtain this support, which was substantial.

Facilitation and Dispute Resolution. A fourth factor that lead to the success of BTC was the role that the United States government played as a facilitator and dispute settler, working to keep the process moving forward when it faced difficulties. The U.S. government made a strong commitment to playing this role and was overall extremely effective. For example, the U.S.

8 The U.S. government alone pledged up to $500 million in Export-Import Bank and Overseas Private Investment Corporation (OPIC) loan guarantees.

government maintained many key staff on the BTC project, even amid senior leadership changes and even through a change in presidential administrations. This staff maintained institutional knowledge of the project, fully learned and understood the project’s commercial pressures and developed strong working relationships with the investors and consortium members. Moreover, BTC enjoyed wide bipartisan support from the U.S. Congress throughout its entire process and continues to enjoy that support today. Some specific examples of U.S. government actions that benefited the project include:

• Expanding potential export options. This reduced the leverage of external actors. In the early stages of BTC, when investors were seeking a major export route, the U.S. government noted that “happiness is multiple pipelines” and that any pipeline project needed to be “commercially viable.” The U.S. government supported early oil routes through Russia and Georgia and carved out an exemption to U.S. sanctions on Iran to allow for Caspian oil swaps. This provided an additional option for early oil routes and the greater competition increased pressure for Turkey, Azerbaijan and Georgia to come up with a commercially competitive alternative. Washington also engaged in a long running, intensive dialogue with investors to understand the commercial ingredients of a successful export system. Only later, as the investors began to seriously examine various options did the United States improve the attractiveness of the BTC by making export credits and financing available.

• Focusing on the legal and political framework. Any cross-border pipeline project is substantially complicated by the fact of crossing multiple jurisdictions. The complexities of such negotiations can drag on for years. With BTC, the United States helped to get the parties around the table and provided encouragement for them to hammer out a legal agreement. Once the negotiations reached the point where most issues were decided but the potential for end game negotiations to drag on indefinitely existed, Washington pushed for closure.

• Providing technical support. The U.S. government provided support to regional governments in the form of feasibility studies, private consultations on pipeline security and advisors to state enterprises. Such technical support helped increase the technical expertise of the regional governments.

The U.S. played a role in each of the following agreements:

• Host Government Agreements (HGAs). • Intergovernmental Agreement (IGA). • The contract between investors and Botas, the Turkish company in charge of constructing the portion of the pipeline in Turkey. • Funding and cooperation agreement. • The Istanbul Agreement of 1998. • The Ankara Agreement of 2000. • A financing agreement where eight IFI institutions participated, representing six countries: the United States, United Kingdom, Germany, Japan, France and Italy. These countries all agreed to help cover the costs and risks of construction.

It is important to realize that, despite this American support, BTC was not a “U.S. government project.” Ultimately, the pipeline was paid for primarily by the consortium participants and commercial lenders. True, the U.S. Export-Import Bank provided loan guarantees worth about $150 million (of a $4 billion project), but this was not a deal-breaker. The U.S. Export-Import Bank acted as an independent government agency pursuing its own incentives to get in on the project. Moreover, commercial interests negotiated the terms of transit and the pipeline’s financing – not the State Department. In fact, the U.S. government refrained from taking a position on any Caspian pipelines until Amoco (later to be absorbed by BP) in 1996, said that it would advocate for the BTC line. Only after this American firm came out in support of BTC did Washington start working on the pipeline to Turkey’s deep water ports.

Phased Approach. The fifth element of success for BTC was the phasing of the project. Phasing means establishing a small scale operation for the purpose of funding and determining if a large scale operation will work. As investors examined possible export routes for Caspian energy (including Baku-Suspa, Baku-Novorossiysk, Baku-Neka and Baku-Ceyhan), they decided to use two relatively shorter routes for early oil exports. These two routes were Baku- Suspa and Baku-Novorossiysk (Supsa and Novorossiysk are Black Sea ports on Georgian and Russian soil, respectively). The Baku-Suspa experience was important in that it helped establish business relationships between Georgian authorities and the commercial players. It also gave the companies the confidence they needed to make a decision to take a larger financial risk and go forward with the larger BTC pipeline.

Political Environment. It is important to note that the political situation was vastly different in the 1990s than it is today. The energy industry was in a low price environment, Russia was struggling both politically and economically, the new states of the former Soviet Union were seeking integration into western institutions and U.S. influence in the Caspian region was higher than it is today.

Furthermore, at the time of the BTC investment decision in 2000, BP had not invested in TNK- BP, the largest Russian joint venture with a western company. The formation of TNK-BP in 2003 significantly altered BP’s global portfolio and made BP one of the largest, if not the largest, foreign investors in Russia.

1.2 Odessa-Brody

The Odessa-Brody pipeline was a project championed and financed by the Ukrainian government. It was conceived as a pipeline that would carry 300,000 bbl/d of Caspian oil to Europe, without traveling through the crowded Turkish Straits. The Ukrainian government also wanted it to avoid transiting Russia and thus increase Ukraine’s petroleum security.

However, Ukraine did not possess any oil rights for the oil that was to flow through the pipeline and had no clear commercial rationale for the project. In contrast to BTC, Odessa- Brody had no commercial champion. The project faced other problems as well. It had no regional alignment, no facilitation and dispute settlement mechanism, and it did not follow a phased approach to development. The pipeline did enjoy international support and was built

in roughly the same global political environment as BTC, but those two positives were not sufficient to make the project a success.

Source: U.S. government

Completed in 2001, Odessa-Brody sat virtually idle until 2004 because of these numerous problems. At that time, a political (not commercial) decision was made to reverse the flow of the pipeline and use it to export Russian crude to the Black Sea. Thus, both of the pipeline’s rationales – avoiding Russia and relieving tanker congestion in the Black Sea – were abandoned. The pipeline may yet be re-reversed and used in its intended direction at some point. Supporters of Odessa-Brody today envision Azeri or Kazakh crude being pumped across the South Caucuses to Georgia’s port at Supsa, from which it will travel by tanker to Odessa, and onward to European markets via either a link with the Druzhba system or a possible extension to the Polish port at Gdańsk. In any case, the pipeline is now seen as a purely political project, which makes it a risky endeavor for commercial entities.

No Commercial Champion. The Ukrainian government assumed that as Caspian oil production increased, demand for additional pipelines would be needed. If Odessa-Brody were already in place, it would benefit as a logical route for Caspian oil – and this would serve as the commercial rationale. Yet rights or access to Caspian oil for the pipeline were never secured and no corporate leader championed the project. Companies that were prospective investors in, or suppliers to, Odessa-Brody did not want to position themselves in such a way as to oppose or anger the Kremlin.9 More specifically, these potential suppliers did not want to risk jeopardizing their position in the Russian market in order to ship relatively modest volumes of oil through Ukraine. As a result, the builders of Odessa-Brody have been unable to convince investors to use the pipeline as intended.

Lack of Alignment. As the Odessa-Brody pipeline was being conceived, the Ukrainian government was aligned with some Caspian producers including Kazakhstan and Turkmenistan. However, Moscow was (and still is) keen to protect its dominant commercial position over the Black Sea’s oil supplies. While Moscow was hardly thrilled with BTC (Moscow was vocal in opposing the pipeline), the main difference with Odessa-Brody is that the Kremlin had fewer cards to play and had far less interest in BTC. As the single most important country for Russian energy shipments to Europe, Ukraine’s Odessa-Brody pipeline

9 Interview with former NSC official, September 26, 2008.

highlighted the regional misalignment of interests. An unsupportive, unaligned Russia decreased the potential for Odessa-Brody’s supply commitments. Whereas BP was a major equity participant in the oil fields earmarked to supply the BTC pipeline, neither the Ukrainian government nor Ukrainian companies owned any oil fields that could supply Odessa. The Ukrainian pipeline would have benefitted from an expansion of the Caspian Pipeline Consortium (CPC) line from Kazakhstan to Novorossiysk, but this oil conduit transits Russian territory in the North Caucuses, requiring that any expansion gain Moscow’s approval.

As previously described, Odessa-Brody backers want Caspian oil to reach the pipeline without traveling through Russia – in order to resolve problems associated with this lack of alignment with Russia. However, this makes the project dependent on the costs associated with transit through Georgia. The oil would also face myriad transportation costs such as the cost of loading the oil onto tankers, shipping costs from Georgia to Brody, unloading costs and multiple transit fees. Moreover, once the oil arrived in Brody, Ukraine, it would have to enter other pipelines. In doing so, the oil could be blended with Urals blend Russian oil (the oil which flows through the most convenient pipelines for this purpose) which is of a lower quality than the light sweet crude produced in Azerbaijan. Consequently, the oil could face significant devaluing issues.10

International Support. Odessa-Brody did have international support from the United States and Europe. For example, the U.S. Trade and Development Agency (USTDA) provided a $750,000 grant to fund a feasibility study of the pipeline and the pipeline was the topic of high level political discussions between the United States and Ukraine. But it faced so many other problems (as already mentioned, a lack of commercial feasibility and a lack of a political alignment with Russia) that this international support was not enough to make it a success.

Facilitation and Dispute Resolution, Phased Approach. Since the Ukrainian government made the decision to build Odessa-Brody and was ready to pay for it in full, there was no need for other governments to facilitate commercial or legal agreements prior to construction. Similarly, there was also no need to phase-in the project.

Political Environment. The overall external political environment was similar during the development of Odessa-Brody and BTC.

1.3 Lessons of BTC and Odessa-Brody

The main lessons that can be drawn from the results of the BTC and Odessa-Brody projects are:

1. A commercial champion in possession of energy resources that is seeking to move those resources to market is critical; 2. Alignment of interests of the transit countries is also critical to the success of a project;

10 The Odessa-Brody oil could protect against the loss of quality through a connection to a convenient refinery, such as the Plock refinery. However, Odessa-Brody is limited to carrying about 450,000 barrels of oil per day, which is not enough to supply an entire refinery. Therefore, either the refinery would have to find additional sources of similar crude or face commercial losses.

3. International political support is not, by itself, going to create an economically viable project; 4. Putting in place a facilitation and dispute resolution mechanism and leader can move a project forward at crucial, yet difficult times; 5. Phasing a project has benefits and can help establish the business confidence necessary to facilitate a major investment; 6. The political environment can impact projects significantly, but even in a favorable political environment, projects can fail.

2. Applying lessons of BTC and Odessa-Brody to Nabucco

The Nabucco project aims to create a new gas connection approximately 3,300 km in length, starting at the Georgian-Turkish and/or Iranian-Turkish borders. The companies involved in the project are: Botas (Turkey), Bulgargaz Holding EAD (Bulgaria), MOL (Hungary), OMV (Austria), RWE (Germany) and Transgas S.A (Romania). The project is expected to cost in excess of $12 billion dollars.11 The purpose of the Nabucco project is to diversify energy supply routes to Europe. The project would be developed in stages with stage one requiring 8 bcm/a of gas for the first phase and an additional 10 bcm/a of gas for the second phase.12 This is breaking the project down into stages, not building a small scale operation to see if a larger scale operation would be viable. While it is a kind of phasing, it is not exactly the type of phasing used on BTC. In the case of BTC, consortium managers operated the early oil route from Baku to Supsa for several years prior to completing the full line to Ceyhan.

At present, it is not clear whether the Nabucco project will be a success. Indeed, it has only one clearly identifiable element of success: political support. Even then, it has received only statements of political support and has not received any binding commitments by the various political actors needed to make the project a success. It also faces numerous challenges such as a lack of a commercial champion and a lack of alignment between countries involved in the project. Moreover, Nabucco faces competition from the Russian-backed South Stream pipeline that is designed to carry Russian gas to Western Europe. Finally, in a time of heightened tensions between the West and Russia, Nabucco faces the problem of a turbulent political and security environment that could itself lead to the pipeline’s failure.

Commercial Champion. An important element of success for a cross-national multi-billion dollar project is a commercial champion able to bring resources – financial or otherwise – to bear. The Nabucco pipeline consortium is not able to fill this role; Nabucco’s shareholders are downstream customers hoping to buy gas when it arrives at the marketplace. What’s more, there is no clear “leader” in the consortium in the same way that BP took the lead on BTC. Ownership in the consortium is distributed equally among the six Nabucco partners. Consortium decisions are reached by consensus.

The lack of a clear commercial champion means the project has to line up the gas (shippers) in advance. This means concluding tariff and other legal and commercial agreements so that shippers know their transportation costs in advance. It is difficult to negotiate the terms of

11 Project description, Nabucco web site, http://www.nabucco-pipeline.com/project/project-description-pipeline- route/project-description.html 12 Comments by U.S. government analyst, July 18, 2008.

many parts of the deal without the shippers, and yet, without an attractive commercial deal in place, it is difficult to attract shippers.

Alternatively, interested governments could make a political determination to pay the cost of the pipeline. Unless the EU steps up to fund the pipeline’s construction, this seems unlikely. Besides, operating on the basis of “if we build it, they will come” was ultimately unsuccessful with Odessa-Brody.

Lack of Alignment. Just as the Odessa-Brody project faced problems of alignment, so does the Nabucco project. In fact, Nabucco has major alignment problems with two vitally important groups: the producers in the Caspian and Middle East regions; and the transit countries in Europe. In addition, Moscow is not aligned, since Russian-backed pipeline projects are competing for both Nabucco’s customers and suppliers.

Producers. The most likely gas producers may not have an interest in aligning on the Nabucco project. In Azerbaijan, the partners in the Shah Deniz gas field (BP, SOCAR and Statoil) have paid for and built another gas pipeline that already exists – the Baku-Erzurm-Turkey-Greece- Italy pipeline system (commonly referred to as TGI). Now, Nabucco partners are telling the Shah Deniz partners to ship their gas through Nabucco. In this way, TGI and Nabucco could be considered competitors for the same gas. But the Shah Deniz partners can use TGI to get their gas to Europe without need of the Nabucco pipeline. Furthermore, the partners have no interest in committing to move their gas through a pipeline they do not control when they already have their own pipeline in the ground. Additionally, Azerbaijan may want to protect its ability to move its gas to market ahead of gas from other countries, including Turkmenistan and Kazakhstan.

Since Nabucco is defined as starting at the Turkish border with Georgia, it is assumed that Nabucco will seek to utilize the South Caucuses Gas Pipeline, which is owned by the Shah Deniz partners, to transport the gas from the Caspian to Turkey. It is not at all clear why Azerbaijan would allow non-Shah Deniz gas (such as supplies from Turkmenistan) through its pipeline and into European markets ahead of its own gas reserves.

Transit Countries. Regarding transit countries, some alignments have been made, but the strength of those alignments are unclear. For example, some countries – Bulgaria, Hungary and Austria have signed onto both Nabucco and the rival Russian-backed South Stream pipeline in an attempt to hedge their bets. In fact, Bulgaria signed a July 2008 agreement with Russia related to the construction of the South Stream pipeline. There is also the added complication that Turkey aspires to be a new “hub,” or aggregator, for gas en route to Europe; in other words, Turkey seems unwilling to accept the role of a simple Nabucco transit state. So the question of whether the Nabucco project will gain sufficient alignment depends on a number of factors including whether Turkey decides to support it, whether Bulgaria, Hungary and Austria fully commit to it and whether Azerbaijan wants it to succeed.

International Support. While Nabucco has garnered many expressions of international support, none of this support is binding or deep. Even Nabucco partners recognize that the project has tepid international backing, relatively speaking. For example, Jeremy Ellis, the Head of Business Development at RWE, one of the Nabucco partners, recently noted that Nabucco does not have a political force that is removing obstacles to the project the way Washington

did for BTC.13 To be fair, the U.S. State Department has been active at the Deputy Assistant Secretary level, but the United States’ ability to be out in front on what is first and foremost a European Union project is limited. And there are no U.S. companies involved in the Nabucco consortium. With BTC, U.S. companies did have at least a small share in the project, and the main commercial champion, BP, had a major portion of its business in the American market – and so had good, close relations with policymakers in Washington.

Facilitation and Dispute Resolution, Phased Approach. The Nabucco project does not yet have in place a lead country to take on a facilitation and dispute resolution "referee" role. Nabucco partners are contemplating a phased approach to development. But Nabucco is adopting a phased approach with Phase I needing only a modest amount of gas. However, Nabucco's shareholders have noted that they need an upfront commitment for Phase II gas before they can undertake construction of the first phase. Therefore, the benefits of Nabucco’s phasing are diminished.

3. The Current Political Environment for Nabucco

3.1 Current Political Conditions

In addition to the commercial and alignment issues outlined above, Nabucco faces a unique global political environment. That environment is drastically different than it was in the 1990s when the BTC project was first developed and executed. For example, the 1990s saw a low price environment for energy, while today energy prices are high. Additionally, in the 1990s, the United States could afford to dedicate cabinet level attention to Caspian energy issues. Today, the United States has its foreign focus on conflicts in the Middle East, and is devoting significant high level government resources and personnel to those conflicts.

Finally, the Russian incursion into Georgia has highlighted the latent risks involved in depending on that country as part of a stable Caspian-Black Sea energy corridor.

There are two additional major political issues that could negatively impact the Nabucco project. The first is the political situation in Turkey. In July, Turkey’s governing party, AKP, narrowly survived a lawsuit seeking its closure when the Constitutional Court held that the party was a “focal point of anti-secular activities.” The Court did not ban the party, but instead levied a financial penalty on it. The Court's vote was close. Some analysts contend that this ruling means that the party is on “probation,” and it is not yet clear how the court case will affect AKP’s conduct.14 A ban would have brought down the government, forcing elections for the second time in a year and pitching Turkey into political chaos.15 The Court's close vote suggests that while the immediate issue was resolved, the overarching concerns about Turkey's political system remain.

This tension in the Turkish political system has implications for business. It increases the risk for doing business in Turkey and raises questions about making deals with the current government. According to one industry official, “Turkey had been frozen for several months

13 Jeremy Ellis, Head of Business Development, Presentation to Conference in Stockholm, Sweden, September 2008. 14 CRS Report: Turkey: Update on Crisis of Identity and Power, Carol Migdalovitz, September 2, 2008. 15 Sabrina Tavernise and Sebnem Arsu, “Turkish Court Calls Ruling Party Constitutional,” New York Times, July 31, 2008.

pending the outcome of this decision.”16 While the decision could have been worse, it does not leave investors with new confidence either.

The second major political issue is that Russia is drastically different today than it was in the 1990s. Russia is politically and economically stronger, and its energy production has rebounded. Its de facto head of state, Vladimir Putin, enjoys broad public support.

3.2 Russia's Energy Dominance

The Russian government not only enjoys more domestic economic and political power today than it did in the 1990s, but also has the largest natural gas reserves in the world. The Russian government (through Gazprom, the Russian gas company owned by the government) maintains control over its energy sources and infrastructure (production infrastructure and transit mechanisms). The state also attempts to control supply and demand rather than allowing market forces to work.

Despite its large reserves, there is some concern that Russia will not be able to maintain its long-term supply position. Gas production from Russia’s largest gas fields is either flat or declining. More worrisome, the rate of decline is increasing. Still, output from independent Russian producers is on the rise. If independent production has access to Gazprom’s monopoly transportation network, Russia could reverse the overall decline in supply.

Nevertheless, Russia remains the largest single energy supplier for Europe. Its gas exports account for about 25 to 28 percent of Europe’s consumption.17 Russia, therefore, has significant market power over Europe's energy supplies. Critics argue that Russia is using this power for political purposes, and is pursuing a policy to ensure that gas demand in Europe is slightly undersupplied, thus guaranteeing upward pressure on prices and increasing leverage over European countries by forcing them to compete with one another over scarce resources.

Russia’s commercial dominance in the energy sector, combined with Europe's growing energy needs, has had a clear negative impact on Nabucco’s prospects.

4. Challenges Ahead for Nabucco

As the above analysis shows, Nabucco faces several challenges going forward. First and foremost, the Nabucco partners need to acquire gas resources. They also need to negotiate the terms of the use of the pipeline. Such a deal must include the terms for each transit country, the terms for potential off-takers (countries that may want access to the gas), tariffs, and legal, security and financing agreements before construction can begin. An IGA has yet to be signed governing the terms of the Nabucco pipeline. Some had expected an IGA before the end of the summer of 2008, yet disagreements between Turkey and the other members of the consortium scuttled these hopes. However, many expect an IGA to be signed by the time of a

16 Interview with company representative, August 10, 2008. 17 “Country Analysis Briefs: Russia,” Energy Information Administration, U.S. Department of Energy, Updated: May 2008. Available at .

Budapest energy summit in January 2009, if not before the end of 2008. Regardless of when the IGA is drawn up, Nabucco’s core challenges – outlined below – remain unresolved.

4.1 Finding the Gas

Steven Woehrel notes in his Congressional Research Service brief to Congress that the success or failure of projects like Nabucco “will likely depend more on whether private energy firms find them profitable than on U.S. diplomatic skill and energy.” He notes that “Russian- supported pipelines appear to have the upper hand because they have copious supplies available.”18 Matthew Bryza, U.S. Deputy Assistant Secretary of State for European and Eurasian Affairs, echoed the commercial needs of any pipeline, noting that “to realize these pipeline investments there need to be gas sales and purchase contracts in place.”19

Nabucco proponents recognize the importance of having adequate supplies lined up, and, according to Jeremy Ellis, Nabucco is already scaling back its stated gas requirements. Rather than the 18 bcm/a of gas that was originally discussed, Ellis claimed the project now needs only 8 bcm/a by 2014 for Phase I development and an additional 4 bcm/a by 2017 for Phase II.20

Despite scaling down the amount of gas needed for the pipeline to begin operating, Nabucco still lacks any gas contracted for the pipeline. This lack of secure upstream resources puts the pipeline in much the same position as Odessa-Brody, requiring the project to create a package deal that will attract suppliers. This represents a major challenge to Nabucco, as it not only makes the pipeline a non-commercial project in the present, but also means that it is less likely to attract financing to improve its viability in the future.21 Nabucco partners do seem to realize this problem, and have stated that they will not begin construction unless and until they have a solid commitment for 12 to 18 bcm/a of gas.

Possible sources of gas for the Nabucco pipeline include Azerbaijan, Iraq, Egypt, Turkmenistan and Iran.22 However, each of these sources comes with significant political and economic hurdles.

Azerbaijan. With Azerbaijan, it’s a question of committing gas volumes. As stated above, Azerbaijan may have the gas reserves necessary for Nabucco, but may not want to commit those reserves when it has its own route and infrastructure – the Baku-Erzurum/TGI pipeline system.

In fact, Azerbaijan has stated that the existing Baku-Erzurum pipeline system can handle Azerbaijani shipments into the TGI pipeline, as well as a potential 8 additional bcm annually

18 Steven Woehrel , “Russian Energy Policy Toward Neighboring Countries,” CRS Report for Congress, #RL34261, Updated: March 27, 2008, p.18. 19 Matthew Bryza, Deputy Assistant Secretary for European and Eurasian Affairs, Trans-Caspian and Balkan Energy Security. On-the-record Briefing with Greek Media, March 18, 2008. 20 Jeremy Ellis, Stockholm, Sweden, September 9, 2008. 21 Interview with industry representative, August 5, 2008. 22 Jeremy Ellis, RWE Presentation to Stockholm Conference September 15, 2008.

to Italy. Stated succinctly, “having a large enough market for its product, why would Azerbaijan be enthusiastic about the Nabucco project and spoil its relations with Russia?”23

Compounding this problem is the fact that Azerbaijan is going to make far more money on its existing oil projects than it envisioned at the time those deals were signed. As the chart below indicates, assuming an average price of $60 per barrel for oil, Azerbaijan stands to make in excess of $20 billion a year for at least five years. This is more than double its 2004 GDP and more than ten times its 2004 annual budget. Further, oil prices may easily exceed $60 a barrel, meaning even more revenue coming into Azerbaijan.

In short, Azerbaijan may not be incentivized to monetize its gas resources quickly because it simply has too much money coming in from its oil projects already. The huge influx of revenue may cause structural economic problems like inflation. By waiting and developing its gas resources several years down the line, Azerbaijan can stretch out its large energy revenues for a much longer period of time and provide greater domestic economic stability in the longer term.

Source: Townshend presentation to CSIS, May 8, 2006.

Iraq. Eventually Iraq might supply gas to Nabucco, but it currently faces difficulties both in terms of security and production capacity. Iraq has ample supplies of natural gas. In fact, it currently flares significant quantities of gas. However, Iraq remains a country in turmoil both politically and economically. The security situation, while improved, remains extremely risky for major construction projects. To date, Iraq has been unable to reach a consensus on an investment framework or hydrocarbon law, both of which are needed to allow foreign investment to help develop Iraq’s energy sector. In fact, the Iraqis recently canceled a series of contracts with Western companies. Iraq has provincial elections scheduled for January 2009 and national elections slated for December 2009. It is unlikely that Baghdad will reach a

23 Ilham Shaban, Director Energy Research Foundation. Azerbaijan: Baku hesitates on Nabucco Pipeline project, April 12, 2008

consensus on its hydrocarbon legislation prior to the national elections. Therefore, Iraq is probably years away from being able to commit gas to Nabucco.

Egypt. This country has ambitious plans for increasing its gas exports, and there is interest in Egyptian gas flowing into Nabucco following the completion of the pan-Arab gas pipeline from Egypt to Turkey by 2010. However, whether Egypt can commit to Nabucco long-term is open to debate. As gas exports to Israel began this year, pricing issues led to a multitude of problems with those exports. Moreover, Egypt may have already committed its gas to other pipelines24 and many of Egypt’s gas exports are being dedicated to LNG.

Turkmenistan. The Turkmen government announced last spring that it was prepared in principle to earmark 10 bcm/a for export to Europe. Moreover, a recent audit of Turkmenistan’s gas reserves suggests that the country would be able to come up with the necessary volumes if its resources are adequately developed.25 However, the problem is how to get that gas to the other side of the Caspian shore. The possibility of completing an undersea Trans-Caspian pipeline to Baku are complicated by the yet unresolved status of the Caspian, and by Russia’s lack of alignment on such a project; Moscow and Tehran have both argued against pipelines crossing the Caspian Sea without the support of all of the Sea’s littoral states.26

Furthermore, it may be difficult for Turkmenistan to route gas through Azerbaijan into Nabucco, because of the competing commercial elements that would be involved in that routing. Azerbaijan has plans to further develop the Shah Deniz project. Azerbaijan wants to sell its gas to Europe prior to allowing other countries to obtain critical market share. Therefore, Azerbaijan has little interest in allowing Turkmen or other Central Asian gas to be sold in Europe ahead of its own exports. Unless and until this alignment can be reconciled, it is unlikely that gas from the eastern side of the Caspian will make it to Europe by way of Azerbaijan.

Iran. The four potential suppliers mentioned so far have been formally invited to supply gas to Nabucco. Even though Iran was an originally-envisioned supplier for Nabucco years back, the country is the odd man out today. True, Iran holds the world’s second-largest natural gas reserves, behind Russia, and the Iranians have recently reiterated their interest in supplying gas to Europe. A number of Nabucco officials have likewise stated that Iran cannot be excluded in the long-term. However, the country is currently off the table as a viable supply source because of U.S. and international sanctions against Tehran – namely the Iran Sanctions Act (ISA). This law prohibits American firms from investing in Iran and calls for sanctions against non-American firms that invest in Iran’s energy sector.

As a result, Washington’s policy towards Iran contradicts, albeit unintentionally, its own efforts to support European supply diversification and long-term energy security.27 Nevertheless, the ISA does allow the White House to grant waivers to the sanctions regime. If

24 Egypt, Jordan and Syria have tentatively agreed to expand an export pipeline that runs from the Nile Delta to Syria and into Turkey. 25 Alexander Vershanin, “Audit firm confirms huge Turkmen gas reserves,” The Associated Press, October 14, 2008. 26 Sergei Blagov and Joanna Lillis, “Despite Lack of Progress, Caspian Summit Leaves Participants Optimistic,” Eurasianet.org, October 17, 2008; “All Caspian littoral states should consider proposed pipeline -Iranian minister,” Interfax- Kazakhstan news agency, BBC Monitoring Reports, December 15, 2006. 27 U.S. - EU Summit Declaration. June 10, 2008.

enacted, these waivers could resolve several major obstacles to Nabucco. First, presidential waivers could open a massive reserve of non-Russian gas in Iran, and very likely create a parade of would-be commercial champions for the pipeline. A secondary export route through Iran would also offer Central Asian gas producers an alternative to Moscow’s transport monopoly and could further diversify Europe’s upstream supply of natural gas away from Russian control. Nevertheless, any action on this front will require clear presidential leadership, and remains unlikely unless it is part of a broader U.S. initiative on Iran.

4.2 Tariff Structure and Economic Viability

Perhaps the most critical factor in determining whether or not Nabucco will become a viable project is whether reasonable tariff rates can be agreed to for the project. The tariff rates are important because, in large part, the pipeline length or distance the gas travels determines tariffs.

According to one U.S. government analyst, in parts of Europe, the transit rate for oil and gas is $3.00 per 100. The Nabucco route will total 1500 km just in Turkey. If the tariff is close to the $3 level, the pipeline will simply not be economically competitive.28 The tariff structure also depends on how Caspian or Middle East gas will get to Turkey. If Nabucco has to build its entire route from the source of gas to the market, it will be prohibitively expensive. If it can obtain access to the South Caucuses Gas Pipeline, it might have a chance to get to the Bulgarian border without major infrastructure costs. Yet the tariff rates could be enormous. Additionally, Nabucco gas would travel through several European countries increasing the potential for large tariffs.

4.3 Competition from Other Pipelines

As is discussed above, the Nabucco partners and their supporters face numerous problems which they have some control over. But Nabucco also faces some external pressures which are out of its partners’ hands, including competition from other pipelines.

As Nabucco struggles to move from a concept to a project, the Russian government is pushing ahead with its South Stream pipeline. South Stream would begin on Russia’s Black Sea coast at Beregovaya and would cross the Black Sea to Bulgaria. From there, South Stream’s northern branch would run through Serbia, Hungary and (possibly) Slovenia en route to Austria and Italy. The pipeline would carry approximately 30 bcm/a. Gazprom and Italy’s Eni are the commercial leaders of the project.29 This pipeline is a major competitor of Nabucco, as it plans to carry gas from the Caspian to Europe and is scheduled to end at the exact same terminus as Nabucco: the Baumgarten facility in Austria – in which Gazprom intends to purchase a 50 percent stake.30 Importantly, South Stream also has commercial champions in Gazprom and Eni, strong government backing and will (presumably) enjoy access to Russian and Central Asian gas. Unless it can secure access to guaranteed supplies, Moscow-backed pipelines may already be in the process of outflanking Nabucco.

28 Conversation with U.S. government analyst. July 18, 2008. 29 Interfax, June 27, 2007 30 “Focus on Austria,” European Gas Markets, September 12, 2008.

Another project which could compete with Nabucco – and in fact may be the main competition already – is the TGI gas pipeline.31 While the United States government backs both TGI and Nabucco on the assumption these are complementary pipelines, TGI is in effect a competitor because it competes for the same gas. TGI is already underway. In fact, TGI enjoys the alignment of its multiple partners, is led by a commercial champion, has robust international support and enjoys dedicated gas supplies. It could, if it was expanded, provide a southern corridor of gas into Europe but on a different route than Nabucco.

4.4 Financing

Nabucco consortium partners have agreed that around one-third of the $12 billion Nabucco pipeline will be paid by the six partners themselves, while the remaining two-thirds will be financed by investors. The consortium hopes to gain access to public financing from the EBRD, the IFC and the European Investment Bank (EIB).32 All have expressed interest, but nothing has been finalized. EU funding is still an open question.

Under current plans, private investors are likely to be wary about putting their money in the project. Some analysts contend that investor confidence in the pipeline, already low due to the lack of firm commitments of gas, have been further rattled by the war over Georgia's South Ossetia region. On September 22, 2008, Kristen Silverberg, the U.S. Ambassador to the EU, called for the EU to help reassure potential investors in Nabucco. She stated, “the fact that we have seen a … military activity close to a Georgian pipeline obviously can make investors nervous.”33 Private companies are also concerned about the political situation in Turkey noted above.

5. Nabucco’s Potential Impact

Despite its commercial challenges, the Nabucco pipeline could overcome these problems or be built for political reasons based on the perceived demands of European energy security. But, assuming for the moment that it could be built and filled as intended, what would be Nabucco’s ultimate impact on the European gas market? In analyzing Nabucco's impact, two distinct points emerge. First, Nabucco will not have a significant impact on Europe’s overall energy supply structure. Second, it will have an impact on the incremental supply of gas coming into Europe, and that incremental impact could significantly alter the energy security environment.

5.1 Nabucco's Impact on Total European Gas Supply

Figure 1 below demonstrates Europe's supply and demand for gas in 2004. At that time, with virtually no Caspian gas coming into Europe, Russia had a 28 percent share of the European market, or 144 bcm of a 515 bcm/a market. By 2020, Central Asian and Middle Eastern gas could enter Europe. However, as figure 2 demonstrates, even with these additional supplies, Russia’s overall position will not change significantly. Russia will supply an estimated 215

31 Conversation with U.S. government analyst, July 18, 2008. 32 “Nabucco Gas Pipeline Project could be delayed by six months or more, says Nabucco Ambassador,” Hungarian News Agency (MTI), September 23, 2008. 33 “US Urges Europe to reassure investors over Nabucco,” Reuters, September 22, 2008.

bcm of an 800 bcm/a market, or 27 percent. In short, a successful Nabucco pipeline means the difference of Russian gas supplying 27 rather than 30 percent of the European market. In other words, a successful Nabucco will supply only about 3 percent of European gas demands.

Gas Supply to Europe in 2004 – 515 bcm/a Market

Source: Michael Townshend presentation to CSIS, May 5, 2006.

Potential Gas Supply to Europe in 2020 – 800 bcm/a Market

Source: Michael Townshend presentation to CSIS, May 5, 2006.

5.2 Nabucco's Impact on Incremental Supply European Gas Supply

Nabucco will have little impact in the overall supply of gas to Europe. However, it can provide needed supply at the margin. New supply at the margin is important because it is the marginal supply that often determines the price or the direction (upwards or downwards) of prices in energy markets. Downward pressure on prices at the margin ultimately serves to limit the political influence that a major, but not majority, energy supplier (in this case, Russia) is able to exert over its customers. Small additions to the gas market may mean the difference between a slightly oversupplied market – which favors European consumers – and an undersupplied market – which favors the Russians. This impact on incremental supply is the key because it will allow an element of competition into the marketplace so that Russia cannot dictate prices to Europe. Yet it also assumes that Russia will continue to be the largest single supplier of gas and that Europe will continue to need Russian gas.

Nonetheless, the Nabucco pipeline will not provide overall energy security in Europe. It will not carry enough volume to alter the current mix of gas coming into Europe, and its success relies on a positive outcome to many difficult political issues such as tensions between Russia and Georgia, Turkish domestic political issues and Russia's energy dominance as described above.

6. Scenarios for the Future

Looking forward, several alternative scenarios are possible that could lead to a more secure energy future for Europe with or without the Nabucco pipeline. These possibilities include:

• Producers of Caspian gas commit to Nabucco, making it commercially viable; • Producers of Middle East gas commit to Nabucco, making it commercially viable; • Nabucco merges with Russian-backed pipeline proposals, making it commercially viable; • The TGI pipeline system expands; • Gazprom reforms, reducing or eliminating the need for Nabucco; • Additional supplies of liquid natural gas become available to Europe.

If, as many hope, the Shah Deniz partners agree to commit gas to Nabucco – not just the 8 bcm/a Nabucco is asking for but additional gas as well, then Nabucco may be able to get off the ground and supply gas to Europe. It is also possible that Turkmenistan, seeking to diversify its own export routes, would commit a modest amount of gas to Nabucco and that this relatively small amount would not be viewed as competition by Azerbaijan.

A second possibility for diversifying Europe's gas imports is for Iraqi, Iranian or Egyptian gas to commit to Nabucco. When the Nabucco project was envisioned, Iranian gas was thought to be a primary source. As noted above, the horizon for Iraqi or Iranian gas is remote in the current political and commercial environment. A political breakthrough in relations with Iran could open new possibilities, but Egyptian gas as a supply source is several years away.

A third possibility, and one that would be unpopular in Washington or Brussels, is for Nabucco to end up taking Russian gas. It is worth remembering that Russia’s current counter- proposal to Nabucco – the South Stream pipeline – was preceded by the proposed Blue Stream II concept. This proposal was to extend Russia’s Blue Stream pipeline to Turkey into Central and Southeast Europe. In theory, at least, this plan could come back in the form of an adapted Nabucco pipeline, possibly under a different name, under partial Russian ownership and dependent at least in part upon Russian supplies of gas. Mitschek floated the idea of letting gas from Blue Stream feed into a future Nabucco pipeline last June. “Imagine that once the Nabucco pipeline is in place then, of course, gas from Blue Stream could also be fed into Nabucco to reach southeast European markets, Austria, and also other regions in Europe,” he stated.34 In this way, Turkey could conceivably serve as an aggregator for Russian, Caspian and Middle Eastern gas en route to European markets. Naturally, relying on Russia as a primary supplier risks undercutting Nabucco’s raison d’être – providing a European alternative to Russian gas.

A fourth scenario may help with Europe's energy security, but would reduce or eliminate the need for the Nabucco pipeline. Under this scenario, the TGI pipeline would be expanded. Prospects for such an expansion are good. TGI’s development is far ahead of both Nabucco and South Stream. For example, the TGI infrastructure is already largely completed and in the ground. The producers of the gas that would flow through TGI into Turkey, Greece, and Italy have built their own pipeline to connect with the system. Expanding on this arrangement may prove easier than constructing an entirely new route that has yet to attract sufficient supplies.

34 Bruce Pannier, “Nabucco Chief Eyes Iranian, Russian Gas Despite U.S. Objections,” RFE/RL, June 23, 2008.

The United States appears to support such an expansion of TGI. A recent statement by Matthew Bryza, Deputy Assistant Secretary of State, when asked whether or not Azerbaijan has enough gas fill both TGI and Nabucco, Bryza responded:

“…based on Azerbaijan’s own professed objectives, based on our careful analysis, is that Azerbaijan has plenty of gas to realize the Turkey-Greece-Italy pipeline. But not just that, it has plenty of gas to launch the Nabucco pipeline after TGI, and probably has plenty of gas to fill Nabucco, but I said probably.”35

Some interpret this comment to mean the United States has prioritized TGI ahead of Nabucco. Working on expanding TGI makes sense especially if Nabucco is not viable.

A fifth solution to Europe's energy security is the reform of Gazprom, or at least the development of a more competitive Russian market that puts market forces in position to make decisions about supply and price. A reformed Gazprom could negate the Russian government’s ability to micro-manage the energy situation and would place gas supply and demand on a sounder commercial footing. In turn, this could significantly reduce tensions related to Russian energy imports by the Europeans, and divorce energy issues from non- energy issues.

There are some signs today that Russia might be moving in the direction of a more market- oriented approach to gas, and that true reform is possible. As the chart below demonstrates, Russia’s projected gas production growth is expected to come from non-Gazprom suppliers (meaning independent private Russian companies).

35 Matthew J. Bryza, Deputy Assistant Secretary for European and Eurasian Affairs, Trans-Caspian and Balkan Energy Security. On-the-Record Briefing With Greek Media, March 18, 2008.

If this non-Gazprom gas is able to acquire access to the Russian transportation and export system, it could push reforms on Gazprom and weaken Gazprom’s monopoly on gas transportation.36 Also, Russia is establishing a gas exchange, which, if implemented, will be a major step towards establishing a more market-based domestic pricing system. Russia is also instituting domestic price increases, which has narrowed the gap between the domestic and export prices for gas.

Russia clearly has more to accomplish before it can claim its system has been reformed, and whether these reforms will be strengthened and truly take hold is debatable. Indeed, some critics argue that Russia is merely allowing the independent producers to produce enough gas to supply the Russian domestic market where prices are lower, freeing Gazprom’s resources for the higher profit export markets to Europe. In addition, some price increases have already been postponed. Nevertheless, Russian reform remains an option for increasing Europe's energy security.

Liquid natural gas could also help to secure Europe's energy supplies, especially for Romania and the Baltic countries. USTDA recently announced a plan to fund two studies costing over $1 million each for furthering the development of LNG in both Lithuania and Romania.37 There are also plans for a LNG terminal on the Croatian coast that could feed Central European markets further inland such as Hungary.38 LNG is a much more fungible commodity compared to pipe gas and can go anywhere there is an LNG facility. Building such facilities in Europe will allow for the import of gas from a greater number of sources and does not require pipelines to transit the gas. While LNG is generally more expensive than pipeline gas, it is a viable solution for enhancing diversity of sources of supply thereby providing greater security.

7. Conclusions

If Russian policy is not predicated on reforming its system, but instead on seeking a high price environment, then there is substantial merit to plans for developing a southern energy corridor in the Black Sea region. A southern corridor supplying incremental gas to Europe would enhance Europe's energy security. Yet Nabucco, a pipeline for that corridor, may not be the answer. While Nabucco is not destined to fail, policymakers would be wise to understand the realities of the project and to review whether a commitment to this specific pipeline is a sound policy.

The United States should not endorse any one scenario for improving Europe's energy security. Rather, it should endorse a broader policy, and should avoid trying to decide (and micromanage the decision over) which pipeline can facilitate a southern energy corridor. In fact, Washington should support all of the above elements: obtaining gas for Nabucco,

36 At the time of this writing, it appeared that Russia’s Federal Anti-Monopoly Service could penalize Gazprom for restricting access to its (domestic) pipeline network. Yet Gazprom, under Russian law, holds a monopoly for now over Russia’s gas export pipelines. See: “Russia: Gazprom’s export monopoly becomes law,” Petroleum Economist, August 2006; “Regulator could fine Gazprom for restricting pipeline access,” Russia & CIS Oil and Gas Weekly, September 10, 2008. 37 USTDA Press Release, USTDA Director Walther to Award Grants to Promote Energy Security in Lithuania and Romania. September 11, 2008. 38 Stuart Elliott, “Croatia's Adria LNG start-up faces two-year delay,” Platts Oilgram News, August 12, 2008.

expanding TGI, reforming Gazprom and building more LNG facilities. The United States needs to recognize its own limitations and expand to the mantra of “happiness is multiple pipelines” to mean “happiness is multiple import options.” Supporting multiple options will allow the United States to have a substantially different policy, both in tone and in substance, than it has today. This, in turn, could have the effect of easing tensions between the West and Russia.

Indeed, in developing this pro-diversification policy, the United States should account for both commercial and regional political interests and should place Europe's energy security in the context of the overall U.S.-Russia relationship. The United States and Europe should continue to encourage more reforms in the Russian energy sector. Making the rewards of a reformed energy market clear to Moscow should be a part of that policy. In other words, U.S. pipeline diplomacy should not become equated with an anti-Russian policy.

In short, a broad policy, with shared goals with our European allies that works with Russia where possible, has a far better chance of success than the current path.