Pipelines To Progress: FSU Oil Exports Past, Present, Future
Richard H. Matzke, President
Chevron Overseas Petroleum Inc.
I have been asked to talk this afternoon about transporting oil in the Former Soviet Union. We will look at that subject from the past, present, and future viewpoints. I will bring you up to date on our Tengizchevroil joint venture in Kazakhstan and the Caspian Pipeline Consortium project, or "CPC." I will also discuss some other proposed FSU oil-export projects and how they fit into the big picture.
It is a widely-held view that the Tengiz project and the Caspian Pipeline symbolize the petroleum future of the Caspian region. They are the pioneers, and in that sense, they are more than projects – they are history itself. Still, I think we should recognize that some day, history will look back on these two projects as unexceptional. They may be remembered for being first, and for setting a precedent, but they will not be unique.
Powerful market forces are pushing the FSU toward revitalizing its petroleum industry and taking full advantage of its oil and gas resources. So, there will be more projects – a lot more – because there has never been any question about the fundamental underlying value of these assets. Of course, just because these developments are inevitable does not mean they will come together quickly or easily. You cannot transform a centrally-planned economy into a market economy overnight. It might be tempting to think of the old "U.S.S.R." as dead and gone. But a closer look reveals that yesterday still has a strong grip on today, and therefore, on tomorrow. And with that in mind, let us look now at FSU oil production and transportation in the past.
It was not all that long ago that the Soviet Union was the world's largest oil producer. At its peak in 1988, Soviet output was nearly 600 million tons of oil per year – about 12 million barrels per day. Most of this was consumed "internally," but about 100 million tons – or two million barrels per day – was exported. After the breakup of the FSU, production dropped almost by half to about 300 million tons. Exports also dropped temporarily, then climbed back up to their previous level of 100 million tons. So the picture today is total production is way down, but exports levels are essentially unchanged.
Largely unchanged also is "the invisible giant" – the central petroleum pipeline system of the FSU. This is the old "Glavtransneft" system. It is the world's most extensive trunk pipeline network. Over 65,000 kilometers of primary lines, 400 pump stations, and a design capacity of 600 million tons per year. Today, it connects the oil fields and markets of 14 different countries. However, this network was not designed to ship today's oil to today's export locations. Under the centrally-planned economy, the network supplied mostly internal markets, as well as the needs of Communist states in Eastern Europe. It was designed, logically, to connect yesterday's internal refining centers to yesterday's major oil fields. Today, those fields are in decline. And the FSU has big pipelines where they are no longer needed, and small lines where they need big ones.
The breakup of the FSU gave the newly independent republics ownership of pipelines within their borders. They split the old Glavtransneft into regional associations. But more than 80 percent of the FSU pipeline system is still in Russia, and this is the system owned and managed by the holding company known today as "Transneft." Today, Russia retains central control of most of the pipelines in the FSU under a series of agreements with its newly independent neighbors. So, history has re-drawn the political boundaries, but Russia still calls the shots on regional oil transport. By this I mean that Russia allocates oil export capacity and it coordinates oil delivery schedules.
Now, when we talk about the need to expand export capacity in the FSU, keep in mind we are talking about marine exports. The FSU pipeline system connects oil from Russia and Kazakhstan to countries like Hungary, Poland and Romania. You might think that this would set up the opportunity for new hard-currency "exports" right next door. Unfortunately, it is not working out that way. Oil demand in these countries is down. One reason is simply that oil today costs more. But, another big reason is that these countries want to diversify their oil sources. They have even been willing to pay more for alternative sources than to remain purely a captive market for Russian oil. So, the pipelines are moving less oil to these countries. But, long-term, it makes more sense to nurture the markets in these countries than to neglect them. Of course, these situations, and the associated relationships, have their own history and their own complexities, and, in time, they will have their own solutions. For now, the fact remains that today's marine export capacity in the FSU is not large enough to meet the demand.
This brings me to a point which I believe is little known, but easily understood. Export access, and export profits in Russia are still linked to what are called "states needs." This year, as much as two-thirds of export capacity has been allocated to exports serving "states needs," and these include such things as food programs, industrial projects and the space program. Government programs still take priority when it comes to spending oil profits. This is true even though it is obvious to everyone that the oil industry needs those very same profits to revive itself, and as long as export capacity remains unchanged, we can expect this conflict to remain a problem for new oil projects.
The export capacity situation is entangled in other big transitional challenges as well. Three years ago, Russia pledged to shift to world-market pricing of all its oil, including internal sales, not just exports. They have not been able to keep that promise. But, internal oil prices are higher than in the past. Combine that with their economic problems and you get reduced internal demand for refined products and crude oil. Unfortunately, this is happening just as Transneft is in need of new revenue. Transneft operates the existing network as a common carrier, so they charge tariffs to move crude. That is a good plan, but right now, this is a pipeline company with more overhead than business to support it. So, the less crude they move, the higher the tariffs need to be. Here is a look at what happened to tariffs over a recent four-year period.
As you can see, they increased sharply. During this same period, the Transneft system's throughput dropped an estimated 25 percent. If Transneft cannot make enough money – and if they are not willing to borrow or to take on new partners – they cannot afford to build new export capacity. Without export capacity, they cannot serve new customers. To get tariffs down, they need more volume. They have got plenty of room on their network, but most of their lines end up inside, where there is no new oil demand, instead of outside the FSU, where demand is growing. The consulting firm Energy Resources Group has estimated that in 1996, constrained exports and artificially-low internal oil prices deprived the Russian Federation of more than $12 billion in oil income. Of course, some experts believe that keeping energy costs down has helped to dampen the political unrest associated with making the transition to a market economy. Clearly, that transition presents challenges more difficult than you and I can imagine. Still, there are compelling reasons to face-up to the oil export problem. Richard Hildahl, a consultant for Energy Resources Group, recently drew the following conclusion about exports, and I quote: "The shortage of capacity imposes an enormous hardship on the industry and effectively eliminates the prospect of new investment in the oil sector until the issue can be resolved."
This brings us to the present. It is not possible to separate pipelines from politics in the Former Soviet Union. But if you can look beyond the politics, you will see the pipeline network for what it really is – an essential asset in need of refurbishment, repair, and re- configuration. This is certainly the view of Transneft, which has been working to assess and improve the quality of its systems. But, they have still got a lot more work to do than money to do it with. Add to that the unresolved political issues in Russia and the new countries surrounding it, and what you get is a financial-risk scenario that would make a grown man tremble. Believe me, I know. I can understand why someone might think that the smartest way to get new exports going in the FSU is to bypass, or avoid dealing with the pipeline systems of the past. I also happen to believe that is dead wrong. With that in mind, let us take a look now at the Tengiz Field and the Caspian Pipeline Consortium.
Tengiz today is producing and selling more than 7 million tons of crude oil per year – nearly 50% above last year's average. The project is on track to achieve annual output of more than 30 million tons by the year 2010. Tengiz is generating positive operational earnings, and it is earning the capital needed for its own growth. In the first quarter, Tengiz delivered $50 million in cash distributions to its shareholders. We are making money because we have worked extremely hard – and I mean extremely hard – to find ways to get this oil to various markets. We have bartered, traded and negotiated. We have shipped oil by train, barge, and pipeline. I would even go so far as to say we have considered shipping it out by camel. We have worked with mayors, presidents, chairmen – and some very tough local officials. Let me give you an example.
Recently we completed a shipment from Tengiz to the Black Sea. First, we filled rail cars with oil at Tengiz and moved them to Aqtau on the Caspian. From there, the oil moved by barge across the Caspian to Baku, where a pipeline moved the oil to Ali Bayramli in Azerbaijan for reloading into rail cars, and then on to the port of Batumi on the Georgian Black Sea Coast. From there it moved by tanker out to the Mediterranean.
We have shipped Tengiz crude across Russia to Finland. We have shipped it to the Baltic port of Tallin. We have moved it up the Volga and Don rivers. And we have learned that one of the keys to success is having lots of options for moving your oil. If you do not already see this story as a triumph of determination, let me assure you – it is. Now Tengiz will never be dependent on a single solution for transportation – for export – or for sales.
Let us look now at an oil-transport solution of particular interest to Chevron – and I might add, to me personally – the Caspian Pipeline. This project is the result of cooperation among 11 oil companies plus Russia, the Republic of Kazakhstan and Oman. We have won the necessary decrees from the Kazakhstan and Russian leadership. The plan is to build a 1,200- kilometer pipeline to transport crude primarily from Tengiz and other Kazakhstan fields, but also from Russian fields, to a port near Novorossiysk. It is going to cost about $2 billion. We hope to start shipments in two-to-three years. Ultimate capacity will be about one-and-a-half million barrels per day. From the eastern Black Sea ports, the oil will move on tankers through the Bosporus Strait, then out to the Mediterranean and other world markets. The line will also move Tengiz crude to markets within the Black Sea region. Some of these are already buying from us. Finally, CPC will have a "quality bank" – something Transneft does not have. This is extremely important for Tengiz because we produce a 47-degree API gravity crude. The quality bank will make sure we get full market value for our production.
Completing the Caspian Pipeline will be a great achievement for the future. But, I think it is important to recognize, here in the present, that the immediate significance of this deal is that it builds on the pipeline network of the past. A lot of it is just existing lines in need of refurbishment. So, while half of the line is new, the other half is old. If you are familiar with the history of our Kazakhstan investment, you know that Tengiz is not new, either. The Russians found this super-giant field and started producing it before Chevron came on the scene. Then the breakup changed everything, and we negotiated the Tengiz deal with the Kazakhstanis. So far, Chevron alone has invested about $700 million in Tengiz, and now Mobil and LUKARCO have invested in the project as well. We will invest another $600 million for our share of Caspian Pipeline, and that project – which a lot of people thought could never happen – has attracted more partners than we ever imagined possible.
Why are these situations working when so many others are still on hold? I believe it is because Tengiz and the Caspian Pipeline are doing more than producing and moving oil – they are solving problems, and they are doing that in an emerging market economy at a time when problems are in surplus, and solutions are in short supply. Russia in particular has a great deal to gain – both directly and indirectly – from the progress with Tengiz and the Caspian Pipeline. The Tengiz project last year spent $52 million on Russian goods, services and taxes. This year, we will spend more than $100 million. Every one dollar of oil-export fees that we pay to Russia generates more than two dollars for Russia's gross domestic product. Over its 37-year lifetime – if all goes well – our pipeline will generate an estimated $20 billion in taxes and dividends for the Russian government.
Of course, Tengiz and the Caspian Pipeline are not the whole story. So, let us turn now to the future. The more export capacity we have in the Caspian region, the better for everyone – for Kazakhstan – for the other new countries – and Russia as well. Besides the CPC, one project that everybody is watching right now is the AIOC "northern" pipeline.
This is a project of the Azerbaijan International Operating Company, which has 12 partners who plan to develop an estimated 4 billion barrels of offshore reserves in the Caspian. The AIOC northern pipeline is based entirely on fixing up about 1,500 kilometers of existing lines and reversing their flow. They are looking to move about 5 million tons of oil per year from Azerbaijan to a point near Novorossiysk. AIOC wants to start pumping before the end of this year. But, political conflicts, including damage to the lines because of the Chechen situation, have already caused delays. This is a very important project, but it is not the only plan for exporting so-called "early oil" from the AIOC developments. One project that is attracting a lot of interest, particularly from the Russians, is the AIOC "western" pipeline. It will run 920 kilometers from Baku to the Black Sea port of Supsa. At no point will it touch Russian soil. It is a $300 million project, and AIOC hopes to get it running by next year with an initial capacity of 5 million tons. As with Caspian Pipeline, half the network will be existing lines. But, even if both of these projects are successful, the AIOC will still need more export capacity.
One proposed solution is the "Baku-to-Ceyhan" pipeline.
In this scenario, AIOC would move oil through or around Armenia, then across Turkey and on to the Mediterranean port of Ceyhan. The Turks like this plan and you can see why. It would bring them tariff revenues and international recognition, plus new supplies of crude to their refineries. The plan would also avoid putting more tankers through the Bosporous Strait. The Baku-Ceyhan line would stretch for 1300- kilometers and it would cost more than $2 billion. So it is not a project for the faint of heart. But, I think it is important to remember that the undeveloped oil resources of the Caspian Basin easily justify this kind of thinking. AIOC's master plan alone calls for eventually producing 35 million tons of oil per year.
Another mega-project on the drawing board is called the Central Asian Oil Pipeline.
This is a proposal by Unocal and the Saudi company Delta. They want to build a $2.7 billion pipeline from the heart of Turkmenistan, south through Afghanistan and Pakistan to the Arabian Sea. Oil would then move by tanker to the fast-growing economies of East Asia. It would cover a distance of nearly 1700 kilometers and move about 50 million tons per year. This Unocal- Delta concept would create a sort of pressure-relief valve to the south of the Caspian region. The project could also be linked to the existing Transneft network, and that would create a new export option for Russian oil as well as Caspian oil.
The concept of going south also raises the question of a pipeline through Iran. One proposal involves connecting to the existing Iranian network and also expanding that network and reversing some flows. The plan would be to deliver oil to a terminal outside the Strait of Hormuz. Nobody can forecast the outlook for these "southern solutions," but I think it is fair to say that the idea of running pipelines across Afghanistan or Iran makes even the CPC project look tame by comparison. The Caspian Pipeline will move oil from east to west – a direction that people are used to. The oil will be loaded on tankers near a long-standing oil port and those tankers will be using an established route for export. This is a project that builds on past relationships and takes advantage of existing and established corridors. It also took five years to negotiate and it will not start shipping oil until the year 2000.
There are other serious export proposals to consider. Some would bypass the Bosporous, which will ultimately reach a point where it simply cannot handle any more tanker traffic. Two proposals would use the surplus capacity at the western end of the Druzhba, or "Friendship" pipeline from Russia into central Europe. The first proposal is for a pipeline that would deliver crude to the port of Gdansk on the Baltic Sea. The second is for a pipeline that would connect to the port of Omisalj in the northern Adriatic Sea. Again, these are not viewed as export solutions for the major new oil production from the Caspian, but they are worthy options for Russian oil exports.
Further out in time – and more speculative – is the Baltic Export Pipeline System. It would move crude south from the Komi Arctic region of Russia and then possibly across to a new export facility near St. Petersberg. Another project is called The Northern Gateway. It would take crude north from the Komi Arctic fields, probably to the port of Murmansk. That would mean using tankers designed to deal with ice. These projects do not seem to have much in common with those now taking shape in the Caspian, except for one thing. Like the big Caspian fields, the Komi Arctic fields need pipelines. In short, development awaits a transportation solution.
I think you will agree, there is an awful lot going on in the area of FSU oil exports. But, I think we can learn some things from what has happened so far. First, let us use the assets already in-place to maximum advantage. Tengiz, the CPC and the AIOC projects are good examples of this. The ideas for extending the Friendship lines to new export points are trying to do the same thing. Second, let us make the right deals. FSU pipeline projects should be funded mainly by the equity participants in the oil fields that will fill those pipelines. We have got to have pipeline owners who are invested in the resources. Speculators and outsiders only bring disruption and delays. Lastly, I think it is a good idea to have the international financial community involved in financing these pipeline deals. When projects set and enforce world standards, they send a message to others that it can be both profitable and safe to invest in the FSU.
This afternoon, We have looked at 10 different pipeline scenarios. There are other projects and proposals for exporting oil from the FSU that I have not mentioned. I am sure there are some I probably do not yet know about. But, the ones I have discussed today – including the Caspian Pipeline – together could increase annual FSU export capacity by more than 200 million tons, or 4 million barrels per day. Now, I can understand how some people might look at the FSU oil situation and see nothing but risk and confusion. I have to admit, I sometimes feel that way myself. If you asked me how many deals will fail, I would say "a lot." If you asked how many will stay on schedule, I would say "none." If you asked me – will some of them work? – I would say "absolutely."
Tengiz is a success. The Caspian Pipeline will ensure that this great resource will achieve its full potential. In the years ahead, I know the spotlight will shift to other projects That means my time for serving-up lessons about the FSU oil industry is probably growing short. So, let me close with some advice. Acknowledge the strong pull of the past. Do not let yourself be discouraged by the present or intimidated by the future. Focus not on what cannot be done, but instead on what can be done. Thank you.
Updated: May 1997