CHAIRMAN LUGAR AND ENERGY EXECUTIVES DISCUSS

C O N F I D E N T I A L SECTION 01 OF 04 BAKU 001247

SIPDIS

SIPDIS

DEPT FOR EUR DAS MATTHEW BRYZA AND H MARIA TREJO

E.O. 12958: DECL: 08/23/2016
TAGS: ECON EFIN EPET ENRG AJ IR RU KZ
SUBJECT: CHAIRMAN LUGAR AND ENERGY EXECUTIVES DISCUSS
AZERBAIJAN'S GROWING ROLE AS REGIONAL ENERGY PROVIDER

Classified By: AMBASSADOR ANNE E. DERSE, PER REASONS 1.5 (B, D).


1. (C) SUMMARY: Chairman Lugar held a breakfast roundtable
with international energy executives August 21 to discuss
Azerbaijan's growing role as an international energy
provider, the challenges facing the country as oil revenues
increase and the GOAJ grapples with sustainable development.
The executives told Senator Lugar that Azerbaijan needed to
begin reforming the economy and the country now before the
effects of its oil wealth overwhelm the government. The
executives noted that the Government of Azerbaijan needed to
implement reforms to combat corruption, reform the tax
system, improve education, reform the judicial sector and
increase economic cooperation with its Caspian neighbors.
Lugar briefed the executives on his recent trip to
Kazakhstan, remarking that Kazakhstan's successes could serve
as a model for Azerbaijan. Lugar and the executives agreed
that based on Azerbaijan's geographic location, between
Russia and Iran, political stability and good relations with
the West were key to its further development. Calling
Azerbaijan a "success story," Lugar stated that that the GOAJ
needed to ensure that all Azerbaijani citizens see the
benefit of the country's oil wealth. He said he was prepared
to raise this issue with President Aliyev. END SUMMARY.


2. (C) At a breakfast roundtable August 21 with international
energy executives operating in Azerbaijan and other Caspian
countries, Chairman Lugar, accompanied by Ambassador and
senior staff in the Codel, heard a wide variety of opinions
on the future of Azerbaijan's role in global energy politics
and the numerous challenges facing the country, most
significantly fighting corruption. The companies at the
breakfast included BP, ExxonMobil, Halliburton, Statoil, and
McDermott. The group told Senator Lugar that there were five
areas in which the GOAJ needed to be pushed: fighting
corruption, reforming the tax system, reforming the education
system, reforming the judicial sector and increasing
cooperation with its Caspian neighbors. All of these
elements represent major impediments to equitable and
effective use of Azerbaijan's growing wealth and the
country's stature as a regional and international energy
player.

BTC OPERATIONS AND RELATIONS WITH KAZAKHSTAN
--------------


3. (C) Senator Lugar opened the discussion by briefing on his
recent visit to Kazakhstan, noting that Kazakhstan's biggest
challenge was finding viable export routes for its oil.
Lugar also noted that the Government of Kazakhstan was
interested in trans-Caspian oil and gas pipelines but
understood that both Russia and Iran would object. Lugar
indicated that based on his discussions, a trans-Caspian
pipeline seems technically feasible but would require immense
political will. AIOC President and BP executive David
Woodward added that in the short-term several oil companies
(including ChevronTexaco) were already exporting crude from
Kazakhstan across the Caspian via tanker ship to the BTC
pipeline in Azerbaijan. These crude shipments, however,
would grow much larger by 2009-2010, making a trans-Caspian
pipeline more valuable.


4. (C) Woodward told Senator Lugar that the recently
completed Baku-Tbilisi-Ceyhan pipeline was currently
delivering 530,000 barrels of oil and this total would slowly
increase over time. Woodward said that most of the
Azerbaijani crude loaded at Ceyhan was headed to
Mediterranean destinations, although in the medium-term more
crude could head to the United States. Asian countries,
including India and China, may also be viable destinations
for Azerbaijani crude. Woodward noted that the ACG
Production Sharing Agreement currently ends in 2024 although
it can be extended for five years. BP and AIOC will begin
negotiating an extension of the ACG PSA with the GOAJ and
SOCAR, although the outcome of these discussions remained
unclear.


5. (C) Woodward noted that Shah Deniz Phase I would begin
pumping natural gas this fall and that AIOC was exploring
additional wells for Phase II. He briefed on the pipeline
construction problems in Turkey and with BOTAS, noting that
Turkey may not be ready to take some of Phase I gas, leaving
it for Azerbaijan. (We understand that President Aliyev, PM

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Erdogan and President Saakashvili agreed in Istanbul in July
that 20 percent of Turkey's share will be sold to Georgia.)
Negotiations between the two countries are reportedly
underway.) He noted that Kazakh gas could be sent via
pipeline to Azerbaijan around 2012 but that most of the gas
was associated with that country's oil production and is not
as "clean" as Azerbaijani gas.

OIL REVENUE MANAGEMENT
--------------


6. (C) Senator Lugar remarked on the booming construction
sector in Baku and the tremendous oil revenues facing the
Government of Azerbaijan. Following up on his visit to
Kazakhstan, Lugar asked the group whether Kazakhstan could be
a model for Azerbaijan, noting its strong banking sector and
successful management of gas and oil revenues. Lugar noted
that Kazakhstan, like Azerbaijan, had been criticized for
placing too much money in the construction sector, that its
development of Astana was well planned and that the President
of Kazakhstan was raising the standard of living for the
general population. Azerbaijan needed to do the same for its
population.


7. (C) Woodward noted that Azerbaijan had successfully
implemented its State Oil Fund to control and sterilize the
oil revenues coming into the economy from the energy sector.
In addition, he stated that the GOAJ's recent appointments of
more Western, forward-leaning economic decision-makers, such
as Finance Minister Sharifov, were a positive move. Woodward
quickly noted, however, that corruption was a serious problem
in Azerbaijan; it is getting worse and is hurting the economy.

FIGHTING CORRUPTION KEY TO IMPROVING
--------------


8. (C) Woodward stated that many in the GOAJ have their own
personal interests embedded in the economy, linking the
problem of money laundering to the booming construction
sector. Woodward lamented that the GOAJ has not taken any
real steps to fight corruption, liberalize the economy and
strengthen the banking sector, casting doubt on whether the
benefits from the oil wealth will reach all Azerbaijani
citizens.


9. (C) One energy executive noted that many members of the
"old guard" with interests vested in the current system see
change as a threat to their survival, further stunting
economic and social development. The appointment of Sharifov
as Minister of Finance, noted one participant to Senator
Lugar, was an exception. Ambassador Derse commented that the
lack of institutional capacity in the GOAJ and Azerbaijan was
also holding back the country and economy. Woodward added
that the lack of managerial capacity and reform at the State
Oil Company, SOCAR, was hampering its efforts to become an
international-caliber energy company.


10. (C) Lugar raised the idea of sending Azerbaijan's best
and brightest to the U.S. or Europe for educational and
vocational training. All the executives thought the idea was
sound and noted that the GOAJ is contemplating such a plan.
The executives noted that the major drawbacks to this idea,
however, were the lack of meaningful employment opportunities
in Azerbaijan and low government salaries to attract back
these students. All the executives agreed on the need to
reform the education system, citing rampant corruption,
unqualified students and the growing brain drain of trained
Azerbaijanis to other countries.


11. (C) The energy executives said that external pressure by
the international community is needed to bring about real
reform in Azerbaijan. One participant noted that since the
arrival of the first petrodollars, some in the government
have come to believe that there is no need for further reform
and development. One executive noted that President Aliyev
talks a good talk, but does not have the power to take on the
vested political and economic interests in the country. The
group returned to the theme of corruption and its negative
effect on the country and economy. The executives noted that
young people are becoming disillusioned and international
companies are not investing in the country due to the
negative effect of corruption.


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PSA SYSTEM AND NEED FOR REGIONAL COOPERATION
--------------


12. (C) The energy executives briefed Senator Lugar on the
Production Sharing Agreement framework regulating the energy
sector and the benefits that it provided. The executives
also touched on the ax system and the required contributions
to Azeraijan's pension system, the Social Protection Fund
One executive who also works in Kazakhstan notedto the group
that the GOKZ was renegotiating PSA with international
energy companies, removing sme of the tax incentives.
Woodward remarked thatthe GOAJ's interest in renegotiating
PSA's was aso growing. The group was unanimous in
encouraging the GOAJ to increase the incentives for
investment, including working with other Caspian countries,
such as Kazakhstan, to maximize regional development. One
remarked that Azerbaijan and Kazakhstan should sign a
regional joint government agreement to share competitive
advantages. Currently, laws and "local content" regulations
in both Azerbaijan and Kazakhstan prohibit international
companies from using base operations and construction
projects in one country for use in the other.

NON-OIL SECTOR AND ENVIRONMENTAL ISSUES
--------------


13. (C) Lugar turned the discussion towards the agriculture
sector in Azerbaijan, noting that the U.S. would be able to
provide assistance to strengthen the sector. Some of the
participants thought that it may be "too early" for the GOAJ
to turn away from its energy sector, growing oil wealth and
efforts to accelerate modernization through infrastructure
projects. Lugar noted the terrible environmental cost that
oil had reaped on Azerbaijan, leading one participant to
comment that Azerbaijan had priorities other than cleaning up
years of oil spills. Woodward said that the World Bank was
studying a project that would begin cleaning certain areas of
Baku, looking to leverage oil recovery and scrap metal
collection as incentives to additional cleaning efforts.


14. (C) Lugar also raised the problem of potable water in
Azerbaijan, noting that with a small population and large oil
revenues the GOAJ needed to improve the lives of its
citizens. He indicated that he would raise the importance of
sustainable economic development with President Aliyev,
adding that Azerbaijan does not appear to have an urban
development plan and the GOAJ needs to implement a strategic
economic development framework. The energy executives noted
that the GOAJ did not always want international consultants
to offer assistance and tended to look inward. The group
noted that Azerbaijanis have a long oil history and that
there is no comparison of the mentality and culture between
Azerbaijan and Kazakhstan. Azerbaijan, according to the
energy executives, was more likely to indicate that it knew
what needed to be done, basing its misplaced confidence on
its long history of working with oil.

DOMESTIC AND REGIONAL STABILITY
--------------


15. (C) Noting the recent explosion of a gas pipeline in
Turkey, Senator Lugar and the executive agreed on the need
for regional political stability. During his April visit to
the U.S., President Aliyev alluded to Azerbaijan's geographic
location between Russia and Iran as a key reason for his
country's interest in fostering good relations with the U.S.
Lugar recounted his previous trips to Azerbaijan, noting how
much as changed and how fast the country had developed.
Calling it a "success story" with its oil and gas finally
reaching international markets, the meeting participants
noted that now is a critical period for reform and combating
corruption. With the reform window slowing closing,
Azerbaijan's success could quickly turn to a failed
petrostate. Lugar noted to the group that one minister's
efforts to reform the economy could influence other ministers
to do so also.


16. (C) The energy executives noted that the 2010
parliamentary elections were more significant than the 2008
presidential elections since President Aliyev will "ensure"
that he is reelected as president. Turning to
Nagorno-Karabakh, the conflict with Armenia and its effect on
the business climate, AIOC President Woodward noted that N-K

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does not directly factor into energy companies' business
plans but that a military conflict would be a disaster. He
added that BP has taken certain precautions with the BTC
route and that in the case of military conflict BP would
continue to operate in Azerbaijan.


17. (C) COMMENT: In other meetings with Chairman Lugar, both
Economic Development Minister Heydar Babayev and President
Aliyev described at length Azerbaijan's poverty reduction and
economic and social development plans and ongoing projects
(septel).


18. (U) Codel Lugar did not have an opportunity to clear this
cable prior to departing post.
DERSE