TURKISH THINKING ON AZERI GAS VOLUMES AND TRANSIT

C O N F I D E N T I A L SECTION 01 OF 03 ANKARA 002955

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E.O. 12958: DECL: 12/13/2014
TAGS: ENRG EPET TU EINV AZ
SUBJECT: TURKISH THINKING ON AZERI GAS VOLUMES AND TRANSIT
ARRANGEMENTS

REF: A. ANKARA 1945

B. BAKU 1256

C. ANKARA 2720

D. ANKARA 2921

Classified By: ECONOMIC COUNSELOR DALE EPPLER FOR REASONS 1.4 (B) AND (
D)


1. (C) Summary: Turkey's energy priorities are increasing gas
supply and diversity of suppliers, and reducing its energy
costs. The Turkey-Greece-Italy Intergovernmental Agreement
that allows Turkey to buy 15% of transiting gas at a netback
price plays a central role in meeting these needs. Netback
pricing will reduce Turkey's gas costs not only by allowing
it to buy Azeri gas at a Greek price less transit costs
across Turkey, but also by triggering contractual clauses
that will force Russia and Iran to meet the (presumably)
lower Azeri price. The Turks adopted netback pricing from the
U.S., where it is a standard pricing system in an admittedly
more liquid and transparent market. While Turkey says it
understands the importance of moving forward on Nabucco and
getting Turkmen gas to Europe, there is no sense of urgency
to reach agreement with Azerbaijan on the 15% domestic
takeoff or netback pricing model. While Energy Minister Guler
has signaled some flexibility on the percentage and resale
rights, the GOT will remain firm on that formula until they
see a different model that meets their energy supply concerns
at an equal or better price. We do not believe the USG
should involve itself in what are essentially commercial
negotiations. Our interests are best served by understanding
the driving forces and suggesting alternative formulas that
bring the parties together. End summary.

Not just transit - Turkey's domestic consumption drives its
energy policy
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2. (SBU) Growing domestic demand for energy is driving
Turkish insecurity about its natural gas supply. For the
last five years, energy demand has increased by 8% per year,
slightly faster than GDP . Turkey is on track to double
natural gas consumption by 2015. (Note: Gas fired power
plants provide a large and growing share of Turkey's energy
supply). Electricity demand is expected to exceed supply as
early as 2008, even if all new power projects are completed
on time. Building new gas-fired plants requires Turkey to
assure itself of additional supply.


3. (SBU) The new Justice and Development Party government's
energy strategy calls not only for increasing Turkey's
natural gas supply, but also for Turkey to diversify its
supply sources so that it is not dependent on any one country
for more than 30% of its supply. Currently, Turkey relies on
Russia for about 60% of its natural gas, under contracts that
begin to expire in 2011. To do this, Turkey will need to cut
Russian volumes in half and increase volumes from other
sources: the Caspian, Iraq, Egypt, the Gulf or Iran. We have
warned Turkey that further energy deals with Iran could
trigger sanctions under U.S. law. Their response has been
that they are aware of our law and our concerns about Iran,
but they expect the U.S. to understand their need for
adequate energy supply.

Intergovernmental Agreement with Greece and Italy: A
Bird-in-Hand
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4. (SBU) As reported ref A, the July 26 Intergovernmental
Agreement (IGA) on the Turkey-Greece-Italy pipeline contained
a provision allowing Turkey to buy up to 15 percent of the
Azeri gas transiting Turkey at a net-back price. This
arrangement is important to Turkey because it secures
additional gas for Turkey's domestic consumption. The IGA
did not specify whether the 15 percent could be used only to
meet domestic demand or could be resold, and Turkey has not
clearly articulated a position on this point. In

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conversations with Minister Guler and others (ref C),we
believe that Turkey is firm on maintaining the netback
pricing formula, while it is indicating some flexibility on
issues such as gas re-sale and the percentage for domestic
offtake. However, they see the IGA as a bird-in-hand and
have firmly attached themselves to this provision as the
means to reach their energy goals.

What Net Back Pricing Is and Is Not
--------------


5. (SBU) Post has noticed that both within the USG and with
other governments that there is confusion about what netback
pricing is in the Turkish model. The Turks adopted net back
pricing from the U.S. natural gas market, where it is the
standard pricing model used at the Henry gas hub. To
calculate a netback price (in a simplified way),you need to
know the cost of production at the wellhead (X),the cost of
transit (Y) and the sales price at a designated location (Z).
Net-back pricing is simply Z minus Y. In a simple
calculation, profit might be Z minus Y minus X. Turkey is
using this pricing formula even though it does not know the
cost at the wellhead (X) or the price at which Azerbaijan is
selling the gas to Greece (Z).


6. (SBU) We have seen some email exchanges that assume that
"net-back price" means "below market price." This view
appears to be based on two erroneous assumptions: first, that
the price set by Gazprom in Europe is a market price (even
though our Caspian energy strategy is based in part on
Gazprom using its monopoly power to inflate gas prices in
Europe); and second that transit costs should be the same for
delivery to any country. In the Turkish pricing model, the
Gazprom price is assumed to be inflated (Turkey's Gazprom
contracts have it paying $240 per tcm, a price akin to
Western European prices),and that Turkey deserves to pay a
lower price for Azeri gas than Italy or Greece because of
lower transit costs.

The Price of Azeri Gas matters -- a lot
--------------


7. (C) Former Energy Undersecretary Sami Demirbilek told us
that the price of Azerbajian gas is especially important to
the GOT because it will affect all other Turkish gas
contracts. According to Demirbilek, the Turks have a "most
favored nation" type clause in their contracts with Russia
and Iran. That is, the contracts state a price but also
state that if Turkey obtains gas at a lower price, the
supplier must reduce its price to match the price of the
cheapest supplier. If Turkey is able to get a net-back price
(i.e. a price for gas that does not include the
transportation across Turkey) from Azerbaijan, it will
undoubtedly be cheaper than the price they are paying to
Russia and Iran. Consequently, a cheaper gas price from
Azerbaijan also forces a cheaper price from Russia and Iran.
(Comment: We have not seen the actual contract language and
are unable to confirm that Demirbilek's analysis is correct.
End comment.)

Why is Turkey moving so slowly?

--------------

8. (SBU) Turkey fully supports the Nabucco gas pipeline
project and shares our view that Southstream is a competitor
project. On some of his first trips abroad, President
Abdullah Gul visited Baku and Ashgabat with a delegation of
Turkish businessmen to raise issues of investment and
cooperation. In Ashgabat, Gul emphasized the importance of
delivering Turkmen gas to Europe (ref D). While Turkey has
told us they understand the urgency in moving Nabucco forward
and they are ready to negotiate with Azerbaijan on transit
terms, we have not any seen evidence of on-going talks nor of
any effort to engage with Azerbaijan. It may be that Turkey
does not see the transit terms with Azerbaijan as the
lynchpin of Nabucco. It may also be that the Turks believe

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they have a strategic advantage in negotiations with the
Azeris, that Azerbaijan need to use Turkish territory more
than Turkey needs their gas. Another obstacle to quick
movement on transit negotiations may be lack of capacity
within the Ministry of Energy and the state-owned pipeline
company BOTAS. At the Ministry, two of the top four
positions are vacant and at BOTAS, two of five Board Member
positions are vacant. These positions have been vacant since
September or October and it,s not clear when they will be
filled.


9. (C) Comment: U.S. gas is sold on a net-back basis.
Granted, U.S. markets are more liquid but it,s difficult to
argue that moving toward a liquid, transparent market is
undesirable. Some worry that Turkey's demand for 15% of the
transit volumes sets a negative precedent for future
suppliers to the Southern Corridor as suppliers want to
choose their market rather than having it chosen for them. We
think it,s too early to judge how the commercial arrangement
will be established for other Southern corridor projects. At
a recent presentation by OMV on the Nabucco project, it,s
clear they are planning a very different gas marketing
approach than TGI. But Turkey is highly unlikely to move
from its netback pricing approach unless they are presented
with a more assured, diversified and cost-effective way of
meeting their domestic energy needs. We do not think it is
in our interest to involve ourselves in a commercial
negotiation between Turkey and Azerbaijan, even if we believe
the terms might not be reasonable. U.S. interests are best
served by understanding the driving forces behind the demands
and, where possible, suggesting alternative arrangements that
bring the parties together. We welcome any ideas that would
advance negotiation between the Turks and Azeris on a gas
transit agreement.


Visit Ankara's Classified Web Site at
http://www.state.sgov.gov/p/eur/ankara/

WILSON