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 SIPDIS SIPDIS USDOC FOR 4212/ITA/MAC/CPD/CRUSNAK EEB FOR A/S SULLIVAN EUR FOR DAS BRYZA SCA FOR MANN DOE FOR HEGBURG USTDA FOR DAN STEIN 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 -------------- -------------- ¶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 -------------- -------------- ¶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 ANKARA 00002955 002 OF 003 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 ANKARA 00002955 003 OF 003 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