SCENESETTER FOR EEB A/S SULLIVAN'S AUGUST 15-16

C O N F I D E N T I A L SECTION 01 OF 03 BAKU 001011

SIPDIS

SIPDIS

DEPT FOR EEB AND EUR/CARC; BERLIN PLEASE PASS TO A/S
SULLIVAN

E.O. 12958: DECL: 08/10/2017
TAGS: PREL ECON ENRG ETRD PGOV AJ
SUBJECT: SCENESETTER FOR EEB A/S SULLIVAN'S AUGUST 15-16
VISIT TO BAKU

REF: A. BAKU 533


B. BAKU 949

C. BAKU 926

Classified By: Charge d'Affaires Donald Lu per 1.4 (b,d).


1. (C) Summary: Your August 15-16 visit to Baku presents an
opportunity to advance energy cooperation and showcase
Azerbaijan's role as an energy producer and regional transit
hub, including growing Trans-Caspian cooperation. With Shah
Deniz Phase II gas scheduled to become available for export
in 2013 and increased SOCAR gas production, Azerbaijan will
have enough gas to fill the TGI pipeline and start the
Nabucco project. Azerbaijan is moving ahead on Turkish
transit talks, a prerequisite for the Southern Corridor
project; it also is exploring new energy cooperation with
Turkmenistan. Azerbaijan's booming energy sector continues
to fuel strong GDP growth but risks distorting the economy.


2. (C) Summary Continued: The Economic Partnership
Commission (EPC) is a valuable mechanism to address
Azerbaijan's precarious macroeconomic position, and we hope
your visit will prompt the GOAJ to implement unmet EPC
obligations in the areas of legislative reform and assistance
co-financing. Your visit presents a good opportunity to
probe Finance Minister Sharifov on his vision for
macroeconomic dialogue and possible technical assistance; his
involvement and support will be key to any future efforts.
Senior GOAJ officials continue to affirm their commitment to
Azerbaijan's WTO accession, but their efforts are hampered by
a lack of resources and capacity. We expect President Aliyev
to issue a decree soon to accelerate WTO accession; it is
vital that this decree include the necessary financial
resources. Given recent, serious declines in media freedom,
it is vital that senior Azerbaijani officials understand that
progress in Azerbaijan's democratic development is equally
important to the development of our bilateral relationship.
End Summary.

ENERGY
--------------


3. (C) Your upcoming informal energy dialogue with GOAJ
interlocutors on energy issues comes after the initial
"Energy Diplomacy Dialogue" in February and the subsequent
March Energy Security MOU signed by Foreign Minister
Mammadyarov and the Secretary in Washington. Your visit will
advance bilateral energy cooperation and will be a very
visible sign of U.S. support for Azerbaijan's role as a key
energy producer and regional transit hub. The
Baku-Tbilisi-Ceyhan pipeline is working well, pumping close
to 800,000 barrels a day. During President Aliyev's August
7-8 trip to Kazakhstan the two countries signed agreements
for strategic cooperation in the oil and gas sector, and
Azerbaijan has expressed interest in a new oil pipeline to
the Black Sea, in preparation for the increased volumes
expected from Kazakhstan. It is hoped that during your visit
the USTDA grant proposal for study of a oil and gas pipeline
from Kazakhstan to Azerbaijan will be signed. Existing
disputes between Azerbaijan and Kazakh energy sector entities
on overland oil transportation to terminals in Georgia (with
Chevron in the middle) are on their way to an agreed-upon
commercial resolution.


4. (C) On the gas front, President Aliyev has told us that
all Shah Deniz Phase II gas would be available for export to
Europe, and that due to SOCAR production increases and
decreased domestic gas use, even some SOCAR-produced gas will
be available for export. Shah Deniz Phase II gas production
is scheduled to start approximately 2013, which means that
the GOAJ will have enough gas to fill the TGI pipeline and
start the Nabucco project, presupposing a slightly delayed
Nabucco starting date. On August 2, the GOAJ signed an Energy
memorandum on, inter alia, Azerbaijani support for the
Turkish-Greece-Italy interconnector project, and on August 7,
Azerbaijan sent a team to Ankara to begin negotiations on the
transit of gas through Turkey, the resolution of which is an
essential prerequisite for the Southern Corridor project.
Shah Deniz gas wells are producing above expectations and as
of late July the SCP pipeline system, to include the portion
inside Turkey, is functioning.


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5. (C) BP, as the major energy operator in Azerbaijan,
submitted to the GOAJ in early August an ambitious proposal
to extend the length of its Production Sharing Agreement
(PSA) for the ACG field and also to access ACG "Deep Gas,"
not covered by the current PSA. If agreed by the GOAJ, the
PSA extension would increase the amount of oil recoverable
from the ACG mega-field, making the GOAJ's production and
revenue drop-off after 2012 much more gradual. Access to ACG
deep gas (estimated to be half the size of the Shah Deniz
mega-field) would substantially increase the amount of gas
the GOAJ had available for export.


6. (C) On the Turkmenistan front, Chevron has opened offices
in Ashgabat and is (with GOAJ consent) pursuing development
of the Sardar/Kapaz field. Any such development would be
joint with the GOAJ, and if achieved would in large measure
solve bilateral delimitation issues, even further isolating
Iran in its Caspian stance.

MACROECONOMIC OVERVIEW
--------------


7. (C) Azerbaijan's booming energy sector continues to fuel
strong GDP growth (35 percent in the first half of 2007).
However, the influx of revenue from the energy sector is
beginning to distort Azerbaijan's economy, with inflation
approaching 20 percent. Some IFIs believe the real figure
may be closer to 30 percent. A recent GOAJ supplemental
budget increase of nearly USD 700 million (ten percent of the
2007 budget) indicates that the GOAJ continues to struggle
with fiscal policy. A strong local currency is lowering the
prices of imports, with negative effects for Azerbaijan's
already struggling agricultural sector. Although the State
Oil Fund has presented macroeconomic models to key Cabinet
officials outlining the risks of unrestrained spending, it is
unclear whether senior GOAJ officials have taken this message
to heart. The GOAJ is likely to continue to increase
government expenditures in the run-up to the 2008
presidential election. Anecdotal reports from Azerbaijani
and foreign business contacts indicate that corruption has
worsened in recent months (ref a).

EPC FOLLOW-UP
--------------


8. (C) Given Azerbaijan's precarious macroeconomic situation
and critical importance to U.S. interests, the Economic
Partnership Commission continues to be a valuable vehicle to
press for real reform. GOAJ implementation of its EPC
commitments unfortunately has been mixed. We hope that your
visit will encourage the GOAJ to take action on its unmet
commitments, particularly in the areas of legislative reform
and co-financing. The GOAJ has not submitted to Parliament
key legislation on Anti-Money laundering and terrorist
financing, conflicts of interest, an ethics code for civil
servants, or the necessary amendments to the civil code
creating criminal liability for corporations/legal persons.
We understand that these pieces of legislation still await
approval from President Aliyev's office. Submission of these
key pieces of legislation to Parliament for consideration in
its autumn session would be an important demonstration of the
GOAJ's commitment to rule-of-law and serious anti-corruption
measures. The GOAJ also has been slow to respond to our
proposed structure for the co-financing working group.
Although Minister of Finance Sharifov personally does not
need to participate in the working group's deliberations, it
is critical that he appoint and empower a senior Finance
Ministry official to begin substantive discussions with us.


9. (C) Your visit also will provide a good opportunity to
probe Sharifov on his vision for a broader bilateral dialogue
on macroeconomic policy and development. Treasury sent a
short-term advisor to Baku earlier this summer, who concluded
that the GOAJ lags far behind other post-Soviet republics in
the area of government capacity-building. While Sharifov
previously has expressed a desire for this type of
assistance, his Ministry's track record in working with the
current Treasury Budget Advisor (charged with developing a
GOAJ budget manual and rationalizing the GOAJ budget process)
has been mixed. Building a stronger GOAJ economic
decision-making process remains a high priority for this
mission, but we need the strong support and involvement of

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senior officials such as Sharifov for any possible future
assistance programs to be effective.


10. (C) On a more positive note, the GOAJ has taken steps to
fund and train personnel to maintain the USAID-funded
legislative database; has completed all legal procedures
required for the Customs Mutual Assistance Agreement to enter
into force; and has convened the first meeting of the
bilateral telecomm and IT working group. The USG has met all
of its EPC commitments, sending Commerce UnderSecretary
Sampson to Baku June 4-5, securing funding for a new USDA
technical assessment of the agriculture sector (planned for
this fall),and organizing a DOE workshop on
energy-efficient, earthquake-resistant building materials in
July.

WTO
---


11. (C) Senior GOAJ officials -- including President Aliyev
-- continue to affirm their commitment to accelerate
Azerbaijan's WTO accessions, but their efforts are hampered
by a serious lack of resources and capacity. Since the EPC,
the GOAJ has raised its WTO commission to the Deputy Minister
level and refocused government efforts to implement WTO
provisions. We expect President Aliyev to issue a decree
soon to accelerate Azerbaijan's WTO accession, which will
include a nine-step roadmap and an announcement of USD 1
million in GOAJ funding to support WTO accession activities
(ref b). We have encouraged the GOAJ to spend part of this
money on a GOAJ-funded advisor to assist with WTO
negotiations, market access offers, and Q&Rs. President
Aliyev and reform-minded ministers have stressed that
Azerbaijan must join the WTO before Russia in order to avoid
problems, a goal that a USAID short-term advisor concluded is
possible within two years, as long as Azerbaijan focuses its
efforts. It is critical that senior GOAJ officials
understand the need to devote serious resources -- including
professional advisors -- to its WTO accession efforts. GOAJ
co-financing of the new USAID Trade and Investment Program
also would be an important sign of the GOAJ's commitment to
WTO accession.

DEMOCRACY AND HUMAN RIGHTS
--------------


12. (C) There has been a steady decline in media freedom
over the last 18 months, with a series of attacks on
journalists, eight journalists in prison, a growing backlog
of defamation cases, and increasingly serious financial
difficulties at most of the pro-opposition and government
newspapers. Many observers worry that these developments are
the result of a deliberate government campaign to squeeze out
significant independent voices in the run-up to the 2008
presidential election (ref c). Although President Aliyev
and his senior advisors repeatedly affirm their commitment to
Azerbaijan's democratic development, they have been reluctant
to take concrete steps to address the deteriorating media
environment. It is vital that President Aliyev understand
that Azerbaijan's continued democratic development is
essential to the development of the bilateral relationship.
Progress in any one area, whether security cooperation,
energy security, or economic and political reform, cannot be
separated from our other interests in this strategically
important country.
LU