AZERBAIJAN-BP NEGOTIATIONS: LET THE HARDBALL BEGIN

C O N F I D E N T I A L SECTION 01 OF 03 BAKU 001224

SIPDIS

SIPDIS

E.O. 12958: DECL: 09/10/2017
TAGS: PGOV PREL ENRG AJ
SUBJECT: AZERBAIJAN-BP NEGOTIATIONS: LET THE HARDBALL BEGIN

Classified By: Ambassador Anne E. Derse, Reasons 1.4 (b,d)


1. (C) SUMMARY: Negotiations between the State Oil Company
of Azerbaijan (SOCAR) and BP concerning the second stage of
Azerbaijan energy sector development have broken down due to
SOCAR's insistence on first resolving shorter-term issues
involving potentially billions of dollars. Although SOCAR
and BP had originally agreed to link resolution of short- and
long-term issues, SOCAR's unilateral cessation of
negotiations in late August signaled a hardening of
Azerbaijan's negotiating position. Billions of dollars are
at stake and an agreement is being forged which will
decisively determine the next stage of Azerbaijani energy
development. Comment: The USG is not versed in the minutiae
of the commercial issues at stake and should not insert
itself in negotiations. Rather, we should stress to the GOAJ
that timely decision-making concerning the next stage of
Azerbaijan energy sector development, with or without BP's
primacy, will allow Azerbaijan to further integrate itself
into the regional and global energy markets, in addition to
maximizing revenues for future generations. END SUMMARY AND
COMMENT.

BACKGROUND
--------------


2. (C) BP is the major international energy company in
Azerbaijan and the company primarily responsible for
achieving the first phase of post-independence Azerbaijan
energy sector development. It is 34 percent shareholder and
operator of the Azerbaijan International Oil Company (AIOC),
the consortium responsible for developing Azerbaijan's major
oil field (ACG - the Azeri, Chiraq, Gunashli field). It is
operator and 25 percent shareholder of the Shah Deniz
consortium developing Azerbaijan's main gas field. It is
also 30 percent shareholder of the Baku-Tiblisi-Ceyhan (BTC)
oil pipeline moving ACG oil and 25 percent shareholder in the
South Caucasus Pipeline (SCP) moving Shah Deniz gas.


3. (C) In October 2006 BP Azerbaijan drafted and subsequently
submitted to President Aliyev a white paper entitled,
"Options for Azerbaijan: A BP Perspective on the Next Phase
of Oil and Gas Development," in which it proposed a roadmap
for continued BP involvement in future energy sector
development. BP's strategy was to link resolution of
existing contentious short-term issues, worth potentially
billions of dollars, with the longer-term issues relating to
the next phase of energy sector development. As Azerbaijan
President Bill Schrader noted on October 1, by linking these
two sets of issues BP and the AIOC Consortium were willing
and fully expected to "give up some value in the short-term
to gain some long-term value."


4. (C) One of the longer term issues for AIOC is extending
the current Production Sharing Agreement (PSA) for the ACG
field, which is scheduled to end in 2024. PSA extension will
allow AIOC to make investments necessary to ensure maximum
oil and gas extraction from the field, which would in turn
increase overall GOAJ revenues and lessen the steep decline
in oil-based income predicted for the period beginning o/a

2012.


5. (C) Another major long-term issue for AIOC is access to
ACG non-associated (aka deep) gas, located under the area for
which the Consortium now has development rights. The
Consortium believes that ACG deep gas reserves are
significant, approximately half that of the Shah Deniz
superfield. Timely development of ACG deep gas is essential
for ensuring the viability of the Southern Corridor project,
i.e., that there is sufficient short- to mid-term Azerbaijani
gas available for export to and through Turkey.

STATUS OF BP-SOCAR TALKS
--------------


6. (C) In May 2007 SOCAR (representing the GOAJ) and BP
(representing the AIOC Consortium) signed an MOU agreeing to
link the resolution of the extent short- and long-term issues
together in a package. However, in late August 2007 SOCAR
President Rovnaq Abdullayev sent a letter to AIOC Consortium
members informing them that negotiations were unilaterally
suspended, arguing that the short-term issues must be
resolved before longer-term issues are addressed.


7. (C) One consequence of SOCAR's suspending negotiations in
late August was that in mid-September the AIOC partners voted

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to cease giving SOCAR the additional free ACG associated gas
it had been providing since the previous winter. (COMMENT:
According to the AIOC PSA, SOCAR is entitled receive to all
associated ACG gas free of charge (excepting that which AIOC
needs for operational reasons, to include gas re-injected for
maximizing oil extraction). In late 2006 BP had started
giving all the associated gas it could to SOCAR as a goodwill
gesture, due to the delayed start of Shah Deniz gas. After
winter's end, the Consortium continued to give this maximum
amount of free associated ACG gas to SOCAR while negotiations
were ongoing. However, as Schrader explained on October 1,
after receiving the late August letter from SOCAR, AIOC
partners suspended the provision of extra associated gas to
SOCAR, using it instead for re-injection into the ACG field
as originally intended. END COMMENT).


8. (C) On October 1, Murat Heydarov, Advisor to SOCAR
President Abdullayev, said that Azerbaijani has "always said"
that it had urgent issues centered around calculating the
"real rate of return" that had to be solved before
longer-term issues could be addressed. He listed the major
short-term issues as follows:

- TOTAL TRANSPORTATION COSTS (TTC): Calculating TTC is
important as it impacts on Netback Value (NBV): the higher
the TTC per barrel of oil, the less the NBV. The PSA
provides for the Contractor's allocation of Profit Oil to
increase by up to five percent if TTC exceeds USD five
dollars per barrel. Due to the high freight rates in the
tanker market and the need to use higher cost export routes
with increasing ACG production, this threshold was triggered
in late 2006. In light of this event, BP adjusted the TTC
calculation method. According to Heydarov, at stake is
approximately USD five billion over the life of the PSA.

- PROFIT OIL SPLIT: The AIOC PSA divides exported oil into
two types: cost oil and profit oil. Revenue for the former
is used for operational expenses, while revenue from the
latter is, as the title indicates, for profit. The PSA
stipulates that in the beginning years, AIOC gets revenues
from most of the profit oil, in order to compensate it for
incurred capital expenditures (Capex). Over time as Capex is
recovered, a higher percentage of the profit oil goes to
Azerbaijan and proportionally less to AIOC. As Heydarov
explained, initially 75 percent of profit oil was going to
the Consortium, with 25 percent going to SOCAR. The final
split, as Capex is paid for, will be 80 percent for the GOAJ
and 20 percent for the AIOC. According to SOCAR
calculations, the shift in profit oil split to a fifty-fifty
division was scheduled to occur in the third quarter of FY
2007, with the final change to 80 percent for the GOAJ and 20
percent for AIOC to occur in mid-2008.

- However, in April, BP told SOCAR of a change in its
calculations due to a change in the underlying variables,
with the 50-50 split of profit oil to occur in the second
quarter of 2008 and the final shift to 80-20 to occur in
mid-2009. Part of this change was to due the Consortium
revising its ACG Oil Production Profile for 2008 downwards
(due to drilling delays) from 950 thousand barrels per day
(mpbd) to 840 mpbd. Heydarov said that a downward revision
of 110 mbpd does not account for such a dramatic shift in
profit oil splits, and added that these changes in profit oil
split timing would involve redistribution of approximately
USD 9 billion over a four year period.

- BTC TARIFF: Heydarov claimed that the actual tariff,
approximately USD eight per barrel, is approximately double
what has originally expected, and hence has served to lessen
overall netback value.

WHAT IS SOCAR UP TO?
--------------


9. (C) When EnergyOff and visiting EUR/ERA EconOff McConaha
discussed the negotiations breakdown with BP Azerbaijan
President Schrader and BP Azerbaijan Commercial VP for
Commerce Dr. Phil Home on October 1, Schrader said that the
problems in large part stemmed from the fact that "no one at
SOCAR has read the PSA." He said during the recent visit of
UK Energy Secretary Malcolm Wicks, SOCAR President Abdullayev
had excoriated BP in their meeting, referring to BP as
"untrustworthy." However, in a later meeting with Wicks,
President Aliyev praised BP, calling it "Azerbaijan's partner
for the future." As such, Schrader mused that the unilateral
cessation of negotiations was either just "Rovnaq being

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stupid" or part of a calculated "good cop-bad cop"
negotiating strategy. In an October 2 readout of the
visiting Duke of York's meeting with President Aliyev, the UK
Embassy energy officer said that the UK Embassy was fairly
confident that President Aliyev was well aware of and had in
fact approved Abdullayev,s hardball negotiating tactics. In
this light, BP Azerbaijan feels that recent complaints from
Georgia about "BP putting the squeeze on Azerbaijan by
cutting off gas," with its possible effects for Georgia
during the upcoming winter, also springs from SOCAR and the
GOAJ trying to increase the pressure on BP.

COMMENT
--------------



10. (C) There is a saying in this part of the world that
"negotiations begin when one party walks away from the
table." In this light, negotiations between AIOC and SOCAR
have truly begun. Billions of dollars are at stake and an
agreement is being forged which will decisively determine the
next stage of Azerbaijani energy development.


11. (C) In terms of the Southern Corridor project, ACG deep
gas is essential for ensuring that sufficient short- to
mid-term Azerbaijani gas is available for export to and
through Turkey. Despite recent press accounts of possible
French Total development of ACG Deep Gas, the reality is that
the current AIOC PSA gives the Consortium the right to match
any existing offer. Also, since developing ACG Deep Gas
would have to be through the existing ACG field, insurance
and indemnification issues alone would allow the AIOC
Consortium as a practical matter to veto any ACG deep gas
development deal made by SOCAR. It also is worth noting that
President Aliyev himself has previously said in conversations
with USG interlocutors that it "makes sense" for BP to take
the lead on the next stage of Azerbaijan energy sector
development.


13. (C) In our view, the USG is not versed in the minutiae
of the issues at stake and should not insert itself in the
negotiating process. Recognizing that negotiations of this
magnitude will take time, we should nonetheless stress to the
GOAJ at each opportunity that expedited ecision-making
concerning the next stage of Azeraijan energy sector
development, with or withoutBP's primacy, will allow
Azerbaijan to more rapily integrate itself into the regional
and globalenergy markets before market opportunities are
lot, in addition to maximizing revenues for futuregenerations.


14. (U) Embassy will be seeking input from other AIOC
Consortium members of the current negotiations and be
reporting it septel.
DERSE