SCENESETTER FOR A/S SULLIVAN'S FEBRUARY 7 ENERGY

C O N F I D E N T I A L SECTION 01 OF 03 BAKU 000155

SIPDIS

SIPDIS

DEPT FOR EB A/S SULLIVAN, SCA PDAS MANN, AND EUR DAS BRYZA

E.O. 12958: DECL: 01/31/2017
TAGS: ENRG EPET PREL ECON ETRD RU TU AJ
SUBJECT: SCENESETTER FOR A/S SULLIVAN'S FEBRUARY 7 ENERGY
TALKS IN BAKU

REF: BAKU 98

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


1. (C) SUMMARY: The U.S-Azerbaijani Energy dialogue comes
at a crucial time in the development of Azerbaijan's energy
sector, when production from major oil and gas projects has
either started or will start soon, and when Azerbaijan needs
to make strategic decisions that will affect both the future
development of its energy sector and global energy security.
Heavy-handed Russian pressures, to include Gazprom more than
doubling its proffered gas price for 2007 while significantly
reducing amounts offered, have encouraged the GOAJ to
increase its efforts for energy independence from Moscow and,
more generally, to seek to strengthen its energy ties to the
West. The October 2006 "Memorandum of Understanding on a
Strategic Partnership between the European Union andthe
Republic of Azerbaijan in the Field of Energy," was an
significant step in this regard. In the gas sector, major
issues to be addressed include beginning a discussion with
Turkey on a gas transit regime that will facilitate transit
of Caspian gas first to Greece and eventually to other
European countries; and Azerbaijan proving up its own gas
reserves, to include 'deep gas' associated with the ACG
field, so that commercial decisions can be made this year
that will allow pipeline construction and subsequent delivery
of significant amounts of gas to Europe starting o/a 2012.
Discussions with Turkmenistan and/or Kazakhstan about gas
shipment westward across the Caspian and through to Europe
should be another GOAJ-US focus. In the oil sector, the GOAJ
needs to increase efforts by the relevant governmental
agencies with commercial and government interlocutors in
Kazakhstan to reach agreement on an HGA to follow up on the
July 2006 IGA, so that Kazakhstan,s North Caspian oil can
link to the Baku-Tbilisi-Ceyhan pipeline. The public launch
of our new high-level Dialogue on Energy Security in the
Caspian Region will be a strong show of USG support for
Azerbaijan,s efforts to strengthen southern corridor routes.
END SUMMARY.

OIL ) ACG/BTC
=============


2. (C) Estimates of Azerbaijan's proven crude oil reserves
range between 7 to 13 billion barrels. The bulk of
Azerbaijan's oil production comes from Azerbaijan
International Operating Company (AIOC),which represents over
70 percent of Azerbaijan total oil exports. Current oil
production is dominated by the BP-operated offshore
Azeri-Chiraq-Gunashli (ACG) field, with its estimated minimal
recoverable 5.4 billion barrels of oil. First oil production
from this major field began in 1997, and July 2006 saw the
official inauguration of the 1,768 kilometer BTC pipeline
built to carry ACG oil through Georgia to Turkey. By the end
of 2006, this pipeline was carrying an average of over
500,000 bpd, with a goal of 800,000 bpd for 2007. Production
from the ACG field is expected to peak by approximately 2012;
proper management of the expected approximately USD 250
billion of energy-based revenues over the next decade in oil
revenue is one of the GOAJ,s greatest challenges.
Production of this field and of other major energy projects
has been regulated by Production Sharing Agreements between
the GOAJ and major energy companies, to which the government
has largely adhered.


3. (C) In addition to the BTC, the AIOC continues to use the
100,000 b/d Northern Route Export Pipeline (Baku-Novorossiisk
and a rail link to Batumi Terminal in Georgia. Repairs
needed on the 155,000 b/d Western Early Oil (Baku-Supsa)
pipeline have forced BP to transfer oil intended for this
pipeline to either rail to Batumi or the Northern Route
Export pipeline. BP is at the start of discussions with the
GOAJ concerning extension of its current PSA to allow for
optimal development of ACG, and for development of the
substantial amounts of associated ACG 'deep gas.'

HGA/IGA
=======


4. (SBU) In June 2006 Azerbaijan President Aliyev and
Kazakhstan President Nazarbayev signed an IGA to facilitate a
link by tanker between Kazakhstan,s North Caspian oil fields

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and the Baku-Tbilisi-Ceyhan (BTC) pipeline. However, the
price of consensus on this IGA was delaying agreement on
unresolved issues such as oil volumes, tariffs and control of
shipping fleets, to subsequent Host Government Agreements
(HGA). There has been no substantive progress on an HGA
since the June 2006 signing, in part because the GOAJ has not
seen the issue as a pressing one. However, for oil volumes
from Tengiz and ultimately Kashagan begin to cross the
Caspian to make their way westward, the GOAJ will need to
resolve the multitude of outstanding issues relating to the
HGA.

GAS ) SHAH DENIZ
================


5. (C) Azerbaijan's major gas field is the offshore Shah
Deniz field, developed by a seven-member consortium with BP
as operator. According to BP, Shah Deniz contains potential
recoverable resources of roughly 35 trillion cubic feet of
gas and 750 million barrels of condensate, making it one of
the world's largest natural gas field discoveries of the last
twenty years. There have been production delays in the first
stage of Shah Deniz, which was to have begun production late
2006 and which is supposed to have peak production of
approximately 8.4 billion cubic meters annually. In
mid-December 2006, a leak in the first of the four wells to
be developed caused production to shut down shortly after it
started, with current BP plans for the second well to begin
production in late February/early March, followed four to six
weeks later by the start of the third well and then four to
six weeks later by the fourth well, after which repairs on
the first well will resume.

07 WINTER GAS SHORTAGE
======================


6. (C) These Shah Deniz production delays exacerbated
problems on how Azerbaijan and Georgia were to face the
regional gas shortage this winter. For reasons largely seen
as political, traditional supplier Gazprom had significantly
raised its offered price to both Georgia and Azerbaijan for
2007 gas, in the latter case from 110 dollars per thousand
cubic meters in 2006 to 235 dollars in 2007, while lowering
the offered amount from 4.5 to 1.5 billion cubic meters. In
response, Turkey, Georgia and Azerbaijan,s governments began
the discussion in November 2006 of redistributing Shah Deniz
gas intended for Turkey in 2007 to Georgia and Azerbaijan,
but talks hung up over the issue of how Turkey was to be
compensated. The unexpected mid-December shutdown of the
first Shah Deniz well (and the subsequent gas purchase of
major Georgia consumers from Gazprom) brought these
discussions to a functional standstill. Azerbaijan
compensated for its domestic gas shortage by exporting
decreased amounts of oil and converting it to heavy fuel to
be used in its own power plants. This process, although
resulting in a major income loss for the GOAJ, allowed the
government to do without Gazprom gas for the 07 winter. To
help the GOAJ and to minimize ill will, BP consented to give
the government as much associated gas from the ACG field as
it technically could, this gas being free under the terms of
the PSA, despite having earmarked much of this gas for
reinjection. BP has made clear that it will give these extra
amounts of ACG associated gas to SOCAR only for the first
quarter of FY 07, after which it will resume reinjection into
ACG, to maintain the health of the reservoir.

TURKISH GAS TRANSIT REGIME
==========================


7. (C) Shah Deniz gas is destined to move through Azerbaijan
and Georgia to the Turkish border via the South Caucasus
Pipeline (SCP). However, Botas has not yet completed
construction within Turkey, and it is unclear whether it will
be able to finish construction, commission the pipeline and
begin requesting amounts of Shah Deniz gas before spring.
Regardless of when Turkey is ready to receive Shah Deniz gas,
the GOAJ needs to begin discussions with Turkey concerning an
equitable transit regime that will allow Azerbaijani, and
ultimately Kazakh and/or Turkmen gas, to transit to Europe
through Turkey. GOAJ perceptions are that Turkey seeks to
play the role of a "mini-Gazprom," buying and selling Caspian
gas, and GOAJ interlocutors have said that the GOAJ will sell

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gas "through but not to" Turkey.

MARKETS FOR CASPIAN GAS
=======================


8. (C) Except for a token amount for Greece, most of the
production from Shah Deniz Stage One is earmarked for Turkey,
Azerbaijan and Georgia. Currently BP is drilling the SDX-04
exploratory well in the southern part of the Shah Deniz
field, which when completed in a few months will give an
indication of how much gas can be expected for Shah Deniz
Phase Two. Baseline projections for Shah Deniz Phase Two are
approximately 12 bcm/a, with much of this production
earmarked for the Azerbaijan and Georgia. However, market
expectations are that some amounts of Shah Deniz Phase Two
production will be available for transmission through Turkey.
The Austrian OMV consortium, seeking a minimum of ten bcm
from Azerbaijan so that it can secure funding for its Nabucco
pipeline, made its first high-level visit to Azerbaijan in
January 07, and is expected to be returning regularly. The
Italian company Edison and the Greek Gas company DEPA have
also engaged the GOAJ in connection with the
Turkey-Greece-Italy (TGI) interconnector project.


9. (C) However, for there to be appreciable amounts of
Azerbaijani gas for supply to Europe, either through the
Turkey-Greece Interconnector (TGI) or the Nabucco pipeline,
Azerbaijan needs to begin to prove up its reserves, to
include "ACG Deep Gas," which BP says could have half-as much
or greater than the approximately 35 trillion cubic feet of
gas in Shah Deniz. In addition to Azerbaijani gas, gas from
Turkmenistan and/or Kazakhstan could be used to satisfy
European demand, and as such we need to work with the GOAJ as
to how best to approach these two countries to explore the
possibility of westward transmission of their gas.

COMMENT
=======


10. (C) In recent weeks, the GOAJ has dramatically changed
its previously discrete public posture on prospects for new
gas sales to Europe. In a blunt Wall Street Journal
editorial, Foreign Minister Mammadyarov rejected Russian gas
tactics as &unacceptable8 and argued that new Caspian gas
sales to Europe would provide protection against &market
bullies." At the same time, Mammadyarov also requested that
we create a new, high-level bilateral dialogue on energy
security that would address the political aspects of new
transport routes (reftel). In our view, the GOAJ has made a
strategic decision to cast its energy future with the West;
the launch of this new energy security dialogue at the
Economic Partnership Commission will be an important public
show of support for Azerbaijan,s decision.
DERSE