SCENESETTER FOR U/S JEFFERY'S APRIL 22-23 VISIT TO

C O N F I D E N T I A L BAKU 000371

SIPDIS

SIPDIS

FOR U/S JEFFREY FROM AMBASSADOR DERSE

E.O. 12958: DECL: 04/18/2018
TAGS: PREL ECON ENRG PGOV PBTS AJ
SUBJECT: SCENESETTER FOR U/S JEFFERY'S APRIL 22-23 VISIT TO
BAKU

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


1. (C) Summary: Energy continues to figure prominently in
Azerbaijan's geostrategic vision, economic development, and
partnership with the United States. President Aliyev and his
senior advisors have repeatedly expressed their commitment to
working with the U.S. on a new phase of energy cooperation,
centered on the export of Caspian gas reserves, in which
Azerbaijan can play an important role as both a producer and
a transit country. The immediate question is whether
Azerbaijan and Turkey can reach agreement on gas transit and,
further on, whether Azerbaijan acts to develop its energy
resources in an optimal and expeditious manner. Azerbaijan's
rapidly growing energy revenues - estimated at USD 200
billion over the next 20 years - threaten to further distort
an already heavily energy-dependent economy. Although
Azerbaijan's overall macroeconomic situation is relatively
stable, endemic rule-of-law and corruption problems, as well
as monopolistic practices severely hinder growth in the
non-energy sectors. End summary.

FIRST ENERGY PHASE: BTC AND SCP
--------------


2. (C) The July 2006 inauguration of the Baku-Tbilisi-Ceyhan
(BTC) oil pipeline (from the offshore ACG oil mega-field) and
the December 2006 start-up of the South Caucus (SCP) Pipeline
(from the offshore Shah Deniz gas mega-field) marked the
successful completion of Azerbaijan's first phase of
post-independence energy development. Income from these two
projects is now fueling Azerbaijan's 25 percent GDP growth.
Azerbaijan is starting the second phase of its development,
which will focus on gas exports to Europe and the development
of new transit routes for Eastern Caspian energy exports.
Azerbaijan is grateful to the United States for its strong
role in promoting Azerbaijan's first phase of energy
development, and is looking to the U.S. for continued
leadership and strong partnership in the second phase.

GAS TO EUROPE
--------------


3. (C) Shah Deniz Phase One gas flows started in late 2006,
with most of the 8.6 billion cubic meters annually going to
Turkey. The second phase of development for the Shah Deniz
(SD2) field promises to yield approximately 13 bcm/a of gas
at a date no earlier than late 2013. President Aliyev has
stated his desire that all SD2 gas be exported to Europe,
with his motivation being to increase Azerbaijan's alliances
with European countries. However, Turkey has been insisting
upon a transit system whereby an amount equal to 15 percent
of transiting Azerbaijani gas is sold to Turkey at a
preferential price. Azerbaijan has staunchly resisted
linking transit and gas sales to Turkey, saying that Turkey
must have a fair and transparent transit regime so that
Azerbaijani and eventually Turkmen and/or Kazakh gas is
encouraged westwards. Azerbaijan has told Turkey it is
willing to sell some SD2 volumes to it at a good price, but
that this sales cannot be linked to other contracts
Azerbaijan makes with consumers downstream. Turkey and
Azerbaijan have been extremely reluctant to discuss this
matter bilaterally at a political level, each seeking
surrogates to put pressure on the other. There are recent
indications that Turkey and Azerbaijan could come to an
agreement on a gas transmit regime.


4. (C) There are three main competing pipeline projects for
SD2 gas: Turkey-Greece-Italy (TGI),Trans-Adriatic Pipeline
(TAP) and Nabucco. The State Oil Company of Azerbaijan
(SOCAR) has been pursuing gas sales and purchase negotiations
with companies involved with each of these projects.
However, Shah Deniz Consortium members are worried since
Azerbaijan is unwilling to conclude any sales and purchase
agreement with European gas consumer companies for SD2
volumes until and unless transit through Turkey is first
worked out.


5. (C) Shah Deniz Consortium members say that SD2 volumes
will be approximately 13 bcm/a, two of which are expected to
go to Georgia and Azerbaijan, leaving 11 bcm/a at the
Turkish-Georgian border. Turkey is expected to buy at least
2 to 5 bcm (and possibly more),leaving 6 to 9 bcm for sale
to Europe. This amount is not enough to fill TGI and also
start Nabucco, hence Azerbaijan will have to make hard
decisions as to which pipeline project to support. Recent
signs indicate that Azerbaijan, as a reward to Turkey for
voting with it on the Nagorno Karabakh UNGA resolution, could
sell more than this amount to Turkey, increasing the

possibility that there would be too little Shah Deniz Phase
II gas after sales to Turkey to sanction any of the pipelines
vying for this gas.


6. (C) Azerbaijan has ample gas resources, with industry and
government analysts saying that it could export at least 20
bcm/a to Europe o/a 2020, but an essential prerequisite is
expeditiously developing its other offshore fields, with the
first focus being the "deep gas" found under the current
Azeri-Chirag-Guneshli (ACG) field. However, ACG Deep Gas,
for which the ACG Consortium led by BP has right of first
refusal, has been held up by disagreements between the GOAJ
and BP. Recent resolution of the most important of these
disagreements could open the way for development of the ACG
Deep Gas. However, given the long lead times involved in
developing gas fields, particularly in the Caspian where
there is a real shortage and competition for capital assets,
Azerbaijan must be exhorted to move quickly to develop ACG
Deep Gas and other promising fields in conjunction with
international oil companies, so that this gas will be
available to the European market in the near-term (i.e., by
o/a 2020). We should continue to encourage the GOAJ to
expeditiously develop its gas resources in conjunction with
(preferably American) IOCs.

TRANS-CASPIAN ISSUES
--------------


7. (C) The December 2006 death of then-Turkmen President
Niyazov sparked a growing rapprochement between Azerbaijan
and Turkmenistan, which could lay the groundwork for new
Trans-Caspian energy cooperation. The two countries resolved
a long-standing debt issue and Turkmenistan reopened its Baku
Embassy this month. More importantly, the two countries seem
to agree in principle that joint development of offshore
energy need not wait resolution of delimitation issues.
Flows of Turkmen offshore gas, such as gas from its Block One
field, can flow west without a full-scale pipeline by making
use of existing underwater pipe systems used for Azerbaijan's
SD and ACG fields, although significant modifications of this
system would have to occur in order to accommodate Turkmen
volumes. Were the GOTX to decide to ship some of its gas
westwards through Azerbaijan to Europe, it could be another
significant source of Caspian gas for Europe, in addition to
helping to lessen the GOTX reliance on Russia. President
Aliyev told us on April 16 in confidence that planning is now
underway for Turkmen President Berdimuhamedov to visit Baku,
possibly next month. Azerbaijan is to be commended for its
outreach to the Turkmen, and we should continue to offer help
as needed.


8. (C) Azerbaijan stands poised to serve as a significant
transit country for Kazakh oil volumes, both from Tengiz and
from Kashagan. However, rent-seeking activities from
oligarchs in both Azerbaijan and Kazakhstan threaten to
weaken the commercial attractiveness of this Southern
Corridor. Azerbaijan should be encouraged to optimize the
commercial attractiveness of this corridor so that Kazakh
volumes are not exported via Russia or Iran.

GEORGIA
--------------


9. (C) Georgia is the weakest link in the Southern Corridor,
as it has no indigenous hydrocarbons and is dependent on
Russia for gas, especially in the winter. Azerbaijan has
traditionally sold Georgia gas during the winter at
sub-market prices, but is unwilling to continue to do so
without compensation in some form. Georgia has sought to
link future sub-market price gas from the GOAJ with issues
such as allowing the opening of the SOCAR-owned Kulavi oil
terminal in Georgia or not charging exorbitant tariffs on
GOAJ petroleum products moving to Georgian terminals by rail.
Despite the difficulties, President Aliyev said on April 16
that he had instructed SOCAR to sign a deal at USD 200/tcm
with Georgia for its gas needs this year. Azerbaijan should
be encouraged to continue to negotiate in good faith with
Georgia over future gas sales.

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


10. (SBU) Azerbaijan's economic performance in 2007 showed
increasing resilience and strength as GDP grew by more than
25 percent, a slight moderation from GDP growth in excess of
30 percent in 2006 and 2005. Azerbaijan's growth prospects
remain closely linked to oil prices, given that the energy
sector provides 95 percent of total export earnings and more

than 50 percent of GDP and 60 percent of budget revenue. In
2007, inflation reached 19 percent and in 2008 inflation
looks likely to exceed 20 percent. In the coming year, the
economy will continue to grow as Azerbaijan will receive a
larger share of profits from the ACG production sharing
agreement. In 2007, the Azerbaijani manat appreciated in
nominal terms against the U.S. dollar by less than 3.5
percent.


11. (SBU) The Government of Azerbaijan's 2008 consolidated
state budget exceeded USD 20 billion and the government will
likely increase budget expenditures in June in the
supplemental budget package. Major structural impediments
continue to hinder growth in non-oil sectors. According to
official statistics, the non-energy sector lead by
construction and services, grew by nearly 12 percent in 2007
with the agricultural sector rebounding slightly. The
agricultural sector still lacks much of the basic
infrastructure required to be a real engine of rural
development and growth. The lack of infrastructure
development (water, electricity, roads, and other basic
infrastructure) has hindered the sector's growth prospects.
Key macroeconomic issues such as exchange rate adjustment and
related price pressures, expansionary fiscal policy and the
slow growth in the non-energy tradeables sector remain the
major challenges for the GOAJ.

STATE OIL FUND
--------------


12. (SBU) Since its creation in 1999, the State Oil Fund of
Azerbaijan (SOFAZ) has acted as Azerbaijan's energy revenue
sterilizer and long-term savings vehicle. The bulk of
SOFAZ's inflows come from proceeds generated under production
sharing agreements from sales of Azerbaijan's share of
hydrocarbons; bonuses paid under the terms of production
sharing agreements; acreage fees and other revenues. SOFAZ
is one of the most transparent GOAJ organizations publishing
internationally audited quarterly and annual reports. SOFAZ
also plays a leading role in the Extractive Industries
Transparency Initiative (EITI). In 2007, the United Nations
awarded SOFAZ a public service award for its transparency,
accountability and responsiveness in the public sector.


13. (SBU) SOFAZ's currently has assets in excess of USD 2.5
billion (expected to grow to USD 6 billion this year, and USD
10 billion by 2010, based on an oil price of USD 55).
SOFAZ's portfolio was invested in 55 percent U.S. denominated
assets (dollars and U.S. treasuries),35 percent in Euros,
five percent in British Sterling pounds and a small amount in
other currencies, corporate bonds and other fixed income
instruments. In 2008, SOFAZ plans to reallocate its
portfolio to 50 percent dollar denominated assets and 40
percent Euro assets. In 2007, its rate of return was
approximately five percent in real terms. Using a grant from
the U.S. Trade and Development Agency, SOFAZ is now
re-evaluating its portfolio strategy and developing a more
aggressive investment strategy with the goal of boosting
SOFAZ assets' rate of return. The management of SOFAZ assets
appears sound. However, not all oil and gas revenues are
managed by SOFAZ. The note that they control only 75 percent
of income above USD 50/barrel. The remainder is controlled
by SOCAR and other elements of the government.

REFORM
--------------


14. (C) Securing and advancing U.S. interests in the longer
term depends on Azerbaijan's continued stability and
development. Although President Aliyev and his closest
advisors continue to affirm their commitment to democratic
reform, Azerbaijan's progress has been disappointing. The
media environment is heavily restrictive, with transparently
implausible criminal court cases against journalists and
violent attacks against journalists that have gone
unprosecuted and unpunished. Freedom of assembly in practice
is severely limited. Opposition parties complain that the
GOAJ has placed undue restrictions on their ability to
organize and do basic grassroots work, and believe that they
must have parity in electoral commissions in order to have a
level playing field. Only a handful of opposition parties
acknowledge that they too have a role to play in creating a
positive environment by developing serious party platforms
and engaging in a responsible dialogue with the GOAJ.
Although the October 2008 presidential election presents a
tremendous opportunity for President Aliyev to burnish
Azerbaijan's democratic credentials at very little domestic
political risk, senior GOAJ officials - including President

Aliyev - have hinted that they see very little incentive for
the GOAJ to provide a political opening in the run-up to the
election, particularly as they believe that Azerbaijan is
unfairly held to a higher standard with respect to democratic
reform than neighboring Georgia and Armenia.


15. (SBU) On the economic front, WTO accession could help
bring about the legislative and regulatory changes needed to
reform Azerbaijan's economy and introduce transparent,
market-driven practices. President Aliyev pledged to support
accelerating Azerbaijan's WTO accession in 2007 and, with the
help of USAID's Trade and Investment Program, Azerbaijan has
made some progress towards accession. The GOAJ has a Working
Party meeting scheduled in Geneva on May 6, and hopes to hold
bilateral negotiations on its goods and services offer with
several countries including the U.S. on the margins of the
Working Party meeting. While the legislative drafts and
services offer are ready for discussion, U.S. Trade
Representative (USTR) has requested several changes to the
format and substance of Azerbaijan's goods offer as a
prerequisite to a bilateral negotiation on goods. To
maintain the timeline the GOAJ set for itself on WTO
accession (to finish the accession process in less than two
years and before Russia),the GOAJ will need to quickly
revise its current goods offer in order to hold bilateral
negotiations on both its goods and services offer around the
May 6 Working Party meeting.

NAGORNO KARABAKH
--------------


16. (C) The Azerbaijani Government - including President
Aliyev - remains unhappy with the OSCE Minsk Group Co-Chairs'
"no" vote on Azerbaijan's UNGA resolution regarding Nagorno
Karabakh and the occupied territories. The GOAJ feels
strongly that the Co-Chairs should have abstained, rather
than voted against the resolution, in order to retain their
neutrality on issues related to the conflict, and maintains
the U.S. position was "unexpected." The GOAJ, which insists
that the Nagorno Karabakh conflict should be resolved on the
basis of Azerbaijan's territorial integrity, seems to
increasingly believe that the Minsk Group is unable or
unwilling to impose or facilitate a solution to the conflict
that is in keeping with Azerbaijan's fundamental interests.
While we do not believe that the GOAJ's current frustration
over the Nagorno Karabakh peace process - and our position on
the UNGA vote - will affect our energy cooperation, President
Aliyev and other senior GOAJ officials are likely to express
their disappointment over the UNGA vote, and urge the U.S. to
play a more active role in seeking a resolution to the
Nagorno Karabakh conflict, which remains Azerbaijan's top
domestic and foreign policy priority.
DERSE