Saudi Arabia's Crude Oil Exports to Asia Might Be Affected by the 2014 Crimean Crisis

March 31, 2014

BEIRUT, Lebanon  —  "Ever since the continents started interacting politically, some five hundred years ago, Eurasia has been the center of world power" said Polish-American political scientist Zbigniew Brzezinski in 1997 in his famous book The Grand Chessboard. Eurasia is the combined continental landmass of Europe and Asia. It's the earth's supercontinent. In fact, physical geography does not differentiate between Europe and Asia, even though the concepts of Europe and Asia as distinct continents have been around since antiquity. Eurasia covers an area around 36.2 percent of the earth's total land area, while it hosts 4.6 billion people, i.e., 72.5 percent of the world's human population. In The Grand Chessboard Brzezinski continued saying that the last decade of the twentieth century had witnessed an important shift in global affairs because "[f]or the first time ever, a non-Eurasian power ha[d] emerged non only as the key arbiter of Eurasian power relations but also as the world's paramount power". Since the end of the Cold War the United States has experienced the power of pre-eminence in Eurasia, which is the chessboard where the struggle for global primacy continues to be played. Now following recent events in Crimea and the possible sanctions that the West would like to impose on Russia, the geopolitical panorama in Eurasia might change ushering in an intensification of the political and economic (energy) relations between Russia and China (as well as other Asian countries). This adjustment could in turn partially create some modifications to the pattern of oil shipments from the Persian Gulf to China and other Asian energy-hungry countries. Also natural gas trade could similarly be affected, but this paper covers only the geopolitical issues linked to crude oil.

Casus Belli

The casus belli for these possible relevant changes in the geopolitical energy trends in Eurasia is linked to the 2014 Crimean crisis between Russia and Ukraine. The Crimean peninsula, which is the principal flashpoint in the 2014 Ukraine revolution, is a pro-Russia part of Ukraine, and it also hosts Russia's Black Sea Fleet. This peninsula has always gravitated in the orbit of Russia. It was absorbed into the Russian empire, together with the majority of the ethnic Ukrainian territory, by Catherine the Great in the 18th century. In 1954 the Crimea peninsula was transferred to the Ukrainian Socialist Soviet Republic within the Soviet Union (S.S.S.R.), and then in 1991 it became part of the independent Ukraine. The Crimean crisis unfolded in late February 2014 as a consequence of the Ukrainian revolution, which had culminated with the ousting of the then-President of Ukraine, Victor Yanukovych and the creation of an interim government. On February 26, pro-Russian forces started a process to took control of the Crimean peninsula. Subsequently, on March 11, the Supreme Council of Crimea and the City Council of the Sevastopol passed a joint resolution through which they expressed their intention that Crimea be independent from Ukraine and join the Russian Federation. On March 16, a referendum about this issue was held in Crimea. The result showed that 96 percent of the votes were in favor of independence — although this percentage was quite debated by those who opposed the referendum. The Ukrainian Parliament opposed this result, while the United States (U.S.) and the European Union (E.U.) declared the vote illegal. On March 18, basing his request on the international law principle of self-determination, Russian President Vladimir Putin claimed that Crimea was a part of the Russian Federation.

Sanctions Against Russia

China abstained from the United Nations Security Council (S.C.) resolution that declared the Crimean succession referendum illegal and Russia vetoed it. Instead, as a response to the crisis in Crimea, both the U.S. and the E.U. have imposed sanctions against persons who played a role in relation to the violation of Ukraine's sovereignty. Moreover, the U.S. has targeted Russia's Bank Rossiya, which the U.S. believes to have been used by Mr. Putin's inner circle. In addition to the sanctions ad personam the G-7 communiqué issued on Monday, March 24, 2014 called for Russia's suspension from the G-8 but not for its expulsion. On the European side an extension of the sanctions may be very complicated for two main points:

• Some European countries strongly rely on Russia for their energy supplies (both oil and gas).
• Some European countries have important overall trading relationships with Russia.

On the side of China, it's evident that Beijing is not inclined to pass sanctions against Russia in reason of at least three important points:

• China always refrains from intervening (non-interference) in the internal affairs of other countries, lest it be questioned about its sovereignty.
• Historically, Russia and China within the Security Council of the U.N. have always tried to develop a sort of mutual support notwithstanding the fact that many times they have seen issues through different perspectives*.
• China imports energy from Russia, and, given its huge demand for energy, it would like to broaden consistently this trade relationship.

(*This Sino-Russian alignment is a way to counterbalancing the alignment between the three Western members of the S.C.: the U.S., France and the United Kingdom (U.K.).)

Also Japan and South Korea have taken a soft line versus Russia. Both countries need to maintain and probably to expand their energy relations with Russia. Indeed, they have now a strong interest in importing more liquefied natural gas (L.N.G.) — given the very high prices of L.N.G. in Asia.

It's out of the scope of this analysis to discuss about the legitimacy of Russia's actions in Crimea or about the legal grounds for the imposition of sanctions against Russia. Instead, the following paragraphs will cover China's third point, which was mentioned above, i.e., China's interest in expanding its energy relation with Russia In specific, attention will be given to the possible outcomes of the expansion of Sino-Russian energy relation for the Middle East.

Yet, concerning the sanctions one consideration stands out: Probably the only real sanction that could have an impact on Russia would be lifting the ban on the export of U.S. crude oil (Meghan L. O'Sullivan, A Better Energy Weapon to Stop Putin, Bloomberg, March 2014). Russia is vulnerable with reference to the price of oil. In fact, Russia's revenues from gas sales constitute only 8 percent to 9 percent of the national budget, while oil revenues accounts for 37 percent to 38 percent.  

  

The Importance of the Power of Alternatives in International Affairs and Especially With Reference to Energy Relations.

The game of chess has a certain resemblance to the moves and countermoves that the countries implement at the international level. When playing chess the objective of the game is to checkmate the opponent — although of course at the international level a win-win solution would be advisable.

Checkmate is a game position in chess in which a player's king is in check (threatened with capture) and there is no way to remove the threat. Checkmating the opponent wins the game. (Wikipedia)

Using the idea of the game of chess, it's interesting to note that possible sanctions against Russia would not corner Russia in check because Moscow would still have the power of alternatives, which in this case would have relevant implications for Asia's energy future. These alternatives pass through an improved energy relation with China. That Russia now needs an improved energy coordination with China and the other energy-hungry countries of East Asia and South Asia is the natural evolution of the incredible development that those two Asian areas have been witnessing in the last four decades. Russia is in a geographical position through which it could well serve with its precious commodities, oil and gas, both the left side (Europe) and the right side (East Asia and South Asia) of the Eurasian continent. Russia needs to diversify away from an excessive reliance on slow-growing and complicated European energy markets (oil and gas). This is a must for Russia, whose economic growth is primarily driven by energy exports. Utilizing the business concept of the Five Competitive Forces, which were elaborated by Harvard Business School's Professor Michael Porter, we could affirm that Russia has to increase its bargaining power as supplier.

Russia (Exporter) — Russia's Oil Exports Needs Diversification

According to P.F.C. Energy, a consultancy, in 2012 Russian oil and gas revenues accounted for 52 percent of the federal budget revenues and for over 70 percent of total exports. Russia is the world's third-largest producer of oil after Saudi Arabia and the U.S.. In 2012 its crude oil production averaged 10.5 million barrels per day (bbl/d). According to the U.S. Energy Information Administration (E.I.A.), in 2012 Russia exported about 7.4 million bbl/d of total liquid fuels (5 million bbl/d of crude oil and 2.4 million bbl/d of petroleum products).

Russia's main production areas are: western Siberia, which has an output of 6.4 million bbl/d, nearly two-thirds of Russia's total oil production, and Urals-Volga, which accounts for 22.4 percent of Russia's total output, i.e., 2.3 million bbl/d. The other Russian producing areas across the country have an output of 1.5 bbl/d equal to 15.3 percent of the country's output. In specific, the producing areas located in eastern Russia are the fields in eastern Siberia (which will have an important role in the future) and those in Sakhalin Island, which is off Russia's eastern shore. Still at an initial stage of development, the area Yamal Peninsula/Arctic Circle, which straddles western Siberia, is new to crude oil but if it solves some infrastructural problems it could serve both the European and the Asian markets — the latter could be served thanks to the already built Purpe-Samotlor Pipeline and to the planned Zapolyarye-Purpe Pipeline.    

As a consequence of the location of Russia's main production areas, still in 2012, the greater part (79 percent) of the crude oil exports was directed to European countries (including Eastern Europe), in specific to Germany, the Netherlands and Poland. Instead, approximately, 18 percent of crude oil went to Asia. 

More than 80 percent of Russian oil is exported via the Transneft pipeline system (88 percent of crude oil and 27 percent of oil products), while the remainder is shipped via rail or on vessels loading at independently owned terminals. Transneft is a Russian state-controlled company that has an extensive domestic distribution and export pipeline (the length of the main Transneft oil pipeline is about 43,495 miles). Of the main Russian pipelines only the Tengiz-Novorossiysk Pipeline is not controlled by Transneft. Among the controlled pipelines there is the Druzhba Pipeline, which is the world's longest oil pipeline (2,400 miles and a capacity of 2 million bbl/d) and has been servicing Europe for decades.

Of the nine Russian pipelines (one pipeline has only been proposed) showed in the table only three play a direct or indirect role as for Asia. They are:

• Eastern Siberia-Pacific Ocean (ESPO) Pipeline (o.6 million bbl/d, direct export)
• Purpe-Samotlor Pipeline (0.5 million bbl/d, indirect export)
• Zapolyarye-Purpe Pipeline (proposed, capacity 0.9 million bbl/d, indirect export). 

Information about ESPO will be provided below in the following paragraph. Rail exports cover a very small portion of Russian oil exports. Oil is transported through rail along the coastline. Russia exports crude oil and petroleum products to Estonia and Latvia in the West and crude oil to Harbin, China, and to central China via Mongolia in the East.

 

Moreover, Russia has at least 18 ports from where it exports its oil to the rest of the world. Among them, eight ports stand out for their relevant their role. And among these eight ports, three are located in eastern Russia. They are:

• Kozmino Bay in the far eastern Primorsky Province. Crude oil loaded at Kozmino Bay is previously transported via the ESPO pipeline and rail to the terminal. The port's initial capacity of 300,000 bbl/d will eventually be expanded to 1 million bbl/d.
• De-Kastri in Russia's Far East, southwest of the Tatar Strait that separates Sakhalin Island from the Russian mainland. Its export capacity is 250,000 bbl/d. The harbor can accommodate Aframax tankers.
• Prigorodnoye on Sakhalin Island on the Aniva Bay. The harbor is capable of loading 100 Aframax and 160 L.N.G. vessels each year.

Data are quite clear: Russia crude oil exports are leaning toward Europe much more than toward Asia, and this could be a dangerous condition for Russia in times when Europe has a reduced interest for Russia's energy sources — Europe's stance is guided by several factors: politics, environmental targets and the necessity of diversifying its energy supplies — if we use the same business jargon of Michael Porter's Five Competitive Forces we could say that Europe has to increase its bargaining power as buyer.   

China (Importer) — China Needs Oil

Currently, China is the world's second-largest oil consumer after the U.S. and in 2010 it became the largest energy consumer on a global scale. These results are quite astonishing because until the early 1990s China was still a net oil exporter. Oil in China is the second-largest source of energy (after coal) accounting for 18 percent of the country's total energy consumption. According to recent statistics by the Oil and Gas Journal (O.G.J.), the country holds 24.4 billion of barrels of proven reserves, which are the highest in the Asia-Pacific region. Over the last twenty years China has increased its oil and liquid production by approximately 54 percent, but, notwithstanding this production growth, the country has not been able to keep pace with the booming demand growth.

In 2013, China produced domestically an estimated 4.5 million bbl/d of total oil liquids (93 percent was crude oil), while in recent years the country's national oil companies have been in a spending spree linked to assets located abroad so as to secure additional oil supplies. In the last decade, China's national oil companies (N.O.C.s) have been active in the Middle East, North America, Latin America, Africa and Asia. "China's oil production from its overseas equity shares and acquisitions has grown significantly over the past decade from 140,000 bbl/d to an estimated 2 million bbl/d in 2012" has recently reported in its latest report on China the E.I.A.     

In 2013, the country consumed an estimated 10.7 million bbl/d (record highs). It's manifest that there is a considerable gap between the domestic and the overseas oil production on the one side, and the country's overall oil consumption on the other side. In 2013, on average China imported 5.6 million bbl/d — in practice oil imports now made up over 50 percent of total oil consumption. These barrels of imported oil come from different location, but the Middle East with 2.9 million bbl/d covers the lion's share of China's oil imports. Then, respectively follow Africa with 1.3 million bbl/d, the Americas 562,000 bbl/d, the Asia-Pacific region 129,000 bbl/d and 736,000 bbl/d from other countries. The following pie chart for year 2011 by the E.I.A. shows that out of a total of 2,525 bbl/d from the Middle East (Saudi Arabia, Iran, Oman, Iraq, Kuwait and the U.A.E.) in 2011 Saudi Arabia covered 40 percent of China's Middle Eastern oil imports. Recently, China has replaced the share of oil lost from Iran (international sanctions) Sudan and South Sudan (political conflicts between the two African countries) and Libya (domestic turmoil) with oil from other locations like the Middle East, Angola, Venezuela and Russia. Data from 2011 show that Russia shipped to China approximately 8 percent of China's overall crude oil imports.  

China has built three international oil pipelines connections with its neighboring countries so as to diversify its oil supply sources. They are:

• The Kazakhstan–China Oil Pipeline — In 2006,  Beijing inaugurated its first transnational oil pipeline, which shipped Kazakh and Russian oil through a 1,384-mile-long pipeline (with a capacity of 240,000 bbl/d) from western  Kazakhstan (Atyrau) to Chinese Xinjiang (Alashankou). Currently, this pipeline is undergoing some expansion plans aiming at almost doubling the capacity by the end of 2014. Under consideration there is the possibility of another pipeline from Kazakhstan to China — this project should supply crude from Kazakhstan's oilfields in the Caspian Sea region. 

• The Eastern Siberia-Pacific Ocean Pipeline (ESPO) — The 3,018-mile-long pipeline was constructed by Russia's Transneft, and it's a system to export Russian crude oil  from the oil fields in eastern Siberia to the Asia-Pacific markets (China, Japan and Korea). The pipeline runs from the Russian city of Taishet to the Pacific Coast. It was built in two stages. The first one consisted of a pipeline with a capacity of 600,000 bbl/d from Taishet to Skovorodino (Russia). From there, the China National Petroleum Corporation (C.N.P.C.) built a 597-mile-long pipeline to China's Daqing oilfield. This Skovorodino-Daqing pipeline became operational in January 2011 and now delivers up to 300,000 bbl/d of Russian oil to China (20-year supply contract). The construction of the second stage from Skovorodino to the Russian Pacific port of Kozmino, near Nakhodka, started after the launching of the first stage. Through the port of Kozmino Russia may export additional oil to China. Russia would like to expand the capacity of the Taishet-Skovorodino pipeline to 1.6 million bbl/d by 2018 and, consequently, to supply more oil to energy-hungry China. Until the ESPO spur to China is brought to full capacity, Russia's oil company Rosneft will ship to 140,000 bbl/d  of western Siberian oil to China through the Kazakhstan-China pipeline.  

   

• The Sino-Burma Oil Pipeline — In march 2009 China and Burma signed an agreement for the construction of an oil pipeline between the two countries. This 479-mile-long pipeline will be of paramount importance for the Middle East's oil shipments to China. In fact, Persian Gulf's oil will be shipped to Burma (via sea tankers) and then to China (via pipeline) bypassing the choke point of the Strait of Malacca (until now 80 percent of China's oil imports has passed through this strait). The maximum capacity of this pipeline will be 440,000 bbl/d when it comes online later in 2014.   

 

The Eastern Siberia-Pacific Ocean Pipeline (ESPO) — Source: The Economic Research Institute for Northeast Asia (Erina)

What Could Heavy Sanctions against Russia Mean for Saudi Arabia and the Middle East?   

Increasing its oil shipments to Asian customers for Russia is an important alternative and, at the same time, the natural and in a certain way long-awaited evolution of its oil-exporting economy. Of course, Russia and its Asian customers will have to strike a fair balance with reference to the agreed oil prices of their exporter/importer relation. It's true that for Russia it won't be easy to reduce its energy exports to Europe and the U.S. This is due to a consistent lack of infrastructures. But Moscow has already implemented steps aimed at developing an increased cooperation with China and all the others energy-hungry Asian countries. What is also clear is that Russia will compete in this Asian market with Middle Eastern suppliers, which are presently targeting Asian buyers in light of the fact that the U.S. covers a rising portion of its oil and gas requirements with its domestic production. Asia is the market to service for both oil and gas.

Let's now consider Saudi Arabia's oil exports. In 2012, Saudi Arabia exported an estimated 7.5 bbl/d of crude oil. Of this crude oil an estimated 54 percent went to East Asia. In addition to crude oil, the majority of Saudi Arabia's refined petroleum product and natural gas liquids (N.G.L.) went to East Asia as well. In specific, in 2012 Saudi Arabia exported to Japan, China, South Korea and India respectively 1.1 million bbl/d, 1.1 million bbl/d, 0.8 million bbl/d and 0.7 million bbl/d. These numbers say that for Saudi Arabia the Asian market is of paramount importance especially when Saudi Arabia and the Persian Gulf's other exporting countries need to maintain a high price of oil as a consequence of growing domestic budgetary obligations.

Together Russia and Saudi Arabia have a production of 22.1 million bbl/p in 2012 (respectively 10.5 bbl/p and 11.6 bbl/p), which equal more or less a quarter of the globe's crude oil production. But, Russia, which is not part of the OPEC cartel, and which is not aligned with OPEC's policies, is completely free to produce as much oil as it wants and to export it — of course provided that it has the required expertise and technology.

In particular, the ESPO pipeline has changed the oil game in Asia. In practice this pipeline has given Russia the possibility of selling crude oil in a market that before it could not reach. Before that, Russia's oil probably existed, but it was out of the market, while now it competes with Persian Gulf's oil in the same Asian market — this crude oil is a real alternative for Asian buyers. To get an edge in the competition with Russia and to maintain their quota in Asia, OPEC countries should reduce global oil prices, but given their budget problem it's almost an impossible task. Moreover, ESPO crude oil is of better quality — closer to the Libyan crude — than most Saudi crude, which not all refiners are able to treat.

It will be quite interesting to monitor future oil trends and the energy relations between Russia, China (and the other energy-hungry countries of East Asia) and Saudi Arabia (and the other OPEC producing countries, especially those located in the Persian Gulf). In fact, now it appears evident that Russia in the medium term could gain crude oil market quota in East Asia to the detriment of Saudi Arabia. The reason of this is linked to the way OPEC works.  

The real power that Saudi Arabia and the other OPEC members (within OPEC's 12 members 6 members are located in the Persian Gulf: Saudi Arabia, Kuwait, the U.A,E., Qatar, Iraq and Iran), which together are sitting on top of three-quarters of the world's conventional oil reserves, is the capacity to reduce/increase oil production. Of course, to adopt such policies these countries have to agree upon their oil policies — and this is not always sure 100 percent. On October 19, 1973 "a reduction of supply in the face of the same level of demand was guaranteed to drive prices up globally —for everyone — not just to those countries targeted by the embargo" affirmed Gal Luft and Ann Korin in their article The Myth of U.S. Energy Dependence (Foreign Affairs, October 2015). Rising and decreasing the price of oil is the power of OPEC. In practice, what the U.S. imports from the Persian Gulf is the price of oil. In fact, the U.S. has never been fully dependent upon Middle East's supply of oil — as a matter of fact today only 9 percent of U.S. oil supply comes from the Middle East and this percentage historically never rose to more than 15 percent.    

In practice with the same level of oil demand and no additional supplies OPEC:

• may reduce its production and contextually may increase the price of oil (Rule I)
• may increase its production and contextually may reduce the price of oil (Rule II)           

But with additional quantities of available crude oil, it is not so straightforward that the cartel may easily implement the two roles it has implemented for a long time — not mention that Libya, Iran and Iraq are all experiencing some exporting problems and their supplies are already partially out of the market. Of course this is a preliminary way to look at the arrival of Russian crude in East Asia. In fact, in addition to the concepts of supply and demand — which are the foundations of Rule I and Rule II — many other complex variables of course should be factored in. Among them it's worth mentioning:

• The impact of distance on deciding between pipelines and sea tankers
• Crude oil extraction prices according to different locations
• Crude oil quality: light/heavy and sweet/sour
• Reliability of the oil supplier (Saudi Arabia is extremely reliable)  
• Pure politics — which many times does not follow pure economic paths          

Conclusion

The basic idea of this analysis is to reflect on how a political crisis happening in Crimea could have in the medium term a geopolitical impact with reference to crude oil exports toward East Asia. The paper examines this geopolitical shift only for crude oil and it does not consider natural gas. The decision to focus the analysis only on crude oil is due to the fact that crude oil is the real money-making tool for Russia (37- to 38 percent of the national budget of Russia). Russia will have to continue developing its oil industry very carefully and in the medium- to long-term horizon it's natural that it will increase its attention to Eastern Asian markets. In this analysis China is the representatives of the countries of East Asia and Saudi Arabia the representative of the countries of the Persian Gulf. The decision to choose these two countries was simple: China has the world's second-largest economy in terms of nominal G.D.P., while Saudi Arabia is the world's most important oil producing country and the most important OPEC member (as well as the world's swing producer). Indeed, this game between Russia and Saudi Arabia to conquer the Asian oil markets could bring about an energy geopolitical shift with, thus far, very unclear outcomes.       

 

Only Political Stability May Provide Lebanon With the Long-Awaited Energy Sector

February 28, 2014

BEIRUT, Lebanon — A country without political stability and consequently without good governance is a country with no encouraging future. And Lebanon exactly epitomizes a  condition of chronic political instability now exacerbated by the possible spillover of the civil war ravaging neighboring Syria. In addition to this, in Lebanon there are more than one million of Syrian refugees, whom the already well-strained Lebanese economy is unable to accommodate. Following recent years' discoveries of relevant quantities of oil and gas — current estimates speak of 1.7 billion barrels of oil and 123.6 trillion cubic feet of gas — in the Levant Basin, in the eastern Mediterranean, Lebanon is now trying to develop its oil and gas sector, which could spur that much needed economic growth and reduce the country's public debt standing in 2013 at 145.9 percent of G.D.P. The problem is that under the current political instability, internal as well as external, such an endeavor is almost an impossible target. Not to mention the security of Lebanon where Al-Qaeda-linked explosions now occur almost on a weekly basis.       

Proof of Lebanon's difficulties is the fact that of the countries touched by the Levant Basin — Syria, Lebanon, Israel, Gaza and Cyprus — in the oil and gas business Lebanon is consistently behind schedule, notwithstanding that it could probably have the largest reserves. For instance, it's quite impressive that after two and a half years of war, Syria, as recently as last December, signed a deal with Soyuzneftegaz, a Russian state-controlled energy group, with reference to the rights to develop and to produce oil and gas off Syria's coast. Similarly, Cyprus is implementing its gas licensing rounds and wants to build an L.N.G. export terminal, while Israel already carried out its first gas delivery on March 31, 2013, and recently signed a deal with two Jordanian firms to sell $500 million of gas — first agreement of this type outside of Israel. In Gaza, after years of embittered relations between Israel and Gaza over territorial waters, the Palestinian Authority and Russia are in talks to sign an agreement permitting Russia to develop Gaza's offshore gas fields.

In Lebanon, 2D and 3D seismic surveys offered positive results and brought the previous minister of energy and water, Gebran Bassil — he is now foreign minister — to affirm that the country could have, under a 50 percent probability, 95.9 trillion cubic feet (TCF) of gas and 865 million barrels (MMBL) of oil. Last year, forty-six companies prequalified to bid for the Lebanese offshore gas riches, which had been split among 10 sea blocks. Last November, the government should have held the auction for these blocks, but since then this auction has been postponed three times and its official deadline is now April 10, 2014. This postponement is linked to the government's inability to approve two decrees that deal with the demarcation of the sea blocks and the clarification of the financial features of the energy contracts. Despite possible interesting reserves, oil and gas companies with difficulty could be lured into investing without plain details.  

  

Minister of Foreign Affairs Gibran Bassil (previously minister of energy and water)

    

Will this auction be postponed one more time? It's probable. But here one consideration stands out immediately. The real problem for Lebanon is not what to include in the two fundamental decrees. Lebanon is not the first country nor the last that will have to strike a balance between its economic interests and those of the energy companies. In the oil and gas sector — where there are always important sunk costs — there is constantly a balance between the involved parties. And similarly, developing reserves in deep waters, like for instance those of Lebanon, is not anymore an impossible task for international oil and gas companies. It could cost more, but again we go back to striking a fair balance between the hosting state, on the one side, and the companies, on the other side. So what is stopping Lebanon from developing its energy sector? The answer is simple: its political instability, which now is increasing thanks to the Syrian civil war.

In fact, also during normal times, politics in Lebanon is difficult because it's based on sectarian divisions. According to the country's Constitution, the president of the republic has to be a Christian Maronite, the prime minister a Sunni and the speaker of the Parliament a Shia. Furthermore, the seats in the Parliament are divided on a sectarian basis as well. After the resignation of Prime Minister Najib Mikati in March 2013, a caretaker government was in charge for almost one year. Only on February 15, 2014, a new government was formed with Mr. Tammam Salam as prime minister. At present, the new government is drafting its policy statement, which later the Parliament will have to approve. Drafting this document is not easy because there is the controversial issue of how to define the presence in Lebanon of the armed resistance embodied by Hezbollah. At the same time, this new government is perceived as temporary because it should be in charge until May's presidential elections, unless the political factions are not able to reach an agreement on the new president. Moreover, to an already complicated domestic political environment, the Syrian crisis has added further complexities: The Lebanese politicians are now divided between those who support Syria's government forces and those who rather favor the opposition to Bashar al-Assad. 

    

Lebanon's First Offshore Licensing Round

Besides, the Sunni-Shia conflict is well evident in relation to the energy issue. Indeed, on the one side, the two still-to-be-signed energy decrees have found strong opposition from the March 14 Alliance (a Sunni and Christian alliance whose main party is the Future Movement, a Sunni party), which is close to Saudi Arabia, a country that does not see with great favor the establishment of an upstream oil and gas sector in Lebanon. On the other side, the pro-Iran March 8 Alliance (a Christian and Shia alliance, whose main parties are the Free Patriotic Movement, a Christian party, and Hezbollah, a Shia party) supports the development of the energy sector. It's still premature to know whether the newly appointed Minister of Energy and Water Arthur Nazarian, an Armenian, will speed up the development of the energy sector. But one consideration stands out immediately: Considering that this winter in Lebanon has been almost completely without rainfalls, it's probable that Mr. Nazarian's first concern will be the availability of water for the agriculture sector and for a population that with the Syrian refugees has increased by 25 percent — from 4 million to 5 million at least. 

Summing up, it's very difficult that the political agenda of the next months may include a real advancement of the energy dossier in Lebanon. It's a sort of irony that during last year's political debates many local politicians discussed how to invest the future energy profits so as to avoid the so-called resource curse, although with Lebanon's proposed contracts (production sharing agreements) profits are postponed to the beginning of production. And in Lebanon if we started to develop the energy sector tomorrow, it would take at least six to seven years before we could get oil or gas. But again, without political stability and  good governance it's quite difficult that Lebanon will establish its oil and gas sector.  

For more information about the development of an energy sector in Lebanon please see:

• BACCI, A., O&G in Lebanon: Interview with Egypt's Citadel Capital's Managing Director, Mr. Mohamed Shoeib, May 2013 
• BACCI, A., Lebanon's Offshore Gas Resources: It's Time to Decide, April 2013
• BACCI, A., Forty-Six I.O.C.s Will Bid for Lebanon's Offshore Hydrocarbon Exploration, April 2013

The Kurdistan Regional Government's O&G Riches Play a Significant Role in the K.R.G.-Iraq Fault Line Conflict

January 31, 2014

BEIRUT, Lebanon — In 1996 with "The Clash of Civilizations and the Remaking of  World Order" Samuel Huntington provided us with a clear understanding of "fault line wars". He defines them as wars between clans, tribes, ethnic groups, religious communities, and nations. Then, he underlines that these wars have been prevalent in every era and in every civilization and are rooted in the identities of people. These conflicts are in general particularistic, which means that they do not involve broader ideological or political issues for nonparticipants. Moreover, they tend to last for a long time, interspersed by truces and/or agreements, but they tend often to resume fighting. Professor Huntington continues saying that fault line wars are communal conflicts between states or groups from different civilizations. 

These wars may occur:

A)Between states,

B)Between nongovernmental groups and

C)Between states and nongovernmental groups.     

Let's focus on fault line conflicts within states. These may encompass groups that are located in geographically distinct areas. In such a case, a group that does not control the central government fights for independence and — still according to Huntington — may or may not be ready to accept anything less than independence. The majority of times the stake is purely the control of the territory.  

The Fault Line Conflict Between the K.R.G. and Iraq Proper

Thanks to the map below it's possible to note how Iraq is a country with a clear geographical demarcation of its territory among different ethnic and religious groups. 

Ethnic and Religious Groups in Iraq - Source: Wikipedia

If we contextualize Huntington's ideas about fault line wars within contemporary Iraq, we may understand that the relations between Kurdish people and the Iraqi central government have always lent themselves to being defined as a fault line war. The only real point that does not overlap with Huntington's definition is that for the American scholar fault line wars do not involve ideological or political issues for nonparticipants — and honestly it's difficult in today's Middle East not to consider the Kurdish-Iraqi dispute as something that does not affect neighboring countries. ­ ­­

To understand today's events in the Kurdistan Regional Government (the K.R.G.) it's of some help to go back to the beginning of the 20th century. After World War I, the League of Nations granted the United Kingdom (U.K.) two mandates: the first over Palestine (at that time Mandatory Palestine and Transjordan) and the second one over what later would become Iraq. On December 1, 1918, in the city of Sulaymaniyah, some Kurdish leaders demanded for Kurdistan a sort of independence under the framework of a British protectorate. The result was not positive. Indeed, the real first initial episodes of the Kurdish struggle for establishing an independent Kurdistan were the two revolts (1919 and 1922) under the leadership of Mahmud Barzanji against the British rule. 

Mahmud Barzanji

The U.K. ended these uprisings only in 1924 after consistent efforts. These two revolts may be considered as the beginning of the contemporary fault line war between the Kurdish people and the central power: a fight first against the U.K. and then — after London granted independence to the Kingdom of Iraq in 1932 — against the central government in Baghdad. Of course, last century saw periods of open fights and periods of relatively more diplomatic relations, but in general for all the 20th century the relations between the Kurdish people and their central government had been difficult for utilizing just an euphemism.  

Today's Iraqi Kurdistan is an autonomous region in northern Iraq, and it's officially governed by the K.R.G. with Erbil as its capital. The path to obtaining regional autonomy has been indeed very difficult. In fact, after the First Iraqi-Kurdish War (1961-70) autonomy was established in 1970, but the new Kurdish Legislative Assembly was a simple and pure emanation of Baghdad's central government and this meant that in reality there was no autonomy at all. Then, things complicated one more time with the Second Iraqi-Kurdish War of 1974-75 because at the end of this conflict Baghdad extended its control over the northern region. The central government also implemented an Arabization program moving Arab people especially to the vicinity of Kurdistan's oil fields (around the city of Kirkuk).

The situation improved only after the 1991 uprising against President Saddam Hussein at the end of the First Gulf War (1991). At that time, the U.N. Security Council with resolution 688 created a safe haven for the Kurdish people. In addition to this, a no-fly zone was established by the U.S. and the U.K. over northern Iraq (although it did not include two important cities like Sulaymaniyah and Kirkuk). Finally, in October 1991, after months of harsh fighting between President Hussein's forces and the Kurdish troops, a sort of unstable balance of power was reached. Iraqi Kurdistan got its regional autonomy. The last step for strengthening Kurdish stance toward Baghdad was during the Second Gulf War (2003-11 — if we consider the timeframe up to the withdrawal of all the American personnel) when Baghdad accepted the creation of a federal system.    

What Are the Reasons for Today's Tensions Between the K.R.G. and Iraq Proper

Today's relations between the K.R.G. and Baghdad are tense, and, notwithstanding some declarations aiming to assuage the current standoff, it appears that no easy way out will be found soon. The current disagreement is based upon two main reasons:

1) The management of the K.R.G.'s oil and gas riches — Current data speak about 45 billion barrels of oil, i.e., one-third of Iraq's proven reserves (proven reserves are those with a 90 percent certainty of being produced at current prices with current commercial terms and government consent; they are known in the industry also as 1P) which are estimated at 150 billion barrels. In other words, quantitatively (not qualitatively because Erbil has heavier oil) the K.R.G. could be another Libya. In addition to oil, the K.R.G. has  3 to 6 trillion cubic meters (TCF) of potential gas reserves. The relations between Erbil and Baghdad have worsened again since the U.S. oil supermajor, ExxonMobil decided to start negotiating drilling contracts with the K.R.G. in 2011. In this way, the American energy company bypassed Baghdad's authorization. In fact, Baghdad affirms that it alone has the right to negotiate and sign energy deals for the whole Iraqi territory, the K.R.G. included. Erbil insists that Iraq's Constitution allows it to agree to contracts, and as a result to ship oil independently of the central government (for more information see: BACCI, A., Chevron and Total Continue Investing in the K.R.G. A Brief Analysis of Baghdad's T.S.C.s vs. Erbil's P.S.C.s, June 2013).

2) Territorial control of the disputed areas — All along the border between the K.R.G. and proper Iraq there are regions that during the rule of the Baath Party were massively Arabized. Historically, the majority of these regions have been inhabited by Kurdish people. With the arrival of the American army in 2003, the Kurds started to move south regaining part of that land that intrinsically they have always considered of theirs. The three governorates Nineveh, Kirkuk and Diyala are all split into two parts: one controlled by Erbil and one by Baghdad. And of course, both the K.R.G. and Iraq would like to have full control of these governorates. The huge importance of Kirkuk is linked to the fact that it sits on the giant Kirkuk oil field, which as of 1998 owned around 10 billion barrels of oil. Recently British Petroleum (B.P.) showed a certain interest for the Kirkuk oil field. 

Map of the K.R.G. and of the Disputed Territories

The K.R.G.'s Reserved Allocation of the Federal Budget 

The K.R.G. receives a 17 percent allocation of the Iraqi federal budget, which is primarily funded by revenues from oil and gas exports. Until December 2012 Erbil exported its oil through the Kirkuk-Ceyhan Pipeline (under the control of Baghdad), and it did not cash in the revenues directly. Instead, these were accrued — like the revenues from other governorates — to Baghdad's central coffers. Then, the resources were distributed as part of the annual budget to the different governorates in proportion to their population — given the absence of an official census, the population was calculated according to the U.N. food ration system created in the 1990s and since then regularly updated.

The K.R.G. is an exception to this system because its three governorates receive a flat 17 percent allocation of the federal budget (before deductions to cover federal expenditures from which the region benefits). This system while, on the one hand, is fair for the individual Iraqi citizens because each of them receives an equal share, on the other hand, is not fair for the oil and gas producing governorates (for instance, the three K.R.G. governorates or Basra Governorate in southern Iraq), which finance also the non-producing governorates. During the last years, many K.R.G. officials have denounced the 17 percent budget allocation as unreal, because for them the K.R.G. has never received the allocation in full. "They never give us 17 percent. They only give us 10 percent" said recently Rashid Tahir, the K.R.G. deputy minister of finance. 
 

Recent data point out that Iraq will not be able to finance its projected 2014 budget deficit unless the K.R.G. pays its oil export revenues. In specific, it seems that if the central government keeps paying 17 percent of the budget allocation to Erbil without getting back the Kurdish oil export proceeds, Iraqi public finances will collapse. The proposed Budget Law 2014 projected a deficit of $18 billion notwithstanding the assumption that the Kurds paid the Treasury the revenues from Kurdish export of 400,000 barrels per day. The federal considerations about the difficulties of stabilizing the federal budget may be correct, but the assumptions that the K.R.G. could export 400,000 barrels per day seem, at least for now, unreal. Reliable energy sources speak of possible Kurdish exports of 255,000 barrels per day. At the moment, the payment of the 17 percent budget allocation is a very hot topic with federal ministers taking different sides. Anyway, until now, notwithstanding the fact that the K.R.G. did not meet its 2013 export commitments, Baghdad is still paying the 17 percent allocation.      

Also linked to the amount of the budget allocated for the K.R.G. is the issue of the payments of the investment and operating costs incurred by the companies working in the K.R.G. This has been a very difficult topic since the spring of 2009 when the K.R.G. exported its crude oil for the first time. This oil came from the Tawke and Taq Taq oil fields. In principle, Baghdad accepted the validity of the K.R.G. contracts signed before 2007 (when there was a stalemate as for drafting a federal hydrocarbons law and subsequently the K.R.G. issued its own hydrocarbons law — in 2014 Iraq does not have yet any federal hydrocarbons law), but it does not accept them as production sharing contracts (P.S.C.s). This differentiation between the contracts on offer in proper Iraq, which are technical service contracts (T.S.C.s), and in the K.R.G., P.S.C.s, is still well present in 2014 — at least on papers. The current position in Baghdad is that the contracts that the K.R.G. signed with foreign companies after February 2007 are completely illegal, unless these contracts have been sent to the federal government which may accept, modify or reject them. Contracts predating February 2007 are instead considered valid after a simple review and potential amendments. Presently in the K.R.G., there are around fifty international energy companies (among them four big names: U.S. ExxonMobil and Chevron, France's Total and Russia's Gazprom), which have invested more or less $20 billion.

Initially, Baghdad had affirmed that the profits of the companies operating in the K.R.G. (of course we are talking of companies working under contracts deemed legal by Baghdad) should come out from Erbil's annual share of the federal budget. But later, after months of difficult negotiations Baghdad accepted to reimburse the companies according to an audit of their expenses. And in November 2010, the two parts renewed their arrangement, and the new terms envisaged that the federal government utilized 50 percent of the U.S. dollar value of the export revenues to repay the companies for the investments and operating costs following presentation of the related receipts. Baghdad was available to pay the so called cost oil. Any payment for profit oil was out of question because P.S.C.s were deemed illegal. If profit oil had to be paid these funds should come from the K.R.G. budget allocation. There was also a quota of barrels that the K.R.G. had to provide. This quota has been revised several times since then, although it has always been difficult for the K.R.G. to satisfy the agreed-on barrels per day. Complaining that the federal government was not paying its dues in favor of the companies, in April 2012 the K.R.G. halted a first time its exports. Then, it resumed them in August before stopping completely them in December 2012. The 2013 budget allocated $650 million to the foreign firms while Erbil's request was $3.5 billion.     

Another point of strong budget disagreement concerns the payments requested by Erbil for its Peshmerga troops. In fact, since 2011 the K.R.G. has substituted foreign security contractors deployed on the oil and gas fields with its Peshmerga troops in both the proper K.R.G. and in the disputed areas. Since then, Erbil has been requesting the reimbursement for this deployment from the central government. Logically, Baghdad strongly has opposed any reimbursement of this type and in specific those payments related to the deployment of the Kurdish troops in the disputed areas.    

Why Does the K.R.G. Have Some Leverage Against Iraqi's Control?

Hydrocarbons mean money (at least if the endowed countries exploit oil and gas avoiding the "Dutch Disease") and money means power. Erbil could monetize its oil and gas riches exporting them to Turkey according to two different ways:

A) Exporting its riches under Baghdad's control, but with no political leverage or

B) Exporting its riches independently of  Baghdad's control with political leverage.

A preliminary consideration stands out immediately: The real customer for the K.R.G. oil an gas is Turkey, which, as recently as last November, concluded a multibillion-dollar energy deal (oil and gas) with the K.R.G.. Turkey has a huge appetite for the K.R.G. oil and gas and it has a ballooning $60 billion energy bill. Ankara needs to diversify the security of its energy supplies. Presently, it imports 92 percent of its oil and 98 percent of its gas and it depends mostly on Russia and Iran.

Until December 2012 Kurdish crude oil was exported under Baghdad's control. In fact, the K.R.G. flowed approximately 200,000 barrels per day to Turkey, via the central government export line, i.e., the Kirkuk–Ceyhan Pipeline. 


Kirkuk-Ceyhan Oil Pipeline - Source: Wikipedia

Then, Erbil closed this route because of its row with Baghdad over payments for the oil companies operating in Kurdistan. Since the stop, the Kurds have been exporting 30,000 to 50,000 barrels per day of oil via truck to Turkey. With no doubt, this was a negligible quantity, but in the meanwhile the Kurds have completed their own independent pipeline (the current capacity is 300,000 barrels per day) from the Taq Taq oil field to Fishkhabur, close to the Turkish border. From there oil enters the Kirkuk–Ceyhan oil pipeline and continues to the port city of Ceyhan. In other words, the K.R.G. “dug up the dormant half of the twin Kirkuk-Ceyhan pipeline, blocked the end coming from government of Iraq territory, and commenced to tie in their own newly built pipeline spur to it,” commented David Romano, a professor of Middle East Politics at Missouri State University. 

The Taq Taq-Fishkhabur Oil Pipeline - Source: The American Interest (Dec. 2013)

The legality of using part of the Ceyhan-Kirkuk oil pipeline, although the section located in Turkish territory, without prior consent of Iraq seems dubious on the basis of the Pipeline Tariff Agreement between Iraq and Turkey. This agreement was renewed in 2010 for 25 years. Similarly, there should be a legal ground for Baghdad to receive transit fees for the oil shipped to Ceyhan by the K.R.G..

After some tests done in December 2013, from the beginning of January 2014 the new infrastructure has been exporting oil to Ceyhan. For the moment, crude oil is being stored in terminals in Ceyhan and it will not be exported. Here, the real question is how long the Turkish state-owned pipeline operator will be able to continue storing crude oil at the Ceyhan's tanks before running out of capacity. Ceyhan's overall capacity for the K.R.G. oil consists of three tanks, each with a 2.5-million-barrel capacity. At the end of January 2014, approximately 220,000 barrels of crude oil has been stored. Recent information released by the K.R.G. Ministry of Natural Resources declared that the first parcel of 2 million barrels of oil would be sold by a tender and that monthly export parcels would increase to 4 million barrels in February and to 6 million barrels in March. The current plan is to arrive at a quantity between 10 to 12 million barrels in December 2014.     

The Turks, through Energy Minister Taner Yildiz, are trying to appease Iraq affirming that oil will not be exported without the consent of the Iraqi central government. Another profile of illegality could be that if the K.R.G. withheld its export earnings it probably would violate a U.N. Security Council resolution under which all Iraq's oil exports proceeds must be paid in a U.N.-approved account in New York, U.S. The reason of this methodology is that a five percent amount should be deducted later to pay war reparations to Kuwait for the invasion of 1990.     

Notwithstanding the construction of the Kurdish pipeline, Baghdad would like now to recreate an exporting scheme under its control. And in this regard, last months have seen Baghdad's constant proposition of exporting the K.R.G. oil through Iraq's State Oil Marketing Organization (SOMO), which alone should have the right of selling Erbil's oil and gas. In specific, Baghdad would like to place the resulting income into the Development Fund for Iraq in New York. Instead, the K.R.G. would like to withhold revenues to account for the money owed by Baghdad (17 percent annual share of the federal budget, the payment for the Peshmerga forces and the payments to the foreign oil companies) or alternatively to put oil revenues in an escrow account with Turkey's Halk Bank.

Until now, the storage tanks are far from being full. Once the tanks are full, Turkey will have to decide what to do with the stored oil. And it will not be an easy decision. And similarly, it will not be an easy decision for the companies interested in buying that oil. The reason is simple: Many companies do important business with Iraq, but why should they put themselves at the risk of Baghdad's retaliations? Especially, when crude oil from Erbil is not a game-changer quantity, while, at the same time, Baghdad controls some of the world's largest projects. We could learn a good lesson in this regard from British Petroleum (B.P.) and Royal Dutch-Shell (R.D.S.), which for economies of scale chose to stay with proper Iraq and up to now have not invested in the K.R.G. (for more information see: BACCI, A., BP Continues Investing in Iraq. With T.S.C.s the Devil Is Always in the Detail(s), October 2013, and BACCI, A., Shell's Majnoon Oilfield and the Company's Other Operations in Iraq, November 2013). In the same way, traders are wary: Switzerland's Vitol and Glencore supply Iraq with shipments of fuel and do not want to risk being banned from Iraq, as it happened to Trafigura, a Swiss trader that had previously traded Kurdish oil.   
    

In this chaotic situation, where both the K.R.G. and Iraq have some cards to play, it will not be easy to find a fast and durable solution. If the K.R.G. proceeds with its plan of bypassing Baghdad's control, Iraq could react implementing the following four actions:

1) Cutting the K.R.G. budget.

2) Taking legal actions against the K.R.G..

3) Taking legal actions against Turkey.

4) Taking legal actions against the companies (oil companies and traders) buying the oil shipped at Ceyhan.  

At the same time the K.R.G. knows that it could reply by:

1) Not allowing the flow of oil from the Kirkuk oilfields to Ceyhan (in fact, a stretch of the Kirkuk-Ceyhan Pipeline runs through the K.R.G. territory).

2)Not supporting Prime Minister Nuri al-Maliki of Iraq during the parliamentary elections due on April 30, 2014. Prime Minister al-Maliki wants to win a third term and needs Kurdish votes.

3) Withdrawing the support of the Peshmerga forces in contrasting al-Qaeda's operations in Iraq, especially in the disputed territories.

Is the K.R.G. Aiming to Becoming Independent?

With no doubt Iraq is one of those Middle Eastern countries whose borders the European countries carved out without a complete understanding of the complex ethnic and religious dynamics present in the area. Kurdish people are an Iranian people speaking Kurdish languages, which belong to the Iranian branch of the Indo-European languages. On the religious side, they adhere to many different religions and creeds. And historically, they have always performed their religiosity in a freer manner than that of the Arabs. In other words, with the Kurdish people we are talking about a group with not many commonalities with the Arabs present in Iraq.

During the second decade of its existence, the K.R.G. has been quite successful in the process of state-building in a complicated region. The K.R.G. is a parliamentary democracy with a regional assembly with 111 seats and has a regional government. It's a stable area with — thanks to the hydrocarbons riches — a fast-rising economy. What was some years ago just a guerrilla force (the Peshmerga) is now an army of approximately 200,000 soldiers equipped with heavy arms. Plus, the K.R.G. owns a fleet of Russian-made warplanes (a legacy of Saddam Hussein's era) as well as tanks obtained during the 1991 and 2003 wars. Last September, the K.R.G. showed interest for the purchase 12 new helicopters from an American company.   

Summing up, the K.R.G. is a de facto state. As Yaniv Voller of the London School of Economics (L.S.E.) puts it:

The K.R.G. is, in essence, a de facto state. It has gained domestic sovereignty, runs its own civilian affairs and has independent (informal) relations with other states. Yet, its right to have such sovereignty is constantly disputed by international society, so does any aspiration to institutionalize this independence.

Moreover, the word Kurdistan does not relate only to the K.R.G. but to an area where the Kurdish people form the majority of the  population. This area encompasses large parts of eastern Turkey, Iraqi Kurdistan , northwestern Iran and northeastern Syria. All the four involved states — Turkey, Iraq, Iran and Syria — have experienced difficulties to deal with the Kurdish people present in their territory. As Professor Ofra Bengio recently well explained in her article "The Elephant in the Room":

... the rise of Kurdish issues in all four states has changed the internal dynamics of Kurdish nationalism. An evolving trans-border current has produced a de facto Kurdish regional subsystem whose manifestations are several. First, the Kurds now imagine themselves to be one nation deserving to live on one united territory; this is new. Thus, the new mind’s-eye Kurdistan is portrayed as one unit divided into four parts: north Kurdistan (bakur) corresponding to the Kurdish region in Turkey, south Kurdistan (bashur) to that in Iraq, east Kurdistan (rojhelat) to that in Iran, and west Kurdistan (rojava) to that in Syria. No one should discount the power of having a common geopolitical language in a nationalist ambition.

Kurdish Inhabited Area - Source: CIA (1992)

In practice, continues Professor Bengio:

the K.R.G. in northern Iraq is the center of gravity of this new subsystem. It functions simultaneously as a quasi-state and as a political center for the other three parts of Kurdistan, as well as for the large number of Kurds in the diaspora. Despite a strong legacy of civil war, jealousy and rivalry, most Kurds now look upon the K.R.G. with great pride and view it as a model.

Considering all the elements mentioned above, it's not easy to rule out the possibility that the K.R.G. will not try to become independent, especially when hydrocarbons are giving the K.R.G. so powerful a tool for getting independence. In fact, according to Kurdish calculations, at current oil prices once Erbil reaches around 450,000 barrels per day, it will own earnings more or less equal to the $12.5 billion which Baghdad handed over to Erbil in 2013. Summing up, 450,000 barrels per day could be the threshold after which the K.R.G. would not anymore be financially dependent on Baghdad. Of course, a conditio sine qua non is to have buyers for the crude oil stored in Ceyhan.    

At that point, it's difficult to imagine why in the long term the K.R.G. should continue to be just an autonomous region within the framework of Iraq. Probably, in the short- to medium-term there could be some advantages for both the K.R.G. and Iraq in maintaining the status quo, but in the long run the above mentioned differences could play a very relevant role. Surely, the next months will be of paramount importance for the future of the K.R.G. and Iraq.