The Baku-Ceyhan Pipeline Mixing Oil and Water with Business and Politics

Van V. Miller College of Business Texas A & M International University Laredo, TX 78041

Milo C. Pierce (Retired)

College of Business Texas A&M University-Corpus Christi Corpus Christi, TX 78412

Robert J. Hoover College of Business Idaho State University Pocatello, ID 83209

The authors wish to thank Joshua Been from the Killam Library for his extraordinary work with the maps. © Van V. Miller, Milo C. Pierce, and Robert J. Hoover, 2003 Submitted to the 2002 AIB-CIBER Case Competition and published in the CIBER Case Collection at the European Case Clearing House

The Baku-Ceyhan Pipeline: Mixing Oil and Water with Business and Politics I.

Introduction

While reading the information and facts presented in the pages that follow, put yourself in the shoes of an oil company executive with primary responsibility for your company’s Caspian Sea investments. As a member of the pipeline consortium, how would you plan for the contingencies presented by the circumstances found in this highly volatile industry and region where a war with Iraq has just commenced?

For the past several years, a major business development facing the international oil industry has been the subject of intense negotiations involving numerous firms and nations. The issue being debated has dealt with how to transport vast quantities of crude oil from the Caspian Sea region to the major markets where it is to be refined and sold (see Kalicki, 2001, for the most recent and authoritative discussion of this issue). As matters now stand, one of the agreed upon primary routes is a pipeline starting in Baku, Azerbaijan on the west coast of the Caspian Sea and terminating at Ceyhan, Turkey on the far eastern shores of the Mediterranean Sea. The best of intentions notwithstanding, it would be folly to consider any contractual agreement for the oil and gas industry in this part of the world to be complete or final. In fact, the reality of the November 1999 Agreement was itself a quite surprising achievement given the circumstances explained herein; however, the Attack of September 11th and Hussein’s apparent downfall in Iraq now make matters even more complicated. Though little has changed in terms of the quantitative analysis that influenced the 1999 decision (oil reserves/supply and demand remain almost the same), the political situation now facing a business decision-maker has been rendered much more complex and uncertain.

The circumstances or the setting of the Baku-Ceyhan Pipeline Agreement are the primary focus of this case analysis. Before examining closely the matters that impact the Agreement, the setting surrounding oil from the Caspian region will be explained and described. That setting includes not only the observable facts regarding global energy production and consumption but also the geography influencing decisions by major actors about the many possible routes for transporting Caspian Sea oil. This descriptive overview is being given in the hopes that it will help to reduce the complexity that can arise when the many circumstances affecting pipeline decisions are presented and examined. That complexity results not only from the sheer number of actors involved, but also from the divergent corporate and national interests and from the several geographical obstacles that have mutually constrained and shaped the terms of the Agreement. Though there are multiple perspectives from which the significance of the Baku-Ceyhan Pipeline Agreement can be studied and appreciated, an approach which emphasizes the underlying

2

influence of geography (please refer to Map 1 in order to visualize the region of the world where the Pipeline will be located) upon business and political decisions will yield greater understanding and shed a distinct light upon the basic parameters of foreign direct investment (Dunning, 2000). Such a view is based first and foremost on the facts of the situation as revealed in the pages that follow, and it is also grounded in the perception that there is an ignorance and dismissal of geographical reality in the emerging world of cyber space. Nothing against the cyber world with its web sites and e-commerce (in fact, much of the information needed for this case was accessed through the Internet), but there does exist geographical reality—mountain ranges and deep seas are very real and quite permanent when compared with web sites that now have half-lives measured in months.

Furthermore, the reality of physical geography can impact

business outcomes. Not all business decisions are directly influenced by geography, but some, such as those involving the Baku-Ceyhan Pipeline (BCP), are, and that is a point needing emphasis in a world that fancies electronic connections to be true reality.

Map 1 The Caspian Sea Region and the Baku-Ceyhan Pipeline Kazakhstan

3

II.

The Setting—The Oil Issue and the Geographic Context of the Caspian Sea Region

For oil has meant mastery throughout the twentieth century… As we look toward the twenty-first century, it is clear that mastery will certainly come as much from a computer chip as from a barrel of oil… Yet the petroleum industry continues to have enormous impact… Until some alternative source of energy is found, oil will still have far-reaching effects on the global economy; major price movements can fuel economic growth or, contrarily, drive inflation and kick off recessions. Today, oil is the only commodity whose doings and controversies are to be found not only on the business page but also on the front page. Yergin (1991, 12-13)

As noted above, oil is incredibly important and controversial because it represents a major energy source in modern economies and a primary input into essential products such as plastics and fertilizers. Modern societies depend on it to such a high degree that they will launch major military actions, e.g. the 1991 Gulf War, when they sense that their security is threatened by a disruption in the oil supply, or the 2001 Afghanistan War, when they sense an opportunity to secure future oil supplies (Banerjee & Tavernise, 2001; Gowans, 2001; Haslett, 2001; Huerta, 2001; Kinzer, 2001; Klare, 2001). As noted by Yergin in the quote above, oil’s economic dominance will wane in the coming decades, but its incredible importance to the world economy will last until alternative energy sources have effectively replaced it. Though several alternatives currently exist, they are still not economically effective; thus, for the foreseeable future oil will continue to reign supreme. Given oil’s current economic supremacy as an energy source, the major issue facing an investorowned oil company, which is clearly the case for a Western oil company like Shell or Chevron, is the financial return earned from its investments in oil assets, e.g. refineries and pipelines. When analyzing and comparing different investment options, an oil company manager must deal initially with projections about the supply and demand for oil. These projections provide an initial glimpse into the revenues and costs that drive calculations of financial return.

A general overview of the market setting can be ascertained by studying the data revealed in Tables 1, 2, and 3. The numbers in those Tables indicate that the three major areas of oil consumption are North America, Europe, and Asia Pacific and that the two major areas of production are North America and the Middle East. Nevertheless, there does exist significant production capability in all areas of the world. North America, Europe, and Asia Pacific all consume more than they produce, but the excess of consumption over production is more pronounced in Europe and Asia Pacific than in North America. Thus, in geographic areas such as the Middle East where production exceeds consumption, the excess oil will be exported mainly to

4

Europe and Asia Pacific and not to North America (Jaffe & Manning, 2000). In light of transportation costs, this trading of oil between the Middle East and Europe/Asia Pacific should continue for many years as shown in Table 3—65.3% of the proved oil reserves are located there.

Focusing more specifically on the Caspian Sea region, for which the BCP is to provide an outlet, it appears at this time to be of minor consequence within the world oil setting. Looking closely at Table 4, we see that its production in 1997 was below that of 1990 but has now recovered and surpassed the output of 1990. In addition, its daily production of more than 1.2 million barrels is just a fraction of the approximately 75 million barrels consumed daily in the world, and its exports of oil are now about three-fourths of its total production. The recent gains made in the region have been outstripped by the increases in production and distribution now being experienced in Russia (Scheiber, 2002; Tavernice, 2003; Yergin, 2002). In terms of proven oil reserves, Table 5, based on U.S. government data, reveals that the region has 10.0 billion barrels (15 billion if data calculated differently by British Petroleum are used), but proven world reserves, according to the figures in Table 3, amount to more than 1,000 billion barrels. The region appears to have one percent or slightly more of the world’s known oil reserves. Possible reserves may raise its importance at some future date, but not now. In light of the region’s current insignificance on the global oil scene, one must ask why, as the discussion below will reveal, has so much emphasis been placed on the development of a pipeline here?

Table 1 World Consumption of Oil

Table 2 World Production of Oil

Table 3 Proven Reserves of World Oil

Table 4 Caspian Sea Region Production and Exports of Oil

Table 5 Caspian Sea Region Proven Reserves of Oil

5

The answer to the pipeline question comes in three parts—two parts business and one part politics. First, the oil in the Caspian Sea region cannot be transported to the markets in Europe and Asia Pacific without a pipeline. Over a century ago when oil fields around Baku were seriously developed for overseas markets, the oil was carried in rail cars to a Black Sea port and then loaded into sea-going tankers, but the rail cars were and still are not as effective as a functioning pipeline (excellent histories can be found in Amineh, 1999; Croissant & Aras, 1999; and, van der Leeuw, 2000). As the map of the region demonstrates, the area is landlocked and far removed from the primary areas of oil consumption. Thus, Caspian Sea oil cannot be utilized efficiently unless it is sent via a pipeline(s) to a port(s) where it can be loaded into tankers and then transported to the major markets. The pipeline represents the tactical part of the business solution for the use of Caspian Sea oil. It is strategic only to the degree that strategy execution becomes dependent upon tactical activities. Second, predictions and forecasts about oil supply, demand, and pricing are notoriously inaccurate. In 2000, the price of oil hovered in the 25 to 35 dollars per barrel range. Such a high price seemed to reflect a scarcity of oil. However, a recent article appearing in the much respected Foreign Affairs (Jaffe & Manning, 2000) talked of an oil glut with future prices at half that amount. In December 2001, it was in the 20 dollars per barrel range and then started to track downward as predicted. A year later, it reversed itself and reached a price of more than 35 dollars per barrel by February 2003. History shows that oil prices are very cyclical. An experienced oil company manager understands the need to hedge one’s current position against the unforeseen and unpredictable in the oil market. Caspian Sea oil represents a strategic part of the oil companies’ need to have sufficient supply for the market. Third, the geopolitics of the region have become highly volatile and complicated since the disintegration of the Soviet Union in 1991. The United States, an outsider but the world’s sole superpower, desires to influence events and leaders in the region so that they are more pro-Western and less pro-Russian or pro-Iranian. Both the Russians and the Iranians wish to influence matters to their liking, just as the other countries directly involved want to achieve their particular ends. In a more complicated way, the current political struggle in the region is a repeat of the Great Game played by Britain and Russia during the nineteenth century when each tried to achieve its particular interests in the Caspian region. This New Game, with the United States in the role of external playmaker (Klare, 2001), represents the political part of the pipeline issue.

By looking again at the map of the region, we can focus better on its current geographic reality. Four of the so-called nations with close proximity to the Caspian Sea—Azerbaijan, Kazakhstan, Turkmenistan, and Uzbekistan—are new and resulted from the breakup of the Soviet Union.

6

Azerbaijan is situated on the western side of the Caspian Sea, and the other three are located on the eastern side and are north of Afghanistan and Pakistan and the Arabian Sea. Two other new nations that directly impact the pipeline situation are Armenia and Georgia. Both lie between the Caspian Sea and the Black Sea. This latter sea provides the closest water routes that tankers can use in transporting Caspian Sea oil to the major markets. South of the Caspian Sea lie Iran, Iraq, and the Persian Gulf, which offers another potential sea route for the oil. Russia borders on the northern shores of the Caspian Sea and can and does provide a pipeline route for Caspian Sea oil. Farther west of the Sea is Turkey—a large country straddling Europe and Asia, both culturally and geographically, that provides direct access to the eastern Mediterranean Sea with its modern tanker terminal at Ceyhan if the Caspian Sea oil can be transported there.

The proposed BCP (more than 1,000 miles in length) will begin on the western shore of the Caspian Sea at Baku, the capital of Azerbaijan and terminate at Ceyhan, Turkey on the Mediterranean Sea just above the border with Syria, a potential belligerent for Turkey due to water disputes. Turkey controls the water in the Euphrates, the principal river flowing into Syria. The terminal at Ceyhan was originally constructed for the purpose of transporting Iraqi oil, but the flow ended with the Gulf War and only recently restarted in spite of the Western boycott of Iraq (Shelley, 2001), which preceded the war there. In order for the oil to move from Baku to Ceyhan, it must pass through Georgia and skirt around Armenia because Azerbaijan and Armenia have been at war and still have an unresolved territorial dispute that Armenia has been able to dominate (Perlez, 2001). Armenia and Turkey also have a longstanding dispute (Henneberger, 2001). The Azerbaijan-Georgia-Turkey route seems to be the most pacific if one discounts Turkey’s Kurdish problem in the eastern part of the country or Georgia’s multiple conflicts throughout much of the country. Pipelines are easy and prime targets for guerrillas seeking independence or for gun-toting vandals (see Murphy, 2001, for the case of the Alaskan Pipeline and a drunk who shot a bullet into it and caused a spill of 285,600 gallons of oil). Another problem that the pipeline’s designers and constructors must confront and surmount belongs to the natural or geological world. As shown in Map 2, the route through which the pipeline passes is not only quite mountainous (Europe’s highest peak, Mt. Elbrus, lies in the Caucasus Mountains that extend into Georgia with mountains dominating the landscape of eastern Turkey) but also earthquake prone. On the Map, the heavy dark lines show where three, major tectonic plates have come together and formed the Anatolian Plate with its earthquake zones surrounding Turkey. The proposed pipeline has a route that takes it through a zone with

7

high earthquake potential which will elevate the cost of construction if the earthquake risk is factored in and compensated for in its design and construction (see National Geographic, July 2000 and EERI Special Earthquake Report, September 1998 for specific discussions about earthquakes in Turkey; see New York Times, 15 December 00, for a report on an earthquake in Baku). Map 2 The Geology of the Caspian Sea Region

In the face of such geographical constraints, one would be remiss not to ask why is there an Agreement to build the Pipeline? The most succinct answer can be found in another feature of the region’s geography. Historically, Caspian Sea oil was first extracted from the earth around Baku, then sent overland to an eastern Black Sea port, next moved by tanker through the Bosporus Strait at Istanbul, and finally transported by tanker through the Mediterranean Sea to a major market. The bottleneck in this transportation route is the Bosporus—a narrow strait that connects the Black Sea with the Sea of Marmara, which flows into the Aegean Sea via the Dardanelles Strait (longer and wider than the Bosporus). As noted by Frantz (2001a), the Bosporus is considered the world’s most dangerous strait with a length of about seventeen miles.

8

It is traversed by 50,000 commercial vessels annually, restricted in width such that it must be closed to traffic when a large tanker passes through it, sloped twenty degrees from north to south with normal currents of three to four knots that increase three additional knots in rough weather, and twisted to the extent that it requires twelve, distinct course changes to navigate. Turkish officials have indicated that the Bosporus will not be turned into a pipeline running through Istanbul, a city with ten million inhabitants. The 1936 Treaty of Montreux legally precludes the Turkish government from restricting or assessing traffic through the straits.

Legalities

notwithstanding, the government still faces the real potential danger posed by the projected increase in tanker traffic—predicted to triple by 2010 if another route is not found. The BCP can be viewed as the route that will circumvent the insurmountable geographical challenge of the Bosporus.

III.

Oil Routes and Actors with Interests

As the above discussion implies, oil moves along a fixed route from initial production to final consumption. Its passage along a given route has either a positive or a negative outcome depending on one’s particular interest in the matter. Thus, determining the route is of critical importance to those national and corporate actors who see their interests affected by the oil’s movement. To transport oil from the Caspian Sea region, there are numerous possible routes, but only a few have seemed viable.

It should be noted that matters can change abruptly and

transform a non-viable route, e.g. a pipeline through Afghanistan and Pakistan to the Arabian Sea, into a viable one. The most viable are discussed below and depicted in Map 3, which reveals the complicated task of taking oil from an isolated region with such geographical breadth.

9

Map 3 Major Potential Oil Routes from the Caspian Sea

Kazakhstan Kazakhstan

The traditional route that was discussed above is through the Bosporus Strait. Oil traversing this route must first reach an eastern Black Sea port (there are several) via a railway or pipeline located in the Caucasus area, then be loaded on to tankers that will carry it across the Black Sea through the Bosporus and Dardanelles Straits, and finally sail across the Mediterranean Sea to a western port, e.g. Marseilles. Historically (dating back to the 1890s), this route has functioned adequately though it has exposed Istanbul to a serious ecological threat and has denied the government of Turkey oil transit fees.

Since 1994, the Turkish government has placed

restrictions, with threats of more in the near future, on tankers going through the straits. Currently, the starting point for the tankers is the termination point of a Caucasus pipeline. As matters now stand, the major pipeline for supplying the Black Sea tankers ends at Novorossiysk in southern Russia. Map 3 shows how the pipelines reach this port. The larger, northern pipeline (Phase I with a circuitous route of 930 miles through Chechnya has a capacity of 560,000 barrels

10

per day and Phase II on a direct route will have a capacity of 1.34 million barrels per day) belongs to the Caspian Pipeline Consortium (CPC) under the control of Chevron.

It comes into

Novorossiysk with oil from the Tengiz field (one of the world’s largest) in Kazakhstan. Phase I had a cost of $2.4 billion, and when Phase II is finished the total projected cost will be $4.2 billion. The smaller, southern line (with a length of 868 miles and a capacity of 100,000 barrels per day) brings oil from several fields around Baku in Azerbaijan via Grozny in Chechnya. Given the size of the pipelines, the facilities at Novorossiysk, and the level of production in the Tengiz field, there is an economic efficiency argument in the near-term for having the oil from Baku pass through Novorossiysk. However, there is a counter argument, usually denied by Chevron, that some oil from the Tengiz field could be channeled via the Baku-Ceyhan Pipeline once it comes on stream.

In our discussion of the routes, we will refer to the Bosporus-

Novorossiysk route as the Russian route in spite of the fact that it passes through the Bosporus Strait.

A second traditional route via the Bosporus Strait goes through the Georgian port of Supsa and will be referred to as the Georgian route. The pipeline ends north of Batumi, which was the original oil port in the Caucasus area. Though new, this line is small and can only handle about 115,000 barrels per day. The Baku to Supsa pipeline traverses 515 miles through the southern Caucasus mountains and cost 590 million dollars to build—some 75% over the original estimate. The cost overruns on the Baku-Supsa line and the other new lines have created fears about what the final cost of the Baku-Ceyhan Pipeline may be. In light of the Georgian route’s limited capacity to carry oil and the need to take that oil through the Bosporus Strait, it has limited longterm potential to carry the vast quantities of oil projected for extraction from the Baku area in the next twenty years.

A third route, which avoids the Bosporus Strait, is the BCP. This line with a length of 1,075 miles will have a capacity of one million barrels per day. It will begin in Baku, next proceed to Tbilisi in Georgia in order to bypass Armenia, then turn south on its journey through eastern Turkey, and finally terminate at Ceyhan. This modern oil port remains open year-round and allows unimpeded passage to all Mediterranean ports. However, the projected BCP will pass over terrain that is both mountainous and earthquake prone. Thus, its estimated cost of 2.5-3.0 billion dollars suffers from much uncertainty and is an issue that will be discussed more in the next section. The Azerbaijani International Operating Corporation (AIOC) being led by the BP Group completed the detailed engineering study (at a cost of $150 million) for the line by the

11

summer of 2002 and expected construction to begin shortly thereafter (Frantz, 2001c; Greene, 2002). The predicted startup date for the Pipeline is early 2005, but that seems to be based on the most optimistic scenario for the project. According to Meixler (2001), though the BCP eliminates the ecological threat to the Bosporus Strait but not to the earth over which it will pass, it has become the most expensive option for moving oil out of the Caspian Sea region.

The cheapest option (Meixler, 2001) and the one preferred by many oil companies was a swap arrangement with the Iranians or an actual pipeline route from northern Iran to the Persian Gulf. Such an Iranian route does not now exist, but it would be relatively cheap compared with the lines discussed above. This would result from the availability of existing pipelines between Tehran and the Persian Gulf—requiring the construction of new, short pipelines only in the north between Tehran and the Caspian Sea.. As will be explained below, the problem with the low-cost Iranian route is not about efficiency and economics; instead, it is about politics.

Of the four routes described above, two—the Russian and the Georgian—utilize the Black Sea and expose the ten-million residents of Istanbul to the ecological risks inherent to shipping oil through the Bosporus Strait. The Iranian route, the most attractive in economic terms, presents almost insurmountable political challenges, esp. to U.S. oil companies. The fourth route, the BCP, appears to be the most costly in financial terms, but the only doable one in light of the relevant, non-financial criteria.

Before discussing those non-financial criteria, other potential routes for Caspian Sea oil should be mentioned. A company could take oil from an eastern Black Sea port by tanker to a western Black Sea port such as Burgas in Bulgaria and then transship it via pipeline to a Greek port on the Mediterranean.

This would eliminate passage through the Bosporus Strait, but it would

complicate the logistical task of moving the oil and increase the number of governments involved in the process. A second route is east toward China. As noted by DeLay (1999), the pipeline currently under consideration from Kazakhstan to northwestern China would be the world’s longest with a cost expected to match its length. Because it reaches only into Kazakhstan, it does nothing to resolve the challenge of moving oil out of Azerbaijan. Given the increasing demand for oil in China as it modernizes, the project does have long-term potential, but its ultimate fate is controlled by the Chinese state-owned oil companies through their joint ventures with privatesector firms (Bradsher, 2003). A third route mentioned above is the one through Afghanistan and

12

Pakistan, but it has only received serious attention since September 2001. Thus, it is still too early to know what its actual potential may be.

Pipeline routes cannot be considered realistically as separate from the interests of those who own and operate them. In the Caspian Sea region, the main participants with shared pipeline interests are national governments (with a location advantage) and major oil companies (with an asset advantage). To develop the region’s oil fields along with the requisite pipelines, the private oil companies and the state-owned oil companies invariably form joint ventures with specific mandates and entities for the different activities of the entire operation (with a focus on establishing a coordination advantage).

In Azerbaijan, the special entities finally organized

themselves around an umbrella consortium—the Azerbaijani International Operating Corporation (AIOC) that was formed in 1994 (Amineh, 1999). Its ownership was initially as follows: SOCAR British Petroleum Ramco Amoco Pennzoil Unocal Exxon Lukoil Statoil TPAO Itochu Delta-Nimir (Hess)

10% 17.1% 2.1% 17% 4.8% 10% 8% 10% 8.6% 6.8% 4% 1.6%

Azerbaijan United Kingdom Scotland United States United States United States United States Russia Norway Turkey Japan Saudi Arabia

The only significant changes in this ownership arrangement were the acquisition of Amoco by British Petroleum (BP) in 1999 and the decision in early 2001 by Chevron to buy a portion of SOCAR’s share of the pipeline entity (Frantz, 2001b). This gave BP a dominant position from which to influence the decisions of AIOC and its various projects—including the pipeline. A dominant partner seems essential if these consortia are to succeed [note the early example of Chevron heading up the CPC or the example of AGIP and TotalFinaElf struggling to control the Kashagan Oil Field with the former finally winning and the project moving ahead, (Pala, 2001)]. BP’s dominance became entirely apparent in October 1999 (Fialka, 1999) when it announced that it would support the AIOC’s BCP project, of which SOCAR (the state-owned oil company of Azerbaijan) owned 50% and a group of oil companies owned the other 50%. Prior to that surprising announcement, the major oil companies had been in favor of the Iranian route, i.e. the low-cost pipeline option.

13

In an effort to understand better this turnaround, the following is a brief explanation of the primary actors along with their known interests as they pertain to the BCP: Armenia It is a former Soviet republic that is now a sovereign state. It has a longstanding animosity with Turkey over mass killings committed by the Ottomans in the waning days of their empire. It has, with some success, been able to have other governments declare the killings an act of genocide and is an effective lobbyist in Washington, D.C. Armenia has been involved in a territorial war with Azerbaijan over Nagorno-Karabakh, which belongs to Azerbaijan but is populated by ethnic Armenians. The territory is now controlled by Armenia, but if it were to relinquish the territory, it could possibly have the pipeline pass through Armenia itself and receive transit fees for the use of its territory. There is talk of a peace agreement between Armenia and Azerbaijan (Perlez, 2001), but so far such a deal has not materialized (Loeb, 2001). Azerbaijan It, too, is a former Soviet republic which wishes to be sovereign, to develop itself economically, and to earn oil transit fees from the BCP. However, its government has been viewed suspiciously by the U.S. Congress and cannot undertake the development of oil and gas resources without relying upon Western technology and capital.

It has formed a state oil

company, SOCAR that has an equity stake in AIOC and the BCP, and is supposedly dedicated to the development of the country’s oil potential. Nevertheless, there is currently not enough potential oil in Azerbaijan to fill the proposed pipeline and have it operate efficiently; thus, the need to obtain oil from other sources, particularly Kazakhstan. Georgia This is another former Soviet republic that stands to earn transit fees from the oil that will pass through the pipeline as it heads toward Ceyhan. The government is quite unstable (Financial Times, 2001 and Economist, 2001) and is constantly being influenced or thwarted by particular interests in Russia. Links with the U.S. help the current government to counter these Russian interests. The country is already earning transit fees on oil passing through a smaller pipeline that terminates at its Black Sea port of Supsa, which due to inclimate weather is not open year round. Iran It is an Islamic country that does not have a good relationship with the United States whose current laws prohibit U.S. companies from trading directly with Iran unless granted an exemption. It is rich in oil and gas and wants oil swaps or a pipeline constructed that will link with an existing line that terminates in the Persian Gulf—the logical choice if only distance, weather, and cost are the factors considered. The major oil companies prefer this choice, but the U.S. and its trading with the enemy laws make this choice very difficult for the U.S. companies.

14

The Iran National Oil Company did approach AIOC with a proposed swap deal for 800,000 barrels per day (www.csis.org1). Kazakhstan It is another former Soviet republic that now has sovereignty, but it has been challenged by its own corruption (Rashid, 2000) and Islamic fundamentalists (Associated Press, 2001). It lies on the eastern side of the Caspian Sea and has vast oil and gas resources that could be transported through the BCP provided that an efficient way to get them to Baku is established. To date, Chevron has been instrumental in developing the oil reserves located there though its relationship with the government is now shaky (Tavernise, 2002). Russia The essence of the former Soviet Union belongs to this proud nation that has long been an influential force in the Caspian Sea region. It does not want to lose that influence, but it faces numerous challenges trying to maintain it. It and China, along with four other central Asian countries, have just formed the Shanghai Cooperation Organization in an effort to foment economic development and to thwart Islamic militancy in the area (Associated Press, 2001). In terms of pipeline routes, the most direct challenge is the political unrest and fighting in Chechnya that threatens the pipeline from Baku to Novorossiysk. Nevertheless, it did succeed in convincing Turkey to purchase gas from Russia via a new pipeline to be placed on the bed of the Black Sea (Frantz, 2001d), and it has announced plans to build lines east into China and to the Pacific Ocean (Tavernise, 2003). The gas project was not supported by the U.S., which had lobbied the leaders in Ankara not to accept the deal. Turkey This is a large, independent country that is seen as a key element in United States policy toward the Middle East. In addition, Turkey wants to become a member of the EU, but there are several major obstacles that impede its joining in the near term. As already stated, Turkey and Armenia are not friendly toward each other. Though its people are Islam, it has been a secular country since its founding by Attaturk in the 1920s; however, its government, dominated by the military, does deal harshly with any opposition—whether it be Islamic or Kurdish. However, its desire to enter the European Union has lowered the degree of harshness toward the opposition to a considerable degree in recent years. The latter opposition can be found mainly in eastern Turkey where the BCP will be. The pipeline will reinvigorate Ceyhan’s port business and will provide much needed revenues from the oil transit fees for the national government that is currently suffering from a devastating financial crisis (Sengupta, 2001) and is being subjected to stringent IMF demands. Turkmenistan It, too, is a former Soviet republic. Like Kazakhstan, it has an autocratic government, but it is on much better terms with Russia (Rashid, 2000/01). Its oil and gas reserves though are barely developed. The threat from the Islamic right seems minor since it did not join

15

the recently formed Central Asian trade group (including China and Russia) whose stated purpose is to battle Islamic fundamentalism (Associated Press, 2001). United States Being the world’s sole superpower, it has taken upon itself the task of trying to stabilize these newly created nations, gain the loyalty of them and Turkey, and to impede any intentions that Russia or Iran may have regarding these nations. It does not want Russia to reemerge as some new Soviet Union in this part of the world, and it wishes to thwart what it sees as Iran’s radical Islamic beliefs that caused the humiliation stemming from the 1979 revolution. In addition, the United States clearly wants the oil spigots to remain open, and it fears that the major pipeline for Caspian Sea oil via Russia or Iran could jeopardize the free flow of oil. Notwithstanding its geo-political interests, the United States also prefers the oil fields and pipelines of the region to be financed and operated by the oil companies. Thus, it wishes to accomplish its ends through traditional capitalist means though the Afghanistan War and Iraqi War have somewhat modified this private-sector preference. The change in the U.S. presidency from Clinton to Bush seems to have altered very little the U.S. position on the BCP. The most notable difference now is the increased participation of Chevron, which has had substantial dealings with Condoleezza Rice who heads the highly important National Security Agency (Mufson, 2000). [See Joseph, 1999, for a thorough discussion of the U.S. government’s position regarding the Pipeline.] Uzbekistan It, like Kazakhstan and Turkmenistan, is a former Soviet republic with some oil and gas resources. It does not border the Caspian Sea but belongs to the region and faces many of the same problems that the two other nations are confronting. Uzbekistan did join the Central Asian trade group and confronts a strong challenge from Islamic fundamentalists (Rashid, 2000/01). British Petroleum (BP) It is an investor owned oil company that is headquartered in Britain with substantial U.S. interests through its recent Amoco acquisition. It was initially opposed to the BCP, and its change in position during the fall of 1999, following its acquisition of Amoco, provided the impetus for starting up the stalled project. It has the largest share of equity in AIOC at 34%, which includes Amoco’s share and leads the BCP consortium. It is legally “represented by Baker & Botts, the law firm of James A. Baker III, a Bush family confidant and former secretary of state” (Banarjee & Tavernise, 2001). SOCAR This is the state owned oil company of Azerbaijan. It reportedly has a ten percent stake in AIOC and is willing to sell part of its fifty percent interest in the BCP to oil companies such as Chevron with its close connections to the Bush Administration. Lukoil It is the state owned oil company of Russia with a ten percent stake in AIOC.

16

Delta Hess, Exxon, Pennzoil, and Unocal These are investor-owned oil companies with U.S. roots and equity shares ranging from 1.5 to 10 % in AIOC. Their shares and those of BP represent a controlling position in AIOC. Itochu, Ramco, Statoil, and Turkish Petroleum These private companies, not headquartered in the U.S., have equity shares in AIOC that range from 1 to 8 %.

IV.

The Negotiated Agreement

The earliest date found for discussion about Caspian Sea oil and the subsequent Baku-Ceyhan Pipeline is 1992. That would be the year following the fall of the Soviet Union and seems likely from the geo-political perspective of the United States government.

But the announced

acceptance of the pipeline proposal did not come until late 1999 when BP said it would lead AIOC in securing the funds for the pipeline. In the years before the Pipeline announcement, the other routes were advocated and often strongly endorsed, but they lost out when BP decided to back the BCP.

As already mentioned, the major oil companies preferred the Iranian route or a swap, but neither was politically acceptable to the U.S. The pipeline’s cost would probably have been a mere 50 million dollars, and it could have connected with an existing line that terminated in the Persian Gulf, which is open all year. However, without a change in U.S. laws this proposal has no chance of being implemented and has subsequently been dropped. The Georgian and Russian routes through the Black Sea ports of Supsa and Novorossiisk are also economically viable, but both are under Russian control or influence. In addition, these routes require traversing the Black Sea with hundreds of medium-sized tankers and passing through the Bosporus Straits at Istanbul. The government of Turkey opposes this option on environmental grounds and has threatened to shutdown the already crowded Straits. Not only is there an environmental risk present in using the Black Sea and the Bosporus Straits, but there is the real problem of the weather which renders the two ports inoperable for several months each year. Lastly and importantly, the routes through the Bosporus preclude the collection of transit fees by the Turkish government. On the other hand, the BCP allows such fees to be collected by the government. The cases against the other routes have been based on multiple grounds, and they appear to have been successful.

17

After much discussion and brinkmanship over the different proposals, the final negotiation centered on issues that are most salient to business leaders—costs. The two major cost factors have been: capital costs for construction and operating costs for use. Thirty percent of the capital is to be provided by the business partners with the other seventy percent coming from international banks and lending institutions (Stern, 2002). Concerning the capital costs, AIOC with its business supporters was very concerned that the construction costs would exceed the Turkish estimate of 2.7 billion dollars (current estimate of 3.0 billion is just 10% over the original figure). As noted, the actual cost of the just finished Baku-Supsa Pipeline was about 75% over its estimated cost, and the oil companies feared this would happen again, especially in light of the rugged and shaky terrain that the proposed route is taking. One would assume that the earthquake threat has been built into the projected construction cost for the BCP. “Good practice” at BP does cost environmental concerns; however, such practices are just recommended by corporate and not necessarily implemented within the business units (Cutteridge, 2001).

Regarding operating

costs—consisting of production costs and transit costs—several sources (Seznec, 2000; Meixler, 2001) indicated that the oil companies could not afford to pay more than $3.00 per barrel in transit costs if the project is to succeed. Early on in the negotiations, AIOC was looking at a transit cost of more than $5.00 per barrel. This cost must be compared with the much lower total cost of Saudi oil, which can be sold profitably at a price between two to five dollars per barrel (Scheiber, 2002). Iraqi oil is even cheaper—operating costs there are around 75 cents per barrel, and the pipeline from the Iraqi fields to Ceyhan already exist (Hoyos, 2002). Some analysts think that BCP oil sold at Ceyhan cannot be priced profitably below $20.00 per barrel (Greene, 2002) due to the high production costs in the Caspian Sea. From a commercial perspective, both capital and operating costs were beyond what the oil companies and the market seemed willing to bear.

For business practitioners and economists, an interesting note to these negotiations was the United States government’s position that the project was commercially viable versus AIOC’s position that it must be commercially attractive.

Of course, BCP became more attractive

financially with funding assistance from the Export-Import Bank of the United States, the Overseas Private Investment Corporation, and the Trade and Development Agency (www.csis.org2).

The deadlock between the negotiating parties was apparently broken when Turkey agreed to cap pipeline construction costs in its territory and BP Amoco consented to the sufficiency of that cap. The Agreement was announced in November 1999 (www.mfa.gov.tr, 1999) and consists of four

18

parts—an intergovernmental understanding, a contract between the governments and the companies along with AIOC, a turnkey contract for construction of the Pipeline, and a guarantee by Turkey limiting construction costs in its territory. These parts deal with capital costs. As of yet, there is no detailed information about operating costs, though the Turkish government did announce sacrifices in terms of tax brackets and transit fees—now reduced to $.55 per barrel for the first 16 years of BCP (www.csis.org3).

There should be no surprise in the future if it is

announced that those costs have been lowered even more, especially the transit costs which are under the direct control of the national governments.

Regarding the future, the important question has become—will the Agreement endure and will the BCP come on stream by 2005 as promised? In June 2001, the head of BP announced that the preliminary engineering study was favorable and that the consortium was moving ahead with the detailed engineering study at a cost of 150 million dollars (Frantz, 2001c). This cost is to be rolled into the total cost of the pipeline which is now estimated at $3 billion upon completion. Initially, 375,000 barrels per day will roll through the pipeline with full capacity of one million barrels per day to be reached in 2007 if one believes the more optimistic scenarios. The answer to the question appears to be affirmative as of now, but the Afghanistan War and Iraqi War against Hussein do add new contingencies to a risky project in a constantly evolving part of the world.

19

References Amineh, M.P. 1999. Towards the Control of Oil Resources in the Caspian Region. New York: St. Martin’s Press. Associated Press. 2001. Central Asian Trade Bloc Formed. The New York Times, June 15. Banerjee, N. & Tavernise, S. 2001. As the War Shifts Alliances, Oil Deals Follow. The New York Times, December 15. BP Amoco Statistical Review of World Energy. June 1999, can be found at www.bpamoco.com/worldenergy. Bradsher, K. 2003. China Buys Another Piece of Big Caspian Sea Oil Field, The New York Times, March 12. Croissant, M.P. & Aras, B. 1999. Oil and Geopolitics in the Caspian Sea Region. Westport: Praeger. Cutteridge, D. 2001. An Alternative Approach to Environmental Decision Making: BP. A presentation to the Business Strategy and Environment Conference, Leeds, September, in conversation with the group. Delay, J. 1999. The Caspian Oil Pipeline Tangle: A Steel Web of Confusion. Oil and Geopolitics in the Caspian Sea Region, edited by M. P. Croissant & B. Aras, Westport: Praeger. Dunning, J.H. 2000. A Rose by any Other Name…? FDI Theory in Retrospect and Prospect. A literature review found at www.jibs.net/LitReviews. Economist. 2001. Strange Bangs: Trouble Is Brewing in the Caucasus as Chechen Fighters Head West, October 13. EERI Special Earthquake Report. 1998. Dinar Aftershock Tests Retrofitted Buildings. September, can be found at www.eeri.org?Reconn/Dinar98. Fialka, J.J. 1999. Amoco Backs Caspian Pipeline Route Seen as Important to Region’s Economy. The Wall Street Journal, October 19. Financial Times. 2001. Georgian Conflict Escalates as Troops Move to Abkhaz Border. October 11. Frantz, D. 2001a. The Busy Bosporus Is Likely to Get Even Busier. The New York Times, January 28. Frantz, D. 2001b. Chevron Talks to Azerbaijanis about Pipeline. The New York Times, February 10. Frantz, D. 2001c. Oil Pipeline to Turkey Backed by Chief of BP. The New York Times, June 21. Frantz, D. 2001d. Russia’s New Reach: Gas Pipeline to Turkey. The New York Times, June 8. Gowans, S. 2001. Getting the Pipeline Map and Politics Right. The Dawn of Pakistan, December 3. Haslett, M. 2001. Afghanistan: The Pipeline War? BBC News, October 29, found at http://news.bbc.co.uk. Greene, R.A. 2002. Work begins on Oil Pipeline Bypassing Russia and Iran, The New York Times, September 19. Henneberger, M. 2001. Delicately, Pope Deplores 1915 Killings of Armenians. The New York Times, September 27.

20

Hoyos, C. 2002. Big Players Rub Hands in Anticipation of Iraq’s Return to Fold, Financial Times, August 25. Huerta, E. 2001. Bush, Tras el Petroleo de Asia. El Norte, September 30. Jaffe, A.M. & Manning, R.A. 2000. The Shocks of a World of Cheap Oil. Foreign Affairs, January/February, 16-29. Joseph, J. 1999. Pipeline Diplomacy: The Clinton Administration’s Fight for Baku-Ceyhan. From the Woodrow Wilson School of Public and International Affairs, can be found at www.wws.princeton.edu/~cases/papers/pipeline.html. Kalicki, J.H. 2001. Caspian Energy at the Crossroads. Foreign Affairs, September/October, 120-134. Kinzer, S. 2001. Ex-Soviet Asian Republics Are Now Courted by the U.S. The New York Times, October 10. Klare, M.T. 2001. The New Geography of Conflict. Foreign Affairs, May/June, 49-61. Loeb, V. 2001. Azerbaijan, Armenia Get Break. Washington Post, December 16. Meixler, L. 2001. Plan to Pump Caspian Oil Progressing. Associated Press, March 8. Mufson, S. 2000. For Rice, A Daunting Challenge. Washington Post, December 18. Murphy, K. 2001. Alaskan Pipeline Poses Special Kind of Security Risk. Los Angeles Times, October 14. National Geographic. 2000. Wrath of the Gods and A History Forged by Disaster. July. New York Times. 2000. Building Collapses in Azeri Capital, One Dead. December 15. Pala, C. 2001. AGIP of Italy Picked to Manage Big Kazakh Oil Field. The New York Times, February 13. Perlez, J. 2001. Powell Begins New Talks with Leaders of Caucasus. The New York Times, April 4. Rashid, A. 2000/01. The New Struggle in Central Asia. World Policy Journal. Winter, 33-45. Scheiber, N. 2002. Where the Oil Is, The New York Times, November 10. Sengupta, S. 2001. Joblessness Is Fraying Istanbul’s Social Fabric. The New York Times, December 15. Seznec, J. F. 2000. Oil and Gas: Fuel for Caspian’s Economic Development. The Caspian Region at a Crossroad, edited by H. Amirahmadi, New York: St. Martin’s Press. Shelley, T. 2001. Iraq Oil Could Begin Loading within 48 Hours. Financial Times, July 3. Stern, D. 2002. White Elephant Turns into Symbol of Triumph over Doubt, Financial Times, September 18. Tavernise, S. 2002. Kazakhstan Gets a Lesson in Oil Politics, The New York Times, November 16. Tavernise, S. 2003. Russia to Build Two Pipelines in the East, The New York Times, February 11. United States Department of Energy can be found at www.eia.doe.gov/emeu/cabs/caspgrph.html.

21

van der Leeuw, C. 2000. Oil and Gas in the Caucasus & Caspian. New York: St. Martin’s Press. www.csis.org1 found at www.csis.org/turkey/CEU000824.htm, accessed on 30 September 02. www.csis.org2 found at www.csis.org/turkey/event00413P2.html, accessed on 30 September 02. www.csis.org3 found at www.csis.org/turket/event011106.htm, accessed on 30 September 02. www.mfa.gov.tr/grupb/bb5/archive /1999/10/20101999%2Do1.htm. Yergin, D. 1991. The Prize: The Epic Quest for Oil, Money, and Power, New York: Simon & Schuster. Yergin, D. 2002. A Crude View of the Crisis in Iraq, Washington Post, December 8.

22

Table 1 World Consumption of Oil (Thousand Barrels Daily)

2000

2001

Change

23473

23386

-0.3%

30.4%

4732

4693

-1.1%

6.2%

15975

16093

0.6%

21.7%

Former Soviet Union

3412

3407

-0.4%

4.8%

Middle East

4307

4306

-0.1%

5.9%

Africa

2455

2490

0.8%

3.3%

Asia Pacific

20941

20916

-0.2%

27.7%

North America S. & C. America Europe

2001 Share of Total

Source: BP Amoco Review of World Energy, 2002

Table 2 World Production of Oil (Thousand Barrels Daily)

2000

2001

Change

13904

14040

1.0%

18.3%

S. & C. America

6894

7001

1.3%

9.9%

Europe

6927

6808

-2.4%

9.0%

Former Soviet Union

8013

8652

7.8%

11.8%

22970

22233

-3.6%

30.0%

Africa

7795

7814

-0.1%

10.3%

Asia Pacific

7980

7943

-0.9%

10.6%

North America

Middle East

2001 Share of Total

Source: BP Amoco Review of World Energy, 2002

23

Table 3 Proven Reserves of World Oil (Thousand Million Barrels)

At End of 2001

Share of Total

North America

63.9

6.1%

S. & C. America

96.0

9.1%

Europe

18.7

1.8%

Former Soviet Union

65.4

6.2%

685.6

65.3%

Africa

76.7

7.3%

Asia Pacific

43.8

4.2%

Middle East

Total

1050.0

Source: BP Amoco Review of World Energy, 2002

Table 4 Caspian Sea Region Production and Exports of Oil (Thousand Barrels Daily)

1990

Production Possible Production 1997 2001 (est.) 2010

Azerbaijan

259

193

311

1200

175

Kazakhstan

602

573

811

2000

631

Turkmenistan

125

107

159

200

107

0

0

0

0

0

Russia*

144

60

11

300

7

Total

1130

1116

1292

3700

920

Iran*

Net Exports 2001 (est.)

*Includes the region bordering the Caspian Sea Source: United States Department of Energy, Energy Information Administration, 1998, 2000 & 2002

24

Table 5 Caspian Sea Region Proven and Possible Reserves of Oil (Thousand Million Barrels)

Azerbaijan

Proven 1.2

Possible 32

Kazakhstan

5.4

92

Turkmenistan

0.6

80

Iran*

0.1

15

Russia*

2.7

14

10.0

233

Total

*Includes the region bordering the Caspian Sea Proven reserves are 90% probable, and possible reserves are 50% probable. Source: United States Department of Energy, Energy Information Administration, 2002

25

Teaching Note

This case has been written for advanced IB students. As such, it serves as a real-world vehicle for emphasizing the limitations of current FDI theory as explained by Rugman (1985) and by Dunning (2000). In terms of the OLI paradigm, the BCP case reveals that i) the O for ownership advantage belongs not to a firm but to the consortium in a specific physical place, ii) the L for location advantage emanates from a multi-faceted geographic setting for a particular group of countries which are simultaneously advanced or thwarted by other national powers, and iii) the I or internalization advantage must be constructed for the Caspian Sea area by the multiple players in the case because of the market failure for oil across the globe (see Yergin’s, 1991, seminal work on this industry for evidence of market failure).

In terms of FDI theory the OLI paradigm and internalization theory clearly have much to offer in the quest to understand foreign investment and economic efficiency. Nevertheless, the O and L advantages must be viewed in the refracted light of a geographical prism that makes both ownership and location advantages subject to and intertwined by geography itself.

The

geographic landscape is spread across regional nations that must come together to provide the L advantage if the multiple firms (both state and private) are to exercise their shared O advantage via a pipeline consortium. Simultaneously, the L advantage created by the regional nations is being construed in favor of the global hegemon, the USA, which is opposed by the regional hegemons, Russia and Iran. Each of them desires to construe the L advantage of the regional nations in its own favor. Given the market failure of the global oil industry, the I advantage is obtainable if the O and L advantages are favorably constructed. However, from a transactioncosts perspective, one would be seriously remiss to think that the OLI advantages of the BCP case have economic efficiency as their central concern.

The role of the hegemon, the USA now and the UK in the nineteenth century, become prominent in the BCP case. That role becomes even more complicated when viewed post-September 11th and the Iraqi War. Thus, the case gives the students both rational and political information (instead of just the rational information—often noted as a weakness of most cases) as they try to decide what to do as an oil-company executive in a highly uncertain and rapidly evolving situation.

26

Student decisions about the case require exploring the various pipeline options along with the possible regional scenarios and then determining how different scenarios may alter oil transit routes that could impact the 1999 decision in favor of BCP. The use of scenario analysis as advocated by Royal Dutch Shell Oil and many other companies is recommended. In addition, it is recommended that the instructor have the students do an Internet search of foreign newspapers to gain a better understanding of how many outside the United States view the Afghanistan and Iraqi wars vis-à-vis oil and gas. Finally, having students search for and review competing websites about the pipeline will increase their appreciation for the difficult challenges faced by those who advocate for sustainable development.

The main objectives of the case are: a) To learn about Central Asian geography, b) To appreciate that geography is not just political boundaries, c) To understand the different goals of political and business organizations, d) To comprehend the complexity of the OLI framework in a global setting, e) To realize that achieving advantage in this setting requires more than the business skills needed for profit maximization. f) To learn about and then apply scenario analysis to a complex situation.

Recommended materials are: Kaiser, R.G., U.S. Plants Footprint in Shaky Central Asia, Washington Post, 26 August 02. Oppel, R.A., U.S. Asks Enron for Details on Dealings Involving Iran, The New York Times, 24 October 02. Banerjee, N., Energy Companies Weigh their Possible Future in Iraq, The New York Times, 26 October 02. A two-part video dealing with this region and oil can be purchased from ABC. It aired on Nightline, April 25 & 26, 2002, and is titled—In The National Interest.

27