ECONOMIC COMMITTEE SUB-COMMITTEE ON EAST-WEST ECONOMIC CO-OPERATION AND CONVERGENCE ECONOMIC AND STRATEGIC STAKES IN CASPIAN ENERGY MARKETS Draft Interim Report MR. MARIANO ALIERTA (SPAIN) Rapporteur* 23 September 1999 * Until this document has been approved by the Economic Committee, it represents only the views of the Rapporteur. TABLE OF CONTENTS I. OVERVIEW II. STRATEGIC ISSUES III. RUSSIAN INTERESTS IV. AMERICAN INTERESTS V. EUROPEAN INTERESTS VI. TURKISH INTERESTS VII. IRANIAN INTERESTS VIII. CHINESE INTERESTS IX. ENERGY MARKETS AND OIL AND GAS RESERVES X. PIPELINE POLITICS XI. RUSSIAN INFLUENCE AND PIPELINE PROJECTS XII. THE BAKU-CEYHAN PIPELINE XIII. OTHER PIPELINE PROJECTS XIV. THE LOCAL ECONOMIES XV. PRELIMINARY RECOMMENDATIONS CHARTS NOTES AND REFERENCES

I. OVERVIEW One axiom of the post-Cold War order is that the international system has moved from an uneasy stasis to chaotic fluidity. In this much altered climate, certain regions which once languished in relative obscurity behind the Iron Curtain are now garnering far greater attention. The Caspian region is a case in point. As countless articles in the Western press have suggested, the Caspian is attracting increasing attention from business leaders and strategic thinkers alike who see the region in terms of its great economic potential but who worry about the strategic challenges it poses. The confluence of opportunity and risk as well as the apparent interest of the world's most powerful countries in the region has inspired some to describe what appears to be the emerging rivalry for influence and riches as a reincarnation of the Great Game - the strategic rivalry between Victorian Britain and Czarist Russia for the riches of India and the East. (1) Such comparisons, while convenient and certainly intellectually stimulating, can also be misleading. As a point of departure, it would be ill-informed to view the Caspian region in colonial terms and, by extension, to assume that the region's governments will be passive players in the now developing "game". To the contrary, the states around the Caspian, while beset by daunting internal problems, are deeply marked by the region's past inclusion in the empires of distant states and consequently seem determined both to preserve their newly gained sovereignty and to ensure a degree of control over their economic development. The interest of some outside actors like Europe and the United States, moreover, lies not only in the development of the region's energy potential and in insuring their own access to that energy. Their policy also recognises that their economic and strategic goals are most likely to be achieved if stable, self-confident countries emerge along the Caspian littoral which are capable of advancing economic and democratic development, promoting peaceful relations with their neighbours and preventing their own subjugation at the hands of any single outside player. Thus one distinctive element of the current Great Game is that local players want to ensure that no single outsider exercises regional hegemony, while some outsiders want to see the emergence of sufficiently resilient, stable and democratic societies capable of entering the global economy with confidence. This is not to say that a clash of interest is not in evidence. The region is beset by clashing interests, and keeping a lid on this cauldron while developing its energy potential represents its greatest challenge.

II. STRATEGIC ISSUES Indeed, the Caspian-Caucasus is a region of almost unspoken instability and upheaval. This area has witnessed some of the worst violence to befall the successor states of the Soviet Union. The region's borders are ill-defined, and, decades ago, Soviet leaders made sure that the borders of the region's Republics did not coincide precisely with ethnic and religious divisions. (2) Once the Soviet Union collapsed, the consequences of this policy became evident. War and civil strife broke out throughout the region in Chechnya, Nagorno-Karabakh, Georgia and now Dagestan. Turmoil on this scale has helped draw great powers into the region but has also inspired a degree of circumspection on the part of foreign investors who must carefully weigh risk and opportunity. Not surprisingly, the Caspian is sometimes characterised as a buffer zone between Russia and Middle East or as an energy-rich "vacuum" that the laws of physics and international relations suggest is unsustainable; the Great Powers driven by their economic and strategic interests will, in this view, invariably be drawn in. The states around the Caspian littoral are deeply insecure; the region itself is unstable, it has long been dominated by outside powers and there is a sense that these outside powers aspire to reassert some degree of control over it, particularly given its energy potential. While several of the region's leaders enjoy decent relations with Russia, others like Azerbaijan's President Heidar Aliyev worry that Russia's traditional hegemonic aspirations are driving Russian regional policy. President Aliyev's concerns, of course, are partly inspired by Russian support for Armenia in its struggle with Azerbaijan, and this has inspired his government as well as several others to turn to the West not only for investment, but also security.

III. RUSSIAN INTERESTS Russia has many interests in the Caspian region, but its influence there may be waning. Iran, Turkey and China have emerged as more important trade partners with the region. (3) The Russian view of the Caspian is also a fractured one. While ultra-nationalist groups advocate reasserting Russian hegemony in the region, more sober-minded Russian gas and oil industrialists want to play a key economic role there without necessarily reasserting sovereignty over it. The business elite, which supports key political groups operating in Russia, is perfectly willing to exploit the fact that Caspian pipeline infrastructure is largely oriented toward the markets of the former Soviet Union. For Russian industrialists, this pre-existing condition is greatly advantageous, and helps it to control the destiny of potential competitors. Above all, the Russian energy moguls want to ensure stable export markets for their oil and gas, which is a vital source of scarce foreign exchange earnings and tax revenues for the Russian state and windfall profits for them. Russian business thus sees the Caspian region as ripe for development for large energy concerns like Gazprom and LUKoil while fearing competition from the region. The Primakov government, like both its predecessors and the current Putin government, saw the Commonwealth of Independent States (CIS) as a potential source of stability in the Caspian, although it has hardly created a coherent block of states. Moscow is strongly opposed to the extension of NATO or American security guarantees to Caspian regional actors and has reacted with anger to the thinking of some in Georgia and Azerbaijan to engage NATO help in defending local energy infrastructure. (4) Pipeline politics in Russia are complex and companies such as Gazprom play an active (and sometimes contentious) role in Russian politics. (5) They do not intend to lose vast potential markets in Turkey and Europe to Caspian producers. Gazprom's European income makes up for the losses in the domestic market where barter is the predominant form of payment. In the words of one analyst, "Gazprom and the whole of the energy sector subsidizes the rest of the Russian economy." (6) Moscow's economic interest in the region is thus unlikely to wane as long as such a substantial component of its income is generated by the oil and gas sectors. For its part, the Russian military is not particularly focused on energy issues at all, but rather is deeply concerned that instability on Russia's southern borders could spill into Russian territory where overlapping ethnic and religious divisions have the potential to explode into more serious strife. (7) This, of course has already happened in Chechnya and Dagestan, and the Russian state's failure to assert its authority in those cases underscores its waning presence in the region. The fact that there are Russian minorities living in the region ensures that Russia will continue to perceive interests in the Caspian and Transcaucasus. (8) Moreover, Russian troops are currently based in both Armenia and Georgia and have actively supported ethnic Armenians in the war over the enclave of Nagorno-Karabakh. (9) This poses a long-term challenge to traditional Russian dominance in the region. The ongoing confrontation in Dagestan between Islamic rebels and Russian troops, after a similar operation in Chechnya a few years ago, suggests that short-term repression of these movements is unlikely to solve the core conflict of interests. Some have accused Russia of fomenting ethnic disputes in countries, like Azerbaijan, which have refused to co-operate with Russia on an array of economic and strategic issues. (10) But if this is the case, they are playing a risky game as ethnic battles are hard to control, risk drawing in other powers, and can raise international stakes in local conflicts. The oil and gas factor obviously compounds this already dangerous problem. At the same time, if the "Islamic Revival" in the Middle East has abated somewhat, it is just beginning to gather strength in Central Asia. The proximity of Afghanistan and its Taliban movement has led to clashes with Muslim radicals in Tajikistan and Uzbekistan and highlighted the failure of a Russian-backed effort to contain these forces.

IV. AMERICAN INTERESTS The United States could never benefit directly from Caspian gas, and even oil from the region is more likely to be shipped to Europe and Asia than to the United States. But oil, of course, is a fungible commodity, and new discoveries in one part of the world will drive down global prices. Thus, as a net energy importer, the United States sees economic benefits from the development of the region's energy potential. That American multinationals, like Amoco Corp., which has invested heavily in Azerbaijan's oil development, are seeking to play a key role in this development is also a critical component of the US government's perspective on the region. US industry has already invested more than $2 billion in the three largest oil producers in the region, and will certainly invest much more if exploration yields results. (11) The United States has also been a guarantor of international access to fossil fuel, and as such, naturally perceives an important set of issues at stake in the Caspian region. The American strategic vision is partly shaped by an optimistic view that some modicum of stability can be achieved for the Caspian partly through a much enlarged Euro-Atlantic Community. This community would extend into distant Central Asia, and overlaying institutions like NATO's Euro-Atlantic Partnership Council (EAPC), the Organisation for Security and Co-operation in Europe (OSCE) and the EU would all contribute to regional integration. Indeed those institutions are all playing a role in the region. It should be noted that NATO relations with the Caspian began with the signing of the Conventional Forces in Europe (CFE) treaty in 1990. Following the Soviet Union's collapse, NATO established deeper security contacts through the Partnership for Peace (PfP) and the EAPC, and the region's forces have subsequently participated in joint exercises. The United States recently tested its capacity to project force in the region when paratroopers flying from North Carolina were dropped into Kazakhstan in a joint PfP exercise with a regional conflict management force that NATO has helped organise. But paratroopers are not the same as a sustainable military presence, and real force projection would require extensive US basing in the region because of the extremely long lines of communication. Building bases and supplying lines, however, would prove extremely expensive and is very unlikely. That has not deterred the chief foreign affairs advisor to Azerbaijani President Aliyev from urging the United States and Turkey to develop bases on its territory. (12) But so far, the US government has not warmed to these overtures. The enormous costs involved in creating a significant presence in the region, the possibility that doing so might be seen as an unnecessary provocation, and the potentially negligible strategic advantage that presence might ultimately yield have discouraged any such initiative. As a result, the Americans are unlikely to be disposed to extend hard security guarantees throughout the region. US leaders seem inclined instead to support efforts to foster regional security and economic co-operation. US policy in the Caspian is also driven by conflicting perspectives on Russia. The American aspiration for a more fruitful US-Russian relationship is matched by a fear that Russia might seek to assert itself over the region. The problem here is that American efforts to block Russian ambitions risk confirming Russia's worst fears about American intentions. This dynamic will continue to pose a dilemma for American policy makers. The Americans are more unambiguous in their desire to isolate Iran, but Europe is not likely to be a willing partner in such a policy, particularly if the government in Tehran continues to move in a moderate direction. Indeed the US view of Iran differs from that of Europe, which has already begun to restore diplomatic relations with Tehran to encourage the Khatami government, which is proving more reasonable than its revolutionary predecessors. Khatami's lifting of the Fatwah against the British writer Salman Rushdie and moderate victories in recent local elections could mark a turning point in the European-Iranian relationship. In March, Iran signed a $1 billion deal with Elf Aquitaine and ENI to refurbish the Doroud offshore field in the Gulf which suggests that American efforts to restrict large foreign investment in Iran has broken down. (13) The United States approach to Iran is far more cautious and the Iranian leadership equally worries that any lessening of traditional anti-American rhetoric would invite the wrath of Iran's conservative clerics who still exercise great power in Iranian society. Finally, the US policy in the region is also informed by other national interests and particularly halting the growing transhipment of arms and drugs.

V. EUROPEAN INTERESTS European interests in the region are largely, though not exclusively, economic. Its energy companies are investing in countries which they anticipate will become major exporters of energy to Europe. European leaders would not claim at this juncture to have fundamental geo-political interests in the region. (14) The European Union is seen as a generally positive presence in the region, and has worked to foster a greater degree of regional co-operation. But until Europe has the machinery for developing and carrying out common foreign and security policies, its activism will be somewhat limited and its most high-profile players will come from the business community. Europe, however, welcomes the opportunity to develop new sources of energy in order to reduce its reliance on Middle Eastern and Russian energy. Like the United States, the European Union hopes to help foster regional stability and promote the development of democratic institutions in these new states. Europe has a long history of exchange with the region, and the European Union's Transport Corridor Europe-Caucasus-Asia (TRACECA) Corridor initiative to upgrade regional transport infrastructure suggests that many European leaders expect to use these traditional commercial ties as a foundation for a common policy toward the region. Most EU governments would not object strenuously to the construction of a pipeline through Iran even though the United States is strongly opposed to doing so. This is obviously an important source of division between Europe and the United States, and the Europeans have complained bitterly about the threat of US imposed sanctions on companies doing business with Iran.

VI. TURKISH INTERESTS Turkey's interest in the region is far greater than any other European or North American state. It shares a common cultural and linguistic heritage with the dominant ethnic groups of several Caspian states, and these ethnic ties underpin Turkey's economic, strategic and environmental interests. Turkey undoubtedly sees the Caspian, Southern Caucasus and Central Asia as regions where it can and should be a player. Some argue that Turkey's sometimes uneasy relationship with Europe gives it few options but to increase its activism in the region. Last summer the Turks called for a NATO-led peace force in the Caucasus region, something which the Russians strenuously opposed. (15) Turkish relations with the states of the region are generally quite good, and Turkish entrepreneurs are operating with some success in the Caspian. Indeed Turkey has emerged as a leading investor in the region. Turkish firms are working on both energy production and transportation projects that could bring profits to investors, while helping Turkey meet its ever-mounting energy demand. Turkey currently enjoys a trade surplus with the Caspian states. Turkey's primary goals in the region are to develop new sources of energy supply to meet rapidly expanding demand and to emerge as a key energy transhipment hub for both economic and strategic reasons. The Turks are also strongly opposed to increasing oil transhipment through the Bosphorus, fearing that an accident would pose a serious hazard to millions of Turks living along the shores as well as to the priceless historical, cultural, and environmental patrimony of that coastline. (16) Partly, for this reason as well as broader strategic interests they favour transhipment through the Mediterranean, and endorse the US-backed projects like the Baku-Ceyhan pipeline, which would transform the port of Ceyhan, near Turkey's Syrian border, into a major transhipment hub. The recent earthquake in Turkey coupled with strong private sector objections to the cost of this project raise new doubts about this particular project's viabliity. At the same time, Turkey has made arrangements with Gazprom to initiate the "Blue Stream" project which would supply Turkey via a pipeline through the Black Sea. Gazprom is competing with Central Asian countries for the access to and possibly control of the Turkish gas market.

VII. IRANIAN INTERESTS Iran too perceives vital strategic and economic interests in the Caspian, and its leaders are certainly disposed to use religious ties to further their ends. In fact, their rivalry with Azerbaijan's secular government has religious overtones. The Iranians have willingly exploited the fact that most Azeris are Shiite Muslims. The Iranians would like to play a role in moving Caspian energy to market. They oppose American-supported projects which would make Baku the focal point of Caspian energy exports. Iranian ambition will thus continue to meet American resistance. Iran is also conducting important trading relations with several of the region's states. For example, it is undertaking oil swaps with Kazakhstan, whereby Kazakhstan supplies crude to northern Iranian refineries in exchange for Iranian oil deliveries in the Persian Gulf, which can then be exported on world markets. Since Kazakstan is not investing directly in Iran and because the trade is in hydrocarbon swaps, it has so far skirted the American sanctions regime. Turkmenistan has built a natural gas pipeline to Iran which links its western fields to industrialised northern Iran. (17)

VIII. CHINESE INTERESTS Surprisingly, China has also become an important player in the region. It hopes to develop new sources of energy to meet rising domestic and Asian demand and to reduce its dependence on ocean-bound energy imports. China has been building up its naval forces partly to guarantee continued access to imported energy; yet it is looking for other energy options as well to ensure, for example, that a naval blockade could never paralyse the national economy. This is perhaps the only way the Chinese can justify such massive projects as the Three Gorges Dam which is costing billions of dollars but which, on paper, should give China new energy options. This same rationale partly accounts for Chinese policy in the Caspian. It is to date the largest investor in Caspian energy projects and is now developing plans for an extremely long pipeline to help meet burgeoning national gas demand. But like Russia, Chinese regional policy must also contend with the emergence of Turkic speaking states that could galvanise its own discontented and culturally oppressed Turkic minorities living along the Tajikistan, Afghanistan and Kyrghyz Republic's borderlands. So far, however, Turkic states have sought to ease tensions with China. In the Fifth Turkic Summit in Astana, Kazakhstan, Uzbek President Karimov cautioned that Turkic unity had limits, noting that supporting the Uighur minority would endanger relations with the "Great China". (18) China, like Russia, does not welcome greater NATO engagement in the region. Finally, it should be noted that so many outside actors claiming strategic interests in the region could undermine regional stability and might, in the end, make it even more difficult to develop its economic potential. (19) How this evolves hinges partly on the restraint exercised by outside players as well as on the capacity of the region's governments to exploit intelligently this outside interest.

IX. ENERGY MARKETS AND OIL AND GAS RESERVES World oil prices will remain a critical variable in Caspian economic development. From January to December 1998, global crude prices fell to around $11 a barrel. (20) This price collapse precipitated industry-wide restructuring which dramatically stretched out exploration and development schedules in the Caspian. Production elsewhere in the world was on the rise and, because oil is a fungible commodity, increased production contributed to falling prices globally. So too did declining demand, which reflected not only more efficient consumption patterns, but in recent months, the downturn in Asian economic growth. Low prices combined with the very high cost of building certain proposed pipelines have rendered the possibility of rapid energy development highly problematic. Large oil companies are well aware of the risks, both economic and political, and are making investment decisions with great caution. Several recent unsuccessful exploration drills have reinforced investor caution. Although Azerbaijan has been producing oil for over 100 years, its recoverable reserves in fields now under production is only 2.6 billion barrels. Recent exploration has turned up more gas than oil. This is not good news for Western drilling consortia as there is no large domestic market for gas and no pipeline in place to export it to markets of dynamic demand. Exploration in Azerbaijan is currently concentrated on the very deep Shah Deniz reservoir near Baku. Since the 23 March 1999 meeting of the Organisation of Petroleum Exporting Countries (OPEC), oil prices have recovered dramatically. OPEC states have adhered to a 4 million barrels/day supply curb. Recently Saudi Arabia reiterated its commitment to keep oil prices in the $18-$20 band. Historically, however, many OPEC states do not have a good record of adhering to their own quotas, particularly as important producers like Norway and the United Kingdom are not in OPEC. If countries like Azerbaijan become important producers, they could further weaken OPEC price discipline. Non-OPEC members have the advantage of not being tied to OPEC quotas, and hence have the possibility of 'flooding' the market with their own petroleum, while OPEC producers limit their sales. Certainly the region is now benefiting from OPEC's cohesion. Prices may be high today, but potential investors are unlikely to forget the recent free-fall of oil prices and are now disposed to proceed with greater caution in the Caspian. Given today's price uncertainty, it often makes more sense to continue investments in geographically favoured states with proven oil reserves, such as Saudi Arabia, than risk developing production and distribution facilities in a region fraught with uncertainties. As such, Saudi Arabia in particular is pursuing a policy to discourage investment in the Caspian, so that it may retain its jealously guarded place as the world's first supplier of petroleum. Caspian oil politics are hence tied not only to a regional "Great Game", but also to global oil politics. A number of small firms have already begun to pull out of the region, and the large ones, which concentrate principally on big reservoirs and which have the resources to operate in this difficult environment, are postponing further exploration and development. Unocal has closed its Central Asian operations, and last January, the Caspian International Petroleum Company Cipco, formed by Pennzoil, Lukoil, Agip and the State Oil Company of the Azerbaijan Republic (SOCAR), ceased operations. The Asian crisis has created a capital shortage for many of the Asian firms operating in the region, while the Russian financial crisis has precipitated a cash crisis for Russian firms and undermined overall confidence in regional economic stability. SOCAR has also curtailed oil experts to Russia because the Russians were not paying their debts. Kazakhstan's large oil firm Tengizchevroil has postponed development projects for three to five years, and production has fallen at the Karachaganak field which has been developed by a BP-Texaco consortium. Most recently, Nurlan Kapparov, chief of Kazakhoil, the Kazakh state oil company, was sacked because of his resistance to government plans to sell shares in Tengizchevroil to raise funds to fill the $560 million gap in the state budget. Kazakhstan has also encountered problems servicing its debts, leading in April to an agreement with the Czech Republic, to pay outstanding debts in gas. Meanwhile the Azerbaijani International Operating Company (AIOC), which in 1994 signed the "Contract of the Century" to drill a number of wells, has slashed its staff and put off development of a large off-shore field and a critical main export pipeline. Uncertainty about the actual oil and gas reserves in the Caspian has fed investor hesitancy. Reserve estimates vary wildly, and political calculations are probably creeping into the numbers. The US Department of State estimated in 1997, for example, that the Caspian region could hold up to 200 billion barrels of oil reserves. Many industry analysts suggest that this figure is incredible and probably politically concocted to justify the growing presence of the United States in the region. Local estimates put the figure at 90 billion barrels of oil and 20 trillion cubic metres of gas; but these figures are probably overstated although gas estimates are rising. Oil companies originally contributed to the "hype", and some analysts suggest they also systematically overstated reserve estimates in order to jack up share prices. Those companies are now beating a rapid retreat from those estimates. Most reserve estimates for Central Asia and the Caspian lie between 15 and 30 billion barrels or less than 3% of the world's proved oil reserves. A relatively optimistic approximation would put oil reserves at between 50 and 90 billion barrels or 5% of total global reserves. To put these numbers in perspective, however, the proved oil reserves in the Persian Gulf region approach 600 billion barrels of 55% of the world total. Proven natural gas reserves in the Caspian approach 5-6% of the global total but could be as high as 10%. Turkmenistan has the world's third largest proven reserves of natural gas. There is a huge potential market for this gas in Asia but tremendous infrastructural barriers will complicate any plans to get it to market. With Azerbaijan's July discovery of a major (at least 400 billion cubic metres) gas reserve at the Shah Deniz field, the energy map has been altered significantly. Azerbaijan now sees itself as a major gas supplier to Turkey, a role that Turkmenistan and Russia each hope to play as well. Azerbaijan will now compete directly with Turkmenistan for the Turkish market, which will most likely prove to create a new source of tension. It could ultimately encourage Turkmenistan to use Iran, rather than Azerbaijan, as a route to Turkey.

X. PIPELINE POLITICS Oil is virtually worthless without a means to move it to blue water, and gas is a valueless commodity without a pipeline grid to deliver it to consumers. Currently Caspian oil is pumped through two small pipelines that end in the Russian Black Sea port of Novorossiysk and the Georgian Black sea port of Supsa. Neither of these pipelines has sufficient capacity to accommodate a dramatically increased flow of oil, and there is still the problem of getting this oil to blue water. Turkey strongly opposes increased tanker traffic through the crowded Bosphorus straits for environmental reasons, and has announced that the number of tanker crossings in 1999 will be curtailed - a move which puts pressure on oil companies to move more rapidly to a financing arrangement on the Baku-Ceyhan pipeline. The AIOC, a BP-Amoco-led consortium is now engaged in a dispute with the Azeri government over this pipeline. It wants to increase the volume of oil pumped through the recently upgraded Baku-Supsa line while the Azeris want a guarantee of that company's support for the eventual construction of the line to Ceyhan. AIOC sees this extremely expensive option as far too risky given the level of proven reserves in the Caspian. The US Ambassador to Turkey has also urged companies to proceed with that project while oil prices are low and their negotiating leverage with regional governments is accordingly higher. But he has also insisted that Turkey would have to compensate companies for cost overruns on the estimated $2.4 billion project. The United States is worried that further delay on the Baku-Ceyhan pipeline will lead to the construction of other pipelines which will invariably render it less justifiable in cost terms. The American government views this proposed pipeline as a prized strategic asset. Naturally economic factors are critical to shaping decisions about new pipeline construction. Firms financing those pipelines need to assess both the potential volume of oil or gas that might be pumped through the system and the price that energy will command on the market. Getting exports to the international market from the eastern Caspian would cost up to $7 a gallon and Turkmenistan and Kazakhstan need oil prices at $15 a barrel to make their oil economically viable. Some optimistic proponents of various projects use numbers which intimate that a particular pipeline would command a high percentage of all the oil or gas produced in the region. But if several pipelines are built, those optimistic figures would change dramatically, and the potential volume for any one pipeline would consequently fall. There is also the fact that Caspian proved oil reserves are still relatively low and may not justify the huge outlays needed to build a complex pipeline infrastructure. If world demand is slack and if oil production remains relatively cheaper for the foreseeable future in regions like the Middle East and the North Sea, then investing in expensive pipelines in the Caspian region may not seem particularly attractive over the short to medium term. Furthermore, any eventual lifting of sanctions on Iran and Iraq would further depress world oil prices, and could therefore further delay much needed investment in the Caspian. One must also consider the inherent risk of laying pipelines across politically unstable regions where warring factions might possess the means and motives to attack pipelines. The recent turmoil in Dagestan raises new concerns about a Baku-Novorossiysk pipeline, traversing the troubled northern Caucasus. Throughout the year, there have also been repeated interruptions of oil flow in Chechnya, a development which in April prevented Azerbaijan's SOCAR from selling any oil. It then renegotiated prices with Russian pipeline operator Transneft in May. Unfortunately Russian policy in the Caucasus has failed to resolve the litany of problems besetting the region, including the rise of fundamentalist, Islamic movements, crime and attacks on the pipelines. The use of Islam as an ideological weapon by both insurgents and the Russian government is likely to perpetuate the Caucasus crisis. Georgia is quite wary of Russian intentions in the region, particularly in light of Russian support for Abkhazi separatists. Accordingly the government of Eduard Shevardnadze supports the development of new pipelines to reduce its reliance on Russian infrastructure. Shevardnadze told journalists in Tbilisi on 22 February that a "special unit" had been created to guard the Baku-Ceyhan pipeline. Another factor that could influence investment decisions is whether there is sufficient financial transparency in host countries, particularly if national authorities are partners in project development. Tax structures are also important and patterns of arbitrary imposition of taxes will have an adverse effect on potential investors. Finally, environmental concerns are also important; the Caspian is flood prone and environmental impact studies constitute a critical cost of project development, particularly as the Caspian is a seismically active zone. There are even serious concerns about the fate of the caviar-producing sturgeon. To understand the political-geographical-economic dimensions of the pipeline problem, it is first necessary to recognise the fundamental technical difference between oil and gas pipelines. Oil pipelines can deliver crude oil directly to refineries or to transhipment points where it is loaded on ocean faring ships for distant delivery. Gas pipelines, however, must deliver energy directly to market. There is therefore no global market for gas; only regional markets exist. Perhaps the most dynamic potential market for Caspian gas is Turkey, and Turkish energy needs are expected to grow significantly over the coming twenty years. It is already suffering from energy shortages, and electrical brownouts are relatively common. The dilemma, of course, is that a large gas producer, like Turkmenistan is remote, and pipelines will be expensive to build. The emergence of Azerbaijan as a producer of gas poses a serious challenge to countries like Turkmenistan, which rely on Azerbaijan for transit facilities. Nor does it ease regional tensions, since in addition to Azerbaijan and Turkmenistan, Iran and Russia are also competing for a share of the Turkish market. It is tempting to look at the laying of pipelines for the delivery of Caspian gas and oil as posing a strictly economic and technical set of challenges. But to do so would be fundamentally misleading. Politics and strategic calculations are playing a fundamental role in this arena as well. Indeed, international pipeline construction tends to be driven as much by strategic and political considerations as economic ones. The Chinese, for example, have signed a memorandum of understanding to build a 3,000 kilometre multibillion dollar gas pipeline from Kazakhstan to the Chinese province of Xinjiang. This represents an extraordinarily expensive infra-structural investment that may never pay economically. But as suggested above, the Chinese feel a strategic imperative to diversify their energy sources and open new alternatives to reduce their current need to import energy through the South China Sea. It should be noted that the Chinese do not sharply differentiate economic and strategic objectives.

XI. RUSSIAN INFLUENCE AND PIPELINE PROJECTS Many Caspian states want pipeline grids that will give them options other than exporting through the Russian system. Relying on the Russian pipeline system has not been a happy experience. There is evidence that some Russian officials use Caspian reliance on this pipeline system to dictate commercial terms to them. For example, Russia granted Turkmenistan access to its pipelines provided Turkmeni officials agreed only to sell in bankrupt CIS states, while Gazprom kept for itself clients in Western Europe capable of paying hard currency for their energy bills. Russia sees the Caspian as a potential competitor to its leading energy firms, like Gazprom, which, it cannot be forgotten, are critical to state financing. The problem for the Russians is that such blunt use of its infrastructural leverage is actually encouraging the construction of alternative pipelines that will reduce this leverage over the long term. If Russia wants to remain a player, it will have to extend relatively equal treatment to Caspian producers while beginning to tackle its many organisational and regulatory deficiencies which make its system so unattractive to foreign oil and gas producers. The Americans feel that the current infrastructure grants Russia too much economic leverage over Azerbaijan, Kazakhstan and Turkmenistan. Moreover, there are general suspicions about the reliability of Russian pipelines because of high levels of corruption and bureaucratic paralysis. Chevron encountered a nightmare of obstacles in organising the construction of a pipeline across Russian terrain to get Tengiz oil from Kazakhstan to the international market. But in November last year, the Caspian Pipeline Consortium finally signed a contract for a $2.2 billion pipeline between Tengiz and the Russian Black Sea port of Novorossiysk. Next year, contracts for the construction of a marine terminal at Novorossiysk will be awarded. This was the first large investment in Russia after the country's financial crisis. But, as mentionned above, the success of any pipeline to Novorossiysk is contingent on a peaceful - or at least well-contained - Caucasus. The United States government additionally wants no new pipelines traversing Iran, and to the chagrin of its allies, the US Congress and the President have taken extraordinary measures to see that Western firms are discouraged from pursuing this option. Nevertheless, there are compelling economic and logistical justifications for an Iranian option, and these could eventually supersede American hesitancy. Another problem has been the ongoing dispute about control of the Caspian seabed. The Treaty of Moscow signed in 1921 divided that sea between Russia and Persia but the break up of the Soviet Union has led to demands for new agreements and the region's governments have insisted that the Law of the Sea is now applicable. The resolution of these disputes is critical to securing investor confidence, and some progress has been made in recent months. Kazakhstan and Russia have signed an agreement on dividing the northern portion of the Caspian seabed . Arrangements between Azerbaijan and Turkmenistan seemed likely until the former country's discovery of gas reserves in July, when Azeri enthusiasm for the trans-Caspian pipeline project seemed to cool .

XII. THE BAKU-CEYHAN PIPELINE Turkey wants pipelines to help it meet national energy needs, bolster its own regional strategic leverage, diversify its supply base and lower the risk of environmental catastrophe in the Bosphorus associated with the potential for more oil tanker traffic through that extraordinarily crowded and narrow waterway. Like the Americans, the Turks are also strongly advancing the case for a Baku-Ceyhan pipeline, arguing that this would provide a safe economical and environmental means of bringing oil to the Mediterranean. Because the Ceyhan terminal can handle super tanker traffic, the proposed Baku-Ceyhan line would provide an alternative to transporting oil across Iran, through the Russian pipeline system or by ship through the Bosphorus. There are concerns, however, that a pipeline through the unsettled regions of Azerbaijan and Eastern Turkey might tempt sabotage on the part of Armenian separatists and the PKK respectively. Azerbaijan, Georgia, Kazakhstan and Uzbekistan have all announced their support for the development of the Baku-Ceyhan line which ideally would move 50 million metric tons of oil per year to the Mediterranean; and the United States has offered Turkey $833 million to support the planning process. However, neither the Americans nor the Caspian states have convinced the oil companies that this project constitutes a worthwhile investment. The cost per barrel of moving oil through Ceyhan is about $4 as opposed to $2 to Supsa. It might well be too costly given the instability of oil prices and uncertainty about Caspian reserves; some industrial analysts suggest that another billion barrels of proved oil reserves are needed to justify such a prodigious outlay. Azerbaijani President Aliyev recently informed the US official Richard Morningstar that the documentation for the proposed Baku-Ceyhan oil export pipeline has been completed.

XIII. OTHER PIPELINE PROJECTS Other energy pipelines like Baku-Supsa and Baku-Novorossiysk would end in Georgian and Russian Black Sea ports respectively and thus do not solve the problem of moving that oil into blue water, particularly given Turkish resistance to allowing this oil to pass through the Bosphorus. Oil companies would probably prefer moving the oil through a relatively cheap Baku-Supsa line but shippers passing through the Bosphorus would, at any rate have to assume liability in the case of an accident and this adds significant costs. It should also be noted that the Turks have been engaged in negotiations with the Russians to increase gas imports, and recently ENI of Italy and Russia's Gazprom agreed to co-operate on a $3 billion project to build a 400-kilometre underwater pipeline to ship natural gas from the Russian port of Dzhubga to Samsun on Turkey's Black Sea coast. Russian gas exports to Turkey currently pass through Ukraine where an inordinate amount of illegal pipe tapping has occurred. The economics of this "Blue Stream" project have also been questioned, and there are signs that the Americans are concerned that it could undermine Turkish support for other gas pipelines in the Caspian and particularly the Baku-Ceyhan project. Pumping oil westward from the Tengiz fields in Kazakhstan and moving gas from Turkmenistan could mean building pipelines under the very salty and environmentally fragile Caspian Sea, and these projects would also be extremely expensive. For this reason, Amoco Eurasia has proposed shipping up to 25 million tons of Tengiz oil from the Kazakh port of Aktau to Baku by barge rather than by pipeline. Russia and Iran strongly oppose an underwater pipeline because of the seabed's susceptibility to earthquakes, but more importantly the Russians fear that a trans-Caspian line would undermine plans for a land pipeline route across southern Russia to Novorossiysk. Iran also wants its own networks used to bring oil and gas from the Eastern Caspian. Both Iran and Russia oppose Baku's emergence as the main transport nexus for Caspian energy. Other non-producing countries are contributing to the pipeline debate. Georgia, for example, is supporting the Areol project for a pipeline from Sangachal to Supsa on the Black Sea which would link with existing pipelines. The Ukrainians are building an oil transportation facility in Odessa and hope to use it as the head of a pipeline system capable of moving oil from the Black Sea to Europe. Ukrainian officials see this project in both geostrategic and economic terms and recognise that such a pipeline would deepen Ukrainian ties to the West and help it meet domestic energy needs with non-Russian energy. Ukrainian dependence on Russian gas is a source of grave strategic weaknesses and grants Russia a high degree of leverage over Ukraine. The Ukrainian project, however, faces vital financial challenges that have yet to be worked out. The Romanians are promoting a pipeline which would ultimately link its Black Sea port of Costanza to Trieste in Italy. ENI has been involved in this particular project. Unocal is looking at plans to construct a Central Asian pipeline to move Caspian oil and gas from Chardzhou, Turkmenistan to Heart, Pakistan via Afghanistan, but that country's ongoing civil war and the Taleban's great hostility to the West makes this route unfeasible. Nevertheless, despite the withdrawal of Unocal, the consortium's largest company, Turkmenistan, Pakistan and Afghanistan agreed in late April to proceed with the project. While the problem is likely to face financial difficulties, its sponsors hope that it will "help restore complete peace in Afghanistan and also serve as a catalyst to economic revival in Afghanistan".

XIV. THE LOCAL ECONOMIES Post-Soviet Caspian economic development is so far a story of misplaced expectations. The legacy of Soviet rule continues to burden the region's economies. Decades of mis-allocated capital, irrational pricing, centralised control and highly inefficient energy drilling techniques have left their mark. Exploration contracts signed by the Soviet Union with international business were terribly disadvantageous to the region, and only recently have governments begun to demand contract re-negotiations. While the signing of oil and gas contracts has created a new class of extremely wealthy power brokers throughout the region, most inhabitants live in poverty. Unemployment and decay are apparent everywhere, and if anything, the region has suffered from de-industrialisation over the last decade. War too has left its mark, not only in terms of added budgetary pressures, but in uprooting entire regions and creating serious refugee problems. Baku, for example, has seen an enormous influx of refugees from the war with Armenia, and their presence has placed an enormous burden on that city's creeking social services and housing infrastructure. The legacy of Soviet economic rule is not a happy one. Decades of capital misallocation and price distortion have left an almost indelible mark on the region's infrastructure which is uniquely ill-suited for the rigours of global competition. There is, for example a marked shortage of drilling platforms and equipment in the region, and there are few prospects that this situation will change quickly. The high costs of bringing in the right equipment constitutes a genuine bottleneck to energy exploration, and this is why it is taking so long to follow up on signed contracts. Moreover, the old industrial base of the region was oriented for trade with the Soviet empire, and that empire no longer exists. The collapse of traditional markets has been devastating, and the obliteration of the social welfare, public health, and educational systems that the Soviet Union offered has led to a crisis of expectations that tempts broad social unrest. School-leaving age has declined drastically throughout the region, and thus the human capital so important to long-term economic development is not being sustained. That the region's educational systems are producing unskilled labour with no job prospects obviously has long-term implications for political stability. It is far from certain that even if the region becomes an important exporter of energy, this will have a necessarily munificent effect on society as a whole. Some have characterised the extractive energy business as conforming to a classic enclave-style pattern of development in which "backward linkages" to the rest of the economy can be quite limited. Moreover, there is also a risk of eventually catching "Dutch disease", an economic malady in which the value of the local currency rises as a result of large oil or gas exports. But this appreciation renders locally produced manufactures and agricultural goods less competitive on the international market, a process which can hasten de-industrialisation and put farmers out of work. Indeed, rapid currency appreciation often makes imported food cheaper than domestic food. The sudden loss of farmer income, in turn, can create tremendous social and economic polarisation, mass internal migration to cities and, ultimately, political instability. It should be noted, in addition, that agriculture in the Caspian region has already suffered enormously since the collapse of the Soviet Union. This has placed even greater burdens on the leaders of countries which are proving unable to feed themselves and lack the foreign exchange to buy sufficient quantities of food on international markets. Food expenditure has accordingly risen to 70% of household income, and malnutrition is on the rise. Insofar as national economies come to rely on the export of a single commodity, externally induced commodity price shocks can have disastrous implications on rigid economies which have few means to "hedge their bets" against such developments. This is particularly true for those countries which are not able to save a high percentage of commodities-generated revenue and which face political pressures to spend those earnings as quickly as they enter the national coffers. The World Bank and IMF are working with Azeri officials to develop the necessary infrastructure to handle an influx of petrol dollars. The Caspian region is also notoriously inefficient in energy use. It requires roughly 1.2 tons of oil to produce $1,000 of GDP, compared to an efficient country like Norway where the ratio is 0.2 tons of oil to $1,000 of GDP. This suggests that without important structural change and micro-economic adjustment, the countries of the region may be compelled to consume an unduly high percentage of their primary foreign exchange earning commodity. The low level of regional economic activity has driven many to turn to the black market and criminal activities. Heroin smuggling has become a big industry in the region. Afghan opium is moving through Tajikistan and Turkmenistan while poppy production is rising in Kazakhstan and the Kyrghyz Republic. Undoubtedly the lack of economic opportunity is contributing to the corruption and criminalisation of local economies, a development which is rendering the prospects for putting local economies on a solid footing all the more remote. Aid and capital inflows to the region have been paltry. The IMF has provided some assistance, as has the World Bank's recovery programme. Strict IMF conditionality has put several governments in the tough position of either cutting away the tattered vestiges of public welfare or facing loan termination. Uzbekistan, for example, lost access to IMF credits when its budget deficits soared. Last summer the IMF warned Azerbaijan that restructuring agriculture, creating stronger financial institutions, regulations, and budget cuts are essential to macro-economic stability, particularly given the country's dependency on uncertain oil prices. The Caspian region is rife with political problems. The collapse of the Soviet Union did not herald the coming of democratic order, and many of today's elites were yesterday's apparatchiks. The groups that gained power have tended to cling to it, and the absence of party alternation in government and the varying degrees of repression in countries like Kazakhstan, Azerbaijan, and Turkmenistan have only spawned endemic corruption and alienation. While Western governments grumble about this, little public complaint is heard from Western oil companies that have forged close relations with the region's governments. The problem is that today's repression can and will most likely yield to tomorrow's instability. Despite these very serious problems, there have been some positive signs over the past two years. The GDPs of most Caspian countries have begun to grow, although this hardly compensates for the precipitous decline earlier in the decade. Indeed, in 1997 the GNPs of Azerbaijan, Georgia and Tajikistan were one third of the level in 1989.

XV. PRELIMINARY RECOMMENDATIONS It would be mistaken to view the Caspian region as a new Persian Gulf and accordingly to over-emphasise its strategic value to the industrialised world. To begin with, its reserves remain unknown, and even if they should turn out to be substantial, they are more likely to resemble those of the North Sea than those of Saudi Arabia. Attaching too much strategic import to the region could overextend both American and European commitments to a highly unstable region in a game that will also involve to varying degrees Russia and China. This could create situations in which, once their strategic stakes have been declared, outside powers could loose their flexibility to adjust to changed circumstances. Flexibility would be further sacrificed if outside powers begin to tie themselves inextricably to particular political groups or factions. Indeed, the political situation is likely to remain unstable, particularly given the high preponderance of autocratic regimes employing time-tested Soviet methods to cling to power. Over-enthusiastic efforts to prop up this or that regime could hypothetically lead to a quagmire where outsiders find themselves ever more enmeshed in local turf battles. Their involvement would tend to raise the stakes of local power struggles and potentially make it more difficult to develop exit strategies. It is for this reason that Zbigniew Brzezinski has labelled the region the "Eurasian Balkans". NATO and NATO members should not rush into building military bases in the region even with some countries like Azerbaijan openly encouraging this. All things considered, to do so could prove needlessly provocative without conferring any real strategic advantages. Indeed it could well lead to further polarisation and tension in the region which a few isolated bases could do very little to contain. Moreover, the building of such bases are often seen as implicit security guarantees, but such guarantees would be difficult financially and politically to sustain, and therefore their credibility would be suspect from the beginning. Even as NATO begins to discuss the idea of playing new roles, it must also be very cautious about overextending itself or creating a kind of Pax-NATO. This does not mean, however, that deeper co-operation with the region is unwelcome. To the contrary, Europe and the North America can play a very healthy role in the region provided the strategic stakes are not overstated. If the United States, for example, lays too much emphasis on a "Russia down and Iran out" policy, this would actually needlessly raise the stakes in the region. Western governments should therefore not approach Caspian security issues from a strictly military perspective. Perhaps the greatest boon to regional stability would come in the form of poverty relief, and any broad policy formulation should consider this. Political extremism feasts on poverty. Europe and the United States must be careful not to contribute to the regional arms race, and indeed, should use their leverage to contain it. Western governments should be cognisant that perhaps another great threat to stability in the Caspian region is not the hegemonic aspirations of any single power, but rather the perception that other powers will be tempted to make a play for hegemony, a possibility that, in turn, will inspire pre-emptive or defensive counter-initiatives by other states. This could lead to a regional escalation of tensions that, on the face of it, are unwarranted. Dialogue and confidence-building among regional and extra-regional actors is essential as this region grows more important economically. That said, Western support for new pipeline options seems perfectly justifiable, at least from a strategic perspective. Multiple pipelines would grant new openings for regional players and could foster improved regional inter-dependence. Caspian states should not bet all their financial and political capital on a heretofore elusive oil and gas boom. That boom might not materialise for some time, and perhaps never will. In the meantime, further industrial and agricultural reforms are essential to alleviating regional poverty. Indeed, economic diversification is a central component of building a stable and sustainable economic foundation. To bet on oil as an industrie industrialisante, to use a phrase once favoured by the Algerian government, is only likely to increase dependency on oil prices and pipeline politics. Central Asian countries could learn much from the problems of other oil-driven states, in the Middle East or Africa, in coping with the economic problems common to such countries. The Silk Road project is a promising and prescient initiative. Given the lack of linkages among Caspian states, the creation of a sub-regional group similar in structure and purpose to Black Sea Economic Co-operation would be most helpful. The Silk Road secretariat in Baku might be a good first start. It will provide a new means for the region to co-operate in forging relations with outside powers and setting up some machinery for economic co-operation and dispute resolution among themselves. Other regional institutions are expanding: last April, during the festivities for NATO's 50th Anniversary, the leaders of Georgia, Ukraine, Azerbaijan and Moldova met with Uzbek President Islam Karimov at the Uzbek Embassy in Washington, and announced that Uzbekistan was to become the fifth member of GUAM, forcing the alliance of former Soviet republics to change its acronym from GUAM to GUUAM. GUUAM member countries seek to expand their co-operation as part of the TRACECA project, the Euro-Atlantic Partnership Council and NATO's Partnership for Peace programme. They also seek to pool their efforts against local threats such as terrorism, secessionism and religious extremism. Greater flexibility in Western policy toward Iran is needed. While recognising that the Iranian state has not abided by rules of international conduct through its past support for terrorism and in its violation of human rights at home, today Iran could well be in the midst of an important transition. A struggle appears to be underway between moderates and more extremist groups. This is not to say that the West should rush to sign pipeline contracts with Iran. Iran must be convinced that its reintegration into the international community hinges on definitively ending those practices which led to its exclusion in the first place. But the time for dialogue is fast approaching. The West should be prepared to support positive domestic changes in Iran by showing a willingness to re-establish economic ties. If events move in this direction, lower cost options for moving Caspian oil and gas could materialise. Corruption is a pervasive enemy of development, and Western governments as well as lending institutions should use what leverage they have to counter it. Vigorous applications of new guidelines against bribery will be welcome and should be applied vigorously to Western firms conducting their affairs in the region. In this respect, the OECD convention on bribery could be very helpful. The Russians for reasons of geography will continue to perceive certain vital strategic interests in the region and will feel these more profoundly than the Americans. Indeed, the Russians do have legitimate concerns that regional instability could create problems within their own territory; but of course, any Russian temptation to destabilise the region for short-term economic gain should be discouraged. Indeed, such behaviour on the part of Russia will ultimately lower its leverage there and will certainly discourage the region's states from forging healthy economic ties with it. The Russians must find ways to make its pipeline system available without using it to club its competitors. Russia must recognise that if it wants to remain a player in the Caspian market, it must be able to provide services to the region that do not tie the hands of the Caspian states and local and foreign businesses. At the same time, a proliferation of redundant pipelines would undermine the economics of this infrastructure. Deepening Western dialogue with other political forces in the Caspian region through EAPC and the NATO Parliamentary Assembly would be welcomed. Along these lines, it might be very fruitful to organise NATO PA Rose-Roth Seminars in the region. NOTES AND REFERENCES Peter Hopkirk, "The Great Game: The Struggle for Empire in Central Asia", Kodansha America, Inc., April 1994. Martha Brill Olcott, "The Caspian's False Promise", Foreign Policy, Summer 1998, p. 96. Remarks by Oksana Antonenko to the Economic Committee at the NAA Autumn Session (1998) held in Edinburgh, United Kingdom. Maria Kielmas, "Caspian energy: Politics vs economics", Middle East International, 12 February 1999. John Thornhill, "Moscow in fight to strengthen its grip on Gazprom", Financial Times, 26 August 1999. Alan S. Cullison and Bhushan Bahree, "Gazprom's role in Russian politics", Central European Economic Review, Wall Street Journal Interactive Edition, 30 August 1999. Remarks by Oksana Antonenko to the Economic Committee at the NAA Autumn Session (1998) held in Edinburgh, United Kingdom. Amy Myers Jaffe and Robert A. Manning, "The Myth of the Caspian Great Game: The Real Geopolitics of Energy", Survival, vol. 40, no. 4, Winter 1998-99, pp. 112- 29. Stephen Kinzer, "Azerbaijan, alone with much oil, Wants U.S. Base", International Herald Tribune, 1 February 1999. Martha Brill Olcott, "The Caspian's False Promise", Foreign Policy, Summer 1998, p. 97. Dan Morgan and David Ottaway, "Power playing the Caspian", Financial Times, 5 October 1998. Stephen Kinzer, "Azerbaijan, alone with much oil, Wants U.S. Base", International Herald Tribune, 1 February 1999. Robert Corzine, "Iran signs $1bn oil deal with Elf and Eni," Financial Times, 2 March 1999. 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