Caspian basin confronts boom and bust energy cycle

Ariel Cohen

Caspian Basin energy exporters stand to reap near-term benefits from the conflict in Iraq, namely from higher oil and gas prices. The expected windfall could potentially help Caspian Basin governments address structural economic imbalances that threaten stability over the longer term. But many analysts believe Caspian Basin states are more likely to miss the opportunity and remain vulnerable to the so-called "Dutch disease."

Regional oil and gas producers – especially Azerbaijan, Kazakhstan and Russia – are looking to take advantage of the current uncertainty in the Persian Gulf, along with rising global energy demand, especially in Asia. Caspian Basin countries all hope to continue expanding output during the first half of 2003. Last year, Kazakhstan boosted oil production by 16.6 percent to 42 million tons. Azerbaijan’s overall production grew more modestly – at a single-digit rate.

Raising output is one thing; getting it to Western markets is another. Caspian Basin states currently find themselves frustrated by limited export capabilities, as virtually all existing pipelines connecting the region to the West are operating at or near capacity.

Kazakhstan benefited in 2002 from the opening of the Caspian Pipeline Consortium (CPC) pipeline. [For background see the Eurasia Insight archive]. But Astana will be hard pressed to duplicate such success this year. The planned Baku-Tbilisi-Ceyhan pipeline [for background see the Eurasia Insight archive] perhaps offers the nearest-term relief for Azerbaijan and Kazakhstan, but experts estimate that it will be 2005 at the earliest before natural resources start flowing through this new route.

States are also exploring other options. According to sources familiar with regional developments, Kazakhstani officials are pondering a collaborative venture with the Italian state-owned ENI, the operator of Agip-led consortium in the Kazakh sector of Northern Caspian, and of the giant Karachaganak field, to export oil via Iran.

As for Russia, the region’s largest oil exporter, companies are planning to export more oil in 2003, even though volume is limited by the current lack of state-run pipeline capacity. According to the Interfax Oil and Gas Report, Russia will export 43 million tons of oil in the first quarter of this year, while Deputy Prime Minister Victor Khristenko promised further expansion of the Russian pipeline capability.

This may include the government decision in March whether to build the first pipeline in Eastern Siberia. The options include a 1,396 mile pipeline to China, which would export 20 million tons of crude a year. Another option is a more expensive and lengthy pipeline to the port of Nakhodka, which has attracted interest from Japan. That pipeline would export up to 50 million tons a year, would be 2,413 miles in length and would cost over $5 billion. The China option could possibly be operational by late 2005, while the Nakhodka pipeline would take until 2008 to complete.

Oil revenues are projected to remain in record territory for 2003. LUKoil is planning that oil prices will be in the range of $21 a barrel; Sibneft is forecasting $16.5 a barrel, while TNK is envisaging $18.5 for Brent crude. Western estimates are higher: so far the prices floated in the $35-39 range for January-March, and Goldman-Sachs is forecasting oil prices in the $30 range for 2004.

With prices this attractive, Russian companies are planning to increase production between 6.8 percent a year, for the government-owned Rosneft, to 12-13 percent a year for aggressively growing private companies.

Natural gas production and downstream production will also grow: Kazakhstan increased natural gas exports by 13.2 percent, and produced 30 percent more gas condensate. Kazakhstan will be developing the Phase Three of the Karachaganak gas condensate field, which will require a $2 billion investment. The Amangeldy field in southern Kazakhstan will be expanded, and ChevronTexaco plans to open a polyethylene plant in April 2003.

Russian gas exports grew only by 2.4 percent in 2002 This is because Russian state-owned gas monopolist GAZPROM is subject to artificially low prices at home, suffers from opaque and politicized management and is not effectively attracting Western investment in order to revamp its aging infrastructure.

The expected near-term increase in the cost of energy actually could heighten the risk of Dutch disease afflicting Caspian Basin countries. Any remedy will depend on sound fiscal policies. To a lesser extent, it will also depend on governments’ commitment to creating the infrastructure and environment that allows individuals and enterprises to flourish.

Dutch disease is an economic malady in which the large influx of foreign currency from oil and gas exports creates distortions in the domestic market and exchange rates that ultimately hinder the development of non-energy sectors. Energy profits tend to inflate the value of a nation’s currency. This, in turn, reduces international demand for the particular country’s durable goods, possibly resulting in a withering of agricultural and non-energy manufacturing. Oil and gas development also tends to monopolize foreign investment, frustrating the potential development of other sectors.

It is questionable whether Caspian Basin governments will try to seize the opportunity to address the dangers posed by Dutch disease. So far, the governments have done little to address the potential economic and social consequences. Because it has the largest and most diversified economy, Russia is less likely to feel the full effects of Dutch disease. Azerbaijan and Kazakhstan, however, appear headed for an economic shock. The risks are perhaps greatest for Azerbaijan, where oil already comprises more than 90 percent of exports and where non-energy industry has virtually ground to a halt.

At present regional governments are keeping internal energy prices artificially low mainly out of a desire to prop up enterprises that should otherwise be drastically overhauled or closed down altogether. Energy, especially artificially cheap natural gas, is thus used today by Caspian Basin states as a hidden subsidy, which ultimately weighs down overall economic development efforts.

On top of maintaining low domestic prices, regional governments have largely refrained from devoting oil and gas profits to the development of non-energy sectors of the economy. In addition, the social infrastructure remains unable to offer adequate protection for pensioners, the disabled and the impoverished.

Preventing Dutch disease will require Caspian Basin government to stimulate non-energy business development and to create jobs. Among realistic options open to officials are the simplification of registration procedures for new businesses. In creating incentives for small businesses, authorities must additionally contain corruption and capital flight.

Even if regional leaders push to implement changes, however, the window of opportunity for the oil and gas revenue bonanza might prove too fleeting for Caspian Basin states to avoid a bout of Dutch disease. Indeed, many analysts say the expected spike in energy prices may be followed by an even more drastic decline. If that scenario comes to pass, Azerbaijan, Kazakhstan and Russia could find themselves scrambling to cover ever widening budget gaps created by diminished oil and gas revenue.

Editor’s Note: Ariel Cohen, Ph.D., is Research Fellow in Russian and Eurasian Studies at the Heritage Foundation. His expertise includes international energy security.

http://www.eurasianet.org/departments/business/articles/eav032403.shtml