Tengiz experience example of oil revitalization advancing in FSU

Richard H. Matzke
President
Chevron Overseas Petroleum Inc.

• Tengiz Liquids Production [18,579 bytes]
• Tariff Escalation [18,716 bytes]
• How Tengiz Crude is Shipped [19,337 bytes]
• Caspian Pipeline Consortium [20,403 bytes]
• Potential Export Routes [31,482 bytes]
• Additional Export Proposals [23,494 bytes]

Adapted from a recent presentation in London to the National Association of Petroleum Investment Analysts.

It is a widely held view that the Tengiz oil field development project and the Caspian Pipeline Consortium (CPC) project symbolize the petroleum future of the Caspian region.

They are the pioneers, and in that sense, they are more than projects-they are history itself. We should recognize that some day, history will look back on these two projects as unexceptional. They may be remembered for setting a precedent, but they will not be unique.

Powerful market forces are pushing the former Soviet Union (FSU) toward revitalizing its petroleum industry and taking full advantage of its oil and gas resources. So, there will be more projects-a lot more-because there has never been any question about the fundamental underlying value of these assets.

Of course, just because these developments are inevitable does not mean they will come together quickly or easily. You cannot transform a centrally planned economy into a market economy overnight. It might be tempting to think of the old U.S.S.R. as dead and gone. But a closer look reveals that yesterday still has a strong grip on today-and therefore on tomorrow.

FSU production, transportation

It was not all that long ago that the Soviet Union was the world's largest oil producer.

At its peak in 1988, Soviet output was about 12 million b/d. Most of this was consumed internally, but about 2 million b/d was exported.

After the breakup of the FSU, oil production dropped almost by half, to about 6 million b/d. Exports also dropped temporarily, then climbed to their previous level of 2 million b/d.

So, the picture today is that total production is way down, but export levels are essentially unchanged.

Largely unchanged also is the "invisible giant"-the central petroleum pipeline system of the FSU. This is the old Glavtransneft system.

It is the world's most extensive trunk pipeline network and includes more than 65,000 km of primary lines, 400 pump stations, and has a design capacity of 600 million tons/year. Today, it connects the oil fields and markets of 14 different countries.

But this network was not designed to ship today's oil to today's export locations. Under the centrally planned economy, the network supplied mostly internal markets, as well as the needs of communist states in eastern Europe. It was designed, logically, to connect yesterday's internal refining centers to yesterday's major oil fields.

Today, those fields are in decline. And the FSU has big pipelines where they are no longer needed and small lines where they need big ones.

The breakup of the FSU gave the newly independent republics ownership of pipelines within their borders. They split the Glavtransneft system into regional associations. But more than 80% of the FSU pipeline system is still in Russia, and this is the system owned and managed by the holding company known today as Transneft.

Today, Russia retains central control of most of the pipelines in the FSU under a series of agreements with its newly independent neighbors. So history has redrawn the political boundaries, but Russia still calls the shots on regional oil transport. This means that Russia allocates oil export capacity and coordinates oil delivery schedules.

Transportation considerations

The FSU pipeline system connects oil from Russia and Kazakhstan to countries such as Hungary, Poland, and Romania.

One might think this would set up the opportunity for new hard currency exports next door. Unfortunately, it is not working out that way. Oil demand in these countries is down.

One reason is simply that oil today costs more. But another big reason is that these countries want to diversify their oil sources. They have even been willing to pay more for alternative sources than to remain purely a captive market for Russian oil. So, the pipelines are moving less oil to these countries.

But, long term, it makes more sense to nurture the markets in these countries than to neglect them. Of course, these situations-and the associated relationships-have their own history and their own complexities; in time, they will have their own solutions. For now, today's marine export capacity in the FSU is not large enough to meet demand.

Export access

Export access and export profits in Russia are still linked to what are called "states' needs."

This year, as much as two thirds of export capacity has been allocated to exports serving states' needs, including such things as food programs, industrial projects, and the space program.

Government programs still take priority when it comes to spending oil profits. This is true even though it is obvious to everyone that the oil industry needs those very same profits to revive itself. As long as export capacity remains unchanged, this conflict should remain a problem for new oil projects.

The export capacity situation is entangled in other big transitional challenges, as well.

Three years ago, Russia pledged to shift to world-market pricing of all its oil, including internal sales, not just exports. That promise has not been kept.

But internal oil prices are higher than in the past. Combine that with economic problems, and that results in reduced internal demand for refined products and crude oil. Unfortunately, this is happening just as Transneft is in need of new revenue.

Transneft operates the existing network as a common carrier and charges tariffs to move crude. That is a good plan, but right now this is a pipeline company with more overhead than business to support it. So, the less crude it moves, the higher the tariffs must be.

Recent tariff picture

During a recent 4-year period, tariffs increased sharply. During this same period, Transneft system's throughput dropped an estimated 25%.

If Transneft cannot make enough money-and if it is not willing to borrow or to take on new partners-it cannot afford to build new export capacity. Without export capacity, it cannot serve new customers.

To reduce tariffs, it needs more volume. Transneft has plenty of capacity on its network, but most lines terminate inside the FSU-where there is no new oil demand-instead of outside the FSU, where demand is growing.

Energy Resources Group (ERG), a consulting firm, estimated that in 1996 constrained exports and artificially low internal oil prices deprived the Russian federation of more than $12 billion in oil income.

Some experts believe that keeping energy costs down has helped dampen the political unrest associated with making the transition to a market economy. Clearly, that transition presents challenges more difficult than one can imagine. Still, there are compelling reasons to face up to the oil export problem.

Richard Hildahl, an ERG consultant, recently drew the following conclusion about exports: "The shortage of capacity imposes an enormous hardship on the industry and effectively eliminates the prospect of new investment in the oil sector, until the issue can be resolved."

The present situation

In the FSU, it's not possible to separate pipelines from politics.

But, politics aside, the pipeline network is an essential asset in need of refurbishment, repair, and reconfiguration. This is the view of Transneft, which has been working to assess and improve the quality of its systems. But, it has a lot more work to do than money to do it with.

Add to that the unresolved political issues in Russia and in the new countries surrounding it, and what results is a financial-risk scenario that would make a grown man tremble.

One might think that the smartest way to get new exports going in the FSU is to bypass or avoid dealing with the pipeline systems of the past. That is dead wrong.

Tengiz

Tengiz today is producing and selling more than 140,000 b/d of crude oil per year-nearly 50% more than last year's average.

The Tengizchevroil project is on-track to achieve output of more than 600,000 b/d by the year 2010. Tengiz is generating positive operational earnings, and it's earning the capital needed for its own growth.

In first quarter 1997, Tengiz delivered $50 million in cash distributions to its shareholders. Tengiz partners are making money because we have worked extremely hard to find ways to get this oil to various markets. We have bartered, traded, and negotiated. We have shipped oil by train, barge, and pipeline. We have worked with mayors, presidents, chairmen, and some very tough local officials.

Recently, we completed a shipment of oil from Tengiz to the Black Sea (see map, p. 21). First, rail cars were filled with oil at Tengiz and moved to Aqtau on the Caspian. From there, oil was moved by barge across the Caspian to Baku, where a pipeline moved the oil to Ali Bayramli, in Azerbaijan, for reloading into rail cars. From there, it was shipped to the port of Batumi, on the Georgian Black Sea coast. From there, it moved by tanker out to the Mediterranean.

We have shipped Tengiz crude across Russia to Finland. We have shipped it to the Baltic port of Tallin. We have moved it up the Volga and Don rivers. What we have learned is that one of the keys to success is having a lot of options for moving oil. Now, Tengiz will never be dependent on a single export solution for sales.

CPC

The CPC project is the result of cooperation among 11 oil companies, plus Russia, Kazakhstan, and Oman.

We have won the necessary decrees from the Kazakh and Russian leadership, and the plan is to build a 1,200-km pipeline to transport crude primarily from Tengiz and other Kazakh fields, but also from Russian fields, to a port near Novorossiisk.

The project is going to cost about $2 billion. We hope to start shipments in 2-3 years. Ultimate capacity will be about 1.5 million b/d.

From eastern Black Sea ports, oil will move on tankers through the Bosporus Strait, then to the Mediterranean and other world markets. The pipeline will also move Tengiz crude to buyers in markets within the Black Sea region.

Some of these are already buying from us. Finally, CPC will have a "quality bank"-something Transneft does not have. This is extremely important for Tengiz, because we produce a 47° gravity crude. The quality bank will make sure we get full market value for our production.

Completing the Caspian Pipeline will be a great achievement for the future. But it's important to recognize that the immediate significance of this deal is that it builds on the pipeline network of the past.

A lot of the CPC project involves the use of existing lines, which need refurbishment. So, while half of the line is new, the other half is old.

The Russians found this supergiant field and started producing it before Chevron came on the scene. Then, the break-up of the Soviet Union changed everything, and we negotiated the Tengiz deal with the Kazakhstanis.

So far, Chevron alone has invested about $700 million in Tengiz, and now Mobil Corp. and the ARCO-Lukoil venture Lukarco have invested in the project as well. We'll invest another $600 million for our share of the Caspian Pipeline, and that project-which a lot of people thought could never happen-has attracted more partners than we ever imagined possible.

Major project catalyst

Why are these situations working when so many others are still on hold?

It's because Tengiz and the Caspian Pipeline are doing more than producing and moving oil-they're solving problems, and they are doing that in an emerging market economy at a time when there are many problems and solutions are in short supply.

Russia, in particular, has a great deal to gain, both directly and indirectly, from both projects. The Tengiz project last year spent $52 million on Russian goods, services, and taxes. This year, the expenditure will be more than $100 million.

Every $1 of oil-export fees that we pay to Russia generates more than $2 for Russia's gross domestic product. Over its 37-year life-if all goes well-the pipeline will generate an estimated $20 billion in taxes and dividends for the Russian government.

Early oil plans

The more export capacity available in the Caspian region, the better for everyone, including Kazakhstan, other new countries, and Russia.

Besides the CPC, one project that everybody is watching right now is the AIOC "northern" pipeline.

This is a project of the Azerbaijan International Operating Co. (AIOC), which has 12 partners that plan to develop an estimated 4 billion bbl of reserves in the Caspian Sea.

The AIOC northern pipeline is based entirely on repairing and refurbishing about 1,500 km of existing lines and reversing their flow. Plans call for moving about 100,000 b/d of oil from Azerbaijan to a point near Novorossiisk.

AIOC wants to start pumping before yearend 1997. But political conflicts, including damage to the lines because of the Chechen situation, have already caused delays.

This is a very important project, but it is not the only plan for exporting so-called "early oil" from the AIOC developments.

One project that's attracting considerable interest, particularly from the Russians, is the AIOC "western" pipeline. That pipeline will extend 920 km from Baku to the Black Sea port of Supsa. At no point will it touch Russian soil.

It is a $300 million project, and AIOC hopes to get it running by next year with an initial capacity of 100,000 b/d. As with Caspian Pipeline, half the network will involve existing lines. But even if both of these projects are successful, the AIOC will still need more export capacity.

One proposed solution is the Baku-to-Ceyhan pipeline. In this scenario, AIOC would move oil through-or around-Armenia, then across Turkey and on to the Mediterranean port of Ceyhan.

It's easy to see why the Turks like this plan. It would bring them tariff revenues and international recognition, plus new supplies of crude to their refineries.

The plan would also avoid putting more tankers through the Bosporus. The Baku-Ceyhan line would total 1,300 km, and it would cost more than $2 billion. So, it's not a project for the faint of heart.

But it's important to remember that the undeveloped oil resources of the Caspian basin easily justify this kind of thinking. AIOC's master plan alone calls for eventually producing 700,000 b/d of oil.

Central Asian Oil Pipeline

This proposal, by Unocal Corp. and Saudi Arabia's Delta Oil Co., calls for building a $2.7 billion pipeline from the heart of Turkmenistan south through Afghanistan and Pakistan to the Arabian Sea. (Developments related to a companion gas pipeline project are covered in a story on p. 25.)

Oil would then be shipped by tanker to the fast-growing economies of East Asia.

The pipeline would cover nearly 1,700 km and move about 1 million b/d. This concept would create a sort of pressure-relief valve to the south of the Caspian region. The project could also be linked to the existing Transneft network, and that would create a new export option for Russian oil, as well as Caspian oil.

The concept of going south also raises the question of a pipeline via Iran.

One proposal involves connecting to the existing Iranian network, expanding the network, and reversing some flows. The plan would be to deliver oil to a terminal outside the Strait of Hormuz.

Nobody can forecast the outlook for these "southern solutions," but it's fair to say the idea of running pipelines across Afghanistan or Iran makes even the CPC project look tame by comparison.

The Caspian Pipeline will move oil from east to west-a direction that people are used to. Oil will be loaded on tankers near a long-standing oil port, and tankers will use an established route for export. This is a project that builds on past relationships and takes advantage of existing and established corridors. It also took 5 years to negotiate, and it will not start shipping oil until 2000.

More export proposals

Some proposed systems would bypass the Bosporus, which will reach a point where it simply cannot handle any more tanker traffic, ultimately.

Two proposals would use the surplus capacity at the western end of the Druzhba, or Friendship, pipeline from Russia into central Europe. The first proposal is for a pipeline to deliver crude to the Polish port of Gdansk, on the Baltic Sea.

The second is for a pipeline that would connect to the port of Omisalj, in the northern Adriatic Sea. Again, these are not viewed as export solutions for major new oil production from the Caspian, but they're worthy options for Russian oil exports.

Farther out-and more speculative-is the Baltic Export Pipeline System.

It would move crude south from the Komi arctic region of Russia and then possibly across to a new export facility near St. Petersburg.

Another project is called Northern Gateway. It would take crude north from the Komi arctic fields, probably to the port of Murmansk. That would mean using tankers designed to deal with ice.

These projects do not seem to have much in common with those now taking shape in the Caspian, except for one thing: Like the big Caspian fields, the Komi arctic fields need pipelines. Development, therefore, hinges on a transportation solution.

Lessons, the future

We can learn from what has happened so far.

First, industry needs to use the assets already in place to their maximum advantage. Tengiz, CPC, and the AIOC projects are good examples. Also, ideas for extending the Friendship line to new export points are trying to do the same thing.

Second, industry needs to make the right deals. FSU pipeline projects should be funded mainly by the equity participants in the oil fields that will fill those pipelines.

We must have pipeline owners who are invested in the resources; speculators and outsiders only bring disruption and delays.

Last, it's a good idea to have the international financial community involved in financing these deals. When projects set and enforce world standards, they send a message to others that it can be both profitable and safe to invest in the FSU. There are other projects and proposals for exporting oil from the FSU. But the ones discussed here could increase FSU export capacity by more than 4 million b/d.

It's understandable how some might look at the FSU oil situation and see nothing but risk and confusion. A lot of deals will fail, and none will stay on schedule, but some will work.

Tengiz is a success, and the Caspian Pipeline will ensure that this great resource will achieve its full potential. In the years ahead, the spotlight will shift to other projects.

We need to acknowledge the strong pull of the past, not be discouraged by the present or be intimidated by the future. Our focus must be on what can be done, not on what can't.

The Author