HOT MOMENTS OF THE COLD YEAR

A barrel of oil costs $27. None of the global oil companies and oil-producing countries would have imagined such a drop in oil prices two years ago. But that was Santa’s surprise for the global energy sector in the middle of January 2016. The reasons have been discussed long and widely: uncontrolled increase of oil production parallel to decrease in economic activity in the consumer countries followed by price wars between traditional producers led by Saudi Arabia and the producers of shale oil in the United States and Canada. Apparently, such a considerable price drop was a cold shower for everybody in the sector.

The oil swing

Almost the whole period of 2016 was marked by negotiations on freezing (reduction) of oil production in OPEC member- and non-member countries.

Previously, OPEC has promptly reacted to price jumps in the market through increasing or decreasing oil production. However, in 2014-2015 when the cartel decided to temporarily exclude itself to neutralize shale producers, albeit at the expense of financial losses of its member-states.

But it was not an easy task to compete with the shale oil: the American companies have reduced the production but were not in rush to completely forget the industry. The state-of-art development technologies helped to reduce the costs to $30 per barrel of shale oil.

Since the end of 2015, OPEC has started exploring the opportunities to regain the management of the oil market. However, the process has been fraught growing contradictions between the main members of the cartel, Saudi Arabia and Iran. After lifting of sanctions, the latter began increasing oil production actively in an attempt to set the pre-sanction production level of 4 million bpd.

In general, Tehran has supported the idea of ​​freezing oil production and was even ready to join it but only when the country reaches the pre-sanction level of production. This meant that Riyadh, which replaced Iran in the market during the sanctions, would have to cut production sharply. Amidst the deepening of political confrontation between both countries, the Kingdom was not ready to leave the market for the benefit of Iran. As a result, the April Summit of OPEC countries in Doha, where the member-states had to make a decision on volume cuts, ended without result. By the way, a number of oil-producing countries outside the cartel have also participated in the summit, including Russia and Azerbaijan.

Non-OPEC countries have ignored OPEC's next attempt taken in September in Algeria to agree on freezing of oil production. However, they have promised to join in the event of clear agreements. But it was the Algerian meeting that was the basis of future breakthrough: later in Vienna, OPEC came to an agreement to limit production at 32.5 million bpd.

This agreement was officially documented at the November meeting of OPEC in Vienna. The cartel members pledged to cut production by 1.2 million barrels cumulative and determined quotas for each country. In such circumstances, a number of countries outside the cartel, also made a commitment to reduce production at 558 thousand bpd with Russia having the biggest share (300 thousand bpd). Azerbaijan has promised to reduce production by 35 thousand bpd.

It was a historic agreement when OPEC member and non-member states agreed to remove 1.7-1.8 million barrels of oil from the market and achieve a balance in the first half of 2017.

The experts of Fitch Ratings believe that the oil demand could exceed supply by about 400 thousand bpd in Q1 2017 and 1.3 million bpd during Q4 2017, if the agreement remains further in force.

The agreement has already affected the oil price. If before the OPEC meeting, the oil was trading at some $45 per barrel, by the end of December in anticipation of cuts the price raised to about $55. Further dynamics of oil prices will depend on the willingness of oil-producing countries to clearly fulfill the agreements, as well as the impact of shale oil market particularly active in the United States.

Gas symbiosis

The gas sector was also full of events in the passing year. The volumes and the share of natural gas in global energy mix are regularly increasing. This process will continue in the foreseeable period.

Azerbaijan is actively developing the Shah Deniz gas field, which is huge even by global standards. The gas field is quite promising in terms of increasing financial income and the significance of energy supplies for European consumers. The second stage of the development assumes the implementation of the Southern Gas Corridor (SGC) project, which is expected to deliver natural gas via the Trans-Anatolian (TANAP) and the Trans-Adriatic (TAP) pipelines to Italy, Greece, Bulgaria with access to the Balkans.

In mid-2016, the consortium started the construction of SGC’s last component, the TAP pipeline. However, this project has faced the greatest obstacles: a number of environmental NGOs opposed the project in Italy referring to the possible contamination of the coast of Puglia. Although the consortium has given guarantees to minimize the environmental impacts of the project, especially since the consortium expects to attract international financial institutions, which are very scrupulous in environmental matters, to fund the project. The visit of the Italian Foreign Minister Paolo Gentiloni to Azerbaijan has contributed to partial removal of tensions around the TAP. The US State Department's Special Envoy and Coordinator for International Energy Affairs Amos Hochstein has also promised the support of his government to the project. "I am confident that we can overcome the difficulties regarding the construction of TAP in Italy. This requires co-operation of the US, the EU and other countries involved in this project", said Hochstein during his recent visit to Baku.

Moreover, he promised that Washington would continue supporting the SGC, as it once did in relation to the Baku-Tbilisi-Ceyhan (BTC) project. "Such a powerful project as Southern Gas Corridor that covers many countries - from Azerbaijan, Georgia, Turkey, Greece, Albania to Italy, may face various political and geopolitical problems. As it was before, we solved these problems together and will continue working together", said Hochstein.

Incidentally, the decline in oil prices had impacted the SGC project costs. It is expected that the costs will be about $39 billion versus the originally planned $45 billion. TANAP will ensure the main portion of savings: a decrease from $12 to $8.5 billion. TAP: from $9 to $6 billion. Toward the end of the year, the consortium received foreign loans for the implementation of SGC, which in this case indicates the profitability and the faith of international financial institutions in the efficiency of Azerbaijani gas delivery system in Europe.

In particular, the following is the list of allocations by international financial institutions: World Bank - $800 million, Asian Development Bank - $1 billion, Asian Infrastructure Investment Bank (AIIB) - $600 million. By the way, AIIB’s loan was the largest loan in the history of this small new financial institution.

In general, by the end of 2016, the scope of works on the following projects are complete as much as: 88% in Shah Deniz Stage II, 75% in the expansion of the South Caucasus Pipeline (SCP), 60% in the construction of TANAP, and 30% in the construction of TAP.

SGC aims to become the first real alternative route to Europe interested in diversifying gas supplies. Moreover, this system has a special significance in terms of expected access to the Southeast Europe market, where in some countries the supply of gas is 100% dependent on one supplier.

Turkey will also receive considerable benefits from the implementation of SGC. And it is not only about additional gas supplies (Starting from 2018, Turkey will receive about 6 bcm of natural gas annually under the Shah Deniz Stage II) but also Turkey’s chance to become a large hub at the southern border of Europe. In particular, the SGC system will allow to pump Turkmen gas to Europe. Theoretically, the connection of Iran, Iraq and Israel to the transportation system is not excluded.

"We are on the threshold of new investments that will make Turkey a significant energy hub. By the end of this year and in 2017, we will take important steps in this direction. Thus, we will speed up the transformation of Turkey into a reliable gas supplier for all regional countries", said the Turkish President Recep Tayyip Erdogan on the 23^rd World Energy Congress held in Istanbul in October.

The implementation of the Russian project Turkish Stream (TS) strengthen Turkey's ambitions on the way of becoming a regional gas hub. Designed to replace the cancelled South Stream Pipeline project, TS will provide direct gas supplies to Turkey from Russia under the Black Sea. The deterioration of relations between the two countries due to the shot Russian military aircraft in Syria has frozen the project. But after the normalization of relations, the Turkish Stream was among the first unfrozen projects.

The presidents of Russia and Turkey signed an intergovernmental agreement on the construction of two lines of the Turkish Stream. Each pipeline will be able to transfer 15.75 bcm of natural gas per year. By the end of the year, the agreement was ratified by the Turkish Parliament and approved by the president and the government.

Initially only one thread of the Turkish Stream will be constructed, which should stop Russian gas supplies to Turkey through the Trans-Balkan pipeline going through Ukraine. Based on the demand of the countries of Southeast Europe, the second pipeline can be constructed. But in this case, much will depend on EU's position, which aims to preserve Ukraine's role in Europe as a major transit country for the Russian gas.

By the way, last year, does not allow the confrontation between Russia and Ukraine in political terms, and thus differences remained and in the energy sector. The Russian Federation intends to firmly refuse the transit of its gas to Europe through Ukraine after 2019, when the transit agreement expires. Therefore, Moscow is promoting new projects, designed to bypass Ukraine as a transit country, such as Turkish Stream and Nord Stream-2. But such a change does not agree the EU, which aims to block all new Russian initiative.

SOCAR without DESFA

End of the year turned out to be quite eventful for the oil and gas sector of Azerbaijan, in particular, SOCAR. The main event was the primary agreement between SOCAR and BP to develop the Azeri-Chirag-Guneshli (ACG) field up to 2050. This field is the main asset of Azerbaijan and provides almost 80% of country's oil production. As part of the development of the ACG in 1997, more than 3 billion barrels of oil were extracted from the field, which accounts for 40% of recoverable reserves.

For the first time in its history, SOCAR introduced dollar bonds to the Azerbaijani market. The volume of emitted SOCAR five-year domestic bonds was $100 million, the cost of each share was $1,000. SOCAR bond yields is 5% per annum. Moreover, under the terms of agreement, only Azerbaijani residents may buy bonds in the primary market. But in the secondary market foreign citizens and companies can be connected.

At this step the company went public for submission of a new financial product for the reduction of investments in terms of confidence in the banking system.

Finally a three-year saga regarding SOCAR’s acquisition of the Greek gas distribution company DESFA ended in 2016. Unfortunately, the deal could not be completed despite long negotiations. After winning the tender for the privatization of 66% DESFA for €400 million, SOCAR has faced opposition from EU antitrust authorities. As from 2020 are expected to supply Azerbaijani gas to Greece, in the opinion of the European structures, SOCAR could give advantage to dictate their conditions. It was possible to resolve the issues after SOCAR pledged to reduce its stake in DESFA to 49%, giving 17% to the Italian SNAM. But then the Greek Government, by initiating changes in the law, which limited future growth rates DESFA, started to cause problems. SOCAR tried to negotiate the cost reduction since the new conditions falling profitability of the gas distribution network but failed to reach agreement.

Instead, SOCAR increased its activity on the African continent, considering the number of projects for the supply of liquefied natural gas in the Ivory Coast, Togo and the further gasification of the region. SOCAR has already entered into an LNG import terminal construction project in Côte d'Ivoire. Another project for the construction of the port of Cotonou, Benin discussed.

SOCAR is also considering participating in the construction of LNG terminal in Croatia and plans to invest in the LNG terminal project and power plant in Malta.

What to expect in the coming year?

The next year, the focus will shift to the implementation of the Southern Gas Corridor project, that already in 2018 to start gas supplies to Turkey under the Shah Deniz Stage II development. In principle, there is no longer any obstacles ahead of the project. To actively address the issue of funding, expanding the scale of construction work on individual components of the SGC.

On the other hand, we hope the agreement on the reduction of oil volumes will work and ensure acceptable oil price for signatory countries. Consistently profitable level of oil prices will allow Azerbaijan to significantly speed up the transition to post-oil economy, and actively implement the roadmap for individual sectors of the economy designed to promote economic development in the coming decades.