Business, Investments and Politics in Central Asia

On an early September morning almost 10 years ago, more than 500 paratroopers from the US Army’s 82nd Airborne Division jumped into a battle zone near the Tien Shan Mountains (“Heaven Mountains”) along the China/Kyrgyzstan border in Central Asia. Their mission was to link up with friendly forces from Kazakhstan, Kyrgyzstan and Uzbekistan and engage in simulated combat against “dissident elements.”



Source: Hartmut Bielefeldt

This exercise, code named Operation CENTRAZBAT 97 (Central Asian Battalion), became the longest-distance airborne operation in military history. Six C-17 transport aircraft left Fort Bragg, N.C., flying nearly 19 hours nonstop with two midair refuelings over a distance of 12,500 kilometers (km; 7,800 miles). As General John Sheehan, the highly decorated Marine and Commander in Chief of the US Atlantic Command who led the American troops and was the first to make the jump, said afterwards, “There is no nation on the face of the earth where we can’t go.”

In 1997, most of these newly independent states were unknown to the majority of US citizens, and few took notice of either the exercise or the enhanced relationships the US had been developing in Central Asia.

Although the official justification characterized the exercise as a show of support for the new states and their quest for sovereignty and self-defense, many observers noted that the region’s stores of natural resources (i.e., oil and natural gas) and its strategic importance were probably significant factors in the decision-making process.

As then Deputy Secretary of State Strobe Talbot said at the time:

If economic and political reform in the countries of the Caucasus and Central Asia does not succeed–if internal and cross-border conflicts simmer and flare–the region could become a breeding ground of terrorism, a hotbed of religious and political extremism, and a battleground for outright war.

It would matter profoundly to the United States if that were to happen in an area that sits on as much as 200 billion barrels of oil. That is yet another reason why conflict-resolution must be Job One for US policy in the region: It is both the prerequisite for and an accompaniment to energy development.

It’s almost 10 years later, and Talbot’s words seem to be quite close to the truth.

The Game

International affairs during the 19th century were profoundly influenced by the rivalry between Great Britain and Russia, empires at least 400 years old still pursuing the acquisition of fresh territories. One shared interest at the time was control of Central Asia.

Russia’s desire for expansion and England’s fear that the Russians were after India and access to the Indian Ocean created an explosive situation that brought the two great Imperial powers to the brink of war numerous times. This competition came to be called “The Great Game.”

According to respected historian Jennifer Siegel:

[t]he term “Great Game” is thought to have been coined by a young Bengal cavalry officer named Arthur Connolly in his 1835 Narrative of an Overland Journey to the North of India. Captain Connolly was an avid chess player and, in inventing the phrase, was paying a high compliment to the Russian proficiency at the game. But it was the use of the term by the veteran great gamer, Rudyard Kipling, within the pages of his Victorian romances of Empire that etched the images of a grand, glorious and irrefutably desperate competition for imperial survival upon the popular psyche.

“The Great Game” is being played once more, this time by three main powers and a few secondary ones. The US, China and Russia are the protagonists, while smaller players like India and Japan are also in the race. (India’s and Japan’s roles will be discussed in a future report.) It can be reasonably argued that, at its end, the Central Asian republics will benefit the most from the renewed competition.



Source: Perry Castaneda

The US’ decisive entrance into Central Asia post-Sept. 11, 2001, was a high-profile event. But few people stopped to think at the time how the US was able to establish a base in Uzbekistan, for example, only a few weeks after the terrorist attacks in New York.

The answer is that the two countries had strong political and military-to-military contacts that were cultivated during the 1990s. In the mid-’90s, Uzbekistan (boasting probably the best-trained military force in the region) was the only country besides Israel to support virtually all US foreign policy moves in the Middle East. And Uzbekistan wasn’t alone, as the US had been working since the collapse of the Soviet Union to gain access in the region.

In the period immediately following the emergence of the newly independent states in 1991, US policy toward Central Asia centered on a security relationship with Kazakhstan. By 1994, this relationship included a defense cooperation agreement, while Kyrgyzstan, Turkmenistan and Uzbekistan also joined Kazakhstan in entering NATO’s Partnership for Peace Program (PfP).

By 1999, the US formally expanded its military engagement in Central Asia and offered financial assistance in support of economic and political reform in both Central Asia and the Southern Caucasus through the Silk Road Strategy Act of 1999.

As the US was increasingly concerned with the danger of nuclear proliferation as well as Islamic extremism, the decision was made for the US to enter into a bilateral security relationship with Uzbekistan in 1998. Consequently, Uzbekistan became the first recipient of a sizeable transfer of military equipment (in an effort to professionalize regional militaries) from the US under the Foreign Military Financing program in 2000.

During the ’90s, while the US was building its position in the region, the two main countries that were losing influence, Russia and China, weren’t in position to substantially react. The former was crippled by disastrous decisions of the Yeltsin administration, while the latter was occupied with establishing its economic growth model. But the dawn of the new century brought a lot of changes.

Since China and Russia are geographically part of the region, each sharing borders with Central Asian states, their level of engagement is natural. Furthermore, Russia and China share with the Central Asian leaders the same views with regards to terrorism and radical Islamic movements. And the two giant neighbors have been the most outspoken supporters of authoritarian Central Asian regimes.

Of Bears And Dragons

China is geographically close to Central Asia, sharing common borders totaling more than 3,000 km with Kazakhstan, Kyrgyzstan and Tajikistan.

China has three long-term strategic interests in the region: keep Central Asia stable; use the region as one more way to diversify its energy resources; and contain separatist movements in its oil-rich Xinjiang province.

The first, rooted in Chinese history (i.e., the centuries-old debate over Chinese strategic security between proponents of maritime power and land power), indicates the pivotal role of Central Asia given its proximity to China’s western borders.

The second interest has been discussed extensively and has to do with efforts by the Chinese to stop being totally dependent in Middle Eastern oil. Furthermore, roughly 80 percent of Chinese oil imports pass through the 600-mile long Strait of Malacca; the Chinese see that as a weakness, given that the route can be easily closed down during times of conflict. This is particularly true where “conflict” involves China and the US. Consequently, pipelines from Central Asia are viewed as more reliable and are therefore highly desirable.

It comes as no surprise, then, that the recently completed 1,000-km oil pipeline connecting Atasu in Kazakhstan to Alashankou in western China was viewed by China as a great first step, even though China provided the entire $800 million to fund the project. Nevertheless, the move is justified by the fact that “between 2010 and 2020 Chinese oil consumption is expected to rise from 355 million tons to 500 million tons annually, and China’s oil deficit will increase by 240 million tons.” Construction started in September 2004 and finished in 10 months, record time for such a colossal project.

The third long-term strategic interest—keeping the region stable—has to do with what the Chinese view as an unstable situation in the Xinjiang Uighur Autonomous Region (XUAR). The more than 7 million Moslem, ethnic Turkic Uighurs living in the region identify more closely with their Central Asian neighbors than with ethnic Chinese. As many Uighurs seem to desire greater autonomy—and it’s believed that foreign-based, radical Islamic organizations are instigating a separatist movement—Chinese leaders often view them as a destabilizing force. China and the US, as well as Russia, generally see eye to eye when it comes to dealing with radical Islam.

Even the Japanese feel that a growing radical Islamic movement in Central Asia would potentially affect Xinjiang and, consequently, destabilize the rest of China. Such a development would have disastrous consequences for Chinese relationships with their East Asia neighbors. This was one of the reasons why the Japanese have contributed monetarily to stabilizing efforts in Central Asia.

It’s been noted by some political theorists—and I laid out the argument it in my book The Silk Road to Riches—that due to its economic ascent and smooth diplomacy, China has been able to start winning the acceptance of the other states in East Asia as well as in Central Asia. In addition to increasing economic interdependence, China’s new diplomatic tack is to portray itself as a rising, responsible power that doesn’t seek to exert political influence on the respective, domestic situations.

Finally, and maybe most important, China seems to be willing to aid its friends with real money rather than worldly ideas for change and future development. Hard cash (along with guidance) has always been extremely effective when trying to influence political systems, abroad or at home.



Source: Maps of China

Even the most casual observer can see that Russia has embarked—after the disastrous years of the Yeltsin era—on a coherent foreign policy plan for Central Asia.

Foreign observers often forget that Central Asia is quite close to Russia in terms of culture, history and language. Most regional elites were educated in Russia; majorities speak Russian, listen to Russian radio and watch Russian TV. Many also have relatives in Russia. In other words, “there are no obstacles in language and thinking habits between the elite of Central Asia and Russia.”

Considering the global geopolitical situation as well as the internal changes taking place within specific countries, my view is that Russia will remain a major global player in the near future. Its status is secure for two main reasons: abundant natural resources and military research and development.

That said, China’s economic and geopolitical ascent has and will continue to be an important factor. Russia wouldn’t have had the opportunity for a revival without China’s (and India’s) needs for resources and weapons in order to facilitate its own development. At the same time, changes implemented by President Vladimir Putin—and hopefully to be advanced by his successors—have given Russia a new life as a more respectable global player and a regional power in the new millennium.

It’s obvious that Russia can’t afford to be a bystander to the changing military and strategic balance of power in its backyard, especially since it has traditionally considered the region a strategic buffer against outside threats.

Russia’s main aim when dealing with Central Asia has been to safeguard its interests through political, economic and military means (the latter referring to military assistance for security purposes).

Russia has kept a close eye on the states it considers most critical, such as Kazakhstan. Kazakhstan is very important for Russia, both politically and economically. It’s the home of significant ex-Soviet defense/industrial facilities, including the Baikonur space launch complex (which recently renewed its lease for the next 50 years) and a nuclear weapons testing facility. Kazakhstan is also the biggest oil producer in Central Asia; being one of the providers that controls the means of transportation affords Russia tremendous strategic and economic leverage.

Another example of economic dependence is that Russia covers a lot of its needs for cotton with imports from Uzbekistan. It came as no surprise when it offered full support to President Islam Karimov of Uzbekistan when his old allies (the US and EU) decided that he was a long-term liability after his security forces brutally suppressed a rebellion in the city of Andijan on May 13, 2005.

Thus, Russia and Kazakhstan signed several economic and military agreements to “develop a wide-ranging security system that would tackle terrorism, weapons of mass destruction, narcotics trade and organized crime.”

Russia has also re-established its presence in Tajikistan in an effort to “guarantee Russian investments and overall stability in the region.” It must be noted that when Tajikistan won independence from the Soviet Union, it fell into civil war between ruling elites and Islamists; the war lasted from 1992 to 1997. As a result, Russian has been traditionally seen as a stabilizing force for the government. Currently, Russia garrisons the 201st Motorized Rifle Division in the country and helps patrol Tajikistan’s border with Afghanistan. And the Russians are operating a new air base within Tajikistan’s borders.

Russia has also developed significant military and economic ties with Kyrgyzstan, expanding its military base near the city of Kant in October 2003 in order to provide “security for Kyrgyzstan.” The base is located 30 km from Manas, where the US—though it’s strictly prohibited from offering security services to the country—operates its own base.

As the race for control in Central Asia heats up, it’s interesting to consider the military ideas put forward by the parties involved. Three years ago, Russian Minister of Defense Sergei Ivanov published a security document, “The Priority Tasks of the Development of the Armed Forces of the Russian Federation,” which can easily be viewed as a Defense White Paper (DWP). Ivanov, also the deputy chairman of government, reached several important conclusions after analyzing wars and conflicts that occurred in the past 30 years.

His report emphasized the fact that “a significant part of all conflicts has an asymmetrical nature;” in other words, a smaller power can count on a conflict being more important to it than the stronger powers, thus limiting the amount of resources the stronger power is willing to spend in order to defeat the weaker power. These conflicts “demonstrate fierce fighting and in a number of cases result in total destruction of a state system.”

In addition, “the outcome of conflicts is more and more determined in its initial phase. The party that takes the initiative has the advantage” while “targets are no longer confined to military forces, but consist of political and military command and control systems, economic infrastructure and civilians.”

Furthermore, “information and electronic warfare now have a great impact in conflicts,” while the “use of airborne, air mobile and Special Forces have increased.” As a result “unified command and control, joint warfare and thorough cooperation between ground and air forces in particular has become essential.”

“A prominent role in modern warfare, as demonstrated in conflicts such as those in the former Yugoslavia (1999), Afghanistan (2002) and Iraq (2003), is taken by long-range, precision-guided munitions in combination with airpower once air superiority has been established.” Hence, “massive use of tanks and infantry has, to a large extent, been replaced by long-range guided weapon systems and massive air raids, although the role of these conventional forces is still important after the initial stages of a conflict;” and “the dominating role of airpower in modern warfare requires a well-equipped and electronic warfare resistant anti-aircraft defense system.”

Without explicitly saying it, Ivanov is indicating that maybe the Russian army is in need of modernization, something that—given the reality that the Russian army is still in reorganization mode and shortages in new armaments and the like exist—should be a considerable task.

That said, Russia still produces state-of-the-art military technologies that continue to impress the world. Aside from producing some of the most sophisticated missiles in the world, it has also been gaining ground in armored fighting vehicles, one of its best-selling being the BMP-3 that’s also been chosen by traditional US allies such as the United Arab Emirates and Oman.



Source: World Security

One of Russia’s finest achievements is the SU-30 fighter (see GIQ, February 2006, The Dragon And The Eunuch). India has traditionally been a buyer of Russian technology; during joint Indo-American air force exercises held in 2004, Indian pilots were able to demonstrate their abilities as well as the capabilities of their Russian-made planes. The Indian Air Force outmaneuvered American-made F-15 planes in a majority of their engagements, and US Air Force General Hal Homburg noted that Russian technology in Indian hands has given the US Air Force a “wake-up call.”



Source: Indian Air Force

The Shanghai Cooperation Organization

The Shanghai Cooperation Organization (SCO; China, Russia, Uzbekistan, Kazakhstan, Kyrgyzstan and Tajikistan), established on June 15, 2001, was initially formed to resolve issues between China and the states of Central Asia. As time passed, the SCO is now considered the de facto regional organization in Central Asia, having expanded its reach into counter-terrorism, defense, energy and economic cooperation.

The SCO has been dismissed by Western observers as nothing more than a talk shop. But if countries that now hold observer status eventually join, it will mean that, “SCO represents—to a certain degree—half of the world population and four nuclear powers.”

The US tried to get observer status at the SCO in 2005, but was turned down.

On Jan. 15, 2004, the doors of the secretariat of the SOC officially opened, institutionalizing the organization. The secretariat, located in northeast Beijing, is made up of three departments responsible for political and security affairs; economic, trade and cultural affairs; and press and legal affairs.

The SCO has brought China and Russia closer, aligning their interests—up to a point—when it comes in issues related to Central Asia and beyond. Consequently, the two countries have been able to voice their opinions regarding global and regional issues and have been able to influence the SCO to do the same.

Before the July 2005 meeting, Russian and Chinese leaders met at the Kremlin to lay out their goals in Central Asia and to discuss the then-upcoming Group of Eight (G-8) summit. The meeting signaled a shift toward greater cooperation as both countries felt threatened by the US’ push into Central Asia.

Their joint statement regarding the “International Order of the 21st Century,” as reflected in the following excerpts, clearly aims at the US:

The PRC (People’s Republic of China) and the Russian Federation (hereinafter referred to as the “two sides”), taking the opportunity of the 60th anniversary of the victory in World War II and the 60th anniversary of the founding of the United Nations,…Acting on the basis of the historical responsibility for world peace and development in their capacities as permanent members of the United Nations Security Council,…Strictly abiding by the propositions on building a multipolar world and a new international order as enunciated in the Joint Statement of the People’s Republic of China and the Russian Federation Regarding Global Multipolarity and the Establishment of a New International Order of 23 April 1997…Confirming the strategic cooperative partnership between the two sides as reiterated in the Treaty of Good-Neighbourliness, Friendliness, and Cooperation of the People’s Republic of China and the Russian Federation of 16 July 2001…

The problems facing mankind can only be solved on the basis of universally recognized principles and norms of international law and in a fair and rational world order. Countries in the world should strictly observe the principles of mutual respect for each other’s sovereignty and territorial integrity, mutual nonaggression, noninterference in each other’s internal affairs, equality, mutual benefit, and peaceful coexistence…

The peoples of all countries should be allowed to decide the affairs of their own countries, and world affairs should be decided through dialogue and consultation on a multilateral and collective basis. The international community should thoroughly renounce the mentality of confrontation and alignment, should not pursue the right to monopolize or dominate world affairs, and should not divide countries into a leading camp and a subordinate camp.

A week later, in a joint declaration issued at the end of the SCO summit in Astana, Kazakhstan, the US was again referenced:

We are supporting and shall continue to support the efforts by the international coalition, conducting anti-terrorist operation in Afghanistan. Today we are noticing the positive dynamics of stabilizing internal political situation in Afghanistan. A number of the SCO member states provided their ground infrastructure for temporary stationing of military contingents of some states, members of the coalition, as well as their territory and air space for military transit in the interest of the antiterrorist operation.

Considering the completion of the active military stage of anti-terrorist operation in Afghanistan, the member states of the Shanghai Cooperation Organization consider it necessary that respective members of the anti-terrorist coalition set a final timeline for their temporary use of the above-mentioned objects of infrastructure and stay of their military contingents on the territories of the SCO member states.

The heads of the member states are convinced that a rational and just world order must be based upon consolidation of mutual trust and good-neighborly relations, upon the establishment of true partnership with no pretence to monopoly and domination in international affairs. Such order will become more stable and secure, if it comes to consider the supremacy of principles and standards of international law, before all, the UN Charter.

US Secretary of Defense Donald Rumsfeld landed in Kyrgyzstan 10 days later to make sure that the US position in the region was still intact.

As mentioned above, there are states that currently have SCO-observer status, but are seeking more permanent positions. These include India, Iran and Pakistan. After the most recent (June 15, 2006) meeting of the Council of Heads of Member States of the Shanghai Cooperation Organization in Shanghai, the heads of state issued a joint communiqué, concluding:

The heads of state also entrusted the Council of National Coordinators to make recommendations on the procedure of SCO membership enlargement. This procedure should fully conform to the purposes and goals set forth in the Charter of the Shanghai Cooperation Organisation, ensure the effectiveness of all treaties that form the legal basis of the SCO, help strengthen its unity and guarantee the applicability of the principle of consensus to consultations on all matters and at all levels of SCO.

Eventually the SCO will include at least some of the states seeking permanent status, thus increasing the SCO’s profile in the region and beyond.

The Eagle

Based on the preceding, it’s clear that the US’ main “problems” in its efforts to establish a solid presence in Central Asia will be Russia and China. And although a first look at the situation might cause some worry, there are ways—via concessions, of course—for all three powers to coexist in the region.

It’s also quite obvious and troubling that Beijing, Moscow and Washington are once again using Central Asia as their game board in a region rarely neglected by the world’s great powers. Today, Washington approaches each state bilaterally, offering incentives to support the operations in Afghanistan while undermining the consensus aimed for by the SCO.

China and Russia are acting together, offering blanket support for the current regimes and implicitly calling attention to US-led efforts to undermine their governments. The Central Asian states will continue to swing their support from China and Russia to the US and back again, so long as they keep their hold on power.

When it comes to Central Asia, the US must concentrate on Russia. As Russia is re-emerging as a regional power (its superpower status long gone), it’s understandable that US foreign policy-makers and defense planners are once again paying attention to the old rival. The current situation is quite different from that of the 20th century, though it seems many players in both camps refuse to face the new realities.

In an article published in the Financial Times in early April, Dimitri Simes—president of the Nixon Center in Washington, DC—made the argument that the US needs to decide on the kind of cooperation it wants to have with Russia.

The idea, though it seems to escape policy-makers in the US capital, is fairly simple: Although Russia has shown signs that it’s prepared to pay a price to accommodate US concerns, for example, regarding the Iran issue, reciprocity from the US hasn’t been there. Instead, policy circles in the US have advocated a “selective cooperation” approach.

As Simes argues, “proponents of an ‘a la carte’ partnership expect Moscow to support fully Washington on an issue of grave importance to the US, while believing that the US can, at no cost, pursue policies that Russia perceives to be hostile to its interests in the post-Soviet space.”

The situation Simes describes is of paramount importance since President Putin’s policy has been in the direction of aligning Russian actions with those of the US and the EU; Putin has also made clear that he won’t tolerate foreign actions intended to discredit his policies.

In addition, and before the US decided to give negotiations with Iran a chance, seasoned US political observers like former US National Security Adviser Brent Scowcroft have noted that “to deter Iran, it is essential that there be a united front between the US, the European Union, Russia and China to prevent Iran from exploiting any differences or finding any short of wiggle room that would allow it to continue with its program.”

It’s possible to make a case that foreign policies based on realistic expectations and true cooperation between the sole superpower and regional powers (Russia, China, etc.) can benefit all and allow smoother solutions to problems, provided that this is what the parties involved are interested in.

In that respect–and given Secretary of State Condoleezza Rice’s new foreign policy directions–it’s conceivable that a slow change may be underway, one that will see the US shift from the dangerous and unsuccessful path of unilateral/hegemonic assertion of power to a more multilateral one.

It’s obvious to even novice observers that since last year, when Rice became Secretary of State, she’s tried to implement a realist vision in foreign relations based on classical balance of power. In a Jan. 18, 2006, speech at Georgetown University, Secretary
Rice noted:

America needs equally bold diplomacy, a diplomacy that not only reports about the world as it is, but seeks to change the world itself. I and others have called this mission “transformational diplomacy.” And today I want to explain what it is in principle and how we are advancing it in practice.

So, I would define the objective of transformational diplomacy this way: to work with our many partners around the world, to build and sustain democratic, well-governed states that will respond to the needs of their people and conduct themselves responsibly in the international system. Let me be clear, transformational diplomacy is rooted in partnership; not in paternalism. In doing things with people, not for them; we seek to use America’s diplomatic power to help foreign citizens better their own lives and to build their own nations and to transform their own futures.

It seems that the old guard foreign policy establishment is starting to get more involved as the thinking changes in Washington–to a certain degree. Policy-makers are now contemplating that maybe the foreign policy choices of the recent past haven’t been all that helpful in perpetuating the US position as the leader of the world.

It’s interesting to note what some of the so-called foreign policy realists are now thinking. The following quote from the official Web site of the Coalition for a Realistic Foreign Policy, a very prestigious organization, illustrates this evolving process:

Against the backdrop of an ever-bloodier conflict in Iraq, American foreign policy is moving in a dangerous direction toward empire. Worrisome imperial trends are apparent in the Bush administration’s National Security Strategy. That document pledges to maintain America’s military dominance in the world, and it does so in a way that encourages other nations to form countervailing coalitions and alliances. We can expect, and are seeing now, multiple balances of power forming against us. People resent and resist domination, no matter how benign.

Central Asian Economies

Central Asia is a vast and complex region with significant contrasts in income (Kazakhstan being the richest, Tajikistan the poorest) and level of development.

Major weaknesses have constrained the region’s economic development: relative lack of economic freedom and overall level of governance, and a landlocked geographical setting with vast distances between ports and markets and policy and infrastructure barriers that make transportation costs very high.

Energy is the region’s main asset. Kazakhstan leads the way in terms of oil deposits and is also Central Asia’s largest producer of coal. Turkmenistan leads in natural gas.

Despite lack of transparency and general governance issues, Kazakhstan has been a leader in terms of moving ahead with market reforms, including in the areas of banking and pensions, and has also done relatively well in managing its oil wealth to safeguard macroeconomic stability.

Given that not even Kazakhstan (every Western government’s favorite) isn’t as open and democratic as a lot of observers would have you believe, the fact of the matter is that people seem to prefer stability over a democratic alternative–as the most recent elections proved.

The situation is not difficult to understand on an intuitive level: In the early stages of economic development–in a place where the middle class doesn’t really exist and institutions are still weak–people are more interested in growth and personal economic advancement than democratic representation. This comes much later, if at all.

But what Central Asian countries have in abundance are natural resources. With an estimated 250 billion barrels of probable oil reserves and almost 600 trillion cubic feet of probable natural gas reserves, the Caspian Sea region has become an important area for securing energy resources.

On the Caspian’s northern shores, Russia and Kazakhstan have effectively established a partnership represented by the Tengiz-Novorossiysk pipeline linking western Kazakhstan with the Russian Black Sea port of Novorossiysk.



Source: Chevron

Alternatively, the Baku-Tbilisi-Ceyhan (BTC) pipeline, built by a consortium of Western oil companies led by BP (which holds a 30.1 percent stake) and the State Oil Company of Azerbaijan (25 percent) to transport Caspian oil from Azerbaijan to Turkey while avoiding Russian territory, delivered its first shipment of about 600,000 barrels of crude oil by tanker to Savona, Italy, on June 9, 2006.

The BTC pipeline utilizes 46/42/34-inch diameter pipe. It has eight pump stations and 98 valve stations across the three transit countries, crosses more than 1,500 rivers and climbs to a high point of 2,700 meters before returning to sea level at Ceyhan.

Although the pipeline had its origin with the idea that the majority of crude would be coming from the Azeri-Chirag-Gunashli (ACG) field in the Azerbaijani sector of the Caspian Sea, it was always known that the grand scheme was for the Kazakh oil to eventually flow in the pipe. What made this necessary was that Azerbaijan has been a relative disappointment in terms of exploration success. It’s therefore no surprise that high-level US officials have repeatedly visited Kazakhstan in an effort to persuade its leader, Nursultan Nazarbaev, to sign an agreement.

Finally, in mid-June, Kazakhstan officially joined the BTC oil-pipeline project. Under the agreement, Kazakh crude oil would be shipped to Baku across the Caspian Sea and then pumped through BTC to Ceyhan. Kazakshtan currently exports its oil through Western, Russian and Chinese pipelines, making it one of the more diversified oil producers in the world.

Kazakhstan and Russia together have proven reserves, in the Caspian region, of more than 5 billion barrels, more than enough to cause a stir among oil companies and foreign investors. Good relations between the two countries, combined with the fact that Russia has become the de facto energy provider of the whole of Europe, means that a future collaboration (through the linking of different pipes) between Western-owned and Russian-owned facilities can’t be ruled out.

My view is that US policy-makers don’t actually think that verbal pyrotechnics aimed against Russia are anything more than domestically driven political tricks. Even when high-ranking US officials speak critically of Russia, they inevitably make a point to note that Washington doesn’t believe “Russia is fated to become an enemy.”

Investing Angle

Only a handful of major petroleum-producing countries have managed to grow their production significantly during the past five years. While oil prices have been high and supportive of greater exploration and development spending, maintaining daily production, let alone boosting output, has proven elusive.

The graph “2000-2005 Change in Oil Output” shows the daily increase in oil output for a handful of major oil-producing countries since 2000. It’s clear that Russia was a notable exception; the country drastically increased its oil output during the past five years.



Source: BP Statistical Review of World Energy 2006

That’s great news for Lukoil (OTC: LUKOY), the dominant crude oil producer within Russia. The company is responsible for nearly a fifth of total Russian crude oil output and has proven crude oil reserves of nearly 16 billion barrels. On a global reserve basis, that makes Lukoil the second-largest private oil company in the world, second only to ExxonMobil.

Lukoil has been exhibiting solid operation performance of late. Overall first quarter oil production was up 4.6 percent year-over-year in the first quarter to just less than 1.9 million barrels of oil per day. Even more impressive is the company’s lifting costs–a measure of how expensive it is for Lukoil to produce oil. Although up 12 percent year-over-year, the vast majority of that cost inflation was due to the appreciation of the ruble against the US dollar; there was little real increase in lifting costs.

This is significant because costs for most of the world’s major oil-producing companies are rising far more rapidly than that. Some of this is due to the fact that Lukoil’s relatively young reserves are easier and cheaper to produce.

For example, costs have been rising faster in places like the US and the North Sea because these fields are getting older and technically more difficult to produce. Lukoil’s cheap-to-exploit reserves are an obvious advantage.

In fact, the average flow rate of Lukoil’s operating wells has increased 30 percent since 2001. That means the company’s operating wells are producing oil more easily than a few years ago. This is in sharp contrast to wells in places like the US that become more marginal producers every year.

Lukoil is far more than just another oil producer. It’s the largest oil refiner in Russia and has refining assets in Eastern Europe. The company has announced intentions to expand its refining business aggressively into Europe, and it’s currently looking to buy a refinery in the United Kingdom. Just like the US, Europe doesn’t have enough refining capacity to meet demand; this is another profitable business line.

Then there’s natural gas. Russia has particularly enormous gas reserves, and the commodity is becoming increasingly valuable worldwide because liquefied natural gas (LNG) has made it possible to ship gas thousands of miles by tanker ship. The importance of Russian gas was underlined in the winter 2005-06 when temporary reductions in Russian supply–due to a pricing dispute with Ukraine–caused widespread gas shortages in the European Union (EU). Even the UK, once energy independent, is looking to build a pipeline to import Russian natural gas.

Lukoil’s gas production was up a whopping 98 percent year-over-year in the first quarter; Lukoil is well-placed to take advantage of that market.

While Lukoil is the dominant producer of Russian oil, Gazprom (OTC: OGZPY) is a more dominant producer of Russian natural gas. The company is far and away the largest gas-producing firm in the world and accounts for about 90 percent of Russian gas output. Gazprom owns more than half of Russia’s proven gas reserves.

As outlined above, gas demand is rapidly rising worldwide; in fact, natural gas is likely to see the highest demand growth of any type of hydrocarbon during the next decade. Gas has the advantage of being environmentally far cleaner than other typical electric power plant fuels, most notably coal.

In the US and Europe, power producers significantly added to their gas-fired power plant fleets during the past 15 years, drastically increasing demands for gas. And India and China, among other developing countries, are seeing even more rapid growth in gas demand.

Gazprom will be a key supplier. Right now, roughly a quarter of Europe’s gas demand is satisfied by imported Russian gas. But Europe’s gas fields in the North Sea, once prolific producers, are in decline; European gas production will likely start falling more rapidly in coming years just as demand for gas is ratcheting higher. Bottom line: Gazprom will become a more important source of that gas.

Gazprom is involved in the construction of the North European gas pipeline that will connect Russia with Northern Europe, Scandinavia and most likely Britain. This pipeline, due to start operating in 2010, will be sorely needed to supplement existing pipelines and keep up with Europe’s gas demands.

Of course, Gazprom won’t rely solely on exports to Europe to fuel growth. It’s also getting involved in the LNG market in a big way. Cooling natural gas to -260 degrees Fahrenheit yields a compact, liquefied version of the fuel that can be transported on specially fitted tanker ships.

There’s considerable infrastructure investment needed in building such projects. A liquefaction plant is needed near the source of the gas to produce LNG. Then the importing country must have a regasification terminal to receive the LNG and turn it to a gaseous state for transport via pipelines.

But LNG infrastructure is being rapidly developed; producers are keen to reduce dependence on fixed pipelines for their export trade. Consumers, desperate for their gas, are looking for ways to guarantee more reliable supply. Gazprom, surprisingly, has been late to the LNG game.

But its giant Shtokman gas field in Russia’s northern Artic regions is the first the company will develop for LNG export. Gazprom has yet to announce which foreign firms it will partner with on the deal; plenty of big foreign producers are interested in partnering with the company. By 2010, Gazprom hopes to be a key exporter of LNG. It’s looking to break dependency on exports to Europe and start exporting more gas to North America and Asia.

Of course, Russian firms are not the only ones to benefit handsomely from Russia’s and Central Asia’s enormous oil and gas reserves. Italian integrated oil giant Eni (NSYE: E) is another interesting play on the region.

Eni is the world’s sixth-largest integrated oil company; it’s much smaller in terms of production and reserve than the likes of ExxonMobil, Chevron and BP. The company has an impressive array of oil and gas assets in promising parts of the world.

For example, Eni has major investments in both Africa and the Middle East; nearly half its current production comes from North and West Africa alone. Africa certainly isn’t free of political risk. Nigerian oil output, for example, has been severely hampered this year by local rebel groups that have kidnapped foreign oil workers and destroyed infrastructure.

Geologically, the region is promising. Oil and gas fields in Africa are much less mature than in most other regions of the world; the continent has seen oil and gas production on an upswing in recent years.

Eni’s position in these markets is enviable. Eni is also a leader in developing Libyan oilfields. Libyan fields haven’t been produced for decades; the nation was the subject of trading restrictions and embargos for years. But Libya has, more recently, been warming relations with the US and Europe, and restrictions on trading and investing with this African nation have eased.

But because Libya’s oilfields haven’t been produced in many decades, they’re much less mature than they’d otherwise be. These fields are attractive for development.

Perhaps Eni’s most-attractive region for expansion is the Kashagan oil field under the Caspian Sea. This is one of the largest oil reserves discovered in many years anywhere in the world. Most analysts believe the field could eventually reach profiction of between 1 million and 1.5 million barrels of oil daily. Eni is a leader in the Kashagan field’s development.

The term “services” is a catchall phrase used to denote many different functions that are part of oil and gas exploration, production and development. For example, on the exploration front, seismic services are considered an oilfield services function.

Seismic involves sending sound waves into the earth to produce a picture of underground rock formations. Other services include repairing blocked or damaged wells, installing pumps used to aid production in older wells and completing newly drilled wells so they’re ready to produce.

Schlumberger (NYSE: SLB) is the world’s largest oilfield service firm. It’s also known as the technological leader for many key oilfield services. For example, its seismic Q-ships are the best in the world, capable of generating a detailed picture of rock formations under the seafloor. These seismic ships can operate in very deep water and earn a fee that’s larger than less-advanced seismic ships.

Schlumberger is the partner of choice when it comes to highly advanced services functions. For example, in the Middle East, producers are currently struggling to maintain production as their oilfields age. Schlumberger has seen particularly strong growth in this region in recent years. The company has even set up a special facility in Saudi Arabia to study that country’s aging oilfields along with Saudi Aramco’s own engineers.

Schlumberger was an early mover in Russia and has been extremely active in attracting Russian talent for its local workforce; it has nearly 5,000 workers in its Russian division. In addition, it’s set up a training facility there that’s due to be opened by the end of this year to expand operations and headcount in Russia.

Schlumberger has also announced plans to manufacture electric submersible pumps (ESPs)–devices that aid in oil production from mature fields–in Russia to feed rapidly growing demand for this key technology. Previously, most ESPs were imported into Russia, but Schlumberger’s plant now has capacity to produce 800 per year, enough to satisfy 5 percent of Russian demand. Further expansion is likely.

Management has stated categorically that Russia will be the company’s fastest-growing market for the next year. In 2006, revenues from Russia alone will exceed $1 billion, far more than any other services firm.

Japan is a nation that few would associate with hydrocarbon production and development; in fact, with next to no domestic energy resources, the nation is almost entirely dependent on imports.

But conglomerate Itochu Corp (Tokyo: 8001) is involved in the energy business in Central Asia. Specifically, the company is part of a consortium involved in the construction and operation of a pipeline connecting Azerbaijan with Ceyhan, Turkey. Itochu was directly involved in the planning and financing of the pipeline.

Eventually, it’s expected that the so-called BTC pipeline will transport roughly 1 million barrels of crude per day from Azerbaijan and the Caspian Sea oil region. While Itochu has a less than 4 percent ownership stake in the pipeline, it also acquired some key rights by getting involved early in the project.

Itochu has reserved capacity on this pipeline to transport oil from fields in which it has an interest. This gives it an advantage in acquiring new fields in the region.

Shots In The Dark?

It should be well understood that accuracy in projecting the geopolitical future diminishes the further out you make your estimate. Any projection longer than 20 years is sheer guesswork.

Looking at the world today, eventually the US and the rising powers will realize that cooperation is the better way; their eventual economic rise means that more participants will attempt to play the geopolitical game, even if only on a regional basis. The movement will intensify as the populations in these countries increase dramatically and their governments scramble to satisfy their needs, putting a tremendous strain on resources.

As Secretary Rice noted in the speech referenced above, “In the 21st century, emerging nations like India and China and Brazil and Egypt and Indonesia and South Africa are increasingly shaping the course of history.”

In his latest book, America at the Crossroads: Democracy, Power and the Neoconservative Legacy, Francis Fukuyama tries to expand the discussion regarding the future of US foreign policy; these are the actions–combined with the actions of other sovereign states–that set up the economic environment that shapes investors’ decisions.

Fukuyama writes, “Benevolent hegemony rests on a belief in American exceptionalism that most non-Americans simply find not credible. The idea that the United States behaves disinterestedly on the world stage is not widely believed because it is for the most part not true and, indeed, could not be true if American leaders fulfill their responsibilities to the American people.”