The Abandonment of South Stream: A Blow to Putin or a Subtle Stroke of Geopolitical Genius?

On Monday December 1^st Russian President Vladimir Putin surprised the world by announcing the end of the South Stream project which would have seen Russian energy resources transferred to European markets by a route which would bypass Ukraine. Initially, the end of the project was greeted with surprise but in hindsight it makes sense. The combination of the European Union’s Third Energy Package, which stipulates that companies that produce and transmit energy must be separate entities, and the reality that the cost of the project has risen consistently have been obstacles for years. One year the project is projected to cost 10 billion euros, a few years later its 15 billion, then its 30 billion. Trends like this make investors nervous. Recent threats by some investors to pull out, thus passing the costs back to Moscow, combined with the sanctions that had been imposed upon Russia due to Moscow’s activities in Ukraine have made the project less and less viable. This is not to say that a similar project will not be developed at a later date but Monday’s announcement makes it clear the current iteration is not in Russia’s interest.

As things stand now Russia’s plan appears to be to utilize the existing infrastructure and direct it towards Turkey. This move would provide Ankara with an additional energy source while allowing the development of a potential transfer point for the redirection of energy resources to European markets, which would benefit both Russia and Turkey. Though Moscow does not have the same leverage over Ankara that it has over Kiev this development would at least provide Russia with an additional revenue stream that the country desperately needs. Estimates suggest that Russia has lost at least $120 billion to capital flight in 2014 with some analysts projecting that another $80 billion could depart the country in 2015. The combination of the ruble being at its lowest value since Russia's 1998 financial crisis and declining oil revenues means that the Russian economy in a difficult position. Diversifying Russia’s economy would presumably improve the country’s economic standing. However, diversifying an economy is not something that happens overnight. Therefore, Moscow must make the best of a bad situation by reaching out to new customers, positioning itself to service old clients if their demand rises, and minimizing competition. Putin appears to be pursuing all of these tactics. 

Though much attention has been paid to the fact that many European countries are dependent upon Russia for the bulk of their energy needs we must also understand that Moscow has been overly dependent upon these countries as customers. If something were to happen that limited the purchase of Russian energy resources by these countries it would be a major blow to Moscow’s budget. Clearly this is what has happened. This shift has forced Moscow to diversify its clientele. May’s 30 year $400 billion plus natural gas deal between Russia and China is an initial step in this direction. (An interesting side note is that deal was executed in a currency swap denominated in Yuan. This can be perceived as an early attempt to diminish the US dollar as the world’s dominant reserve currency).

In addition to finding a major new client in China Moscow is hedging its bets closer to Europe. Using Turkey as an energy connection point could in theory serve as a hedge against the proposed Trans-Caspian Pipeline. Though the September 29^th meeting of the Caspian 5 (Russia, Iran, Azerbaijan, Uzbekistan, and Kazakhstan) ended with an agreement which better delimited which portions of the Caspian Sea falls under the sovereignty of each state, and appears to give Russia a degree of the control over the management of energy resources of the sea, there is no guarantee that this agreement might not be undermined if it benefits a Caspian 5 country. In theory, Moscow could use the energy connection point in Turkey to undersell, and thus undermine the Trans-Caspian Pipeline, if such an action was perceived as being in Russia’s interest. Though that move would not make sense economically (especially because Moscow would have to get Ankara on board which, if possible, would not be cheap) it would make sense politically and would be in line with Moscow’s history of using energy resources to accomplish political goals even if the action ran contrary to Russia’s economic interests. Just the threat that Russia could pursue such a policy affords Moscow a degree of leverage over the other Caspian 5 countries.

The fact that much of the European Union shares a currency but fiscal policy is dictated by the capitals of the bloc’s respective members rather than by Brussels combined with the reality that the constituent members of the EU have varying economic interests has meant that Europe has been unable to effectively tackle its fiscal and unemployment crises. Clearly, the EU needs money. South Stream would have provided states, such as Bulgaria, income from transit fees and construction jobs and companies, like Italy’s Saipem, revenues from service rendered. The abandonment of the project impacts the interests of these entities. For example, Saipem estimates that the termination of the project will cost the company about $3 billion. There is no doubt that there are EU member states and European companies who have a vested interest in South Stream or a comparable project. Given the rise of anti-establishment parties in Europe and the concomitant decline of the power of the traditional political parties in many European countries we could see a political shift in the EU that could set the stage for a reincarnation of South Stream somewhere down the line. Though such a development is unlikely to occur anytime soon it is not unreasonable to believe that Russia is playing the hands that it can now while keeping an eye on the long game in Europe.

In Russia’s ideal world the realization of large profits through the sale of energy resources to customers who are located near existing infrastructure would be an ongoing phenomena. Clearly, the world is not ideal. Europe’s desire to reduce dependency on Russia, sanctions due to Moscow’s actions in Ukraine, and drops in oil prices and the value of the Ruble has forced Moscow to begin the diversification of its client base. Might this be less profitable than before? Absolutely. That said, this is not about missing the good old days. This is about adapting to new realities even if they are not as fortuitous as in the past. We must recognize the reality that though Russia’s economy is experiencing a great deal of pain it does not mean that the Russians are alone in their suffering. As the economic crisis in Europe deepens (and it looks like it will) the pain that many countries feel could turn into desperation and we should never underestimate the ability of desperation to changes public interests, state policies, and who is deemed as a suitable trading partner. South Stream as we know it may have been abandoned. This does not mean that a project that closely resembles it will not take its place somewhere down the line. 

Russia’s Shift to the East and It’s Potential Impact on September’s Caspian 5 Summit

On Wednesday May 21st Russia and China agreed to a 30-year natural gas deal worth $400 Billion. This agreement serves as a clear indication that Moscow recognizes Russia’s need to diversify its client base. Though all of the terms of the deal are unclear it would appear that the Chinese were able to get the pricing that they wanted (a factor which had delayed this deal for a decade). Moscow would not have agreed to China’s price if it were not in Russia’s interest. In the past this price was not beneficial for Russia but recently a variety of factors such as Iranian-American détente, the situation in Ukraine, and the reality that Russia will be facing demographic challenges in the coming years has changed the equation. The deal will allow Russia to demonstrate that it has options other than European market as well as affording Moscow the opportunity to focus its attention on other areas where its interests are threatened. The Caspian is once such place.

On September 29th the Caspian 5 (Russia, Azerbaijan, Turkmenistan, Kazakhstan and Iran) will meet in the Russian city of Astrakhan to discuss the management of the Caspian Sea. This summit could serve as a starting point for Russia to ensure that Russian companies have a stake in any potential agreement which would see oil and natural gas pipelines running through Iranian or Turkish territory. Such a move would give Russia a degree of control over energy resources that bypass Russian territory and would presumably be lucrative. In the past it was in Russia’s interest to hinder the development of transit routes which did not pass through Russian territory. Now Moscow’s ability to interfere could be weakened especially if Turkey, Iran, Azerbaijan and Georgia cooperate. If the infrastructure is going to be built and Russia is less dependent on European markets Moscow could have a financial interest in aiding the exploitation of energy resources rather than hindering projects. It is also possible that Russia could have a degree of control over the operations of key infrastructure. Pipelines that bypass Russian territory are by no means an ideal development for Russia but if this outcome is inevitable Moscow will ensure that the situation evolves in the manner that is most beneficial to Russian interests. The fact that Russia is a significant regional player means that it has leverage. Even in a weakened state Moscow can project power. For example, in 1993 Russia demanded that Lukoil be awarded a 10% stake in a consortium to develop Azerbaijan’s offshore oil fields. Baku consented. Given that China will have a 19% stake in Rosneft means that Beijing might also become a player in the region as well if Rosneft is involved in any deals (a likely scenario). This would add an additional dimension to the geopolitical situation in the Caspian.

Wednesday’s deal allows Russia to demonstrate that in the coming years it will have alternatives to the European market. The reality is that Europe has an interest in diversifying its energy supplies while Iran, Azerbaijan and Turkey appear to be coming to some sort of agreement which could potentially see the development of transit corridors which link Caspian energy resources to the Mediterranean and the Persian Gulf. The United States also has a variety of interests in undermining Russia’s energy exports. Essentially, this shift is inevitable.  Moscow clearly understands this and is now making the best arrangements that it can. The terms of the China-Russia gas deal seem to favor Beijing. That said, Moscow is powerful enough to presumably force agreements in the Caspian that will favor Russia. September’s summit will provide insight into how this story will progress.   

The Impact of Turkish, Georgian and Azerbaijani Infrastructure Projects on European and Asian Markets

On Wednesday the foreign ministers of Turkey, Azerbaijan and Georgia met in Ganja, Azerbaijan to discuss regional cooperation. This is the most recent step in the ongoing integration of the three countries which, amongst other things, links Caspian energy resources to the Mediterranean. This development is occurring at a time when the instability in Ukraine calls into question the viability of that country as a transit state for energy that is intended for Europe. After all the deep divisions between Eastern and Western Ukraine and the reality that the opposition movement is highly fragmented makes it questionable that today’s concessions by the Yanukovych administration will lead to long term political stability in Ukraine. Existing and proposed infrastructure in the Azerbaijan, Georgia, Turkey corridor could help offset disruptions that instability in Ukraine might produce.

In 2012 the Trabzon Declaration called for stronger economic, energy and political relations between Ankara, Tbilisi and Baku. This declaration formalized an existing pattern of relations between Turkey, Georgia and Azerbaijan which has resulted in several important infrastructure projects. The Baku-Tbilisi-Ceyhan (BTC) Pipeline transports crude oil from the Caspian Sea to the Turkish coast of the Mediterranean. This pipeline is complemented by the Baku-Tbilisi-Erzurum Gas Pipeline which aids the export of natural gas. The Baku-Tbilisi-Kars Railway is expected to be completed by the end of 2014. This corridor will connect Azerbaijan, Georgian and Turkish railways and will expand freight service which should make the export of raw material from Central Asia more economical. These projects can help develop the region and could serve as an important source of primary commodities for Asian and European markets.

Despite Turkey’s current political turmoil, the ability to serve as an energy corridor to the Mediterranean benefits whoever is in power in Ankara while the expansion of rail services would help Georgia and Azerbaijan’s exports. For these regions all parties have an incentive to cooperate.  Though Russia will not want to see its control over energy exports to Europe lessened it is important to note that Moscow could benefit from these projects.  For example, there are ongoing talks between Moscow and Baku to reverse the flow of oil through the Baku-Novorossiysk Pipeline with the intent of sending some of the oil through the Baku-Tbilisi-Ceyhan Pipeline which in theory could be a more economical manner for Russia to serve some of its European clients. There have also been proposals to link regional railways to Russian rail infrastructure which would aid Russian exports. Though it is likely that Russia would attempt to stop the development of an alternative energy source to Europe it is not unreasonable to think that the development of an alternative energy corridor in which Moscow has a degree of control would be allowed to progress without Russian interference. No matter what happens the development of pipelines and railways in the Azerbaijan, Georgia, Turkey corridor could lead to greater development in the region and serve as a reliable supply of raw materials to Asian and European (and potentially East and Southern African) markets.