Azerbaijan Plays Russia Off Against Europe in Contest Over Gas

By Celestine Bohlen
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Nov. 4 (Bloomberg) -- It is boom time in Baku, the capital of Azerbaijan: The skyline is dense with cranes and high-rise buildings, and the streets of the port city on the Caspian Sea are clogged with luxury shops and traffic.

Oil revenue has fueled the country's growth, and even as prices have plummeted, Azerbaijan's energy resources remain a valuable prize. Evidence of this is the tug-of-war between Russia and Europe over natural gas from the next phase of a project that's expected to at least double current production when it moves from the planning stage to completion.

The competition is testing the former Soviet republic's ability to maintain its political balance in the months since Russia's invasion of Georgia heightened tensions between East and West.

``As always, Azerbaijan is trying to find common ground with all sides,'' says Fariz Ismailzade, director of the Advanced Foreign Service Program at the Azerbaijan Diplomatic Academy in Baku.

Over the past two months, Russia and the U.S., acting with the Europeans, have stepped up their attentions to this mostly Muslim nation of 8.5 million people. In addition to selling its gas, Azerbaijan wants to parlay the international interest into the resolution of its conflict over the separatist region of Nagorno-Karabakh, occupied by Armenia since a bloody ethnic war ended in 1994.

Easing Tensions

It inched toward that goal in a Nov. 2 meeting, where the two countries agreed to resolve the dispute under Russian, U.S. and French mediation, easing tensions in the South Caucasus after two Azerbaijani oil-export routes were disrupted by the Georgian war.

``This is our neighborhood and everything that happens here worries us,'' says Novruz Mammadov, head of President Ilham Aliyev's foreign-policy department.

Given its strategic location between the Caspian and Black seas, Azerbaijan is used to being in the middle. Since becoming independent in 1991, it has sought to minimize reliance on Soviet-era pipelines that go through Russia, a major trading partner and home to 2 million Azeris. At the same time, it has maintained neighborly relations.

``We have a strategic partnership with Russia and with the U.S., and we don't see any contradiction,'' says Khazar Ibrahim, spokesman for Azerbaijan's Foreign Ministry.

One-Day Visit

U.S. Vice President Dick Cheney visited Baku in September, followed a month later by Deputy Secretary of State John Negroponte. In between, Aliyev, 46, was invited to Moscow for a one-day visit with Russian President Dmitry Medvedev. The European Union's energy commissioner, Andris Piebalgs, is due in Baku this month.

One topic of discussion is Shah Deniz II, with natural-gas reserves estimated to at least equal the 9 billion cubic meters produced by the project's first phase. That gas is now sold at home and to Turkey and Georgia.

Once the second phase is developed, Moscow-based Gazprom OAO, which holds a monopoly on Russian exports, wants to buy the gas to boost reserves for future contractual commitments. The U.S. and EU want the new supplies sent directly to Europe through the proposed Nabucco pipeline, an $8 billion venture at the center of the region's efforts to reduce dependence on Russia.

Diversification of sources and routes has been a European priority since January 2006, when Russia, which accounts for 25 percent of EU gas imports, briefly halted shipments over a price dispute with Ukraine, a transit country.

Waiting for Europe

Azerbaijan has yet to decide when it will develop Shah Deniz II and says it's waiting for the Europeans to make an offer. Azerbaijan can bide its time, Mammadov says.

``We have said no to the Russians, for now,'' he says. ``To the Europeans, we have said we are ready to be good partners: for oil, for gas, for transit; but they need this, not us.''

In trying to strike a balance between East and West, Aliyev is following in the footsteps of his father, whom he succeeded as president in 2003. Heydar Aliyev, a former KGB general, played a key role in securing one link with Europe that bypasses Russia: a $4 billion pipeline that, by 2005, was carrying Azeri oil from the Caspian region through Georgia to Turkey's Mediterranean coast.

Operated by London-based BP Plc, Europe's second-largest oil company, the pipeline now exports a million barrels of oil a day on average -- roughly one percent of the world's supply.

Shrinking Revenue

The International Monetary Fund predicts Azerbaijan's gross domestic product will total $53.2 billion this year, compared with $8.6 billion in 2004. Revenue will likely shrink in 2009 as declining economic growth worldwide slows demand for crude oil. Prices have fallen 57 percent to about $64 a barrel Nov. 3 from a record $147.27 on July 11.

For now, though, the signs of oil wealth are everywhere in Baku. In its old city, tycoons have rebuilt modern villas on narrow, winding streets in the style of the mansions of their 19th-century predecessors. Oil has always been key to the fortunes of Baku: Marco Polo spotted a gusher here in the 14th century. In the 1800s, it drew European families, including the Rothschilds and the Nobels, who rushed to profit from the region's hydrocarbons.

Still, the dangers to Azerbaijan's thriving energy business from festering conflicts are all too evident. On Aug. 5, the BP pipeline was temporarily closed after an explosion on its Turkish portion, allegedly the work of Kurdish terrorists. That was followed by the closing of two oil-transit routes that cross Georgia because of its five-day war with Russia over the separatist region of South Ossetia.

Azerbaijan has been able to leverage some of the interest in its energy resources to try to end its own ``frozen conflict'' over Nagorno-Karabakh, which has cost it 20 percent of its territory. Medvedev arranged the Nov. 2 meeting in Moscow at which Aliyev and Armenian President Serzh Sargsyan agreed to seek a resolution -- signaling Russia's willingness to play mediator in this dispute.

``We have to find a way to have a peaceful, stable region,'' Ibrahim says.

To contact the reporter on this story: Celestine Bohlen in Baku, Azerbaijan, at cbohlen1@bloomberg.net