Energy relations between Iran and the Republic of Azerbaijan go back to the 1990s, after the collapse of the Soviet Union. Before Azerbaijan gained its independence, direct economic relations between the two were impossible. Once the leadership of Heyder Aliyev emerged as uncontested, however, the first energy agreement between the two countries was signed. Azerbaijan, with huge oil and gas reserves, began to present itself as a key ally in the European energy market, partly by retaining an interest in having a potential role in the southern gas corridor. At the same time, Iran — holding the largest natural-gas reserves in the world and the fourth-most-abundant proven oil reserves — has been planning to take its rightful share in the world energy market, primarily as a major natural-gas exporter.

The primary objective of the European Union is the diversification of energy resources. Thus, Iran and Azerbaijan have the potential to become key suppliers of gas to the European market. Iran may involve itself as a player in the trans-Anatolian and trans-Adriatic gas-pipeline projects, inviting foreign companies to make investments in its energy sector in time for the post-sanctions era; Azeri companies have a potential role in this also, investing in the current energy sector from a close, and therefore more knowledgeable, proximity. Energy cooperation could help both Iran and Azerbaijan to improve their mutual relations and develop ties. However, energy resources in the Caspian Sea — and the exact delineation of the maritime borders within it — are a major contributor to the rift between the two, impeding a cohesive policy on sharing oil and gas revenues from their common inland sea.

ENERGY PROFILES

Iran

The capacity of Iran's oil and gas production decreased dramatically under the sanctions placed on the country by the EU and the United States in a row over Iran's alleged attempts to build a nuclear program. After the 2015 P5+1 agreement, however, the country has begun to reinvigorate its oil and gas production and export capacity. Tehran is looking for markets to target, and Europe is interested.

Azerbaijan

Azerbaijan, located within the South Caspian Sea Basin, is among the oldest oil producers in the world; revenue from the production and export of oil and natural gas is a mainstay of the country's economy. Azerbaijan is one of the Caspian region's most important strategic oil and gas export routes to the West. According to the U.S. Energy Information Administration, which updated its report on the country in early 2014, Azerbaijan's proven crude-oil reserves are currently estimated at 7 billion barrels. In 2013, it produced 880,000 barrels per day (bpd) of oil, while consuming only 85,000 bpd.¹ As to natural-gas reserves, the existence of approximately 35 trillion cubic feet (tcf) has been estimated. In 2012, Azerbaijan harvested 607 billion cubic feet (bcf) of dry natural gas, consuming 379 bcf over the same period. The country has a generating capacity of roughly 6 gigawatts.²

ENERGY RELATIONS

The first energy agreement signed between Iran and Azerbaijan came in 1992 during the premiership of Heydar Aliyev on a visit to Iran, with the aim of solving the energy problems of the Nakhchivan Autonomous Republic. According to the agreement, Iran was to build a pipeline from Khoy (a province in western Azerbaijan) to Jolfa and into Nakhchivan. By 2004, the two countries agreed to deliver gas to Nakhchivan, with Iran pledging to supply the small statelet with 1 million cubic meters (mcm) per year over the next 25 years.³

Iran's economic relations with Azerbaijan cover natural gas, oil, electricity, commerce, customs, construction, communications and transportation. In October 1995, Azerbaijan officially invited Iran to join in the Shah Deniz oil-field development project. In 1996, Iran agreed to participate in the consortium. In late 1994, Azerbaijan bought electricity from Iran in order to meet Nakhchivan's fuel demand. In December 2006, Iran and Azerbaijan agreed to build a hydrocarbon dam on the Aras River with the aim of being able to benefit from the river equally. Electricity from Iran began flowing into the Azerbaijan Republic, via the Astara border, on August 21, 2006.⁴

THE POST-SANCTIONS ERA

Iran and the Southern Corridor

The Southern Gas Corridor, initiated by the European Commission (EC) as part of its diversification strategy, requires infrastructure to transport supplies from the Caspian Basin and Middle Eastern supplier states (primarily Azerbaijan, Turkmenistan, Iran and Iraq) to EU markets. Political and economic concerns, as well as a lack of developed infrastructure and gas resources, mean that Azerbaijan remains the only partner on this project.⁵ According to Miguel Arias Canete, EU Commissioner for Climate Action and Energy, the Southern Corridor is a top priority for the EU. Its member states are doing all they can to realize this dream, and Iranian gas will be strongly connected to the project, if it finally takes place.⁶ The Southern Gas Corridor aims to provide an alternative source of natural gas for Europe, eroding the continent's dependency on Russian reserves. The move comes at the time when Turkmenistan is trying to reduce its economic dependency on Russia, the main destination of Turkmen gas, just as Turkey and Europe are looking to diversify their supply lines.⁷

As Canete himself has stated, the EU has discussed with Turkmenistan's president the possibility of transporting Turkmenistani gas via Iran. According to European Commission Vice President Maros Sefcovic, both sides have discussed the idea of building a pipeline through Iran, now that diplomatic relations with Iran are developing positively. At present, the EU is working on the Southern Corridor route to transfer Azerbaijani gas. However, the main issue is that Azerbaijan does not have enough gas to make the pipeline a viable source of power. Thus, the EU has maintained the possibility of importing natural gas from Iran,⁸ but this has been a major challenge, given Iran's under-investment in even the most basic logistical infrastructure.

This underfunding is mostly due to the U.S. and European sanctions that have restrained Iran's national oil and gas sector. However, this is by no means the sole reason; the situation is not helped by infrastructural constraints, such as the geographical distribution of Iran's resources relative to its consumption, as well as a lack of production and export infrastructure in the country. Though Iran is the third-largest natural-gas producer in the world after Russia and the United States, its gas sector remains underdeveloped. The bulk of production is used to meet growing domestic demand. In 2013, gas production increased by less than 1 percent, to 167 bcm, while domestic consumption reached 162 bcm.⁹

Iran has several options for exporting gas to European markets: through Turkish territory to Greece via a potential Iran-Turkey-Europe pipeline; the Turkey-Greece-Italy Interconnector via the Trans-Anatolian Pipeline (TANAP) and Trans-Adriatic Pipeline (TAP), including the Greece-Bulgaria Interconnector and Ionian-Adriatic Pipeline; and to Bulgaria via the former Nubucco-West or the existing interconnector in Southwest Europe. Since the decision was made to lift sanctions on Iran's energy sector, Azerbaijan officially announced that it was ready to consider offers for the sale of part of its shares in the TANAP project. Turkey's minister of energy and natural resources, Taner Yıldız, also mentioned that it would "be possible for Iran to take a stake in the TANAP project as long as certain commercial conditions are fulfilled." At the same time, TAP's head of communication, Lisa Givert, said that "TAP is open to additional, new shareholders." This means that, after the removal of sanctions on the Iranian energy sector, the TAP Consortium might also consider Iran's participation in the project.¹⁰

Iran officially stated that it has removed gas transport to Europe from its priorities because of the continent's waning economic value. "Given the gas-price decline in Europe, the economic viability of the project has probably decreased. Besides, the market share of single shipments of LNG has grown," said the CEO of the National Iranian Oil Company, Rokkendin Javad, in May 2015. According to the minister of petroleum, the gas price in Europe has made infrastructure projects such as pipelines economically unviable.¹¹

Renewable Energy

Both Iran and Azerbaijan have been paying greater attention to the development of renewable energy resources and have coordinated on various joint ventures. Iran is planning to generate about 1000 MW of electricity from renewable energy resources and, in July 2015 asked Azerbaijan to invest in Iranian renewable energy with the aim of generating more electricity from renewables. Azerbaijan is also interested in making investments in its own renewable-energy resources. It is expected that cooperation in this field will yield stronger energy relations.¹²

Gas Storage

Iran is interested in using Azerbaijan's facilities to store its own gas. Iran's natural-gas production in winter constitutes less than its domestic consumption, while in summer it produces about 700 mcm above that. It stores some of the surplus gas in the Sarajeh and Shoorijeh gas facilities to pump into the national gas network in winter. Azerbaijan has two natural-gas storage facilities; Garadağ and Kalmaz, with a total capacity of 3 bcm. Iran can store about 2 bcm of its surplus gas in Azerbaijan's gas-storage facilities and take them back in winter.¹³

Caspian Legal Status

Before the collapse of the Soviet Union, the Caspian Sea was shared solely between Iran and the Soviet Union. However, following their declarations of independence, three of these states asserted claims to shares of the inland sea. Today, the Caspian is shared grudgingly among Iran, Russia, Azerbaijan, Turkmenistan and Kazakhstan. While they have tried to reach agreement over the Caspian's legal status, negotiations have not led to much. Iran's position is that the Caspian should be divided into five equal parts, though the main issue is the exact demarcation of these borders.

The maritime-boundaries issue is a thorn in the side of Iranian and Azerbaijani diplomats as they seek to foster more ties in the two countries' energy relations. Both nations maintain conflicting claims over offshore energy reserves. Outstanding among these disputes are Azerbaijan's Araz-Alov-Sharg hydrocarbon blocks, a 1400 km2 area with about 700 bcm of natural gas. Azeri control of this field, referred to as "Alborz" by Iran, is heavily disputed by Tehran, which claims that the Alov field, located 120 km southeast of Baku, is partially located in Iranian territorial waters. In 2001, two BP research vessels were driven away from the Alov fields by an Iranian gunboat. BP has not returned to the field since, and neither has anyone else.¹⁴ That Azerbaijan argues the Caspian should be divided by the Median Line and over national coast lines refers to the UN Convention on the Law of the Sea (1982). Azerbaijan is interested in extracting hydrocarbon resources from its near coastline. Russia and Kazakhstan also refer to the UN Convention on the Law of the Sea and are planning to extract hydrocarbons from their own territory in the Caspian.¹⁵

Oil Swaps

Iran in the post-sanctions era is faced with the immediate task of building up its infrastructure in the hope of exporting oil and gas to consumer markets. Azerbaijani officials have invited Iran to use Azerbaijan's infrastructure for export, making use of the Baku-Tbilisi-Ceyhan oil pipeline, along with the TANAP and TAP projects.¹⁶ However, in the meantime, the Iranian energy sector is preoccupied with seeking foreign investment. This is expected to have an impact on the economic relations between Iran and Azerbaijan, especially in their border regions. Iranian officials have often called on Azerbaijani state and private entities to make investments in its economy, especially in the oil and gas sectors and renewable energy.¹⁷ These industries present ideal opportunities for cooperation. By developing this potential, the two countries could realize joint programs that will help them to gain access to foreign markets, including the European energy market.¹⁸

Currently, there are five clear ways in which the two could develop energy cooperation, primarily in combining fields. Iran has disputed ownership of the Alborz field in the Caspian Sea; a shared field would put an end to this dispute. Iran has been cooperating with Azerbaijan for many years to develop the Shah Deniz gas-field oil for consumption in Azerbaijan. Iran has a 10 percent share in the Shah Deniz project. The second phase of the Shah Deniz gas field is projected to come on stream by 2018-19, increasing its gas output by 16 bcm annually. Azerbaijan is planning to export the second-phase gas production to Turkey and Europe via the TANAP project.¹⁹ Iran is interested in increasing its share in the Shah Deniz second-phase project and of the output from this field with the aim of playing a key role in Caspian energy resources. Negotiations as yet have not led to a result.²⁰

Second, both countries need to maintain and expand conduits for gas export. Iran has declared its willingness to supply natural gas to Europe on many occasions, but it was only with the Ukrainian crisis of 2014 that a great opportunity was provided. Diversification of energy resources became cemented as a top priority in EU energy policy. The EU is looking for any alternative to Russian gas, and Iranian and Turkmenistani gas resources would be the most realistic option. It is expected to export Iranian, Azerbaijani and Turkmenistani gas through new pipelines that connect the continent with suppliers. This new pipeline will begin in Iran and transport about 25 to 30 mcm per day from these countries through Turkey to the EU.²¹

The Challenge of Iranian Gas and the Southern Gas Corridor

As the EU is trying to reduce its dependency on Russian gas, Iran is in an ideal position in terms of resources and timing, but several challenges lie ahead if Iran wishes to commit itself to the Southern Gas Corridor. If the EC Commission left 50 percent of TAP's total capacity for third-party access, 100 percent of the initial capacity of both TAP and TANAP projects are secured by 25-year long-term agreements to pump Azeri gas.²² As Iran is a shareholder in the Shah Deniz field and represented in the Shah Deniz Consortium, it can take part in the transportation of Azeri gas only for the initial capacity of both TANAP and TAP.²³ Iran believes that the transfer fee for its gas is too high and that, at present, it is not economically viable to transfer Iranian gas via TANAP. Certain shareholders in the TANAP and TAP projets are trying to increase their shares. As SOCAR's president, Rovnag Abdullayev, has stated, SOCAR-Turkey energy is planning to buy 7 percent of a 58 percent stake in TANAP.²⁴ The Italian natural-gas company Snam Rete holds a 30 percent share, the same as BOTAŞ, but is interested in increasing its stake by buying Statoil's part of the TAP project.²⁵

Iran's desire to deliver huge amounts of natural gas to the EU necessitates an expansion in the capacity of both TANAP and TAP and means greater interconnectivity and capacity infrastructure within Iran.²⁶ Rokneddin Javadi, NIOC's CEO, has stated that Iran has removed the idea of transporting natural gas to Europe from its list of priorities due to its waning economic value. Minister of Oil Bijan Zanghaneh adds that current gas prices in Europe have made infrastructural projects such as pipelines economically unviable.²⁷

Iran needs more investment in its oil and gas sectors to recover its production capacity. Thus, it will take many years for Iran to have an impact as a major player on the international gas market. At present, Iran only exports 10 bcm annually to Turkey. The sanctions of the last decade have caused incalculable damage to the country's oil and gas sector. In the words of Chi Kong Chyong, a research associate at the Judge Business School and director of the Energy Policy Forum at Cambridge University, "The major challenge in getting Iranian gas to Europe seems to be Iran's under-investment in the gas sector — there are infrastructural constraints, namely geographical distribution of resources relative to its consumption as well as a lack of production and export infrastructure in the country."²⁸

Iranian gas prices are also a very important issue to overcome before participation in the TANAP and TAP projects is possible. Iran exports 1000 mcm of gas to Turkey at a cost of $490. This is more expensive than Azeri ($335) and even Russian ($425) gas. In this regard, the gas price and transit fees render the prices of Iranian gas for European consumers undesirable for the time being.

By 2016, Iran is planning to increase its gas production by 100 mcm/d. In the event that phases 12, 15, 16, 17 and 18 of the South Pars field become fully operational, it is expected that the country's total raw gas-production capacity could increase from the current level of 660 mcm/d to 800 mcm/d by the end of the next fiscal year. The volume is likely to increase to 1.2 bcm/d by 2020.

Under EU and U.S. sanctions on its energy sector, all five Iranian LNG projects were halted before launch. These include the Pars LNG Project, Persian LNG Project, Iran LNG Project, Golshan & Ferdowsi LNG Project, and the North LNG Projects. Some foreign companies such as Total, Petronas, Shell and Repsol have worked on Iranian LNG projects, but all withdrew their participation under pressure from the sanctions regime. Iran is interested in exporting LNG to the EU instead of exporting gas via pipelines. As NIOC CEO Javad expressed in October 2015, LNG is more promising for the European market and much more economically sound than the pipelines.²⁹ Iran's geographical position in the region, with huge offshore natural-gas fields, enables Iran to enter the LNG markets of Asia and Europe in an advantageous position.

Iran plans to become a major LNG exporter by the end of 2018, and negotiations to complete Iran's first LNG facilities are ongoing with foreign companies. Iranian LNG has a capacity of 10.5 million tons annually. Shell has officially stated that it is ready to complete Iran's LNG project,³⁰ while Iran has agreed to export gas to Oman to have it liquefied for export to international, particularly European, markets.³¹

By December 2015, after long negotiation between Iran and French companies, a deal was struck on the floating production of LNG from associated gas fields in the Persian Gulf. According to Rokenddin Javadi, companies will form a consortium to build the Middle East's first FLNG plant, with the capacity to produce 1 million tons of LNG per year.32 The plant's feedstock will come from the gas currently being burnt at the Forouzan oilfield, which Iran shares with Saudi Arabia. Iranian and French investors are charged with acquiring LNG tankers for shipment and an FLNG vessel for turning natural gas to LNG. Nevertheless, marketing and sales will be managed by NIOC.³³

CONCLUSION

The lifting of sanctions over Iran's oil and gas sector will allow Iran to play a key role in world energy markets and recover its production capacity in oil, gas and petrochemicals. Simply put, the European Union needs more gas from the Caspian Basin, Iran, Iraqi Kurdistan and anywhere else that helps decrease its dependency on Russian supplies. At present, Iran needs about $6 billion to facilitate the creation of the infrastructure to export natural gas from its South Pars field to Europe via Turkish territory. In the short term, Iran's first priority is to export LNG to European markets. Its first LNG facilities will come online by the end of 2017, and the country could become a major LNG exporter. In the mid-term, Iran may use Azerbaijan's infrastructure to export to Europe. Iran has an alternative plan to export LNG to the EU as early as possible.

Iran may soon export gas via the TANAP and TAP projects. After all, it holds the largest natural gas reserves in the world and, if all phases of the giant South Pars field come on stream, it can produce about 1.2 bmc of natural gas daily and export about 40 percent of that production. Iran views its neighbors as the first natural consumers, with its sights on the EU once ties have been strengthened with those in its immediate surroundings.

Energy cooperation between Iran and Azerbaijan is beneficial for both sides. Iran needs gas-storage facilities in summer, when it produces more than is needed. If the use of Azerbaijan's gas-storage facilities during winter can solve its seasonal domestic gas shortages, this would be a coup for relations on both sides. The Baku-Tbilisi-Ceyhan oil pipeline is a good way for Iranian oil to reach the European market, albeit a pipedream for the moment.