Iran-Turkey Energy Cooperation: Strategic Implications

Iran and Turkey, the two non-Arab Middle Eastern states, are among the largest and most populous in the region. The former occupies a strategic location on the Persian Gulf and the Strait of Hormuz; while the latter controls the Straits — the Bosporus, the Sea of Marmara, the Dardanelles — that link the Black and Aegean Seas. The two nations descend from the most ancient civilizations in the world and have strong national identities. Both are predominantly Muslim. The majority of Iranians are Shiite, and since the 1979 Islamic Revolution their government has been based on the velayat e-faqih doctrine (rule by an Islamic jurist). Turkey, prominently Sunni, is a secular state.

The Islamic Republic is endowed with massive oil and natural-gas reserves and is a founding member of the Organization of Petroleum Exporting Countries (OPEC) and the Gas Exporting Countries Forum (GECF). Iran was the first country in the Middle East where oil was discovered, in 1908, and has since established itself as a major oil exporter. The Islamic Republic consumes a large proportion of its gas and is currently a net importer. However, ambitious plans are being implemented to substantially increase both production and export. Turkey has limited oil and gas deposits and is heavily dependent on foreign supplies to meet its growing energy needs. However, given the country's strategic location between major producing regions (the Persian Gulf, the Caspian Sea and Russia) and a key consuming market (the European Union), Turkey is widely considered a major oil and gas hub.

These differences in function have created a strong foundation for cooperation between Tehran and Ankara. They need each other. Tehran needs to export more gas to Ankara and build pipelines via Turkey to reach European markets. The fast-growing Turkish economy needs stable and secure oil and gas supplies, which are also essential for establishing Turkey as a major transit country. In his address to the Turkey-Iran Business Council last June, President Hassan Rouhani underscored these mutual interests:

Turkey is a bridge connecting to the West and Europe, while Iran is a bridge to the Far East; we should use these two countries as bridges for regional development. Turkish and Iranian economies should complement each other.¹

These mutual energy interests are the main drivers behind the emerging cooperation between Tehran and Ankara. Strategically, however, the two nations have adopted different stances on several regional issues, most notably the civil war in Syria. In recent months, the evolving energy interdependency seems to have drawn Tehran and Ankara closer despite their regional and international differences; Iranian and Turkish officials have exchanged visits and called for more cooperation.

In late January 2014, after meeting with visiting Turkish Prime Minister Recep Tayyip Erdogan, Supreme Leader Ayatollah Seyyed Ali Khamenei stated, "Iran and Turkey enjoy their best relations in history."² Erdogan, who was accompanied by a large delegation including ministers of foreign affairs, economy, energy, culture and tourism, and development, said that Iran was like his "second home."³ Six months later, in June 2014, accompanied by seven cabinet ministers and a 90-member trade delegation from the private sector, President Rouhani visited Turkey, the first official visit since 1996. Turkish President Abdullah Gul described the visit as a "milestone in the countries' bilateral relations."⁴

These statements underscore the growing cooperation between Tehran and Ankara in fields such as culture, education, security, economy and trade. In 2014, the two countries established a Strategic Cooperation Council "for the first time in their history."⁵ This evolving partnership is underscored by a growing trade volume, although it had plummeted to $13.8 billion in 2013 from $21.8 billion in 2012 due to economic sanctions. According to the Iranian Customs Administration, Turkey was the sixth-leading trading partner of Iran in the calendar year (March 20, 2013, to March 20, 2014).⁶ The interim deal signed between Iran and the so-called 5+1 powers (the United States, Britain, France, China, Russia and Germany) was widely perceived as a positive sign for the easing of sanctions. Thus, the volume of trade between Tehran and Ankara is projected to reach $30 billion by the end of 2015,⁷ a target set at the twenty-fourth meeting of the Iran-Turkey Joint Economic Commission, held in Tehran in April 2014. Oil and natural gas represent the bulk of this large and expanding trade volume.

TURKEY'S ENERGY OUTLOOK

With approximately 74 million people, Turkey is one of the most populous countries in the Middle East. Furthermore, its economy has been growing rapidly over the past several years. All economic indicators point to broad economic expansion and improvement in the standard of living. In the last decade (2003-12), the population grew from approximately 66 million to 74 million, and the gross domestic product (GDP) more than doubled, from $303 billion to $789.3 billion.⁸ The World Bank projects that this impressive economic performance is likely to continue. Real GDP grew by 5.1 percent from 2003 to 2012 and is projected to grow by 4.2 percent from 2013 to 2018.⁹

This combination of population increase and economic growth deepens the nation's need for sustainable and secure energy supplies. Demand is rising at an alarming rate, and the nation's indigenous energy resources are inadequate to meet it. According to the International Energy Agency (IEA), Turkey's total primary energy supply (TPES) jumped from 24.4 million tons of oil equivalent (Mtoe) in 1973 to 114.1 Mtoe in 2011, at a compound growth rate of 4 percent. From 2015 to 2030, the growth rate will reach 4.5 percent, amounting to 237 Mtoe by the end of the period.¹⁰ The IEA projects that Turkey will likely see the fastest medium- to long-term growth in energy demand among IEA member countries.¹¹

Turkey has negligible proven reserves of oil and natural gas and, accordingly, depends heavily on foreign supplies. In order to reduce its energy vulnerability and ensure steady and secure supplies, the Ministry of Energy and Natural Resources highlighted several major targets in a Strategic Plan (2010-14). These include:

• Diversifying the energy mix and increasing the share of renewable energy

• Increasing energy efficiency

• Improving the investment environment

• Turning the country into an energy hub

• Minimizing negative environmental impacts.¹²

Large investments in energy infrastructure, especially for electricity and natural gas, are needed to avoid bottlenecks in supply and to sustain rapid economic growth. The Turkish government estimates that the total amount of investment required to meet the country's energy demand by 2023 is around $120 billion, more than double the total invested in the last decade.¹³ Turkey is a party to the Energy Charter Treaty (ECT), which requires that states create a fair environment for international investors and establish mechanisms for arbitration and enforcement. In recent years the government established the Incentives Implementation Authority for Foreign Investment (Tesvik ve Uygulama ve Yabanci Sermaye Genel Mudurlugu) to create an investor-friendly environment for private and foreign capital and passed a new petroleum law to attract international oil companies.¹⁴ The government offers several types of tax breaks to encourage exploration for and extraction of natural resources, including lower corporate tax rates, exemption from import duties for material and equipment and exemption from value-added taxes for exploration activities. Currently more than 50 private and foreign companies are licensed to conduct oil and natural-gas exploration and production activities. Power distribution is conducted exclusively by private companies, and the privatization of power-generation assets is set to be completed within the next few years.

The energy equation has two sides — supply and demand. Per capita energy consumption is low, slightly below the world average and equal to half that of the European Union (EU). However, since the early 2000s, total consumption has grown at the rapid rate of 4.9 percent annually.¹⁵ In order to curb this rising consumption, particularly in the transportation and building sectors, the government has undertaken several initiatives, including the creation of an Energy Efficiency Coordination Board.

Fossil fuels (oil, natural gas and coal) account for about 90 percent of Turkey's energy mix, with the rest provided by renewable resources including hydroelectric power. In order to diversify the mix, reduce pollution and enhance energy security, Turkish authorities seek to exploit the nation's alternative potential, including wind and geothermal capacities. Nuclear power is another target. Ankara has had plans for establishing nuclear-power generation since 1970. Plans are underway to build two nuclear plants, one in Akkuyu on the eastern Mediterranean coast and the other in Sinop on the Black Sea in partnership with Russian, French and Japanese firms.¹⁶

Despite these plans to diversify the energy mix, the Turkish economy still runs largely on fossil fuels. Most of the country's modest proven oil reserves are in the southeast region, though there are also potential offshore reserves under the Aegean, Black and Mediterranean Seas. However, territorial disputes with Greece, Israel and Cyprus might impede plans for the development of these deposits. Turkey has never been a major oil producer; production peaked in 1991 and has since declined. Most of Turkey's crude oil and petroleum products are imported from Iran, Iraq, Saudi Arabia and Russia. But consumption has risen. In 2003, it was approximately 649,000 barrels per day (b/d); a decade later (2013), it reached 714,000 b/d.¹⁷ Transportation is by far the dominant consuming sector, followed by industry. Table 1 illustrates the nation's heavy dependency on foreign oil supplies.

Over the last three decades, natural gas has accounted for an increasing share of Turkey's energy mix. Interest in gas has intensified since the Justice and Development Party (AKP) assumed power in the early 2000s. In 2003, the country consumed 20.9 billion cubic meters (bcm); a decade later (2013), consumption had more than doubled, reaching 45.6 bcm.¹⁸ Most of the gas is consumed in power generation, heating and industry. Given its limited indigenous deposits, Turkey has grown more dependent on foreign supplies, as Table 2 demonstrates.

The bulk of the country's gas needs are met by imports from Russia, Iran and Azerbaijan — mostly by pipelines — and Qatar, Algeria, Nigeria and Norway — mostly as liquefied natural gas (LNG). Imports from Iran started more than a decade ago. In 1996, the two countries signed a contract for 10 billion cubic meters per year. After several delays, a pipeline running from Tabriz to Ankara was completed in 2002. Since then, Ankara-Tehran gas relations have faced three major challenges: security, sanctions and disagreement over prices.

The pipeline is occasionally shut down due to sabotage by the Kurdistan Workers' Party (PKK). Because of these interruptions, given Turkey's soaring demand for gas, Ankara sought to invest in the Iranian natural-gas sector. In the late 2000s, the two countries reached an agreement under which Turkey's national oil company, Turkiye Petrolleri Anonim Ortakligi (TPAO), would invest in the development of the Iranian South Pars field. The goal was to boost gas production and export. This agreement was never implemented, due to American and international sanctions imposed on Tehran over the nuclear dispute. Turkish officials claim that Iranian gas is more expensive than gas from other sources. In 2012, Ankara took Tehran to an international court of arbitration, arguing that Iran was overcharging for its natural gas. The two sides have yet to reach an agreement.

Turkey's dependency on foreign energy supplies is projected to further deepen due to rising consumption. However, the country increasingly plays a key role as an energy transit hub because of its strategic location. Addressing a meeting of the Caspian Forum in Istanbul last December, Trade and Customs Minister Hayati Yazici pointed out that approximately three-fourths of the world's oil and gas reserves are located near Turkey, in the Caspian region, Russia and the Middle East. "This situation makes Turkey a 'bridge' between energy-rich countries and Europe. While Ankara develops projects to meet its own energy demand, it also aims to serve as an energy route."¹⁹

In addition to the Straits, Turkey has several oil and gas pipelines and ports that connect major producers and consumers. The Bosporus connects the Black Sea with the Sea of Marmara, and the Dardanelles links the Sea of Marmara with the Aegean and Mediterranean Seas. Both supply Western and Southern Europe with oil from the Caspian region.²⁰ In 2013, three million barrels of oil flowed daily through these Turkish Straits, making them some of the world's busiest chokepoints.

Two major international oil pipelines run through Turkey. Since the mid-1970s, the Kirkuk-Ceyhan pipeline has connected Iraqi oil fields to the Ceyhan oil terminal on the Mediterranean. In 1987, a second pipeline, parallel to the first, was commissioned: the Baku-Tbilisi-Ceyhan (BTC) has been in operation since 2006. It transports Azeri (and more recently Kazakh) oil via Georgia to the port of Ceyhan. Frequent attacks on the pipeline regularly result in disruptions. Four international gas pipelines are also in operation: the Russia-Turkey West Gas Pipeline via Kofcaz on the border with Bulgaria; the Blue Stream via Samsun on the Black Sea; the Baku-Tbilisi-Erzurum Pipeline through Georgia via Ardahan; and the Iran-Turkey Pipeline via Dogubayazi close to the border with Iran. The Turkish government and private and foreign companies are also backing several other projects.

IRAN'S ENERGY OUTLOOK

Iran holds some of the largest oil and natural gas deposits in the world. They include the largest proven natural-gas reserves (33.8 trillion cubic meters, about 18.2% of world's total) and the fourth-largest proven oil deposits after Venezuela, Saudi Arabia and Canada respectively (157 billion barrels, roughly 9.3 percent of the world's total).²¹ In addition to its strategic location on the Persian Gulf, Iran is "at the crossroads of many current and planned energy-transit corridors."²² The country is a founding member of both OPEC and the GECF and has a long history of oil and gas production.

Despite these geological and geographical advantages, Iran's current oil and gas production and its role in the regional and global energy markets do not reflect its massive hydrocarbon deposits. After a decade of stagnation, oil production declined in 2013, and the country is a net importer of natural gas. Economic sanctions over Tehran's nuclear program are a major reason for the slow development of oil and gas deposits. The international negotiations between the P5+1 to reach a peaceful solution could be a first step towards reintegrating Tehran into the regional and global energy markets.²³ Iranian authorities have been trying to capitalize on the diplomatic momentum to lay the ground for the return of major international companies and lift sanctions on the oil and gas sectors. There are significant uncertainties in reaching and implementing a diplomatic settlement. Furthermore, it will take considerable time to rebuild production capacity due to a lack of investment, as well as through constrained access to technical expertise and equipment.²⁴

Iran's oil was discovered in 1908. The country's production and exports reached a peak in the mid-1970s. Since then, both have fallen for several reasons: relatively high natural-decline rates, low recovery rates, domestic political instability (1978-79), the Iran-Iraq War (1980-88) and various kinds of sanctions (beginning in 1979). Since the late 2000s, Iran has been under comprehensive sanctions targeting its energy sector. Several international oil companies have suspended operations; consequently, new projects have either been delayed or developed at a slower pace than planned.

The figures show stagnant production and soaring consumption, the latter partly due to heavy subsidies. In 2010, Iran's subsidies were in both absolute and relative terms the heaviest in the Middle East and North Africa.²⁵ The country has since embarked on ambitious subsidy reform, the effectiveness of which remains to be verified.²⁶ On the supply side, the Iranian authorities have sought to increase crude-oil and petroleum production. According to Oil Minister Bijan Namdar Zanganeh, crude-oil output will reach 5.7 million b/d by 2019. In pursuing this goal, the country will invest $2 billion to increase production at Salman, Hengam, Forouzan and Reshadat offshore oil fields in the Persian Gulf.²⁷ Another significant development is in the downstream sector. Iran used to be a major importer of petroleum products due to a shortage of refineries; in 2006, it imported 30 million liters of gasoline daily. In the last several years, new ones were built. When the Persian Gulf Star comes on line early next year, Iran will become self-sufficient and start exporting gasoline.²⁸

Similarly, Iran's natural-gas sector has been hampered by international sanctions and has experienced fundamental changes in recent years. First, the country holds the world's largest proven natural-gas reserves (18.2 percent).²⁹ Most are located offshore as "dry or non-associated" gas. According to the Energy Information Administration (EIA), 85 percent of these reserves "have not yet been developed."³⁰ In short, Iran holds massive gas deposits. Second, despite these huge reserves, Iran is not a major player in the global gas trade. It exports gas to Turkey, Armenia and Azerbaijan and imports from Turkmenistan. The country is a net importer. Furthermore, it does not have terminals to export LNG. Plans to build such terminals have been slowed by lack of technical expertise and the necessary funds, due to international sanctions. On the other side of the Gulf, Qatar has established itself as the world's largest LNG exporter.

Third, over the last decade (2003-13), gas production has doubled, making Iran the third-largest producer in the world after the United States and Russia. Most of this production comes from the South Pars Field. Discovered in 1990 by the National Iranian Oil Company (NIOC), the field has a 24-phase development scheme. Production started in December 2002 and has since increased with the completion of several phases. Other important fields include North Pars, Kish, and four sizable new fields announced in 2011: Kayyam, Farouz B, Madar and Sardare Jangal.

Fourth, this rise in production has been matched by a significant surge in consumption. In the last few decades, Iran has sought to lower its domestic oil consumption and increase the share of natural gas in its energy mix. Gas is widely used in the residential sector and in injecting mature oil fields as part of enhanced oil-recovery techniques.

Despite investments by some Asian companies and indigenous efforts to revive the country's oil and gas sectors, it is clear that Western companies are needed, particularly given their advanced expertise in the areas of enhanced oil recovery, offshore discovery and LNG, among others. The election of President Hasan Rouhani in 2013, the signing of the interim agreement between Iran and the P5+1 to address the nuclear dispute and the ongoing negotiations between the two sides have all intensified Iran's pursuit of foreign investment. Western oil giants were forced to pull out in 2010, as the EU banned their participation in Iran's energy sector. During the January 2014 World Economic Forum in Davos, Switzerland, President Rouhani and Oil Minister Bijan Namdar Zanganeh met with representatives from BP, Eni, Royal Dutch Shell and Total. Minister Zanganeh estimated that the energy sector needs at least $50 billion in foreign investment.³¹ In mid-2014, NIOC introduced 41 projects, valued at $100 billion, to foreign investors at the World Petroleum Congress.³²

In addition to sanctions, there is the major challenge of the so-called buy-back contract terms. Iran shifted from production-sharing contracts to service contracts in 1974, when the country adopted a petroleum law. In 1987, the Majlis (parliament) revised the petroleum law and adopted the buy-back model. Under buy-back, one or more parties are contracted by the Ministry of Petroleum to carry out necessary exploration and development work on a field, which, once completed, reverts wholly to the ministry. Thus, the foreign company is neither a partner nor a concessionaire, but a hired contractor servicing the national company. The model demands that the foreign partner provide all investment capital for exploration and, in return, be paid a predetermined rate of return on capital invested. This is paid in kind after the production of the first commercial oil.³³ International companies have been dissatisfied with these terms, demanding contracts that would reward them for growing production and provide compensation for unexpected cost overruns. Paolo Scaroni, chief executive of Eni, underscored these sentiments: "The price in contracts is as important as sanctions. If we don't have a good contract, we won't go into Iran even if sanctions are lifted."³⁴ Mehdi Hosseini, who heads a committee set up by the oil ministry to revise oil-contract terms, stated that Tehran was consulting with international oil companies and soliciting their views on how to make contracts more attractive.³⁵

EUROPE'S ENERGY SECURITY

Three developments have recently highlighted Europe's energy vulnerability and how emerging cooperation between Iran and Turkey might contribute to steady oil and gas supplies to EU-member states. These are the shale-gas and tight-oil revolutions in the United States, the deteriorating security situation in Iraq, and the Russian invasion and annexation of parts of Ukraine.

Thanks to technological innovations, the U.S. energy outlook has significantly improved in the last few years. From 2008 to 2012, tight-oil production has seen a fourfold increase; overall oil production is projected to reach 9.6 million b/d. More impressive, total gas production is projected to increase 56 percent by 2040, mostly due to the surge in shale-gas production.³⁶ These projections have led to expectations that the United States might soon become a major oil and gas exporter (the latter as LNG), reducing the significance of Middle East producers. The IEA does not endorse these expectations. Rather, it asserts that meeting long-term growth in oil demand relies on the holders of the large remaining conventional sources, which are concentrated in the Middle East.³⁷ It projects that by the mid-2020s, non-OPEC production will start to fall back, and countries in the Middle East will provide most of the increase in global supply.³⁸ The IEA also suggests that the expectations that a surge in new LNG supplies will totally transform gas markets need to be tempered, due to the high capital cost of LNG infrastructure.

The deteriorating security conditions in Iraq and the escalation of sectarian and ethnic conflicts have cast doubt on its ability to increase and sustain its oil output. Over the last several years, the country's production has steadily increased. Moreover, Iraq was projected to provide most of OPEC's incremental supplies in the next several years. These projections are currently highly uncertain. This conclusion also applies to another OPEC member, Libya. In short, political instability and lack of security in several major oil producers suggest that the relatively more stable OPEC members are likely to play even more important roles in supplying adequate and steady supplies to consuming countries.

In the wake of the Russian invasion and annexation of parts of Ukraine, the European Commission released an EU energy-security strategy to address the medium- and long-term security of supply challenges. The document underscores the EU's energy vulnerability: it imports 53 percent of the energy it consumes, including 90 percent of its oil needs and 66 percent of its natural gas. The price of these imports is more than €1 billion per day, more than one-fifth of total EU imports.³⁹ The strategy specifies eight areas where action is needed:

• Increase the EU capacity to overcome a major disruption during the winter of 2014-15

• Strengthen emergency/solidarity mechanisms

• Moderate energy demand

• Build a well-functioning and fully integrated internal market

• Increase energy production in the EU

• Further develop energy technology

• Improve coordination of national energy policies

• Diversify external supplies and related infrastructure.⁴⁰

The last recommendation is relevant to the emerging Iran-Turkey energy cooperation. In dealing with the Iranian nuclear dispute, the EU's objective has always been to pursue "a comprehensive, negotiated, long-term settlement which restores international confidence in the exclusively peaceful future of the Iranian nuclear program."⁴¹ For most of the 2000s, the EU and the United States pursued a dual-track strategy, with the former adopting diplomacy and the latter implementing sanctions. Indeed, the European countries were Iran's major trading partners, and the EU was the top export market for Iranian oil (approximately 25 percent of Tehran's total).⁴² Until 2010, the European Council limited its measures to implementing all UN Security Council resolutions within the European territory. But from 2010 onwards, the EU joined the United States in increasing pressure on Iran through "comprehensive unilateral restrictive measures that went far beyond the scope of the UNSC resolutions."⁴³

In 2011, the EU banned the export to Iran of key equipment and technology for the refining and production of natural gas. A year later, foreign assets of the Central Bank of Iran that were held in EU financial institutions were frozen, and the Brussels-based Society for Worldwide Interbank Financial Telecommunication (SWIFT) cut Iranian banks from its system. The EU also banned the purchase and transport of Iranian crude oil, and EU companies were prohibited from insuring Iranian oil shipments.⁴⁴

Following the signing of the Joint Plan of Action (JPA), some of the EU sanctions have been suspended, including the prohibition of the import, purchase or transport of Iranian petrochemical products; the prohibition of trade in gold and precious metals; and the prohibition of the provision of insurance and transport to current customers importing Iranian oil (China, India, Japan, Korea and Turkey). In anticipation of the lifting of sanctions, several European commercial delegations have visited Iran and expressed interest in re-entering the Iranian market.

On the other side, responding to the Ukrainian crisis, Iranian officials have sought to promote their country as a reliable contributor to Europe's energy security. Minister of Industry Mohammad Reza Nematzadeh stated, "We don't want to compete with Russia, but we know that Europe's demand for gas is increasing and would like a share in this. We have the energy reserves and cooperation plans."⁴⁵

Part of the "cooperation plans" is the Iran-Turkey-Europe (ITE) pipeline. In November 2008, the Iranian Oil Ministry and the Turkish Ministry of Energy and Natural Resources signed an "Agreement Protocol" for transit of natural gas from Iran to Europe through Turkey. The annual target amount of gas to be conveyed to Europe is approximately 35 billion cubic meters.⁴⁶ Under U.S. pressure, there was no move to implement this agreement. However, the signing of the JPA between Iran and the P5+1 (November 2013) has eased tension between Tehran and Brussels and brought life to the ITE scheme. In 2013, the Turkish cabinet approved the urgent expropriation of land along the proposed route of the pipeline. Turang Transit, the Turkish firm that will build the section of the pipeline located in Turkey, received an incentive certificate that includes an exemption from the value-added tax (KDV) and customs taxes. The Turkish government will also provide other tax reductions and the employer insurance premium.⁴⁷

The emerging energy cooperation between Iran and Turkey is likely to contribute to Iran's strategy to fully utilize its oil and natural-gas deposits. It would also provide Ankara with the energy sources it needs to maintain its impressive economic growth. Furthermore, a Tehran-Ankara energy partnership would enhance Europe's pursuit of energy security by diversifying its oil and gas suppliers. Finally, re-integrating Iran into the regional and global systems would reduce tension and improve chances for the peaceful settlement of regional and international disputes. It is one of the few positive developments coming out of the Middle East in the last few years — a win-win proposition.