Most investors are aware of BRIC (Brazil, Russia, India and China).  Now a new term may be on the horizon, BROW (BP, Russia, Oil and War).

So our question is whether we will receive a BROW beating in Monday’s market (BP, RSX, USO).

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The hot war between Russia and Georgia over South Ossetia and involving Abkhazia, is reported by some new agencies as “Russia’s Pipeline War”.

What are the parts to that story?

The integrated oil company BP owns 30% of a recently completed pipeline (the BTC Pipeline) that runs from the Caspian Sea oil and gas fields of Azerbaijan through Georgia and Turkey to the Mediterranean Sea for ocean transport to the US and Europe.

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That route passes between Iran to the south and Russia to the north, both of whom could be problematic for US and European oil supplies if they wanted to be.  The pipeline carries about 1% of the world’s daily oil supply, and marginally reduces the energy-based geopolitical power of Russia and Iran.

A Bloomberg article said:

“Georgia is a key link in a U.S.-backed “southern energy corridor” that connects the Caspian Sea region with world markets, bypassing Russia. The U.S. seeks to connect Central Asia natural gas supplies with European markets, skirting Russia in an attempt to weaken the grip of Russia’s state-run OAO Gazprom energy company.”

Disruption of that pipeline could have impact on world oil prices. Destruction or disruption of the pipeline would be damaging to the financial health of BP, which is already damaged by a situation inside Russia with respect to it major investment in a Russian oil company.

Concerns over Russia’s increasing scope and frequency of hostile activities toward the West, and its strong-arm energy practices, could dampen short-term investment flows into Russia mutual funds, thereby reducing Russian share values.

Iranian TV reported claims that Russia bombed and destroyed the Georgian Black Sea oil port Poti, which is distant from all of the disputed territories, and is another strategic Georgian energy sector asset serving the international community.

“Russia razed key port of Poti … Russian military jets have bombarded and destroyed the Black Sea port of Poti, the Georgian Foreign Ministry has claimed in a statement.”

The BTC Pipeline:

Here is information about the pipeline taken from the US DOE Energy Information Agency’

“.. the Baku-Tbilisi-Ceyhan (BTC) Pipeline, the first direct pipeline to deliver crude oil from the Caspian Sea to the Mediterranean without crossing Russian soil … The 1,100-mile pipeline cost nearly $4 billion to build, and is operated by a BP-led consortium of 11 national and international oil companies … on July 13, 2006, the first tanker at the Turkish port of Ceyhan was filled with oil from BTC… The line is estimated to have a peak capacity of more than one million bbl/d.”

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Here is information about the pipeline taken from the BP-BTC website:

“… the Baku Tbilisi Ceyhan (BTC) Pipeline is one of the great engineering endeavours of the new millennium.  It runs 443km through Azerbaijan, 249km through Georgia and 1,076km through Turkey to the Ceyhan Marine Terminal.

The pipeline is buried along its entire length. At its highest point where it crosses the Caucasus Mountains the pipeline climbs to an altitude of 2,800m. It has a capacity to export one million barrels of oil a day, designed to meet the export requirements of the full field development of the ACG [Azerbaijan] field.

The BTC Pipeline facilities include eight pump stations (two in Azerbaijan, two in Georgia, four in Turkey); the Ceyhan Marine Terminal located on the Turkish Mediterranean Coast; two intermediate pigging stations; one pressure reduction station, and 101 small block valves.

Approximately 70% of BTC costs are being funded in the form of financing by third parties. The group providing loans, export credits and risk insurance to BTC comprises the European Bank for Reconstruction and Development (EBRD) and the International Finance Corporation (IFC), the private sector arm of the World Bank, export credit agencies of seven countries and a syndicate of 15 commercial banks.”

Here is a map of the Azeri oil fields operated mostly by Western companies that will depend on the BTC pipeline to distribute their 1 million barrel/day output potential.

Pipeline Dimensions:

By our reckoning, the pipeline holds nearly 40 million barrels of oil, using these figures:

• 3.5 foot diameter pipe
• area of circle = pi * r2
• 1,100 miles of pipe
• 5,280 feet per mile
• 5.615 cubic feet per barrel of oil

That is about 1/2 of 1 day of world oil consumption (about 85.2 million barrels per day in 2007 according to BP estimates).

The pipeline throughput of 1 million barrels per day is about 1.1% to 1.2% of daily world consumption.

We suppose from these figures that if the pipeline were damaged and bled dry, aside from the environmental damage and the weeks or months required to patch the holes, it would take more than a month to refill the pipe.

BP Dimensions:

BP has 17.8 billion barrels of proved reserves (of course, that depends on your definition of “has”, given the expropriation risk to which they are exposed.

They produce approximately 2.4 million barrels of oil (about 2.8% of world daily consumption).  They also produce about 1.4 million barrels of oil equivalent in natural gas daily.

They refine about 5.6 million barrels per day of petroleum products.

Pipeline Damage:

The $4 billion, 1,100 mile long, 42 inch diameter pipeline was shut down last week due to an attack that took place in Turkey.  Expectations are for a two week offline status.  However longer term, how can a pipeline so vast be protected?

In the same way that modern military tactics of the superior air force is to take out the eyes and ears of the enemy before launching an invasion, a growing tactic of smaller indigenous forces is to disrupt systems. The BTC pipeline is a globally significant system, that anti-Western forces could essentially perpetually disrupt without actually destroying it.

Geopolitical Risk:

There are important energy resources in difficult parts of the world.  Major countries have and will continue to use local “client states” in their continual struggle to gain or maintain access to key resources.

As investors, we would rather be as far away from all that as possible. We think investing in energy resources that are as insulated from geopolitical risk as possible is a favorable thing to do — US and Canada oil and gas producers being the best alternative.

Given the anti-oil company and windfall profits tax rhetoric in the US within the party likely to control Washington after the elections, Canadian oil companies may be a better place to be than US oil companies.

Venezuela has nationalized energy.  Saudi Arabia did decades ago.  Nigerian energy assets are under rebel siege.  The Middle East is always a hotspot.  Russia is an increasing bully, and has used high handed tactics to effectively expropriate Western integrated oil company assets in favor of state owned enterprises.

We wrote before about how Russia is now claiming extensive Arctic undersea territories, including ones traditionally claimed by Canada.  Russia is flexing naval muscle in the area, such as planting a flag on the sea bed under the North Pole, and Canada has begun naval patrols in the same areas it claims for itself.

Russia has been a high return fund investment alternative for some years until this year when emerging markets generally declined, but we continue to be concerned about the integrity and intentions of the Russian government when it comes to business.  We would look for alternatives to Russia, or at least keep exposure limited.

Russia ranks poorly in global corruption rankings, which is also not a particularly good sign for a place to send your money.

There is probably more money to be made in “dangerous” situations like Russia — increased risk generally correlates with increased profit potential, but sometimes it’s just more risk.  Predictability is low with Russia.  As generally conservative investors, we would prefer to invest where relations are more cordial than they are with Russia.

There is no denying that big money has been made speculating on or investing in Russia, but there are other places and ways to do the same.

Monday’s Questions:

Will BP and Russia decline, and will oil rise due to the war in Georgia?   Will it favor the Dollar, which otherwise looked Friday like it needed a rest, or even a bit of backing and filling?

Is this war about Russia protecting ethnic Russians in South Ossetia, or about Russia in payback to the West for Kosovo, or Russia in payback over nearby US missile defense installation plans, or is it ultimately a “pipeline war”?

If it is not a pipeline war, why would Russia decide to bomb a Georgian oil port that is far from South Ossetia, but that is an alternative to the BTC pipeline for oil flow through Georgia to the West?

What does destroying that internationally important oil port have to do with protecting ethnic Russians in South Ossetia?  Could that destruction be more aimed at maintaining Russia’s level of physical and economic control over the flow of a globally significant resource? What does all that mean for oil prices, for BP’s future and for short-term retail funds flow into Russia investment funds?

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UN Heat:

If the exchanges at the UN today are indicative of the international situation, we’d say tensions are high.  High international tensions would tend to have currency effects, oil price effects and stock market effects.

Consider these snippets.

US UN Ambassador Khalilzad:
Moscow “is on the wrong side here” … running a “campaign of terror” … “The days of overthrowing leaders by military means in Europe — those days are gone.”

Russian UN Ambassador Churkin:
(responding to Khalilzad)
“This statement, ambassador, is absolutely unacceptable — particularly from the lips of the permanent representative of a country whose actions we are aware of, including with regard to civilian populations in Iraq and Afghanistan and Serbia,”

Russian UN Ambassador Churkin:
(responding to Secretary-General Ban Ki-moon)
“shows that the Secretariat of the United Nations and its leadership was not able to adopt that objective position that is required by the substance of this conflict.”

Domestic Russian Perspective:

The Russian newspaper Pravda has run numerous articles about the war that may express the Russian domestic perspective.  Here are the most recent story headlines:

• Georgia declares war on South Ossetia
• Georgian troops burn South Ossetian refugees alive
• Putin: Georgia’s actions are criminal, whereas Russia’s actions are absolutely legitimate
• Georgia’s Saakashvili commits war crimes against humanity
• War between Russia and Georgia orchestrated from USA

Within the article about assumed US orchestration of the war, this is what was said:

“In the meantime, Russian officials believe that it was the USA that orchestrated the current conflict. The chairman of the State Duma Committee for Security, Vladimir Vasilyev, believes that the current conflict is South Ossetia is very reminiscent to the wars in Iraq and Kosovo.

‘The things that were happening in Kosovo, the things that were happening in Iraq – we are now following the same path. The further the situation unfolds, the more the world will understand that Georgia would never be able to do all this without America.’ “

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Markets generally should be moving tomorrow in response to all this. Pay particular attention to:

• BP (British Petroleum)
• RSX (Russia)
• USO (near month crude oil)
• UUP or UDN (Dollar index up and down)
• FXE (fx EUR/USD)
• IEF (intermediate US Treasuries).

Richard Shaw
QVM Group LLC

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