Oil Depletion and Peak Oil

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Working paper

Resource Depletion,Dependence andDevelopment: Azerbaijan

Elisa Cassinadri

November 2008

Chatham House is independent and owes no allegiance to government or toany political body. It does not hold opinions of its own; the views expressed in

this text are the responsibility of the author. This document is issued on theunderstanding that if any extract is used, the author and Chatham Houseshould be credited, preferably with the date of the publication.


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Working paper: EEDP 11/08 Depletion, Dependence & Development Project Azerbaijan

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TABLE OF CONTENTS

INTRODUCTION.....................................................................................................................................4

MACROECONOMIC OVERVIEW ..........................................................................................................6

Growth .................................................................................................................................................6

Fiscal position......................................................................................................................................8

Current account .................................................................................................................................10

Capital and financial account ............................................................................................................11

Resources..........................................................................................................................................11

SIMULATIONS......................................................................................................................................14

Phases of development.....................................................................................................................14

A dependent phase........................................................................................................................14

A transition phase ..........................................................................................................................14

A sustainable phase.......................................................................................................................14

The scenarios ....................................................................................................................................15

The reference case assumptions ......................................................................................................16

REFERENCE SCENARIO ....................................................................................................................18

Consumption .....................................................................................................................................18

Production..........................................................................................................................................18

Government finance ..........................................................................................................................21

Current account .................................................................................................................................22

Key findings of the reference scenario ..............................................................................................23

VARIANT SCENARIOS ........................................................................................................................24

Higher prices .....................................................................................................................................24

Additional reserves ............................................................................................................................27

Depletion choices ..............................................................................................................................30

Energy efficiency ...............................................................................................................................32


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Questions for Further Discussion ......................................................................................................32

Bibliography ..........................................................................................................................................34


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INTRODUCTION

Azerbaijan (population 8.6 million) is at the beginning of a large oil production boom

which is likely to be temporary. The country was an oil exporter in the early 20th

century, but production declined during the Soviet era from 286,000 b/d in 1987 to

200,000 b/d in 1993. The present boom is led by foreign companies who have

brought capital and technology to Azerbaijan since independence in 1991. By 2006,

oil production had tripled; passing from 200,000 b/d in 1993 to 868,000 b/d in 2007. It

is expected to double again by 2009-10. This led to an impressive real GDP growth

rate of 31% in 2006 estimated 23.4% in 2007). The hydrocarbon share of GDP rose

from 30% in 2003 to 58.6% in 2007 and will increase further.1 The state budget is the

main channel for transmitting this boom to the rest of the economy. Government oil

revenue increased fivefold between 2003 and 2007.

There are three main challenges for Azerbaijan with regard to its economic

dependence on hydrocarbons:

How to use the hydrocarbon revenues: the capacity of the non-hydrocarbon economy is limited by the legacy common to the other CSI

countries: economic distortion and contraction, deterioration in social

services and infrastructure and a rise in poverty. The armed conflict with

Armenia over the Nagorno-Karabakh region from 1988 to 1994

produced an influx of over one million refugees and internally displaced

persons. It has also disrupted trade and transportation across the

region. The current oil boom represents a unique opportunity for

Azerbaijan's government to modernize the country and reduce the

poverty which affects 46 percent of the population.

How to sustain hydrocarbon production: the maximum oil production isexpected to be reached in 20102. However, Azerbaijan undoubtedly has

potential for additional reserves to be discovered or added through

technical developments in producing reservoirs. Estimates of oil

reserves range from 7 billion barrels (Bn bbls), the generally accepted

1 IMF Country Report 2007

2 IMF Country Report 2007: By 2010-11 the ratio oil reserves to production will have fallen to around 10,usually the minimum technically sustainable.


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figure for proved reserves, to 13 bn bbls; for gas the range is 5-12 Bn

bbl oil equivalent (oe)3;

How to develop the non-hydrocarbon economy with efficient use of

energy: present energy consumption is small in relation to energyproduction (about 40% in 2006 and is likely to fall (as production rises)

to about 20% by 2010), but as the non-hydrocarbon economy grows

thereafter, while oil production reaches a plateau and eventually

declines, consumption will become important again.

3 EIA Country Analysis Brief, Dec 2007


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MACROECONOMIC OVERVIEW

DependenceAn explosion of oil revenues and expenditure since 2003 has greatly increased the

dependence of the non-hydrocarbon economy on fiscal revenues from oil and foreign

exchange earnings from the oil sector. In 2007 oil and gas revenues paid for 48% of

government current and capital expenditure. Oil and gas export earnings paid for 55%

of current account expenditures. These are lower dependence ratios than those of

some more mature oil exporting countries, but large enough to threaten massive

adjustments as and when oil revenues decline.

Growth

Azerbaijan is a transition economy whose productive base wasdestroyed by the transition from a communist economy to one

orientated towards markets. Between 1990 and 1995 output fell by 55

percent.

However, since the start of this decade, Azerbaijans annual real GDPgrew by nearly 10%, accelerating to 23% in 2007driven by growth in oil

output and the start-up of natural gas production.

This growth, focused in the capital Baku, is mainly driven byconstruction and services, sectors fed directly by the oil boom.

GDP per capita has been increasing due to increased oil production andoil prices, reaching $3000 in 2007. Consequently, per capita income is

vulnerable to decreases in oil production and future oil price volatility.

The oil windfall has resulted in high real growth and a strengthening ofmacroeconomic indicators, such as the external position. Yet, recent

accommodating macroeconomic policies have dramatically spurred

inflationary pressures, which constitute a serious threat to the economy.

During the last 5 years, the Azerbaijani manat has been appreciating

against currencies of major trading partners. In mid 2007, inflation was

running at 15 percent. The nominal exchange rate has been

strengthening at 3 percent over the last four years, whilst the real

effective exchange rate (overall, and for non-oil sector) has been

appreciating at 7% during last two years. The competitiveness of the


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non-oil sector is also hindered by continuing real exchange rate

appreciation.

The hydrocarbon sector has been a key driver of private sector

development. However, this has mainly been concentrated in import-competing and non-tradable sectors, which raises concerns about their

sustainability.

The financial system remains small and highly concentrated, withsignificant vulnerabilities in the banking sector although the regulatory

environment has improved in recent years. Currently Azerbaijans

banking sector consists of less than 50 banks, with total assets

amounting to only 20 percent of GDP, compared to 40 percent in other

transition countries in Central and Eastern Europe. Access to credit

remains a key barrier to private sector development. There is concern

that a rapid increase in credit growth might lead to a deterioration in the

banks loan portfolios

To improve the business climate, key productivity-enhancing reformssuch as the privatization of Kapital Bank and the introduction of an anti-

monopoly code are seen as crucially important. The introduction of a

single-point registration for commercial entities was a big step forward

and greatly simplified starting up new businesses. Public sector reforms

to improve business operating conditions have also been implemented.

However, in general the process of economic reform has been slow.

Most companies are still inefficient family-based small enterprises.

Existing organisational and management capacity still fails to attract

foreign investors, while local companies need to be better prepared for

access to foreign capital markets. Local capital markets suffer from

institutional weakness, a lack of trust from shareholders and non-

transparent financial management.

From about 300 oil service and supply companies, about half areAzerbaijani. Since most of the engineering and construction works took

place outside of Azerbaijan, local companies did not have enough

opportunity learn and develop skills to serve the international oil industry

in key areas. Therefore, local supply and services companies are mainly

in support services roles, and not in specialist services role. This is the

result of weaker PSA requirements on local spent and local content,

which does not help local companies to develop skills and capacity in


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specialist services areas. Furthermore, supply and service companies

are heavily underutilized following the completion of construction and

commissioning projects, which leads some well trained individuals to

move into other sectors of economy, and some employees of such

companies are leaving the country

The technological modernisation of the economy will depend onimproving technical training and specialist education. Low level of labour

productivity is a key challenge.

The main challenge Azerbaijan confronts is to use the oil windfall, whichis likely to be temporary, to spur non-oil output growth and reduce

poverty. If the positive externalities and synergies are taken into

account, the return on hydrocarbon revenues invested in the non-

hydrocarbon economy will be more than 15 percent, making it highly

advisable to use to use hydrocarbon revenues to finance large national

non-hydrocarbon projects. However, these investments should be

limited to natural monopolies and critical infrastructure, avoiding non-

productive, luxury sectors.

The authorities have to commit to an effective strategy to reduce thedouble-digit inflation which mainly affects the poor. This needs to

translate into a tightening of monetary policy and much greater fiscal

discipline (see below). Notwithstanding the countrys substantial poverty

reduction over the last few years as a result of an IMF Poverty

Reduction Strategy implemented in 2001, nearly 29 percent of the

population still lives in poverty and 8 percent in extreme poverty.

Fiscal position

Thanks to the oil windfall, over the past few years the fiscal stance hasimproved allowing for an increase in the public spending andaccumulation of large savings in the State Oil Fund of the Republic of

Azerbaijan (SOFAZ). Public debt in 2007 was around 5.4 percent of

GDP. Compared to economies with similar levels of GDP per capita,

Azerbaijan enjoys a structural surplus of revenue over expenditure for

the time being. as Table 1 shows.


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Table 1: Selected macroeconomic indicators for Azerbaijan and comparableeconomies

GDPper capita(currentUS$)

GDP(current millionUS$)

GovernmentRevenue(as percentof GDP)

GovernmentExpenditure(as percentof GDP)

ExportRevenue(aspercent of

NP GDP)

Azerbaijan 2336,029 20.122 25,1 22,7 72

Morocco 2148,912 57.307 28,8 31,3 38

China 2012,516 2.668.071 9,5 11,1 37

Colombia 2905,213 135.836 27,6 31,4 21

Thailand 3137,666 206247 21 16,3 71Source: data for GDP per capita for the year 2006 taken from IMF, World Economic Outlook Database;data for GDP for the year 2006 and government finance for year 2005 taken from World Bank; data forexport revenue for the year 2006 taken from World Bank, World Development Indicators online.

Between 2003 and 2007, the overall fiscal surplus has risen due tocontinuing high oil revenues and buoyant non-oil revenues. Over 70

percent of budget revenues are from the hydrocarbon sector. The non-

oil fiscal balance remains dangerously negative and is expected to

widened to 32 percent of non-oil GDP in 2007 owing to continuing

increasing public spending, mainly caused by the public sector wage

increase.

Non-oil revenues have risen as a percentage of non- oil GDP, thankssimplification and enforcement of VAT and tax administration, though

collections are still below potential. The ratio of non-hydrocarbonrevenues to non-hydrocarbon GDP has risen from 22% to 33% from

2003-2007.

The large fiscal relaxation in 2006 government spending increased by80 percent - has fuelled inflation. Likewise, the accommodating

monetary policy adopted to prevent Azeri manat appreciation in a

context of a de facto crawling peg to the US dollar fostered price

increases. The large unsterilized purchases of foreign currency

undertaken by the Azerbaijan National Bank to limit the annual

appreciation to the targeted 5%, resulted in an increase in the money

base and inflationary pressures.

Despite the recognition of the economic consequences, Azeriauthorities intended to continue the expansive fiscal policy over the

medium term in order to raise salaries and pensions and make public

investments in the social sectors and infrastructure after years of under

investment and neglect. This lax fiscal policy posed serious risks of

entering an inflation/indexation spiral. In 2008, it appears the


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government has had a change of heart and formally announced its

intention to reduce the non-oil fiscal deficit to 35 percent in 2008 with an

eventual target of 20 percent by 2012. The IMF regards these targets as

ambitious. They were to be achieved in the 2008 budget by increasing

spending restraints and longer term by increasing non-oil revenuereceipts.

Regarding subsidies, domestic energy prices are still below averageinternational prices, with the hydrocarbon sector long being a source of

subsidy for inefficient public enterprises and utilities. Domestic energy

pricing policy combined with low levels of payment to state energy

enterprises negatively impacts on the competitiveness of the national

economy and fails to prepare domestic enterprises for open

competition. However, the government is implementing a five-point

strategy to eliminate the negative consequences of the current pricing

and subsidy system. In 2007, the IMF estimated implicit energy

subsidies at 14.8% iof the non-hydrocarbon GDP Thus some reforms

have been implemented, but weak points remain.

Current account

Over the last three years, the combination of impressive oil exportgrowth and rising oil prices have led to strong improvements in the

current account balances. In 2007 the balance was estimated at $9

billion.

In 2005 the current account balance turned positive and since then ithas been significantly strengthening, reaching the 28.8 percent of GDP

in 2007.

More than 90 percent of export earnings originate from hydrocarbonoperations., but Azerbaijan receives transfer income (migrant workers)and investment income from abroad, so that its direct dependence4 in oil

and gas export earnings was 45% in 2007.

4 % of current account payments met by oil export earnings


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Capital and financial account

In recent years, high foreign direct investments largely coming into theoil sector contributed to the large capital account surplus. However, in

2005, the financial account balance turned negative due to negative net

FDI in the oil sector as projects came on stream and foreign oil

companies recovered their investments according to the production

sharing agreements.

Resources

Azerbaijan is endowed with sizeable mostly untapped crude oil and gasreserves, which made it the largest contributor to non-OPEC supply

growth during 2006 and 2007.

Most estimates of Azerbaijans proven crude oil reserves are around 7billion barrels and are located offshore in the Caspian Sea. The majority

of Azerbaijans oil output (80 percent in 2007) now comes from the

Azerbaijani International Oil Consortiums (AIOC) Azeri-Chirag-Guneshli

(ACG) fields, whose exploitation has driven the country's oil production

rise to 860,000 bbl/d in 2007 compared to 654,000 b/d in 2006. This is

expected to peak around 2011-2012. In 2007, estimates suggest that

exports were equal to 796,000 b/d.

Azerbaijan planned to increase its own natural gas productionsignificantly by 2010 in order to become net natural gas exporters. The

major natural gas production increases in the future are expected to

come from the development of the Shah Deniz field, which is expected

to mitigate the decline in hydrocarbon production after 2012.

In 2007 with the commercial start of the South Caucasus Pipeline(SCP), Azerbaijan began exporting gas to the West. Thus, after more

than four decades of dependence on Russian imports, Azerbaijan

became self-sufficient in gas. Still, with only one major foreign

investment focusing primarily on natural gas (Shah Deniz), the country

will need considerable investment in upstream projects and export

infrastructure before its full potential can be realized.

In recent years, further exploration efforts for oil and gas have proved tobe disappointing. Azerbaijan has long lacked the money and technology

to explore its onshore and offshore basins. However, plans are being


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developed to increase oil revenues in order to enhance exploration and

replace depleted reserves in the future.

The government is actively developing energy transport and transit

infrastructure to position itself as an energy hub.

In terms of energy intensity of GDP, Azerbaijan performs 2 4 timesworse than its peers. Introduction of metering, tariff reforms and

incentives to increase energy efficiency have led to a reduction in

energy use and slower growth in domestic energy consumption.

However, the continuation of these reforms is hindered by rising inflation

and the inflow of easy oil money.

As Table 4 illustrates, the major share of total energy demand in 2006was met by gas, followed by oil. Alternative sources of energy play a

minor role. Table 3, compares Azerbaijans key energy indicators to

non-hydrocarbon economies with a similar GDP per capita.

Table 2: Key energy indicators for Azerbaijan and comparable economies

Total Primary EnergyConsumption

Total Primary EnergyDemand per capita

GDP per unitof total primaryenergy use

(Billion barrels of oilequivalent)

(Barrels of oilequivalent)

2000 PPP $ per Kgof oil equivalent

Azerbaijan 0,10 11,4 2,4

Morocco 0,17 2,8 10,3

China 12,44 9,1 4,4

Colombia 0,21 4,6 10,9

Thailand 0,63 11,2 4,9

Source: data for total energy consumption for the year 2006 from BP Statistical Review of World Energy

2007; data for GDP per unit of energy use for year 2004 taken from World Bank, World Development

Indicators


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Table 3: Primary energy matrix for Azerbaijan and comparable economies

Share of oilin total primaryenergy demand(percent)

Share of gasin total primaryenergy demand(percent)

Share of coal intotal primaryenergy demand(percent)

Share ofalternativesources in totalprimary energydemand

(percent)Azerbaijan 33,9 61,9 0 4,1

China 20,6 2,9 70,1 5,5

Colombia 35,7 22,7 8,3 33,2

Thailand 51,4 31,9 14,4 2,1Source: BP, Statistical Review of World Energy 2007

* The section above has been supplemented with information from Commentary on

Azerbaijan by Ramin Isayev for Chatham House, April 2008.


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SIMULATIONS

Phases of development

Post-Soviet Azerbaijan is in the early stages of dominance by its hydrocarbon

economy.

A dependent phase

For Azerbaijan, as for most petroleum exporting countries in 2006-07, as in 1974-76

and 1978-83, there is a period when export revenues grow faster (because of rising

petroleum production or export prices, or both) than the historic trend in the non-

petroleum sector of the economy. Government oil revenues are used to fund a

growing fiscal deficit in the non-oil sector and stimulate its growth. Foreign exchange

earned by petroleum exports enables a rapid expansion of imports for the non-

petroleum sector. To the extent that the petroleum revenues run ahead of the fiscal

and current account deficits of the non-petroleum sector, surpluses are created which

are used to pay off debts, or are invested, usually abroad, in sovereign funds and

foreign financial assets. (When petroleum prices fall, the inertia in spending in the

non-oil sector may reverse the surplus, leading to deficits of the type encountered by

many countries in the late 1990s). Dependence, measured as a ratio of the non-

petroleum fiscal and current account deficits to non-petroleum GDP (the extent to

which the latter depends in oil revenues), has increased for Azerbaijan, like manyexporters since prices rose in 2003.

A transition phase

This is yet to come for Azerbaijan. It would begin at when export revenues begin to

decline, as a result of rising petroleum consumption taking an increasing share of

plateau production, in which essentially unsustainable trends build up, leading to a

permanent and growing deficit in the government budget and in the country's current

account on the balance of payments. In the reference case, Azerbaijan's current

account surpluses would begin to decline in 2011 and deficits would begin in 2020.

The fiscal balance would begin to decline in 2014 and go into deficit in 2021.

A sustainable phase

When petroleum production eventually declines the non-petroleum economy must be

sustained with rapidly diminishing petroleum revenues. In this longer term, the

prosperity of Azerbaijan will depend on the necessary adjustments achieved in terms

of increased productivity and growth of its non-petroleum sector. In other words, when


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the plateau is reached the capacity of oil revenues to support the NHGDP begins to

decline because growing domestic consumption reduces the amount of petroleum

available for export.

When production comes off the plateau, the decline in exports becomes very rapid.

Under the baseline assumptions, which are unsustainable in the long-term,

Azerbaijan would cease to be self sufficient in oil in nearly 20 years from now: an

extrapolation which mirrors the unsustainable outlook for oil consumption in the planet

as a whole.

The scenarios

The aims of the research are to track Azerbaijans hydrocarbon dependence through

these phases; to investigate the sustainability of Azerbaijans depletion policy and to

determine the size of the necessary economic adjustment once hydrocarbon

production declines.

The simple analysis of scenarios is aimed at illustrating a general tendency, not at

providing exact answers and precise numbers, which need to be treated with care.

The reference scenario represents a baseline of hydrocarbon dependence evolution

and eventual adjustments in the absence of major changes in Azerbaijans current

hydrocarbon strategy (or the fiscal and export capabilities of the non-hydrocarbon

economy). Alternative price and production scenarios were developed to analyse the

impact of such variations on the size of necessary adjustment compared to the

reference scenario.

Four indicators are used to compare the reference scenario with the alternative

scenarios:

1. When total hydrocarbon production is set to decline

2. The number of years until Azerbaijan becomes a net importer of hydrocarbons

3. In 2025:

The overall fiscal deficit5 as a percentage of non-hydrocarbon GDP

The overall current account deficit as percentage of non-hydrocarbonGDP

4. The Net Present Value (NPV) at 3% in real terms, of 2007-2025:

5 Throughout the paper, the fiscal and current account balance is meant to include the foreign income


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Government hydrocarbon and investment fund revenue

The current account balance (including investment income)

There are numerous statistical and definitional problems with both themacroeconomic and the energy data for Azerbaijan. For this study, simplification has

been preferred to spurious accuracy. The results should be treated in the same spirit:

they are not forecasts.

The reference case assumptions

The simulations define, in broad terms and under simple assumptions, the size of the

challenge to be faced in developing a sustainable part for the non-hydrocarboneconomy when oil revenues and export earnings decline.

The reference case is in some respects a worst case:

The international oil price (taken as Brent) is assumed to fall to anaverage of $60/bbl in 2008 and to remain constant in real (2006 $)

terms;

Proved reserves are taken to be as at end 2006, as reported in the 2007BP Statistical Review (7 Bn bbloe, 1.35 trillion cubic metres) thereference case does not allow for additions to reserves. It is assumed

that the foreign oil companies maintain a policy of constraining

production to preserve a 10-years ratio of reserves to production (a

depletion rate of 10%). For gas a 20-year ratio is assumed, to reflect

infrastructure commitments.

The ratios of government revenue and expenditure, exports and importsfor the non-hydrocarbon economy are assumed to be constant, so that

the fiscal and current account deficits of the non-hydrocarbon economy

grow at the same rate as the non-hydrocarbon GDP. This is a severe

assumption, since the ratio of revenue to the non-hydrocarbon GDP has

been rising steadily and is expected to improve further as the tax

administration is tightens and exemptions are reduced.

A pivotal assumption is the rate of growth of the non-hydrocarboneconomy from 2007 onwards. We assume real non-hydrocarbon GDP

growth rates equal to the ones estimated by the IMF for the period from


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2007 to 2012. Afterwards, they are assumed to level off to 6 percent

and remain constant for the rest of the period considered.

Government hydrocarbon revenue projections are obtained assuming

that the government hydrocarbon income as share of hydrocarbonproduction is 50, %. In practice, this share fluctuates under the

production sharing agreements for each field, as foreign companies

recover their costs early and the government share increases after

costs have been recovered. 50% is probably a low estimate for the

future.

Total energy consumption is projected to increase at 80% of theprojected growth rate of the non-petroleum economy.

For the 2003 to 2006 period, data was taken mainly from IMF 6, ADB and Azerbaijan

National Bank, EIA and BP. For the projections the exchange rate is kept constant at

the 2006 level and variables are dealt at 2006 prices.

6 International Monetary Fund (2007), Country Report 2007 (07/191), Country Report 2008( 2008/216) andAsian Development Bank (2007), Key Indicators 2007. For the other sources, see the bibliography.


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REFERENCE SCENARIO

ConsumptionAs Azerbaijan is not endowed with coal, and hydro consumption is negligible, its

primary energy needs are satisfied mainly by gas and oil.

Under the reference scenario, Azerbaijans energy mix is projected to remain mainly

constant over the period considered after an initial rise in oil consumption at the

expense of the gas one. Gas is assumed to remain a major source of energy for

power and industry, at nearly 60% of the total primary energy use. Over the period

2007-2025, the hydrocarbon balance for Azerbaijan in the reference case is as

follows:

Table 4 Hydrocarbon balance 2007-2025

REFERENCE SCENARIO

Oil production 2007 through 2025 6.1 Bn Bbls

Oil consumption 2007 - 25 1.3 Bn Bbls

Net Oil balance 2007-25 4.8 Bn Bbls

Gas production 2007-2025 3.0 Bn Bbls OE

Gas consumption 2007 - 2025 2.0 Bn Bbls OE

Net gas balance 1.0 Bn Bbls OE

Net hydrocarb balance 5.8 Bn Bbls OE

Hydrocarbon imports begin 2026

Source: Authors calculations based on simulations and data provided by the IMF, Azerbaijan Country

Report 2007

Production

Under the reference scenario, at a Brent oil price of 60$ per barrel, oil production is

projected to rise steeply until 2010, during the so-called development phase.

Afterwards, it is forecast to plateau at 1.3 mbd/d for four years and then start declining

in 2014.


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As oil production will be static or shrinking while consumption steadily rises over the

next three decades, oil exports are projected to start declining when production

reaches its plateau in 2010. The decline will accelerate when production declines, and

Azerbaijan would become an oil importer in 2027. Chart 1 shows this development.

Chart 1: Oil production, consumption and exports

-0.5

-0.3

-0.1

0.1

0.3

0.5

0.7

0.9

1.1

1.3

2010

2015

2020

2025

2030

Millionbarrelsa

day

Oil Consumption Oil Production incl. NGL and Condensates Oil Exports

Source: Authors calculations based on simulations, and data provided by BP World Energy Statistics 2006

and EIA

Gas production is projected to reach 0.52 mboe/d in 2011, following completion of

phase 1 of the Shah Deniz project. In the reference case it is held at that level until

lack of reserves forces decline (at 5% decline rate) from 2020. With gas consumption

steadily increasing, gas export would become nil in 2023. Chart 2 shows the

development in the reference cases:


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Chart 2 Gas production, consumption and exports

Source: Authors calculations based simulations and on data provided by BP World Energy Statistics 2006and EIA

As a result, hydrocarbon production is projected to increase over the next five years.

It would reach a plateau in 2011. Total hydrocarbon export would then start to decline

the beginning of a transition from the hydro-carbon-dependent development of the

current decade. Decline in hydrocarbon production, expected in 2014, would produce

a downturn in government hydrocarbon revenue and accelerate the decline in

hydrocarbon export earnings end the transition phase. The results for 2025 roughly

ten years later give an indication of the adjustments that will be required to the non-

hydrocarbon economy.


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Chart 3:Total hydrocarbon production, consumption, exports: reference case

-1.0

-0.5

0.0

0.5

1.0

1.5

2.0

2010

2015

2020

2025

2030

Millionbarrelsofoilequivalentaday

Hydrocarbon Consumption Hydrocarbon Production Hydrocarbon Exports

Source: Authors calculations based simulations and on data provided by BP World Energy Statistics 2006and EIA

Government finance

During the development phase (to 2011-12 in the reference case), the fiscal position

is forecast to become stronger. Owing to the announced surge in oil production, thegovernment's hydrocarbon revenue is expected to increase fivefold compared to

2006, even with the assumption that oil prices fall to $60 in 2008. This would exceed

the growth of 50% in the non hydrocarbon fiscal deficit and create potential reserves

(accumulated surpluses) of $ 40 bn by 2012. From then the fiscal surplus would

diminish with falling production and a deficit would appear in 2021. By 2025 the deficit

would be equivalent to just over 20% of the non-hydrocarbon GDP, despite an

increasing contribution from income from the investment of surpluses (the potential

investment fund would reach $138 bn, built up during the period of fiscal surplus).


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Chart 4: Government finance: reference scenario

Government finance

-15

-10

-5

0

5

10

15

20

2010

2015

2020

2025

2030

bnManat

Fiscal balance

Government oil revenue

Investment income


Report 2007

It is clear that any return to immoderate expansionary fiscal policies would lead to

enormous fiscal deficits, jeopardizing long-term growth and fiscal sustainability.

Current account

Over the next few years, during the development phase, when oil production and

exports are expected to be increasing sharply, the current account surplus as a

percentage of non petroleum GDP is forecast to be strengthening. During the

transition phase, associated with high oil production at a plateau, the current account

surplus as percentage of non-petroleum GDP is expected to shrink. The decline

would accelerate when hydrocarbon production begins to decline (in 2014 in the

reference case), the current account surplus will further reduce and turn negative in

2021, reaching 20% of the non-hydrocarbon GDP by 2025,


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Chart 5: Current account: reference scenario

Current account bala

-20

-15

-10

-5

0

5

10

15

20

25

2010 2015 2020 2025 2030

$bn

Hydrocarbon balanc

Non-hydrocarbonbalance

CA balance

Source: Authors calculations based simulations and on data provided by the IMF, Azerbaijan Country

Report 2007

Key findings of the reference scenario

Azerbaijan is endowed with sizeable crude oil reserves, whose development and

production has contributed to the strong GDP growth since the start of the decade. If

no new oil reserves are discovered, the maximum oil production is expected to be

reached in 2010-11.

The analysis of the scenario, although simplistic, illustrates that under the reference

case the present hydrocarbon dependence is expected to be sustainable until around

2021-22, when both fiscal and current accounts will decline into growing deficits.

If, in the meantime, the Azeri government will not maintain its commitment to holddown the fiscal expansion, the combination the continuing trend in the growth of

public expenditure with falling oil revenues would clearly lead to unsustainable fiscal

deficits over the medium term, jeopardizing long term growth and macroeconomic

stability. This problem is addressed at length in Azerbaijans annual consultations with

the IMF.

The model calculates the various adjustments to revenue, expenditure, imports and

exports in the non-petroleum sector which would be necessary to eliminate the fiscal

and current account deficits during the transition period. These are summarized in thetable below:


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Table 5: Economic results of reference scenario

SCENARIO Reference

Brent price ($ 2006): $ bbl 60 $/bbl

Oil ( Gas) Reserves Bn bbloe 7 (5.347) Bn bbls

Fiscal balance 2025: % of NHGDP -20 % NHGDP

Total NH Revenue 2025: % NHGDP 59 % NHGDP

NPV foreign revenue to 2025 M bn 25 Manat BnNPV Gov hydrocarbon & foreign revenue to2025 M bn 167 Manat BnNPV Gov hydrocarbon & foreign revenue to2025 % NHGDP 78 % NHGDP

Current a/c balance 2025 % NHGDP -20 % NHGDPHydrocarbon balance as % of exports:2025 -2 % Exports

NPV current account balance 2007-2025 $Bn 71 $ BnNPV current account balance 2007-2025 %NHGDP 38 % NHGDP

Foreign income % NHGDP 11 % NHGDP

Foreign income % NHGDP 2007- 12 % NHGDP

Investment funds $bn 2025 113 $ Bn

VARIANT SCENARIOS

Higher prices

The study shows three additional price scenarios:

Oil prices and related gas prices rising by 2% per year from 2008 untilthey reach $100 (in 2034)

Oil prices and related gas prices rising by 2% a year from $75 in 2008until they reach $100 (in 2023)

Oil and related gas prices flat from 2008 onwards.

Given the hydrocarbon balances of the reference scenario, the main effect of higher

prices is to increase the fiscal and current account surpluses during the development

and transition periods. The resulting increase in potential investment funds generates

7 Oil and Gas Journal estimate of 30 tcf of gas, published in EIA (2008). The BP Statistical Review reports afigure 50% higher.


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investment revenue which delays the onset of fiscal and current account deficit and

thus reduces the adjustments to the non-hydrocarbon economy which are required by

2025. Higher prices would eventually work to Azerbaijans disadvantage if and when it

became an importer which even in the reference scenario would not happen until

after 2025. Higher prices both reduce the adjustment required (the fiscal and currentaccount deficits in 2025) and have a higher net present value for government

revenues and the current account during the period 2007-25. Investment funds by

2025 are $248 bn in the $100 bbl case (and still rising) compared to $113 bn in the

reference case. These results are summarized in table 6 below.

Table 6: Economic effects of higher price scenarios

The possibility of prices higher than $60 places even more weight on the need to

invest the surplus revenues in a way which will reduce hydrocarbon dependence inthe long term. It also raises the question (discussed below) of the merit of increasing

production or even of maintaining the current plans for production of hydrocarbons in

the development period: the revenues only contribute to development through the

income generated in the fund for the long term: they have no use in Azerbaijan while

fiscal surpluses last. Chart 5 compares the fiscal surpluses under the various price

scenarios, after taking account of the income generated by investments.


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Chart 6: Fiscal balance under various price scenarios

Fiscal balance

-10

-5

0

5

10

15

20

25

20

10

20

15

2020

202

5

bnManat

$100

$75-100

$60-100

REF($60)


Report 2007

Even the highest price scenario leads to the edge of a fiscal deficit by 2025 so that

the trend is unsustainable.

The question remains of how best to transfer the value realized from the surpluses

resulting from early production to the later period when dependence on hydrocarbons

must be reduced. Clearly the investment fund will not do it. Rather the temptation will

be to use the surpluses to achieve an early (but unsustainable) increase in the

welfare of the population (or the power of the government) through current

expenditure, given that the capacity of the non-hydrocarbon economy to absorb these

sums may be limited. Even in the lowest price (reference) case, the fiscal surplus at

its peak in 2011 would be equivalent to 95% of the non-hydrocarbon GDP.

The countrys main challenge is therefore to manage the windfall associated with the

large temporary oil production boom. Azerbaijan has to combat the oil related

difficulties, such as Dutch disease (the inflationary pressures associated with the

sharply rising oil revenues and the capital inflows), and the diversification of the

economy. Key considerations are:


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The temporary oil boom represents a unique opportunity to modernizethe country and reduce poverty

Continuation of past immoderate economic policy would pose risks tothe achievement of these targets in terms of inflationary pressures

jeopardizing long term growth and fiscal sustainability

The necessity to maintain a moderate expenditure increase pace(through reduction in explicit energy subsidies and higher efficiency)

and monetary tightening

The authorities intent to moderate fiscal expenditure is welcome

Delay in moderation of fiscal expenditure would heighten the probabilityof entering an inflation/indexation spiral

Additional reserves

There is no doubt that there is scope for additional reserves of oil and gas to be

proved in Azerbaijan, though the scale and timing depends on exploration and

continued investment in the productivity of existing reservoirs. Some reports already

place gas reserves 50% above the level assumed in these simulations, though their

development may depend on as yet unsolved questions of transportation

infrastructure for export markets. Gas exports are, moreover, unlikely to bring the

same economic returns as physical equivalent oil exports: their value in the market is

lower and the cost of transportation higher. For these scenarios we assumed that

Azerbaijan could replace its reserves annually up to a maximum of 50% of the 2006

level. The immediate result would be to extend the lifetime of the plateaus of

production of oil and gas assumed in the reference case. This is illustrated in Chart 7

for oil, compared to the reference case. The plateau of production is extended by six

years and the end of oil exports postponed by 4-5 years, though the inevitable declinestill begins before 2020.


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Chart 7: Oil production with 50% additions to reserves


Report 2007

The effect on gas production is similar, but greater (because the reference ratio of

reserves to production is higher than for oil). The production plateau is extended by

10 years and the end of exports prolonged for six years, as chart 8 shows.


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Chart 8: Gas production with 50% additional reserves

-0.4

-0.3

-0.2

-0.1

0.0

0.1

0.2

0.3

0.4

0.5

0.6

2010

2015

2020

2025

2030

Millionbarrelsoilequivalentaday

Gas Consumption Gas Production REF gas production

Gas Exports REF Gas exports


Report 2007

Table 7 shows the hydrocarbon balance with additional reserves.

Table 7: Hydrocarbon balance with 50% additional reserves.

SCENARIO REFERENCE Add 50% reserves

Oil production 2007 through 2025 Bn Bbls 6.1 8

Oil consumption 2007 - 25 Bn Bbls 1.3 1

Net Oil balance 2007-25 Bn Bbls 4.8 7

Gas production 2007-2025 Bn Bbls OE 3.0 3Gas consumption 2007 - 2025 Bn Bbls OE 2.0 2

Net gas balance Bn Bbls OE 1.0 1

Net hydrocarbon balance Bn Bbls OE 5.8 8

Hydrocarbon imports begin 2026 2030

The economic benefits of additional reserves and the longer production plateaus are

significant, particularly for the adjustment required by the non-hydrocarbon economy

before 2025. Additional reserves under a $60 bbl price scenario are almost as good


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as $100 bbl prices with existing reserves, reducing the fiscal deficit to 2% of the non-

hydrocarbon GDP by 2025 (compared to 1% with $100 bbl and existing reserves) and

the current account deficit to zero (compared to a deficit of 20% of the NHGDP in the

reference case). With higher prices and additional reserves, the fiscal surplus would

extend beyond 2025. Investment income would be 2-4% higher, depending in theprice scenario. Table 8 compares the results for each price scenario and each

reserve scenario.

Table 8: Comparison of economic results for reserves and price scenarios

Depletion choices

The size of the potential surpluses, and the difficulty of using them in ways which will

enhance the ability of the economy to replace oil revenues and export earnings in the

long term, raises the question of whether deferring oil production might have merit.

In the MINPRID scenarios we have calculated, from 2008 inwards, the level of oilproduction which would be needed, in each price scenario, to keep the fiscal balance

close to zero (for simplicity, gas production is capped in 2011, after the completion of

Phase 1 of Shah Deniz, and is increased only when it is necessary to meet rising

consumption. These are not realistic scenarios: they imply a cut in reduction of oil

production of nearly a third to reduce the fiscal surplus to near zero in 2009. They do,

however, give an indication of the parameters within which depletion policy could

operate and incidentally show why the Azerbaijan government may not share the

foreign oil companies degree of urgency for rapid development.

The production profiles are illustrated in Chart 8:


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Chart 9: Low depletion

-0.5

-0.3

-0.1

0.1

0.3

0.5

0.7

0.9

1.1

1.3

2010

2015

2020

2025

2030

Millionbarrelsaday Oil Consumption

REF oil production

Oil Production incl.NGL andCondensates


Report 2007

The economic consequences of this policy would be mixed: The adjustments required

to the non-hydrocarbon economy by 2025 would be less severe, but the net present

value of the government revenues and the current account balance would be

reduced, as Table 9 shows, for both the existing reserves and additional reserves and

under the reference case and the rising price ($60-100 bbl) case, which should be the

most favourable to deferred depletion.

Slower depletion would improve the fiscal balance in 2025 by about 2% of the

NHGDP, and the current account by about 1%, but the NPV of government revenue

over the period would fall by 7% of the NPV of the non-hydrocarbon GDP, and the

NPV of the current account over the period would fall by 1% of the NHGDP. For the

higher reserve cases the improvement in the fiscal deficit in 2025 would still be only

2% (because the investment funds built up, and related income, would be higher in

the reference production profile). So a lower depletion profile would only marginally

reduce the need for adjustment in the non-hydrocarbon economy and the risks of

managing the investment funds successfully


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Table 9: effect of low depletion with existing and additional reserves

Energy efficiency

We ran a scenario in which the demand for energy grew at only two-thirds of the rate

of the non-hydrocarbon GDP (compared to the 80% assumed in the reference case).

There was little effect on government revenue, which is related to production, but by

2025 the current account balance would improve by 6% of the non-hydrocarbon GDP

a percentage improvement (worth $7 billion) that would apply to the NPV of the

current account over the whole period.

Questions for Further Discussion

The Key challenges for Azerbaijan are to:

Use the high oil revenue to increase the non oil output growth andreduce poverty

Ensure macroeconomic stability particularly after the oil peak

Put in place a strategy to reduce the double-digit inflation

Manage oil revenues (finding the appropriate pace of spending out thehydrocarbon revenues)

Find the key productivity-enhancing structural reforms

Tackle poverty; Notwithstanding the countrys substantial povertyreduction over the last few years, nearly 29 percent of the population

still lives in poverty and 8 percent in extreme poverty.


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The simulations show that the continuing expansion of hydrocarbon production in

Azerbaijan, its revenues (and the indirect effects not represented in these simulations)

offer a unique opportunity to modernize the economy of Azerbaijan and raise the

standard of living of its population. The speed of expansion of these revenues

presents difficult problems in managing inflation, increasing local expenditure at asustainable rate, and choosing investments which will enhance the ability of the non-

hydrocarbon sectors to replace hydrocarbon revenues and export earnings.

Unless additional reserves are proved over the next decade, the support given to the

non-hydrocarbon economy by the hydrocarbon sector will diminish rapidly. By 2025,

under even high price scenarios, the continued growth of the non-hydrocarbon

sectors, in which the people are employed, will be at risk. Proving additional

hydrocarbon reserves will simultaneously lengthen the period of adjustment (thus

reducing the changes needed by 2025) and increase the fiscal surpluses whose wisemanagement will be the ultimate determinate of the long-term sustainability of

Azerbaijan. More efficient use of energy will make little difference to this decline, but

could ease the transition for other sectors, from dependence on hydrocarbon export

earnings to support their imports.

EC/JVM 18.03.08


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BIBLIOGRAPHY

Asian Development Bank (2007), Asian Development Outlook 2007. Available

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National Bank of Azerbaijan (2007), Statistical Bullettin, 09/2007. Available at:

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