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