1 Analysis of Azerbaijan Oil and Gas Sector Aitor Ciarreta 1 and Shahriyar Nasirov 2 Abstract: This article is study of Azerbaijan oil and gas industry. It illustrates the business climate, the impact of this sector on Azerbaijan’s economy including role of SOFAZ and highlights recent developments in the energy production and the main concepts of Azeri PSAs. Meanwhile, the article establishes the government policy by indentifying several factors that influenced to attract foreign investment to oil and gas sector and examines significant challenges that still remain for further development of the country’s oil industry. JEL Classification: Keywords: Oil and gas industry, PSA, Regulation 1 Universidad del País Vasco, Departamento de Fundamentos del Análisis Económico II. Avda. Lehendakari Agirre 83, Bilbao 48015, Spain. Phone: +34946013823 fax: +34946017123. E-mail: [email protected]2 Orkestra, Instituto Vasco De Competitividad, Fundacion Deusto. Avda. De las Universidades 24, Bilbao 48007, Spain. Phone: +34 944 133 552. E-mail: [email protected]* We thank MICINN (SEJ2006-06309 and ECO2009-09120) , Gobierno Vasco (DEUI, IT-313-07), and Okrestra for their financial support. Finally, we are very grateful to Elnur Soltanov from ADA, Elmeddin Hasanov from BP and Khagani Guliyev from European Parliament for their useful comments and suggestions.
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1
Analysis of Azerbaijan Oil and Gas Sector
Aitor Ciarreta 1 and Shahriyar Nasirov2
Abstract:
This article is study of Azerbaijan oil and gas industry. It illustrates the
business climate, the impact of this sector on Azerbaijan’s economy including role of
SOFAZ and highlights recent developments in the energy production and the main
concepts of Azeri PSAs. Meanwhile, the article establishes the government policy by
indentifying several factors that influenced to attract foreign investment to oil and gas
sector and examines significant challenges that still remain for further development of
the country’s oil industry.
JEL Classification:
Keywords: Oil and gas industry, PSA, Regulation
1 Universidad del País Vasco, Departamento de Fundamentos del Análisis Económico II. Avda. Lehendakari Agirre 83, Bilbao 48015, Spain. Phone: +34946013823 fax: +34946017123. E-mail: [email protected] 2 Orkestra, Instituto Vasco De Competitividad, Fundacion Deusto. Avda. De las Universidades 24, Bilbao 48007, Spain. Phone: +34 944 133 552. E-mail: [email protected] * We thank MICINN (SEJ2006-06309 and ECO2009-09120) , Gobierno Vasco (DEUI, IT-313-07), and Okrestra for their financial support. Finally, we are very grateful to Elnur Soltanov from ADA, Elmeddin Hasanov from BP and Khagani Guliyev from European Parliament for their useful comments and suggestions.
2
Introduction
The Republic of Azerbaijan is located in the south east of the Caucasus, and borders on Russia,
Georgia, Turkey, Iran and Armenia. Throughout history, oil has been used as a leading
mechanism in its political and economic life. Since Azerbaijan’s independence, oil has become
the main political and economic factor for solving several national problems such as
strengthening the country’s independence, defending its territorial integrity and especially
providing economic development by attracting huge amounts of foreign investment.
Azerbaijan is one of the world’s oldest oil producers and the city of Baku and the Absheron
Peninsula have long been known as historic sites for oil. The first oil well in the world was
drilled in Absheron, Bibiheybat in 1847 using a primitive percussion drilling mechanism. It was
not until eleven years later that the first oil well in America was drilled in Pennsylvania. The
first oil refinery was also built in Baku in 1878. This refinery was connected to the Balakhani
oil fields via a newly constructed pipeline 12 km long. By the end of the 19th century Baku had
become a centre for world-scale industrial investment. In the time of the Russian Empire, Baku
was the main oil provider, providing 97.7 % of Russia’s oil in 1890 and half the world’s output
in 1901. In World War II, during the Soviet era, Azerbaijan supplied 23.5 million (hereafter,
mln) tons in 1941, and accounted for approximately 75% of the total oil output of the former
Soviet Union. However, oil production subsequently declined sharply to 39.15% in 1950, 5.7%
in 1970 and 2.4% in 1980 (Nasibli, 1998).
Following its independence from the Soviet Union in 1991, Azerbaijan experienced an
economic recession, resulting in a decline in oil production from 20 mln tons in 1970 to 10 mln
tons in 1995 due to conflict with Armenia over Nagorno-Karabakh, outdated technology, poor
planning and lack of investment in new drilling and rehabilitation of existing wells (Energy
Information Administration, 1995). However, a successful oil and gas strategy implemented by
the Azerbaijan government with the signing of the "Contract of the Century” in 1994 followed
by a deal on the Shah Deniz gas field in 1996 led to an extraordinary amount of international
investment flowing into the oil and gas sector. Azerbaijan has received $ 60 billion in foreign
investment in its oil and gas sector over the past 16 years (Azernews, 2010). The country’s oil
and gas revenues are expected to reach $200 billion by 2024.
Another important event took place in 2006 with the construction of the giant Baku –Tbilisi –
Ceyhan (BTC) pipeline for transporting oil from Baku to western markets via the cities of
Tbilisi and Ceyhan. This project practically put an end to the Russian monopoly on
transportation of energy resources from the Caspian Sea.
This paper sets out to review recent development trends in Azerbaijan’s oil and gas sector.
Section 2 presents business climate and Section 3 describes an impact of oil and gas sector on
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the country’s economy and role of State Oil Fund (SOFAZ), Section 4 summarises the
country’s prospects for energy production and Section 5 analyses the type of oil contract known
as a Production Sharing Agreement (hereafter, PSA), adapted to suit the Azerbaijan model.
Section 6 outlines the government policy on oil and gas investment, and challenges related
sector; the legal status of the Caspian Sea. Section 7 sets out some conclusions.
2. Business Climate
Azerbaijan declared its independence from the former Soviet Union in 1991. The
country is confronting both significant prospects and challenges in its transition to a free
market economy. In recent years, Azerbaijan has implemented a successful strategy of
developing its oil and gas sector as the main driver of the economy. Despite
development of the oil sector, the non oil sector of the economy remains undeveloped
and very fragile with significant obstacles to both domestic and foreign investment.
According to IFC/World Bank 2011, Azerbaijan has made notable improvements in
business and labor freedom, and its economy continues to improve and undergo
transformation and restructuring. Azerbaijan is listed as the top global reformer in the
Doing Business report (2009-11) with major improvements in seven out of ten
indicators of business environment reform, mainly in doing business, starting a
business, employing workers, registering property and protecting investors. Azerbaijan
has moved a long way up the global rankings, from 97th place to 33rd in 2009 and 54th
in 2011 in overall ease of doing business, but corruption, access to finance and tax rates
remain as major constraints to doing business there (Enterprise Survey, 2009).
The main obstacle to investment is the high level corruption in the country. This legacy
of corruption dates back to Soviet times and currently the huge injections of money
injections from the oil and gas sector are considered as the greatest sources of
corruption there. In recent years the government has established a state commission on
anti-corruption measures, e.g. legislation has been introduced requiring public officials
to disclose their assets on an annual basis. However, bureaucratic control often hinders
the application of the law and regulations. Laws and decrees are usually adopted by the
government but their implementation is often delayed. Compared to the 1990s, the level
of corruption in the country has improved slightly but Azerbaijan still ranked 134th out
of 180 countries in 2010 in the Transparency Initiatives Corruption Index (2011).
Recently the Azerbaijan Government has started a massive anti-corruption campaign,
but it is still open to debate whether this campaign is a long term policy or a short-term
4
measure. However these efforts may raise hopes for an improvement in the country’s
business and development climate (Rosenblum,2011).
Access to finance and tax rates other major challenges that entrepreneurs face in
Azerbaijan: three out of four entrepreneurs experience difficulties while seeking
financing. The limited availability of credit funding, restrictive conditions, high interest
rates and expensive processing of payments make loans unattractive for entrepreneurs.
Lack of financing to invest in new technologies and equipment makes local
entrepreneurs less competitive in quality terms than international suppliers. According
to the 2009 Doing Business report, Azerbaijan ranks 102nd of 178 economies in the ease
of paying taxes. This survey reveals that tax administration is still a burden and is
ranked fifth out of the six most difficult regulatory issues in Azerbaijan. Firms operating
in the formal economy face high tax rates and cumbersome tax administration
procedures in the standard tax regime as their businesses grow. Compliance with the tax
system – preparing and filing numerous tax reports and making tax payments – is time
consuming and expensive.
3. Impact of Oil and Gas sector on Economy
The switch from a state-run to a capitalist economy and the Nagorno-Karabakh conflict led to a
collapse in trade and a decline in economic output of more than 60% between 1989 and 1995.
Trade among the former Soviet countries failed and led to a decline in GDP and to high
inflation. The country’s GDP fell by almost 60%; agriculture by about 43% and industrial
output by about 60% from 1989 to 1994 (International Monetary Fund, 1994). However, since
political stability was regained, thanks to oil contracts signed between the Azerbaijan
government and Azerbaijan International Operating Company3 (hereafter, AIOC), Azerbaijan’s
economy has shown significant economic growth over the past decade.
From 2001 to 2009 as Azerbaijan started to seriously develop its oil and gas sector,
GDP growth averaged 16% a year due to strong investment in this sector. Strong oil and
gas production gains, high international oil prices and sharply higher public spending
propelled growth to an average of 27% a year between 2003 and 2009. Oil revenues even
increased more than predicted due to the spike in oil prices on world markets between 2005 and
2008, leading the country’s currency reserves to reach 18 billion USD by the end of 2008—
twice its foreign debt. The oil sector accounted for 42 % of value added (of GDP), 90.7 %
3 A group currently numbering 10 oil companies (BP, SOCAR, Chevron, TPAO, Statoil , Devon Energy, Amerada Hess, ExxonMobil, Inpex, Itochu) that have signed extraction contracts with Azerbaijan
5
of total gross exports and 83.9 % of total foreign investment in 2009 (See Table 1).
Foreign direct investment, particularly in hydrocarbons, and public investment remain
important contributors to growth, and the share of GDP captured by higher public
investment was around 21% of GDP in 2009. However, foreign investment is expected
to decline over time as the major oil and gas projects move toward less intensive stages.
Indeed, they fell to just 6% of GDP in 2009 .
Table 1: The oil and gas sector in Azerbaijan, 2003-2009
Despite development of the oil sector, the non oil sector of the economy remains undeveloped
and very fragile. In 1995 agriculture accounted for 35% of value added (of GDP) and industry
26 %, but since the country began to export huge amounts of gas and oil industry, especially the
oil industry, has grown rapidly, and by 2009 it accounted for 70%of value added (of GDP). In
2010 non oil industries accounted for only 8%, while agriculture performed poorly at 2.2% in
2010 (World Bank Indicators, 1995-2010). Current estimates indicate that the oil and gas
industries are only responsible for a little over 1% of employment in Azerbaijan, while
agriculture employs nearly 50% of the country.
Large oil revenues allowed the government to achieve success in reducing poverty
through continuously increasing in the minimum salaries and pensions under social
transfer programs from SOFAZ, indicated by a drop in the poverty rate from 27% to
4 Extraction of crude oil and gas + refined petroleum products 5 International Monetary Fund 6 The State Statistics Committee of the Republic of Azerbaijan 7 Central Bank of Azerbaijan
6
just 2 % today. Although social transfer measures have reduced the number of people
below the poverty line, they do not automatically lead to sustainable poverty reduction,
as oil revenues capture 70% of state budget expenditures and such measures are
effective for a short-term period. Therefore, it is important to maintain the sustainability
of this process while oil-gas revenues are expected to decrease in the long term. The
government is aware that the current observed growth rate is temporary as oil output
will start to decrease in 15-20 years' time and the country’s economic performance will
have to be supported by growth of the non-oil sector in the future, so the economy must
be diversified. Economic diversification will reduce not only Azerbaijan’s dependence
on the oil sector but also its resulting vulnerability to adverse international oil price
fluctuations.
As transfers from SOFAZ are an important source of public revenues, and encouraging
economic diversification by financing infrastructure projects is one of the important
objectives of SOFAZ. This has a very important role to play here.
State Oil Fund (SOFAZ):
In fact the non-oil economy is mainly driven by state expenditures through transfers
from SOFAZ, and its share of GDP is falling as those transfers increase. According to
the Center for Economic and Social Development (CESD), although the assets of
SOFAZ total 30.2bn US dollars (as of July, 2011), oil dependency has increased greatly
in Azerbaijan in 2011. The share of the oil sector in the state budget has reached 78 %
and it accounts for 65 % of GDP, with more than 92 % of exports taking the form of oil
and oil products. With the approval of the amendments in the state budget in May,
2011, $ 12.1 billion will be transferred from the Oil Fund to the state budget in 2011
alone, which is a 41.7 percent increase on the previous forecast and represents 59
percent of total budget revenues.
SOFAZ was created in 1999 to guarantee the saving and effective use of oil revenues.
The Fund is a legal entity with an independent administrative structure and reports
directly to the President of Azerbaijan. Its main goal is to ensure collection and proper
management of revenue flows from oil and gas PSAs.
The Fund has operational features similar to other funds across the world to guarantee
its savings and stabilization responsibilities; however it was structured with more
weight on savings than stabilization. According to Kuralbayeva et al(2010), a paper
based on a comparative analysis of the oil sectors in Azerbaijan and Kazakhstan,
7
Azerbaijan started to consume its revenues too much too soon between 2001 and 2007,
although more recently it took steps that led to a large increase in savings in 2008 and
2009. The outflows have been allocated to the financing of public investment by the
government, however private sector investment remains low and increasing it is a
priority.
According to revenue rules, all revenue flows from PSAs go directly to SOFAZ with
the exception of taxes paid by foreign oil companies and SOCAR, which go directly to
the state budget. SOFAZ’s expenditure policy does not assume any limit on
expenditures from the oil fund. However, the articles of association of the fund state
that withdrawals from the fund in one year cannot exceed inflows obtained in that year.
The operations of the fund are under control of the president and parliament has also the
power to approve or disapprove transfers from the fund to the state budget. Transfers
from SOFAZ are determined through a discretionary process within the budget
framework. The funds are actually spent mostly on covering the budget deficit, though
there can also be special expenditures determined by presidential decree. The following
table shows SOFAZ’s asset trends, transfers and revenue sources between 2005 and
2009.
Table 2: SOFAZ’s asset trends, transfers and revenue sources.
(Millions of dollars) 2005 2006 2007 2008 2009
Revenues: Sale of oil and gas
662.00
1,116.0
2,159.92
13,960.18
9,444.96
Management of fund assets 32.40 67.14 86.75 325.41 367.33
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