Chapter 4. The Oil Sector in Azerbaijan

Niko Hobdari, Eric Le Borgne, Chonira Aturupane, Koba Gvenetadze, John Wakeman-Linn, and Stephan Danninger
Published Date:
April 2004
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Azerbaijan has a rich natural resource endowment and a long history of oil and gas exploration. Oil and gas reserves in the country are estimated to be the third largest in the Caspian region.1 Oil production peaked in 1941 at 172 million barrels of oil, or almost 75 percent of the output of the Soviet Union. Production then declined steadily, dropping off sharply in the final years of the Soviet Union. Only in the late 1990s did discoveries of new oil and gas reserves lead to a turnaround in output, driven primarily by foreign investment from international partners.

The management of the oil sector falls into two categories. Soviet-era oil and gas fields are operated by the state oil company (SOCAR) with weak prospects for a further expansion of production. Current production levels of the Soviet-era oil and gas fields are at around 177,000 barrels of oil per day (bpd) and 4.4 billion cubic meter of gas. Most new oil and gas fields are developed and managed under the leadership of international partners. Income from these operations is shared with the government according to predetermined production-sharing agreements (PSAs).

Azerbaijan has signed a number of PSAs for the exploration and development of the country’s hydrocarbon resources. In 1994, the government signed its first foreign-partnered PSA, popularly referred to as the “Contract of the Century,” with an international consortium, the Azerbaijan International Operating Company (AIOC), to develop the Azeri-Chirag-Guneshli (ACG) oil fields in the Azerbaijan sector of the Caspian Sea. In addition, 21 other PSAs have been signed and ratified since then for the exploration and development of the country’s onshore and offshore hydrocarbon reserves.

Despite some significant oil and gas discoveries, most PSAs have yet to find commercially viable oil or gas deposits. In 1999, potential recoverable natural gas resources in excess of 14 trillion cubic feet were confirmed in the Shah Deniz field, reportedly the largest natural gas discovery since 1978 for British Petroleum.2 In 2002, total oil reserves in the ACG fields were determined to be higher than previously anticipated, at 5.4 billion barrels. Current production stands at around 130,000 bpd, with peak production of slightly over a million bpd anticipated at the turn of the decade from the ACG oil fields. The recently initiated pipeline project from Baku to Ceyhan has greatly enhanced these prospects. However, the success of the other 20 PSAs has been limited. A few PSAs have been abandoned due to the lack of commercially viable oil deposits. To date, only one other PSA (Salyan Oil Consortium) is in the production stage, with 8.2 thousand tons of oil exports in the first quarter of 2003, while some others are under discussion for abandonment.

A. Current Institutional Arrangements for Managing Oil Revenues

The separate operational structures for old and new fields have led to a division in the management of oil and gas revenue. Figure 1 summarizes the government’s main oil revenue sources and the two government bodies—the state budget and the State Oil Fund—involved in the management of oil and gas revenues. The consolidated government receives profit oil and income tax from the development of new fields, as spelled out in the PSAs with international partners. The profit oil component of these flows accrues to the State Oil Fund while the income tax (personal and profit tax) component flows to the state budget.3 The old fields, operated by SOCAR, generate income tax revenue, which is paid to the state budget.

Figure 1.Sources of Oil and Gas Revenue in Azerbaijan

Source: Azerbaijani authorities and IMF staff.

The State Oil Fund (SOFAZ) is the key institution for the management of oil wealth in Azerbaijan (Box 1). It was established in 1999 as an extrabudgetary fund in order to ensure transparency in the management of oil revenue and to curtail the use of assets. Its main purpose is to save funds for future generations, but assets are also used for investment projects. As of end-March 2003, SOFAZ’s total assets amounted to US$727 million.

Significant additional oil revenue accrues to the state budget primarily from SOCAR tax payments. In 2002, oil- and gas-related revenues of the state budget were US$340 million, about US$100 million higher than receipts of SOFAZ. However, as SOCAR’s production declines over time and new fields are developed, inflows to the oil fund will dwarf state budget revenue as early as 2006 (see discussion below). Unifying the government’s management functions for oil revenue should be an important consideration in view of the challenges arising from the expected oil boom, as discussed below.

Box 1.State Oil Fund of the Azerbaijan Republic

The State Oil Fund of the Republic of Azerbaijan (SOFAZ) was established in 1999 as an extrabudgetary institution. Its main objective is the professional management of oil- and gas-related revenues for the benefit of the country and its future generations—i.e., savings. The inflow and outflow rules of Azerbaijan’s oil fund have been designed to reflect this feature and to save a large part of government oil and gas revenue. SOFAZ receives all government revenues associated with the post-Soviet oil and gas production fields. The oil fund has no immediate stabilization objective and net flows are not related to the oil price level or a budgetary position. On the outflow side, Azerbaijan’s oil fund rules currently prohibit spending in excess of inflows in any given year. A conservative expenditure policy has ensured a steady growth of savings in the fund. Asset management regulations require that financial assets be kept offshore at highly rated banks. The fund is not permitted to extend credits to private or state organizations and assets cannot be used as a guarantee against any obligation.

In order to reduce political pressures to spend windfall oil revenues rapidly, the government established the oil fund under direct presidential control. The members of SOFAZ’s supervisory board are appointed by the President of Azerbaijan. An independent auditor conducts an annual audit of the fund, and the audit report is made public. SOFAZ reports quarterly in the press on total inflows received, expenditures, and interest earned. To strengthen the legislative foundation of SOFAZ, its budget and asset management rules were approved by Parliament in June 2003 as amendments to the Budget System Law. The creation of an oil fund in Azerbaijan has had a positive impact on fiscal discipline and contributed to better transparency and accountability of oil revenue management.

B. Prospects for Government Oil and Gas Revenues

Substantial, but short-lived, revenues associated with the development of the oil and gas fields are expected to accrue to the country from (1) profit oil and profit gas according to the terms of the ACG and Shah Deniz PSAs, (2) profit tax payments from partners under the PSAs, and (3) SOCAR tax payments. Figure 2 presents the accumulation of natural resource revenue from the three sources for different production scenarios. Projections for SOCAR revenue are based on a slightly declining output profile consistent with current production expectations. Profit tax and SOFAZ inflows of profit oil and profit gas associated with the development of the ACG and Shah Deniz oil and gas fields are calculated under three oil production profiles consistent with proven, probable, and possible oil reserve4 estimates for the period 2000–25.

Figure 2.Azerbaijan Oil and Gas Revenues, 2000-251

(In millions of U.S. dollars)

Sources: Azerbaijan International Operating Company and IMF staff estimates.

1Based on June 2003 World Economic Outlook oil and gas price assumptions and excluding asset management revenue.

The profile of Shah Deniz gas production is the same for all three oil production profiles and is consistent with the Shah Deniz Stage 1 production profile and associated sales agreements for the time period.5 All three scenarios use World Economic Outlook (WEO) oil and gas price assumptions as of end-June 2003. Under the conservative proven reserves scenario, substantial oil- and gas-related revenues are expected to accrue, with revenues increasing more than sevenfold during the period 2000–13. However, this sizable increase in revenues is short-lived, as following the peak in 2013, inflows to SOFAZ decline fairly rapidly. ACG PSA-related oil revenues are expected to end after 2024, following the depletion of the ACG oil reserves, absent a significant new hydrocarbon discovery.

Even under more conservative price assumptions the expected revenue stream is large. Figure 3 presents the same three production scenarios, but assumes a fixed US$20 per barrel oil price and gas price assumptions more conservative than WEO’s. Under these more conservative assumptions, oil- and gas-related revenues are still expected to increase almost sixfold during the period 2000–13 in the proven reserves volume scenario. As these charts indicate, even under a wide range of production profiles and different oil and gas price assumptions, a similar pattern of oil and gas revenue receipts emerges: an accrual of substantial revenues during a relatively short period of time.

Figure 3.Azerbaijan Oil and Gas Revenues Under Conservative Price Assumptions, 2000-251

(In millions of U.S. dollars)

Sources: Azerbaijan International Operating Company and IMF staff estimates.

1Based on a fixed US$20/barrel oil price assumption, gas price assumptions more conservative than World Economic Outlook and excluding asset management revenue.

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