Wednesday, 23 October 2002


Published in Analytical Articles

By Peter Laurens (10/23/2002 issue of the CACI Analyst)

BACKGROUND: Because of its wealth of hydrocarbon resources, Azerbaijan has for over a century been the object of some degree of foreign commercial interest.  However, this foreign interest increased markedly since the reestablishment of the country's political independence a decade ago.  Azerbaijan is now emerging as a focal point for a new initiative, led chiefly by the U.

BACKGROUND: Because of its wealth of hydrocarbon resources, Azerbaijan has for over a century been the object of some degree of foreign commercial interest.  However, this foreign interest increased markedly since the reestablishment of the country's political independence a decade ago.  Azerbaijan is now emerging as a focal point for a new initiative, led chiefly by the U.S. and rooted in geopolitical strategy, to source a greater proportion of fossil fuel imports outside of the volatile Middle East. It is estimated that from 1991-2001, Azerbaijan received more foreign direct investment (FDI) per capita than any other of the former Soviet republics. The total stock of FDI had reached about US$7.9 billion by end-2001. In the last few years, as concrete decisions on pipeline routes had yet to be made, investment flows had fallen considerably from their highs of over US$1 billion in 1997 and 1998.  Flows are now once again approaching these levels. Large-scale foreign investors have targeted the oil and gas sectors, except for Turkish investors, who have invested in construction and services. At present, several projects are poised to move off the drawing board and into reality.  First and foremost is the $10 billion Azeri-Chirag-Guneshli oilfield project, or ACG, phase 1 of which will cost over $3 billion.  The first oil from ACG is expected to flow in early 2005, through the 1,760 kilometer-long Baku-Tbilisi-Ceyhan (BTC) pipeline.  Ground has just been broken, and construction should continue through late 2004.  A consortium of international oil companies will pay for a third of the cost; multilateral agencies and international banks will finance the rest.   The development of another project, the huge offshore Shah Deniz gas field, is expected to parallel that of BTC.

IMPLICATIONS: The commencement of BTC finds the Azerbaijani economy growing at about 9% per annum.  Development of oil and gas is still only at a preliminary level, yet has already had a positive effect on such macroeconomic variables as the balance of payments.  The government's cautious fiscal policy keeps the deficit at about 3-4% of GDP, and foreign exchange reserves are close to $1 billion. In fact, the slight deficit to some degree reflects the government's policy of supporting the non-oil sectors of the economy. Indeed, fears of the "Dutch disease", that oil exports would cause overpricing of the currency, have not yet materialized. However, Azerbaijan now faces a conundrum.  The country is dependent on foreign capital to boost its exports of fossil fuels and supply the state's coffers with enough money to enable it to spend massively on physical and commercial infrastructure. But foreign investors are leery of committing more capital to oil and gas so long as the overall economy remains underdeveloped.  Given the capital required to bring the country to a competitive footing, the total amounts invested are still small.  The local population, many of whom were adversely affected by the turmoil of the first years of independence, have yet to see much material benefit from the structural economic changes that are occurring. Their low purchasing power is one of the chief reasons that private investment in non-oil sectors is growing so slowly. The government's present revenue stream is insufficient to meet the necessary expenditures in the non-oil sectors, and foreign capital must take up the slack.  However, many potential investors perceive the country's bureaucracy, chiefly the tax, customs and regulatory authorities, as corrupt. To this end, the Azerbaijani government has launched new institutional reforms and new programs for privatization and poverty reduction. Because it is concerned over the potential for serious social instability if the benefits of oil development are not forthcoming, the government is likely sincere about improving conditions for foreign investors. Multilateral creditors such as EBRD and the IMF play a very significant role in Azerbaijan, but they are limited in how much funding they can provide. Their role is largely twofold: to provide financing for new projects, often in conjunction with private companies, and to support institution building.  They are a ubiquitous and necessary presence in the transition economies. Nevertheless, much of the needed foreign investment will have to be supplied by private creditors. Most private creditors, in turn, will be from the West and from Turkey.

CONCLUSIONS: The Consortium has now taken final form and has decided on commercial grounds to support the BTC project, so Azerbaijani oil has the potential to be a viable, though limited, supplement to energy from OPEC. However, the major revenues expected from such projects will not begin to come in until 2005, and in the meantime the government faces two very serious issues: to convince skittish foreign creditors that the country's economic trajectory is sound, and to garner enough support among the population to ward off political instability. This includes promoting an investment climate that does not revolve around oil and gas. Azerbaijan lacks expertise in modern commercial practice, and oil has a sorry historical record in building linkages with other economic sectors. The multilaterals, who are so heavily involved in disbursing seed capital and in coordinating syndicate lending with the big foreign private investors, will continue to make clear that continued financing up to the expected revenue windfall in 2005 is conditional upon continued reforms in economic policy. The Azerbaijani government is taking some positive measures. Last year, the State Oil Fund was established, a kind of stabilization fund to draw upon if oil revenue should fall and the government should find it hard to fund projects, especially in the non-oil sectors. Total assets are said to be already in the neighborhood of US$400-500 million, and should expand rapidly as production of hydrocarbons increases. The country's financial system is undergoing serious reform, and fiscal policy continues to be prudent.  A new government investment plan for 2003-2005 is said to be in the final stages of preparation. The economic trends in the country are generally positive, and will become more so if the authorities pay greater heed to the concerns of foreign investors. In the final analysis, the Azerbaijani government alone will have to make the hard decisions.

AUTHOR BIO: Peter G. Laurens is Senior Associate, Fixed Income Credit Analysis at Carlson Investment Management LLC. He holds master's degrees from Columbia University and New York University in International Finance and Business and in Middle Eastern Studies. The opinions expressed in this article are solely his own and do not represent the opinions of these organizations.

Copyright 2001 The Central Asia-Caucasus Analyst. All rights reserved.

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