How Azerbaijan’s Oil Boom – and Impending Bust – Affects Armenia

In November of 1997, Armenia’s Foreign Minister Alexander Arzoumanian cited the limitless wealth and influence awaiting Azerbaijan from its oil industry as the reason the Armenian government was preparing to agree to the highly controversial 1998 Karabakh settlement.

Since then, Azerbaijan’s economy – driven by its energy sector – has grown at an unparalleled rate, with gross domestic product (GDP) rising from $7.3 billion in 2003 to $73.5 billion in 2013. This economic growth has resulted in a surging military budget that has made Azerbaijan increasingly aggressive in its policy toward Armenia over its unequivocal position that it guarantees the security of the Artsakh Republic (also known as the Nagorno Karabakh Republic.) In that vein, Ilham Aliyev, Azerbaijan’s dictator, has threatened war with Armenia several times, most recently in a Twitter tirade.

In the wake of Azerbaijan’s belligerent posturing, and despite massive shortcomings in Armenia’s budget by comparison, the Armenian government has had to dedicate a significant amount of its resources to security and, forced into an arms race by its neighbor, has become one of the world’s most militarized nations. This, of course, has come with a fair share of political and societal sacrifice for the country. For one, money that would be available for investing in education, industry, and infrastructure – elements that would stimulate and grow Armenia’s economy – is instead being used for the country’s defense and military. And, perhaps more importantly, Armenia’s ability to maneuver its relationship with Russia has been limited given its heavy, almost exclusive, dependence on Russian arms sales.

Years ago, the military and economic picture was reversed. Immediately following the Nagorno-Karabakh War (1988-1994), Armenia’s economy was the first in the region to reach pre-independence GDP levels. Being the first nation to reach a positive GDP growth rate in the South Caucasus, Armenia’s economy was outperforming that of Azerbaijan and Georgia. This economic superiority meant there was more balance between the military budgets of Armenia and Azerbaijan. Combined with the fact that Azerbaijan’s military had been devastated in the recent war, with a significant portion of its military hardware destroyed or lost, the country did not pose a serious threat to Armenia. That more comfortable status also meant that Armenia was not as dependent on Russian military support – a vulnerability that the government is well aware of today.

However, at the turn of the 21st century, as Azerbaijan began earning revenues from its energy sector, circumstances began to change. From 2001 to 2009, Azerbaijan’s annual GDP growth rate averaged 16 percent, with a peak of 35 percent in 2006 – the highest in the world for that year. The economic growth led to a ballooning state budget, with a corresponding increase in the military budget, and transformed an otherwise disorganized, corrupt, and incompetent military into a force that, if not any more organized, upright, or competent, is fantastically armed to the teeth.

The implications for Armenia have been substantial: Armenia now relies on Russia’s support more than ever, leaning on its discounted military weapons and hardware, understanding that, without them, the military balance would favor Azerbaijan, putting Artsakh and the rest of Armenia at risk. But Russia isn’t picking sides: the country has also sold advanced weapons to Azerbaijan. This may ultimately be Russia’s goal, as it prevents either Armenia or Azerbaijan from growing powerful enough to expel Russian influence from the region.

Today, Azerbaijan’s economic growth has slowed following the peak of oil production in 2010 – but declining oil production hasn’t directly translated into a decline of the national economy.

To understand the future of the energy sector and the overall economy in Azerbaijan, the energy sector in the region should be divided into three key components: the oil industry, the natural gas industry, and the SOFAZ sovereign wealth fund of Azerbaijan. It is only when these three elements are analyzed separately that we begin to understand the complexities within the region and the repercussions for countries like Armenia.

In the past decade, it’s been Azerbaijan’s oil industry that’s been the predominant force driving the region’s economy. Starting with proven reserves of about six to seven billion barrels of oil, Azerbaijan has extracted roughly half of that amount to date. Peak production was reached in 2010, when Azerbaijan averaged a collection of 1.035 million barrels of oil per day. By 2014, this number declined to about 0.86 million barrels per day. And, according to projections made by the Organization of the Petroleum Exporting Countries (OPEC) in December of 2014, oil production is expected to decline to 0.80 million barrels per day in 2015. That would represent a 23 percent decline in five years. This descending pattern is only expected to continue as the Azeri-Chirag-Guneshli complex of oil fields, which accounts for about 80 percent of oil production in the region, reaches the end of its production life. Despite 23 exploration contracts, no new oil fields have been discovered in Azerbaijan since the discovery of the complex before independence, during the 1980s. So, it’s reasonable to assume the unlikelihood of Azerbaijan discovering further significant oil reserves in the near term.

The adverse effects of declining oil production have been compounded due to the recent  decline in oil prices, with the average cost of a barrel of oil at around $50. Considering cost of production for oil is roughly $15 per barrel in Azerbaijan, the profit margin of the oil industry for Azerbaijan is rapidly shrinking. The combination of these unfavorable facts represent a direct threat to Azerbaijan, a country that depends on oil for over 90 percent of its exports and 70 percent of its state budget.

However, the repercussions of this downturn has so far been mitigated by the State Oil Fund of Azerbaijan (SOFAZ.) Established in 1999 by then-president Heydar Aliyev through the recommendation of the International Monetary Fund (IMF) and World Bank, SOFAZ was created to manage the wealth Azerbaijan has accumulated from to its oil and gas profits and preserve it for the future. Namely, Azerbaijan wanted to avoid Dutch Disease, the economic phenomenon of negative backlash arising from unexpected increases in a nation’s economy. To date, SOFAZ has collected more than $110 billion, investing most of it internally on a yearly basis as part of the state budget.

These investments and the employment opportunities they produce constitute a majority of Azerbaijan’s “non-oil” economic sector. The construction industry, powered by SOFAZ projects, is the second-largest enterprise of Azerbaijan’s economy, following the energy sector. Some investments from the State Oil Fund also go to more extravagant projects that offer little long-term economic returns, like the inaugural European Olympic Games, which will be held in Azerbaijan this summer and has cost the nation $8 billion, but which raise the profile of the country. This hasn’t always proved to be a winning strategy for the country: In 2012, Azerbaijan hosted the Eurovision Song Contest and was subject to calls of boycott after a light was shone by international journalists on its feverishly covered-up human rights abuses.

However, not all of the $110 billion-plus in revenue from the State Oil Fund has been spent. As of the end of 2014, the Azerbaijani government stated that about $37 billion has been preserved for the transitional period of lower oil production and thus, lower profits. This is why the recent decline in oil production has yet to translate into a decline in government revenue or gross domestic product; during its peak years of production, Azerbaijan was only spending a portion of its oil revenue while saving the rest. So, even though the SOFAZ revenue has been gradually shrinking since 2010, it has so far been sufficient enough to maintain the country’s spending levels. As long as there is reserves remaining in the fund, Azerbaijan’s overall budget is not expected to drastically decline.

This is why, despite the alarming level of price and production decline, Azerbaijan was expected to have a stable budget and continued – albeit much smaller – GDP growth in 2015. That’s because regardless of the total revenues received, SOFAZ is expected to contribute $13.2 billion, or 53.4 percent, to the state budget. This trend will continue until the sovereign wealth fund has been exhausted, at which point the negative effects of oil production decline will become more profoundly felt.

It must be noted, however, that simply having a sovereign wealth fund does not solve all problems, even for the short term. For example, despite Azerbaijan’s $37 billion sovereign wealth fund, and $12 billion foreign reserve fund, the country’s currency was under heavy pressure because of the economic volatility in the region and fall of oil prices. Azerbaijan spent roughly $2 billion from December 2014 to January 2015 in defending its currency, before capitulating in mid-February and dramatically devaluing its currency by 33.5 percent against the dollar. In addition to fueling panic and creating loss of faith in the currency, this action is bound to introduce a notable rate of inflation in the coming months.

You’re probably wondering how long it will take before SOFAZ runs out of money. During its staff visit to Azerbaijan in October of 2014, the International Monetary Fund (IMF) predicted that Azerbaijan should expect a decline of $5.5 billion, or 14 percent, to its fund in 2015. That means the fund would be at $32.8 billion at the end of this year, while ending the previous year at $38.3 billion. This would represent the first annual decline in the fund.

Even those predictions now seem too optimistic with a further drop in the price of oil. In the two months following the publication of that report, SOFAZ received $1.2 billion less than what was predicted. This trend has continued in the past two months. In January and February of this year, Azerbaijan’s income from oil was $760 million and $810 million, respectively. Those numbers represent roughly 45 percent of the $1.76 billion in revenue Azerbaijan received last June, before the fall of the price of oil.

Moreover, major energy companies like ExxonMobil and BP have predicted that current prices for oil will stay low in the immediate future. In fact, Exxon has assumed a price of $55 a barrel for 2017, which is roughly the price of Brent Crude oil today.

Though such projections are not always accurate, and external and regional factors contribute to the equation as well, it’s reasonable to project that with declining production, high spending levels, and limited economic diversification, Azerbaijan will have exhausted its sovereign wealth fund before the end of this decade.

The Azerbaijani government, however, maintains that the temporary financial relief from SOFAZ is enough to sustain a stable economy until its rising gas industry takes off. This is what Azerbaijan is counting on to continue to maintain its economy. Because investment in gas requires a longer stage of infrastructural development, the gas industry in the region has developed more slowly than oil. When the Shah Deniz Pipeline finally began delivering gas in late 2006, Azerbaijan experienced a surge in its gas production and became a net gas exporter for the first time. Since then, gas production has stayed at a roughly consistent rate. According to the State Statistics Committee, Azerbaijan planned to produce 28.8 billion cubic meters of natural gas in 2014. This number is expected to grow slightly to 30.2 billion cubic meters in 2018. Then, when Stage 2 of the Shah Deniz II pipeline begins delivery in 2019, another surge is expected. Ultimately, with all its upcoming developments in the gas sector, Azerbaijan expects to produce up to 40 billion cubic meters of natural gas by 2020 and hopes that the industry will soon replace oil as its primary source of income.

But there are a few factors that the Azerbaijani government has failed to mention in its public statements. For one, Azerbaijan has been earning nearly $100 per barrel of oil compared to about $50 per thousand cubic meters of gas. So, even the most optimistic projections would put Azerbaijan’s future gas revenue at a small fraction compared to the region’s oil revenue. Moreover, the price of natural gas roughly mirrors the price of crude oil, and as such has dropped by roughly 30 percent in the past few months. Therefore, if the price of oil continues at current levels as predicted, the price and revenue from natural gas will also suffer in the coming years. Moreover, considering that a great portion of the non-oil economic sector is fueled by short-term projects through investments by SOFAZ, it seems implausible for that sector to be sustainable, let alone continue to grow, once the oil revenue and wealth fund have severely diminished. Therefore, in spite of hopeful government projections, it’s logical to conclude that gas revenue and other economic sectors will not become significant enough to change the realities of the vast decline of oil production and the depletion of the SOFAZ fund.

These three factors – oil, natural gas, and SOFAZ – shape Azerbaijan’s energy sector and ultimately uphold its economy and regime. And it’s these factors that we must understand if we aim to predict the seemingly unpredictable behavior of the Azerbaijani government and designate a sound course of action for Armenia.

The entire Azerbaijani political structure has been based around a power- and wealth- sharing system between various influential families, with the Aliyev clan at the top. Though Azerbaijan has tried to avoid Dutch disease through the establishment of SOFAZ, the Aliyev clan and its friends have gone on ridiculous spending sprees around the world, undoubtedly lessening the funds available for the rainy days when the oil runs out. This corrupt political system has functioned thus far because, for the average citizen, the benefits from consistent national economic growth outweigh the negatives of corruption and the widening gap between the wealthy and poor. But, as the economy inevitably staggers in the coming years with a decrease in government investment, popular unrest will undoubtedly rise and threaten the reign of the Aliyev regime. For Aliyev, the only opportunity to silence the opposition would be to unite all of Azerbaijanis and pit them against their external foe: Armenia.

It is this unstable situation, more so than the recent economic boom in Azerbaijan, that Armenians should fear most in terms of a military conflict. At that point, regardless of its economic capabilities, Azerbaijan will be at the peak of its military capability due to the arsenal it will have amassed in the preceding years. Aliyev, with his grip on power slipping, will have little to lose and the region will be in prime position for war. It’s crucial for Armenia to be militarily prepared for this possibility, whether it’s discouraging Azerbaijan from launching a war in the first place or ending the fight quickly and on its own terms if it does begin.

These political realities dictate the course of Armenia’s policies – namely, its current prioritization of military preparedness and military spending over investment in other sectors. They are based on the assertion that war may be imminent and that all possible steps must be taken to be prepared. More importantly, they are based on the understanding that Armenia’s current dependence on Russia for military support is a temporary factor in a dynamic situation – that if Armenia is able to avoid a war with Azerbaijan in the next five years, it will likely be dealing with a significantly weakened Azerbaijan wrought with internal problems. Only then will Armenia be able to pursue a foreign policy not hamstrung by existential defense considerations and, at last, prioritize its economic growth.