The Coronavirus pandemic has affected almost every sector of the global economy in the first five months of 2020. To add insult to injury, the economy of Azerbaijan has been further pressured by the historically low oil prices. In this post, I decided to take a brief look at the oil sector of Azerbaijan today and its potential implications for us in the near future.
The grave situation of the oil sector in 2020 is no news for anyone, with the BRENT crude oil prices averaging at 23.34 USD during April. The underlying reason behind the situation is significant collapse of the economic activities worldwide, which exerted a negative pressure on oil demand as the energy consumption crippled. Another factor why the prices fell as significantly was the inability of OPEC+ members to reach an agreement on March 6th, which resulted in major oil producing countries to extract as much as crude oil as they please. Over the course of January – April 2020, BRENT lost 63% of its value in international markets.
Yet the events took a positive turn for oil producers in April when the members of OPEC+ agreed to cut oil production by 9.7 million barrels a day in May/June. This is by far the largest cut made by the coalition. The deal also provisions that after June 2020 the cuts will continue to exist, albeit at a lower degree, until the April of 2022. As a corollary of the deal, the BRENT oil price steadily heightened, averaging 31 USD per barrel in May and reaching as much as 42 USD in early June. Motivated by the success of the deal, the OPEC+ coalition extended the first phase cuts (initially only intended by May/June) by an additional one month.
As part of the OPEC+ coalition, Azerbaijan also agreed to production quotas. The country needs to cut its daily oil production by 164 thousand barrels per day (from its level on October 2018, which was 718 thousand barrels per day) in line with the agreement during the May – July period. That means, when compared to the first 4 months of 2020, Azerbaijan will have to decrease its oil production by 18.2% until the end of July, and after that it will be allowed to produce additional 33 thousand barrels of oil (phase 2) until January of 2021. The 3rd phase of the agreement, which will run from January 2021 until April 2022 caps Azerbaijan’s daily oil production at 620 thousand barrels per day, which is 8% lower than the average production of early 2020. In the table and graph below, you can see the implications of this deal for Azerbaijan:
Table 1: The obligations of Azerbaijan under the OPEC+ deal
|Covered Period||Daily Production Limit||Relative Cut|
|May – July 2020||554,000 barrels||18.2%|
|Phase 2||June 2020 – January 2021||587,000 barrels||
|Phase 3||January 2021 – April 2020||620,000 barrels||
Source: Ministry of Energy of Azerbaijan
Graph 1: The obligations of Azerbaijan under the OPEC+ deal
Source: Ministry of Energy of Azerbaijan
Now the reason why I am going into the details of this deal is simple. Whilst looking merely at the price of oil one can become optimistic about the short-term outlook of the oil sector of Azerbaijan and henceforth expect no pressure on the state budget for the fiscal year of 2020. Yet the reality is far from that. Yes, the price of oil is rising, but we should not ignore the fact that it is rising at the cost of less oil production. Thus, we need to look at this situation as a trade-off, on the one side Azerbaijan is gaining from the higher oil prices, on the other side, we are losing from lower production. Additionally, we also need to consider the effect of the extremely low oil prices for the past 3 months if we wish to assess the situation of the state budget. Then two natural questions arise. Firstly, does the benefit of the OPEC+ deal surpass its cost for Azerbaijan’s oil sector? And secondly, how much should the average price of oil be for the rest of the year in order to avoid a significant budgetary deficit?
The first question is easy to answer: yes, the deal is quite beneficiary for Azerbaijan. My calculations indicate that as soon as the average price of BRENT crude oil surpass 27.6 USD per barrel, the net gain of Azerbaijan from the deal is positive. Considering that the average price of BRENT was 31 USD during May, we can say that so far, the deal has been working well for us and the other oil producing countries.
The second question is a little more complex to answer. We know that whilst drafting the state budget of 2020, the officials took the base price of a barrel of oil at 55 USD (this value is given as “Exp. Price” in the formula below). Based on the dynamics of monthly oil production of 2019 and the OPEC+ agreement from December 2018, we can also say that the expected average production of crude oil for 2020 was around 680,000 barrels per day (Exp. Production). We therefore know the expected price, and expected quantity of production, according to the state budget legislation for the year of 2020.
On the other hand, we also know the actual price for the first 5 months of the year. Additionally, thanks to the OPEC+ deal, we can easily predict the daily oil production of Azerbaijan for the whole year of 2020. Thus, using all of these variables given to us, we can simply calculate the average price of BRENT crude oil for the June – December period in which the actual revenues of the state budget would be as much as the expected revenues envisioned in the state budget legislation. To put it into an equation:
where “t” represents the months of the year starting from January (t = 1) till December (t = 12).
Note that the only variable here that we do not know is the Price of oil during June – December. Solving the equation for that variable yield us the result of 77.5 USD.
That number is the exact average price of oil for the June – December period in which the state budget of Azerbaijan’s revenues from the oil sector would be in line with the budgetary legislation of 2020. Simply put, if for the next 7 months the price of BRENT crude oil averages around 77.5 USD per barrel, then Azerbaijan state budget’s oil revenues will be the same as the officials have anticipated back in 2019 November. If the average price of oil is any lower than that, then the state budget will face a bigger deficit than expected.
When one also takes into account that due to the pandemic the non-oil revenues are also bound to shrink, unless the oil prices do not jump significantly hike these months, then the outlook for the state budget looks rather grim. The government can offset this shock by selling certain assets of the State Oil Fund (SOFAZ) and transferring the cash amount to the budget (after exchanging them in currency auctions, of course) but in that case, the future of SOFAZ, an already disoriented Sovereign Wealth Fund, would look depressing, mainly due to two reasons: (a) the Fund is likely to take the burden of the additional costs of the state budget during the pandemic, hence face higher expenditures than it has expected and (b) SOFAZ is not only losing revenue because of the historically low oil prices, but also from its investments abroad and hence will face far lower levels of revenue than it has anticipated. I will dedicate a separate post to the situation of SOFAZ once the report of the second quarter is released next month.
The agreement of the OPEC+ countries have certainly benefited the oil producers, including Azerbaijan. For the moment, the benefits from higher price far outweighs the costs related to the lower production. However, the fiscal situation of the state budget is still troubled. My calculations indicate that in order to receive as much revenue from the oil sector as expected in November 2019 (when the state budget of 2020 was prepared), the average price of BRENT crude oil for June – December period should be 77.5 USD. Since such a scenario remains unlikely, we can expect the government to go forward with the sale of certain SOFAZ assets not only for transferring the amount in legislation, but also to potentially cover the additional deficit of the budget during the epidemic. The only potential alternative is financing the deficit thru external borrowing, which simply means shifting today’s burden of SOFAZ to a later date. At the end of the day, we can say that the Oil Fund will likely be the worst-hit macroeconomic stakeholder in Azerbaijan from the coronavirus epidemic.
 This indicator refers to the relative size of the cut when compared to Azerbaijan’s average oil production during January – April period of 2020
 Please be noted that my calculations are straightforward, in the sense that I assumed that in the absence of the OPEC+ deal, the average monthly price of oil would not change during June – December period, which certainly would not be the actual case as the world economy starts opening up. However, since the economists credit the recent rise of the oil prices primarily to the agreement of OPEC+, I believe that we do not lose much precision by making such an assumption, at least for the months of June – July.
 Also, such an action would mean violating the Fiscal Rule of Azerbaijan. But government can temporarily suspend the Rule due to an extraordinary situation, namely the coronavirus epidemic, and get around the limitations of the Fiscal Rule.