State Oil Fund of Azerbaijan: Azerbaijan goes the other way (06.01.2009)

Dominic O'Neill

Tuesday, January 06, 2009

Unlike most sovereign wealth funds, the State Oil Fund of Azerbaijan is still growing strongly and looking for more foreign risk. Will the country's experience of the global downturn rob the international capital markets of a new hope? Dominic O'Neill reports from Baku.

AT THE END of the 19th century, Baku, the capital of Azerbaijan, was one of the world's first oil boom towns. Now it is one of the latest. Baku is fast becoming a Moscow by the Caspian: a greed-is-good mentality, a skyline fringed with cranes, black Mercedes cars, swish cafés and Italian designer clothing stores.

Such are the signs of an incipient oil boom. However, Azerbaijan's most recent windfall is not all being frittered away on speculative real estate and consumer goods. The State Oil Fund of Azerbaijan is building the infrastructure to take on a bigger role, more capital, and more risk. It is taking the opposite route to most other sovereign wealth funds.

In the past 12 months, the State Oil Fund (Sofaz), has gone from being a detail to being a force in the country. From January to December 2008, its assets grew from $2.5 billion to more than $11 billion: a quadruple rise of almost a third of the country's GDP. In comparison, Morgan Stanley estimates that sovereign wealth funds' assets globally dropped from $3 trillion to $2.5 trillion during the first 10 months of 2008.

Even after the oil-price crash of the second half of last year, the rise of Sofaz continues. When, in September, the price of oil was about $100 a barrel, the fund was receiving $2.5 billion a month. Even with oil at about $50, the fund still receives $700 million a month. Two years ago, a higher oil price gave it a fraction of this revenue (the fund only had $1.5 billion at the beginning of 2007, for example).

Shahmar Movsumov, the fund's executive director, tellsEuromoney: "There has been a big scale-up in Azerbaijan's oil production and a rise in the government's share of profits from production-sharing agreements with foreign firms." In particular, drilling is intensifying in the 5-billion-barrel Azeri-Chirag-Gunashli oil field, which is run by a consortium lead by BP. In the second quarter of 2008, the state's share of profits from this field rose from 50% to 80%. These profits flow directly into Sofaz.

In 2009, Azerbaijan hopes to bring oil exports through the two-year-old Baku-Tbilisi-Ceyhan pipeline up to 1 million barrels a day. Movsumov says that consequently, once a pre-agreed portion has been transferred to the state budget, if oil prices average $50 a barrel, his fund will have about $20 billion by the end of 2009. Assuming an average oil price of $40, Movsumov says the fund will receive about $200 billion in oil receipts over the next 15 years. Most of this will come over the next four years, when Azerbaijan's oil production is expected to peak.

In past years the fund has saved at least 60% of its annual income. But, the logic goes, even after the oil rush thins to a trickle, an average return of 5% on $100 billion, for example, would still allow an annual transfer to the state budget of $5 billion: $1 billion less than the $6 billion transfer projected for 2009.

"Because we will be able to build up reserves very quickly, we hope we will be able to provide the government with a non-depletable source of return. This is how we see our role increasing. It is a new endowment for the country," says Movsumov.

Such are the dreams of Sofaz.

Rise and fall

Last year bluntly showed how sovereign wealth funds, like empires, may rise and fall, and go through various stages of development on the way.

"The first phase tends to be one of caution and capital preservation; then they get bigger and bolder and invest more in riskier assets," says Drosten Fischer, who follows sovereign wealth funds for consultancy Monitor Group.

Azerbaijan's fund is unusual because it is still in the first of these stages, in part thanks to the political volatility the country went through after its break from the Soviet Union. This delayed the growth of Azerbaijan's oil industry. But Sofaz will soon move into Fischer's second stage. Indeed, the caution of the Oil Fund rewarded it in 2008 with what the executive director expects to be a positive return on capital, although probably lower than the 4.5% return in 2007 (on a currency-basket basis). Most sovereign wealth funds, which have been more risk-hungry, suffered asset drains in 2008 in line with the global markets in which they had invested.

"We have had some hits on our financial corporate debt but because we made huge gains on our government debt, we managed to make a profit in 2008," says Movsumov. In comparison, Norway's sovereign wealth fund, which is also noted for its caution (but unlike Sofaz has an equity portfolio) had a loss of 7.7% in the third quarter of 2008 - its worst result ever.

Monitor's Fischer says: "In 2008, sovereign wealth funds have been reminded that capital can shrink as well as grow. This has caused more of a movement towards the third and final stage of the general development of sovereign wealth funds: less risky assets, and more investment at home."

Unable to become much more conservative, however, and still in its first, most rapid stage of expansion, Azerbaijan is taking a different path. As a long-term investor, the fund's managers think the global financial and economic crisis will provide a good opportunity to begin moving away from fixed-income investment. The logic is that in the relatively short term, an ideal climate will arise in which to move more towards under-priced global equity, real estate, and perhaps private equity and alternatives.

"The Oil Fund was designed to be a buffer for the fiscal side of the government, and that gave us a contingent liability. Now with the significant growth in the fund's assets, this contingent liability is much more remote. This has increased our risk appetite," says Movsumov.

The first prerequisite for this bolder strategy is a larger force of managers, and improvements in logistical support and infrastructure. These were in any case required because of the growth in oil income. Sofaz was expecting a windfall from increases in oil production and the government's share in profits. But none of the inflows in 2008 was outsourced, and 98% of the fund's capital is still managed internally. The proportion of funds managed by third parties decreased in 2008, giving the managers of Sofaz much more to do even without learning how to pick equities and buy real estate.

Since 2006, Sofaz has expanded its staff from 40 to 70, and has also sent its employees around the world to be trained in portfolio management, strategic asset allocation and risk management. But it is still recruiting. Movsumov says: "We are trying to find the brightest and most talented people from across the country."

Transformation

Sofaz is on the lookout for Azerbaijanis educated in western universities in particular. The executive director, who is appointed by presidential decree, did his bachelor's degree in Moscow. Between 2003 and 2004 he took a master's degree from Harvard during a sabbatical from Azerbaijan's central bank.

Such influence has helped the transformation of Sofaz, over the past couple of years, in preparation for a dramatically higher pile of reserves, into an institution much like a Wall Street investment house. It is now organized into front, middle and back offices. It has built a Chinese wall to prevent conflicts of interest, and invested in technology, buying the best available software for portfolio management.

But in terms of its asset allocation, the development of Sofaz away from being little more than an account with the finance ministry or central bank is only just beginning. The fund has monthly investment committees to discuss changes in allocations. So far, the global crisis has prompted the fund to become even more timid.

"Since summer 2007, we decided to take the most cautious stance possible. We decided to cut our exposure to anything that could be risky," says Movsumov.

So whereas the biggest proportion of Sofaz's debt at the beginning of 2008 was in investment-grade financial corporates, by the end of the year, it held most in government agencies such as Fannie Mae in the US and Germany's KfW.

Movsumov tellsEuromoney that agencies are underpriced compared with other government issuance such as treasuries. But since mid-2007, Sofaz itself has increased its holdings of sovereign debt.

Sovereign debt remains the smallest proportion of the investments held by Sofaz. Sofaz has a higher proportion of debt issued by multilateral institutions such as the World Bank than of debt issued directly by sovereigns. At the end of 2008, it held least in US treasuries, which the fund deemed overpriced (indeed, since the second quarter of 2008 most of its entire debt has been from Europe, whereas before most was from the US).

This preference for European agency debt is a sign of increased caution as well as a continuing instinct for returns amid the general dive for cover. But in many ways it is difficult for Sofaz to get more conservative. Indeed, apart from a negligible proportion of less than 1% managed by its external managers, the State Oil Fund has no equity investments. Nor has it ever invested in any kind of structured products or derivatives, and it cannot partake in currency arbitrage.

Sofaz allocates 50% of its capital to dollar-denominated securities, and has 40% in euro, 5% in sterling and 5% in other currencies, which must all be of investment-grade sovereigns. It considers the maintenance of that balance to be a sufficient hedge against currency fluctuations over the long term. It has no investments in real estate or in gold, or in other precious metals or gemstones, because of the severe price volatility of these investments. During the first part of 2008, it even reduced its small investment-grade portfolio from Russia and Kazakhstan to zero. It no longer has any emerging market debt - investment-grade or otherwise.

As one might expect, Sofaz is taking the move into equities, real estate and alternatives with extreme caution, even trepidation.

Conservative change

The plan is ultimately to build an equity portfolio of 15%. Even Norway's fund has around half its holding in equities. But there will be no big bang at Sofaz. The fund will start with just 5% in equities, bringing the allocation, perhaps, to 10% the following year and maybe 15% the year after that.

For new asset classes, the Oil Fund's method is to start by employing reputed third-party managers, which will educate the fund's own staff. It then gradually reduces outsourcing to a minimum. It has done this before, and until the middle of last year it was in discussions with partners to do this again with equity and other asset classes. It stopped the discussions because of the sub-prime crisis.

"Somewhere in the middle of the recession we will start again," says Movsumov. "We are still in the acute stage of the financial crisis and this will be followed by what I think will be a quite prolonged recession."

But is this extreme caution in some ways a sign that the dreams of Sofaz will be impossible to achieve? It is difficult for Sofaz, unlike the Qatar, Kuwait, or Abu Dhabi Investment Authorities, to pounce on big prey of whatever species, as soon as it saunters along. For a start, one investment cannot take more than 15% of the fund's assets. Global financial partners of Sofaz know that when it decides to act, it reviews the decision many times before finally implementing the decision - as the postponement of the move into equities shows.

Sofaz is transparent and accountable. Detailed annual reports are available on its website, and it has regular press conferences. This transparency reflects the principles on which the fund was founded in 2000 by the late president Heydar Aliyev (the father of the current president, Ilham Aliyev).

"Oil is a major wealth of Azerbaijan that belongs not only to this generation but also to future generations," runs a quote from Heydar Aliyev on the Oil Fund's website. The executive director has to follow these principles too.

Movsumov says: "We are managing the money of the people of Azerbaijan, not only for the current generation, but for all generations. That makes it important to be very open, so that the population can participate in the management of the fund."

But does this accountability make it more difficult for the fund to grow and make profitable transactions based on experience and knowledge of international capital markets? Professional managers, it seems, determine investment decisions more rarely at Sofaz than they might in some other funds. A general populace that is more or less ignorant of the workings of international capital has an important input into the fund. This is more democratic in a sense but it holds its own dangers.

As the executive director says to justify the 15% ceiling in equities: "We run a huge political risk if we have negative returns. People are not very sophisticated here. They would prefer not to earn 30% annually rather than to lose 2%."

Under lock and key

The openness of Sofaz is partly a mark of the inspiration it received from Norway's sovereign wealth fund. The two share a concern to stabilize the state budget and sterilize oil windfalls by keeping assets in foreign currency, restricting inflation. They also share the ideal of inter-generational equality.

A high-ranking government delegation from Azerbaijan was sent to Norway while Sofaz was being set up. Like Norway, which has about 5 million people, Azerbaijan's population is much larger than the rich citizen bases of some Gulf states, such as Kuwait. Azerbaijan has about 8 million people compared with Kuwait's citizen population of about 1 million out of a total population of about 3 million.

But the industrial development of Norway and Azerbaijan are far apart, both in and outside the oil and gas industry. Entrusting billions of dollars to banks and companies of much richer foreign countries is likely to be more politically problematic in a country such as Azerbaijan, which has a GDP per capita of $8,000, than in Norway, which has a GDP per capita of almost $50,000. For the future of Sofaz, it is thus a good thing that, unlike in Norway, the government can only access most of the oil income after an amount has been pre-approved by parliament and by the president as part of the official annual state budget.

"Politicians always find ways to spend money," says Movsumov. "We decided we shouldn't tempt them by sending money into the budget, and then deciding how much to send to the Oil Fund. Rather, we decided to send everything to the Oil Fund, and then decide how much to pay out."

Nevertheless, budgetary transfers from Sofaz have been increasing proportionally to the income of the fund. They have not exceeded 40% of the fund's income over past years, as the executive director points out. However, the fund's revenue has grown so unexpectedly quickly that every year since 2005 the budget has been amended mid-year to allow a bigger transfer. Last year, the oil price rose so high during the first half that in July the projected annual transfer was increased from a local-currency equivalent of $1.4 billion to an equivalent of $4.7 billion - almost twice as much as the fund's total assets at the beginning of 2008.

Pulling on the purse strings

A transfer from Sofaz to the government of $6 billion is projected for 2009. According to the executive director, such transfers are used for capital expenditure, for example, in developing the country's infrastructure. Current expenditure, such as government salaries and pensions, are paid by taxes, he says.

"We think that the high oil price environment is exactly the right time for those expenditures. You shouldn't expect the private sector to create jobs if there is no basic infrastructure such as water supply, electricity and roads, and that's where the government is spending money," says Movsumov.

In 2009, 15% of the state's budget is expected to come from oil revenues that do not even come from Sofaz, but mainly from Socar, the state oil company. That means a higher transfer than has been planned from Sofaz might be necessary if oil prices stay relatively low in 2009, as that 15% was based on an oil price of $70.

The projected transfer from Sofaz is already financing 40% of the state's 2009 budget, and that amount was fixed during an assumed average oil price for 2009 of $70 per barrel. If next year Sofaz did have to make up for a shortfall from Socar, it would already be contending with much lower than expected revenues itself.

So Movsumov says: "If the oil price doesn't rise again there will be two options: either cut expenditures, or increase the transfer. I frankly think only the first one is viable. No one will allow a higher transfer in this case."

Nevertheless, if Sofaz is to grow to $100 billion, transfers to the budget will have to be severely reduced if the oil price stays below $40 per barrel for much of the period to 2012. Azerbaijanis' aspirations might persist, leading the government to continue with ambitious projects that were planned during the oil bubble, even as the revenues of Sofaz decline.

A source in the country says: "Azerbaijan has a lot of gaps in its infrastructure and in its private sector. Its needs are still quite high, especially outside the oil industry."

Developments for richer generations

One of the stated aims of Sofaz is to stimulate the development of the non-oil sector. Transfers to the government's budget do this. Sofaz also directly funds 10 domestic socioeconomic projects. In 2009, out of a total domestic expenditure by Sofaz of a local-currency equivalent of about $7 billion, $6 billion is to be passed to the government, while around $1 billion is to finance these projects directly. The projects are in irrigation and water supply. They also include a railway line to Turkey, and houses for Azerbaijan's refugees and internally displaced people. The amount spent on these projects has to be approved by parliament as part of the overall annual budget of the state; yet again, mid-year amendments are possible, and normal.

If low oil prices prevail, the government might still continue to dip into Sofaz in order to maintain the breakneck economic growth that Azerbaijan has come to expect. For 2009, the government has targeted growth of almost 20%. But there are signals Azerbaijan will soon enter a more difficult period, meaning demands on Sofaz might be higher in the future when oil prices might stay low, and not only because of lower revenues from Socar.

For a start, with international capital markets still quiescent, Azerbaijan's banking sector will have difficulty rolling over, never mind increasing, the $2 billion it has borrowed from abroad. With reserves of $5.2 billion, the central bank will be able to help these banks renew their debt. But a bigger problem for Azerbaijan's economy might be the real estate bubble.

International funding (around 25% of total liabilities) has helped asset growth in Azerbaijani banks of up to 100% in recent years. Property prices have rocketed as a population still mistrustful of bank accounts has put their money into houses. According to Eldar Garibov, chairman of Unibank (one of the top three lenders in the country), about 70% of the banking system's loan portfolio is collateralized by real estate. Garibov says the banking system, including his bank, takes maximum loan-to-value ratios of about 60%.

"Everyone expects the real estate bubble to decrease. Even with a fall of 25% or 30% we will still feel good, and the banking system will still feel good," he says.

Nevertheless, such issues show the continuing contingent liabilities of the sovereign wealth fund of this relatively poor if rapidly developing country. The international crisis has reminded other sovereign wealth funds of the immediate necessity of economic development at home: even in such relatively rich countries as Kuwait, for example. The inter-generational equality ideal is admirable. But achieving it will be a different matter.