UPDATE ON SOFAZ, AZERBAIJAN'S OIL FUND

C O N F I D E N T I A L BAKU 000291 SIPDIS SIPDIS E.O. 12958: DECL: 03/29/2018 TAGS: ECON EFIN ENRG PREL AJ SUBJECT: UPDATE ON SOFAZ, AZERBAIJAN'S OIL FUND REF: (A) 07 BAKU 1518 (B) 07 BAKU 1487 (C) 06 BAKU 1274 (D) 07 BAKU 1330 Classified By: AMBASSADOR ANNE E. DERSE PER REASONS 1.4 (B, D) ¶1. (C) SUMMARY. Since its creation in 1999, the State Oil Fund of Azerbaijan (SOFAZ) has acted as Azerbaijan's energy revenue sterilizer and long-term savings vehicle. With current assets in excess of USD 2.5 billion (expected to grow to USD 6 billion this year, and USD 10 billion by 2010, based on an oil price of USD 55),SOFAZ has consistently published fully audited quarterly and annual reports. For Azerbaijan, it is a model of transparency. SOFAZ's portfolio is inherently conservative, investing in U.S. denominated assets, Euros and other fixed income instruments. In 2007, its rate of return was approximately five percent in real terms. In 2008, SOFAZ plans to reallocate its portfolio to 50 percent dollar denominated assets and 40 percent Euro assets. The GOAJ's recent heavy reliance on SOFAZ for budget support impacts SOFAZ's effectiveness in insulating the Azerbaijani economy from the negative effects of its burgeoning inflow of energy revenues, especially inflation. It also raises concerns about SOFAZ's ability to fulfill its role of safeguarding energy revenues for Azerbaijan's long-term sustainable development. The budget transfer rate, however, is a sensitive policy decision outside SOFAZ's mandate. END SUMMARY. ¶2. (C) Since its creation in late 1999, the State Oil Fund (SOFAZ) has played a key role as an energy revenue sterilizer and long-term savings vehicle for Azerbaijan. SOFAZ's inflows include proceeds generated under production sharing agreements from sales of the Republic of Azerbaijan's share of hydrocarbons; bonuses paid under the terms of production sharing agreements; acreage fees paid by foreign investors for use of the contract areas in connection with the development of hydrocarbon resources; dividends paid under the terms of production sharing agreements; revenues generated from the transit of oil and gas; revenues generated from the transfer of assets from investors; revenues from management of SOFAZ assets; and grants and other aid. ¶3. (C) Every year its assets have grown and as of January 2008 SOFAZ assets totaled more than USD 2.5 billion. With the profit split from the Azeri-Chirag-Guneshli oil field between the Azerbaijan International Oil Consortium (AIOC) �A;and the Government of Azerbaijan to shift in favor of the GOAJ 80-20 in 2008, SOFAZ will receive a huge infusion of energy revenues over the coming decade. At a January 25 press conference, SOFAZ Executive Director Shahmar Movsumov said that by some estimates SOFAZ assets may increase by USD 5 billion in 2008, reaching more than USD 7 billion. In 2007, SOFAZ assets increased by more than USD 1 billion. If global oil prices remain in the USD 100 a barrel range, SOFAZ assets could increase by approximately USD 10 billion in 2008. PORTFOLIO AND EXTERNAL MANAGEMENT -------------- ¶4. (C) The investment profile of SOFAZ is inherently conservative. During his state of the union speech in October 2007, President Aliyev highlighted his intent to invest strategically in the West, noting the State Oil Company's (SOCAR) growing international presence (REF D). As of January 1, 2008, SOFAZ's portfolio was invested in 55 percent U.S. denominated assets (dollars and U.S. treasuries),35 percent in Euros, five percent in British Sterling pounds and a small amount in other currencies, corporate bonds and other fixed income instruments. In 2008, SOFAZ plans to reallocate its portfolio to 50 percent dollar denominated assets and 40 percent Euro assets. Movsumov said that in 2007 SOFAZ assets returned approximately five percent in real terms with the global depreciation of the dollar offset by the appreciation of SOFAZ's Euro assets. Using a grant from the U.S. Trade and Development Agency (TDA),SOFAZ is now re-evaluating its portfolio strategy and developing a more aggressive investment strategy that would invest some assets in equities, real-estate and other non-traditional instruments with the goal of boosting SOFAZ assets' rate of return. SOFAZ should be able to generate a real return of seven to eight percent annually with a sound risk management based investment strategy. Over a 20 year period, this could increase SOFAZ assets by hundred of billions of dollars. ¶5. (C) According to SOFAZ information, in 2007 there were only three foreign companies managing Oil Fund assets - the World Bank, Deutsche Asset Management and Clariden-Leu (Switzerland). Despite local press articles speculating on SOFAZ assets with French bank Societe Generale, it has not been an external manager of SOFAZ assets. The World Bank manages USD 106 million through its Treasury Reserves Asset Management Program (RAMP),Deutsche Asset Management handles USD 83 million and boutique firm Clariden-Leu manages USD 50 million. TRANSPARENCY -------------- ¶6. (C) SOFAZ is one of the most transparent GOAJ organizations. SOFAZ is audited annually by international accounting firms and publishes quarterly and annual reports on its Internet web site. SOFAZ prides itself on the level of transparency and it plays a leading role in the Extractive Industries Transparency Initiative (EITI). In Azerbaijan, SOFAZ actively dialogues with the EITI non-governmental organization coalition. The EITI NGO Coalition, a loosely organized group of different NGOs, supports SOFAZ activities and often complains that the AIOC members are not transparent enough on SOFAZ payments. The EITI NGO Coalition is also looking to have the GOAJ provide detailed information on how the government is making budget expenditures (SEPTEL will provide further background on Azerbaijan's participation in EITI). THE ROLE OF SOCAR -------------- ¶7. (C) The State Oil Company of Azerbaijan's (SOCAR) financial relationship with SOFAZ is unclear. Neither SOFAZ nor SOCAR publishes the amount SOCAR contributes to SOFAZ. SOCAR is a 10 percent partner in AIOC and receives profit oil revenues and has its own domestic energy production assets. As SOCAR does not yet publish international financial statements, it is difficult, if not impossible, to discern how much of SOCAR's revenue is going into SOFAZ. In 2009, SOCAR is scheduled to publish for the first time internationally audited financial statements for 2008. SOFAZ BUDGETARY SUPPORT -------------- ¶8. (C) In recent years, the GOAJ has transferred significant amounts of SOFAZ assets to the budget. In compliance with regulations governing SOFAZ, its assets may be used for solving major problems affecting the nation, and for construction and reconstruction of strategically important infrastructure to support socio-economic progress. A portion of SOFAZ's assets are utilized for improvement of the social and living conditions of refugees and internally displaced persons. Transfers to the state budget also constitute a significant component of SOFAZ's outflow. According to the budget law, all SOFAZ expenditures, except for operating expenditures, are incorporated as part of an annual consolidated government budget presented to the Parliament for approval. ¶9. (C) In developing its budget, SOFAZ coordinates closely with the President's office the list of proposed projects for consideration within SOFAZ's asset utilization program. SOFAZ carries out expert examination of the projects and includes approved projects to draft SOFAZ budget for the next year. SOFAZ establishes the criteria for project evaluation and the format for project submissions, including volume of investment, duration of the project and an assessment of the availability of co-financing or other investment sources. ¶10. (C) In 2006 and 2007, the GOAJ instructed SOFAZ to transfer more than USD 650 million to the budget; in 2006, SOFAZ retained only five percent of incoming energy revenue stream. In 2007, SOFAZ received approximately USD 2.2 billion in revenues and transferred to the budget USD 684 million. In total, in 2007 SOFAZ transferred USD 1.2 billion, or 57 percent of its revenues, to the budget and other state and social programs. In 2008, SOFAZ is expected to transfer more than USD 1.2 billion to the State Treasury for budgetary support (REF B). According to U.S. Department of Treasury statistics, had SOFAZ retained 70 percent of its energy revenues since 2004 its total assets would have been 69 percent higher. In addition, SOFAZ also directly finances several social and infrastructure projects, including assistance to Azerbaijan's internally displaced populations, water rehabilitation projects and the planned Baku-Tbilisi-Kars railroad project. SOFAZ MODELING UNIT -------------- ¶11. (C) SOFAZ maintains and utilizes a BP-funded macroeconomic model and receives regular training from the Oxford Economic Forecasting Group (REF C). BP supported the macroeconomic modeling unit at SOFAZ in the hope that it would be a key tool for GOAJ economic decision makers to rationalize the GOAJ budget planning and budget execution processes. However, the due to its overall complexity as a forecasting tool and the limited transfer of skills and knowledge to SOFAZ analysts by the Oxford Economic Forecasting experts who developed the model, the model has not been effectively integrated in the annual budget process. Movsumov presented the modeling unit to other GOAJ ministers, including Finance Minister Sharifov, Economic Development Minister Babayev, and National Bank Chairman Rustamov in early 2007. However, the National Bank and Ministry of Economic Development prefer a more basic and reliable short-term forecasting approach based on the application of an IMF-based financial programming model. COMMENT -------------- ¶12. (C) The transparency of SOFAZ's operations and activities, recognized with a UN Public Service Commission award in 2007, are a model for other GOAJ state-owned entities. In contrast to SOFAZ, an extremely small number of GOAJ-owned entities are fully audited by international accounting firms and publish public results. However, SOFAZ's effectiveness as a vehicle for getting the best return on Azerbaijan's long term savings, and in protecting the economy from the risk of increased inflation and corruption resulting from Azerbaijan's burgeoning energy revenues, is impacted by the high rate of transfers from SOFAZ to the consolidated GOAJ budget in the absence of a transparent public investment, budget planning and budget execution process, and by SOFAZ's extremely cautious investment policy -- which means it earns much less than it prudently could earn from investment of SOFAZ assets. DERSE