The oil industry in Azerbaijan and the need for forecasting activities

After the collapse of the Soviet Union in 1991, Azerbaijan obtained a status of independence and became a self-governing republic. During the weak transition conditions, the country had to mainly rely on extractive industries, particularly on oil and gas resources, as main engines of economic recovery. The petroleum industry plays a major role in the health of the country’s economy, and the oil sector currently accounts for 53% of gross domestic product and over half of export revenues (CIA Factbook, 2011).

However, one of the pitfalls in Azerbaijan economic development stability is it being highly driven by external demand for energy resources, while domestic consumption compounds a small share of total production.

Azerbaijan relies heavily of Foreign Direct Investment (FDI) influx to keep oil production buoyed. For example, global companies like Chevron-Texaco, Exxon Mobil, Shell, British Gas, Eni-Agip and Philips Petroleum have, in recent years, invested significant amounts of funds into Azerbaijan oil production, increasing production from 530,000 bbl/d (barrels per day) in 1992 to more than 1 million bbl/d in 2005 (Caspian Mainport, 2011). This dependence means there is a risk of the industry collapsing if investment levels decrease. In order to continue attracting FDI, Azerbaijan needs to support a stable political environment, favourable financial taxing and legislation conditions in order to successfully compete with other oil producing countries. Another risk exists in the possibility of a so-called “Dutch disease” or “curse of resources” phenomenon development, when significant financial inflows to the country may result in the domestic currency appreciation, with the subsequent increase in the production cost being to the detriment of the industry’s profitability (Burke, 2009). The level of institutional corruption influences the revenue allocation for the industry’s development and, subsequently, the prospects of taking control over oil industry development without high reliance on external funds.

Azerbaijan has successfully managed to keep political stability to date and enacted numerous laws and subsequent amendments to establish an attractive legal and commercial environment (STRATFOR, 2009). It has also managed so far to survive the global economic recession that began in 2008, achieving a 6.6 % Gross Domestic Product (GDP) growth rate in 2011 (Trading economics, 2011). This was attained through such rescuing actions as a long-run nationalisation of main companies and banks, currency depreciation in 2009 by 22% (BBC news, 2009) and the increase of commodity prices (Silk road intelligencer, 2011).

Those manipulations, however, had certain consequences: currency devaluation resulted in the external country debt value appreciation and an increase in the national budget deficit (STRATFOR, 2009). The situation worsened by the collapse of oil prices in July 2008 (BBC news, 2009) and the subsequent revenue fall, so that Azerbaijan was forced to cut national expenditures for oil industry development by almost 20% for 2009-2011 (Saidov, 2009).

Therefore, as seen from the discussions above, Azerbaijan’s oil industry is vitally important for equilibrium and development of the economy. Given the vulnerable situation in the oil industry development, forecasting future oil production trends and perspectives is paramount in the strategic planning for future progress of the country. Failing to accurately predict oil supply may results in serious consequences for Azerbaijan’s economy due to the incorrect finance and physical resource allocations and revenue estimations, increasing the country’s external debt and slowing down the GDP growth rate. Hence, forecasting is a vital part of strategic planning and decision making for Azerbaijan economy development.

Chapter 2. Business forecasting methods

2.1. What is forecasting?

Hereby, it is understood from the introductory discussions that forecasting is a vital part of decision making for future strategic and tactical operations planning overall.

Below, the dependence of performance, success and strategic planning on the forecasting activity will be explored structurally, based on the academic theory in the forecasting domain.

One of the common practices used to predict the future outcome is to evaluate past history in order to estimate the directions or trends that are likely to feature. In other words:

“Forecasting deals with phenomena whose future shape we want to predict by using their past values or the matters related to them” (Pecar: 6, 1994).

Business literature (Saunders et al., 1987; Pecar, 1994) specifies the purpose of forecasting within the following agendas:

1. resource allocation;
2. policy determination;
3. performance appraisal;
4. strategic planning;
5. contingency planning.

Resource allocation planning is essential for making realistic appraisals of future activities and deciding what resources it would implicate. Resources may be human, financial, time, facilities and others. Resource allocation planning is important for day-to-day operation as well for long-term planning. This may involve the assessment of the environmental changes. For example, financial market conditions, which influence funds availability (bank interest, currency exchange rates, foreign investments etc.).

Policy determination involves the estimation of policy changes on the variables concerned. For example, human resource policy in staff redundancy influence on the industrial production level.

Performance appraisal implicates the assessment of achieving corporate goals against such factors as quality, quantity, cost and time. Forecasting under the influence of those variables variations will allow undertaking corresponding actions toward performance improvement.

Strategic planning is about making decisions to achieve long-term goals that the enterprise defines for itself. Forecasting activity is very complex due to the amount of work needed to collect all the influencing variables and project their values into the future in order to estimate the likely future scenarios. (Saunders et al., 1987; Franses, 1998).

Contingency planning is performed for unexpected events that may happen and have a great impact on the company’s performance. The planning needs to be performed at two levels: a) the operational level of production planning, so the enterprise can continue acting as normal after or during the unexpected changes; b) and the strategic level, so the strategic shift can be introduced quickly and smoothly, e.g. the introduction of cheaper production facilities (equipment, energy resources) to cut costs in case of an emergency. Contingency planning is based on forecasting future unexpected events and scenarios.

Correspondingly, there are various terms forecasts discerned in business practice: a) short-term; b) medium-term and c) long-term.

Short-term forecasting is generally referred to the forecasting term of one hour to one week (El-Keib et al., 1995). Normally, such short-term forecasts are needed for the scheduling of personnel, production and transportation.

Medium-term forecasts are considered to be those that produce projections for a few months to up to three years (Kurawarwala and Matsuo, 1998). This type of forecasting may be needed for determining the requirements for future resource requirements: the number of personnel, raw materials to purchase, or the need to buy machinery and equipment.

Long-term forecasts then should be counted as those that exceed three years of forecasting terms. This would normally be used in strategic planning for decisions regarding market opportunities and company perspectives.

There is a plethora of works that have researched long-term forecasting of oil and gas supply (Soderbegh et al., 2010; Al-Fattah, 2006; Hallock et al., 2004; Kemp and Kasim, 2003; Laherrere, 2001; Hammond and Mackay, 1993), while only few looked at short and medium term forecasting (Uri and Flanagan, 1979; Ayeni and Pilat, 1992).

Short and medium-tierm forecasting is important to manage oil production operation efficiently to minimise costs: plan physical and financial resources and production potential. The shorter periods also allow obtaining more accurate data and detailed planning in the near-term where decisions with shorter lead times are more necessary.

In Azerbaijan, the petroleum industry is a key input to the economy and therefore medium forecasts are crucial for the country’s survival and development. Accurate estimations of costs and resources will help to allocate funds correctly and keep on the right track toward economy growth, avoiding the oil industry funding deficit, which would result in a fall in production and conversely, the growth of financial inflation due to overinvestment.