Azerbaijan faces considerable political risks as it attempts to develop its resource-rich economy. Securing a reliable export route for the country's abundant oil and gas reserves remains the top priority for President Heidar Aliyev's administration. But as they pursue their development goals, Azerbaijani leaders are confronted with seemingly intractable diplomatic and domestic governance obstacles. A potential leadership transition is also adding to Baku's challenges.

The country may face internal and external shocks in 2003. If American and allied troops fight a war in Iraq, oil prices could spike. This would increase demand for Azerbaijani energy exports, potentially raising revenues but straining the delivery system. The Baku-Tbilisi-Ceyhan (BTC) pipeline, which is under construction and aims to deliver oil to a Turkish port, will not go into service until the end of 2004 at the earliest, according to experts. [For additional information see the EurasiaNet Business and Economics archives].

In recent weeks, questions have arisen over Azerbaijan's existing rail-based transport system.
On January 29, a train carrying Azerbaijani oil from Baku to the Georgian port of Batumi fell from a bridge across the Kheve River. This event, which followed an explosion, was the second suspicious accident involving rail tankers during January. Akaky Chkaidze, director of the Georgian Railway Company, did not "exclude" the possibility that the explosion may have been a terrorist act. The Georgian security officials have downplayed a connection to terrorism.

Even if BTC pipeline construction meets the existing deadline, two diplomatic dilemmas threaten to impede the realization of Azerbaijan's energy export potential. Azerbaijan has yet to find a way to break the current stalemates on both the search for a lasting political settlement to the status of Nagorno-Karabakh [for additional information see the Eurasia Insight archive] and on a treaty among Caspian states on the sea's territorial division. [For additional information see the Eurasia Insight archive]. Finding agreement on both issues promises to be painstaking. Azerbaijan would also benefit from improved relations with Iran. [For background see the Eurasia Insight archives].

In the domestic sphere, Azerbaijan's international image has been dented by pervasive corruption. "There are still the problems of corruption and government control," says Jayhun Mollazade, president of the US-Azerbaijan Council in Washington, DC.

Another potential source of domestic instability is the looming leadership transition. President Heidar Aliyev is reportedly 79 years old and in frail health. Aliyev has already indicated that he will run for another term in presidential elections, expected to be held in late 2003. However, opposition leaders say that Aliyev is intent on engineering a transfer of power to his son, the 41-year-old Ilham. The younger Aliyev is a top official at SOCAR, the Azerbaijan state oil company.

So far, Aliyev has not successfully positioned Ilham to take over the presidency. But even if the elder Aliyev manages to set up a dynastic political succession framework, many observers believe Ilham will be hard-pressed to retain power once his father leaves the political stage. Mollazade, for one, believes several opposition leaders could emerge as credible challengers to Ilham for political power. [For background information see EurasiaNet's Opposition Reports]. Other experts say Ilham lacks the political instincts needed to survive in Azerbaijan's rough-and-tumble political world. "Ilham lacks his father's political astuteness to steer the state through what will inevitably be a difficult political transition," says the Economist Intelligence Unit, in its January 1, 2003 report.

Problems with governance have already caused the International Monetary Fund (IMF) to express concern over the government's development strategy. The IMF has indicated that it may halt $100 million in loans to Azerbaijan due to dissatisfaction with the government's management of the $700 million State Oil Fund, according to the Oxford Business Group. Several observers have described the IMF as troubled that Baku is dipping into the State Oil Fund to finance BTC pipeline construction. The fund was created with the intention of funding social programs. [For background, see the Caspian Revenue Watch.]

Rising social tension is an additional problem. According to Mollazade, Azerbaijan has struck 22 production-sharing agreements with multinational energy companies since the late 1990s, worth more than $60 million. Private investors get the bulk of the revenues, until they have recouped their initial investments. Mollazade said the government of Azerbaijan might start receiving about $200-$300 million in 2003 from these agreements, and could be bringing close to $1 billion annually by 2005. Despite Azerbaijan's natural resource wealth, poverty and unemployment are expected to rise while a "small enriched elite" reap the bulk of benefits from energy development, Mollazade indicated.

Despite these uncertainties, foreign investment in the country is growing. China, which is expected to have massive energy import needs in the coming years, has begun showing pronounced interest. On January 27, a unit of China National Petroleum Corporation committed to doubling its stake in a venture that intends to explore, develop and produce in the oil fields of southwest Gobustan. In November, another Chinese unit paid $14.5 million to raise its stake in the Kursangi and Karabagly fields south of Baku from 10 percent to 25 percent. The two fields are estimated to hold reserves of 750 million barrels of crude oil. There is also talk about closer Chinese-Azerbaijani trade relations.