Azerbaijan has a substantial endowment of oil and gas deposits, estimated to be the third largest in the Caspian region. Oil production in Azerbaijan is projected to increase sharply starting in 2005, and to reach a peak in 2009 of 1.3 million barrels per day, or four times current production. Gas production is expected to increase in 2006 following the development of the Shah Deniz gas field and construction of the related gas pipeline, reaching an annual peak of 20 billion cubic meters (bcm) in 2010. Even under conservative assumptions about international oil and gas prices, the expected revenue windfall to the government of Azerbaijan over the next 20 years is substantial. However, given the known reserves and production profile, oil and gas revenues are expected to peak at the turn of the decade and decline gradually thereafter, and to return to current levels by 2024.

Azerbaijan faces the challenging task of reducing its dependence on short-lived and potentially volatile oil revenue. It is vital to the country's economic future that the government manage this revenue in a way that allows the diversification of the economy, in order to ensure a steady increase in the living standards of the Azerbaijani population. This is essential not only because of the temporary nature of the boom, but also because the oil sector-while a substantial source of revenue for the country-is not a source of much employment, with only 1.1 percent of the Azerbaijani labor force employed in the sector in 2001.

Few countries that have been heavily dependent on the oil sector have succeeded in managing oil wealth in a manner that allowed the simultaneous development of the non-oil sector. Norway and Indonesia are frequently cited as exceptions. The Norwegian economy has experienced solid economic growth for the last three decades. The fact that Norway was already a developed and diversified industrial economy, with a long tradition of democracy, a market-oriented economy, significant and varied nonenergy exports, and solid and mature institutions may largely explain its success. Indonesia also had other export commodities (rubber, coffee, timber) and sought to ensure that they continued to generate considerable income. Indonesian authorities undertook prudent macroeconomic policies, which at times required significant expenditure cuts and correction of misaligned exchange rates in order to adjust to volatility in oil revenues (Appendix 1).

The list of countries that failed to avoid the problems associated with natural resource booms is long, including Nigeria, Angola, Algeria, Mexico, Venezuela, and Ecuador. For most countries, natural resource booms were the impetus for economic disorder and crises (some examples are discussed in Appendices 2 and 3). It is crucial that Azerbaijan design and adopt prudent and coordinated macroeconomic policies and institutional reforms that take into consideration the experience of these countries in order to avoid the mismanagement of natural resource wealth and its implications.

This paper aims to provide a guide to the management of Azerbaijan's expected natural-resource-generated windfall, based largely on the lessons that can be drawn from the experiences-mostly negative-of other countries. Chapter 2 discusses the economic theory of natural resource booms and briefly explains the standard Dutch disease phenomenon. Chapter 3 discusses common characteristics of policies leading to the mismanagement of natural resource wealth in natural-resource-abundant countries. Chapter 4 explains the institutional arrangements of oil revenue management in Azerbaijan and estimates oil and gas revenue prospects for the country. Chapter 5 outlines a medium- and long-term strategy for oil wealth management in Azerbaijan, building on the lessons in Chapter 3. Chapter 6 concludes.