ANNUAL REPORT 2012.indd

CONTENTS INTRODUCTION 2. NATIONAL ECONOMY AND THE OIL FUND

4 10

2.1. Macroeconomic development

10

2.2. SOFAZ Revenues

15

2.3. SOFAZ Expenditures

18

3. INVESTMENT STRATEGY AND RISK MANAGEMENT

28

3.1. Global economy during 2012

28

3.2. SOFAZ investment portfolio

37

3.3. SOFAZ investment portfolio performance

42

3.4. Restrictions on investment

44

3.5. Risk management

46

4. MANAGEMENT

54

5. OIL FUND - TRANSPARENT SOVEREIGN WEALTH FUND

66

5.1. SOFAZ public relations

66

5.2. Extractive Industries Transparency Initiative (EITI) activities

67

5.3. International Forum of Sovereign Wealth Funds

69

6. OUR VALUES: RESPECT, TEAMWORK, TRUST, TRANSPARENCY

76

7. 2012 STATE OIL FUND’S BUDGET EXECUTION

77

8. CONSOLIDATED FINANCIAL STATEMENTS OF THE STATE OIL FUND OF THE REPUBLIC OF AZERBAIJAN

88

APPENDIX

132

INTRODUCTION

ANNUAL REPORT 2012

The Oil Fund, in accordance with its mission and objectives, continued its activity on accumalation and proper management of revenues generated from Azerbaijan's national treasure-black gold and also celebrated its 13th anniversary in 2012. As in previous years, the Fund’s assets increased by 14.5% by the end of the year, reaching USD 34.1 billion. The portion of the Fund’s inflows set aside for reserves equalled 22.7%.

STATE OIL FUND OF THE REPUBLIC OF AZERBAIJAN

4

2012 was a successful year in terms of diversification of the investment portfolio of the Fund. The new investment policy enabled SOFAZ to include new assets, such as gold bullions conforming to the requirements of London Bullion Market Association (LBMA) and real estates to the State Oil Fund’s invesment portfolio in 2012. At the same time, Russian ruble, Turkish lira and the Australian dollar have been included to the Fund’s portfolio. Starting from 2010, the Fund`s annual reports include quotations from the works of famous Azerbaijani writers and poets, together with biographical notes. The cultural theme of the State Oil Fund's 2012 Report will trace the legacy of the founder of Azerbaijani philosophical poetry, outstanding poet Imadaddin Nasimi. The State Oil Fund's 2010 Annual Report was the first report to feature this new design and it was dedicated to the great Nizami Ganjavi, while 2011 Annual Report was honoured to Muhammad Fuzuli. This new reporting concept, complete with literary quotations, should also serve as a small but valuable contribution by the Fund to bring the literature of Azerbaijan to international audience.

Seyyid Imadaddin Nasimi e eyyid Imadaddin Nasimi (1369-1417) is one of the lleading lights among Azerbai an’s 14th century poets and intellectuals. i Proficient in all three dominant languages of the Islamic I world, this outstanding poet is mainly known through his hi unfading f di lyrical verses (gazal), written predominantly in his mother tongue, i.e. the Azerbai ani Turkic. Studies by the European orientalists like H.Purgstall, E.Gibb, H.Ritter, K.Hewart, F.Barbinger, E.Brown, A.Bombachy or their US counterpart C.Burill and others shed the light into a number of literary and philosophical issues related to Nasimi. The poet used a number of pen names like Seyyid, Huseyni, Nasimi, Hashimi, Qureyshi, Ibrahimi. Nasimi was the most widespread among them. Seyyid Imadaddin Nasimi was born in 1369 in Shamakhy, one of Azerbai an’s oldest cultural and poetic hubs. The poet’s personal life and environment is shrouded with real stories and legends. Out of his close kin, only his brother, Shah Khandan, more or less covered in historic sources. Some records on Nasimi’s brother Shah Khandan, nicknamed Julidamu (the disheveled one), are found in recollections by Gastamonulu Latifi, whereas Ali in his "Kunhul-Akhbar" refers to Shah Khandan’s famous couplet (beyt) addressed to his brother Nasimi (The mystery of lords reveal me not, The assets of elite is never the folk’s plot!) and thus mentions him as a poet in one of his book’s sections. Records by Salman Mumtaz regarding Shah Khandan’s grave in Shamakhy being a longterm shrine among local people were viewed as another valuable piece of information by researchers of later generations. The following couplet by Seyyid Azim Shirvani, another recognized Azerbai ani poet, even though incomplete, is a clear indication of this: I wish to be buried at Shahandan upon my decease, For Shahidi-Khandan’s resting there with ease. Shah Khandan’s death in 1426 was confirmed by the Turkish researchers.

Upon conversion to Hurufism1 in 1387, Nasimi had been travelling all over the Middle east for good 30 years disseminating his ideas and beliefs unless he was atrociously executed in Haleb, Syria, in 1417 following fatwa (decree) passed by retrograde clerics. As the story goes, innocent poet admitted his authorship of verses recited by one of his young disciples who was to be executed for the recital, ust to save a young soul. As a result, he was apprehended and had his skin stripped off in public. The poet faced the sentence with courage, so the tortures failed to break his will. Once Nasimi turned pale from blood loss, one of the clerics issuing the verdict spitefully asked him: “You claim you are the Truth, so why have you got that yellow then?” In response, mustering his remaining strength Nasimi said: “In the skies of eternity it is me who is the Sun of Truth. No surprise the Sun grows yellow at the sunset”. According to another story, one of the clerics passing Nasimi’s death sentence ordered “to chop off and destroy anything that shall have a droplet of this infidel’s blood on it”. Accidentally, while Nasimi’s skin was stripped off, a stream of blood resulted on the cleric’s finger. So when people claimed his finger cut off, frightened cleric stated that he did not mean this literally. The dying poet bravely gazing at the zealot recited: While chopped off finger of ascetic cleric turns off his face from truth he likes to preach, A poor poet with his skin all stripped off says not a word from torture, pain and stitch. This way or another, a tragic death of Nasimi, an innocent person brutally executed for his verses and beliefs, made him ever more popular among the masses. No surprise, his grave turned into a shrine over time. Pilgrimage to Nasimi’s grave since his burial to this very day is a clear indication of this enduring homage, whereas claims by numerous persons bearing his name of being of Nasimi’s descent are probably not that far from real truth.

____________________ 1

Hurufism (Arabic:

hurufiyya, adjective form hurufi literal meaning “letters”

[of the alphabet]) was a mystical kabbalistic Sufi doctrine, which spread in areas of western Persia, Anatolia and Azerbaijan in later 14th - early 15th century.

NATIONAL ECONOMY AND THE OIL FUND

2. NATIONAL ECONOMY AND THE OIL FUND

In 2012, AZN 15.3 billion was invested in fixed capital, of which 79% was internal investments and 21% foreign investments. GDP per capita amounted to AZN 5.9 thousand, real income increased by 12.5%, unemployment and poverty declined to 5.2% and 6%, respectively. Inflation rate was 1.1%, the lowest level compared to the previous years. Real sector. The decrease in oil production resulted in 3.8% decline in the volume of industrial production in 2012. Real GDP growth was greater than in the previous year and the non-oil sector surpassed oil sector in contribution to the overall GDP. The share of non-oil sector in total GDP reached 52.7% (Chart 2.1.1).

Source: Ministry of Economic Development

Source: Ministry of Economic Development

of the Republic of Azerbaijan

of the Republic of Azerbaijan

According to the forecasts of local and international organizations, the growth is expected to be higher in the upcoming year. Thus, based on the latest reports of the World Bank (WB), International Monetary Fund (IMF), European Bank of Reconstruction and Development (EBRD), and Asian Development Bank (ADB), the economic growth of the country is expected to be around 4 % in 2013.

Chart 2.1.1. Share of non-oil sector in total GDP Chart 2.1.4. Expected economic growth

Source: Ministry of Economic Development of the Republic of Azerbaijan

Industrial production was the largest contributor to GDP with a 50% share. In addition, significant growth was observed in different segments of the non-oil sector. Thus, the real growth was 18.4% in construction sector, 7.6% in services, 7.0% in net taxes on products and imports and 5.8% in agriculture, forestry and fishery sector. Charts 2.1.2. and 2.1.3. present the breakdown and growth of GDP by sector.

Strategic foreign exchange reserves. The State Oil Fund’s assets under management increased by USD 4 329.4 million, or 14.5%, from USD 29 800.0 million to USD 34 129.4 million in 2012.

11 ANNUAL REPORT 2012


10

The economy of Azerbaijan performed sustainably during the ongoing global economic crisis which was mainly observed in the Eurozone throughout the previous year. Despite decreasing crude oil production and diminishing oil sector, gross domestic product (GDP) maintained its growth rate thanks to the rapid expansion in the non-oil sector of GDP. As a result, in 2012 the non-oil sector grew by 9.7% and the overall economy grew by 2.2%.


ANNUAL REPORT 2012

2.1. Macroeconomic Development


In recent years, the share of the Fund’s assets in total GDP significantly increased and amounted to 50% in 2012. Chart 2.1.6. Share of SOFAZ’s assets in GDP

12

During 2001–2012 the State Oil Fund’s revenues equalled to USD 83.7 billion, 40.8% of which was set aside for reserves in 2012. The Oil Fund’s reserve level is shown in Chart 2.1.8. Chart 2.1.8. Revenues and reserves of SOFAZ, 2001-2012 (USD million)



Chart 2.1.7. Strategic Foreign Exchange Reserves of the Republic of Azerbaijan (USD billion)


ANNUAL REPORT 2012

Chart 2.1.5. Growth in SOFAZ assets, 2001-2012 (USD million, as of 31.12.2012)


As of 31 December 2012, the country’s total foreign exchange reserves, including those held by the Central Bank of the Republic of Azerbaijan (CBAR), amounted to USD 45.8 billion, 74.5% of which were formed by the State Oil Fund’s assets (Chart 2.1.7.).

Thus, by the end of the last year, 41% of the Oil Fund’s overall revenues were set aside as reserves, 59 % for use.


Chart 2.1.9. The Oil Fund’s reserve level, 2001-2012 (USD million)


In 2012 higher crude oil prices in the world energy markets affected Azerbaijani foreign trade balance positively. Foreign trade turnover amounted to USD 33 560.8 million, including export volume of USD 23 908.0 million and import volume of USD 9 652.9 million. Foreign trade balance surplus was USD 14 255 million (source: The State Customs Committee of the Republic of Azerbaijan).

Securing fiscal sustainability. The State Oil Fund has played a more prominent role in securing fiscal sustainability in the state economy for the last few years. The amount of transfers to the state budget from the Oil Fund has significantly increased since 2008. Thus, in 2012, AZN 9 905.0 million transfer was the major contributor to the state budget revenues. Chart 2.1.10. SOFAZ transfers as a percentage of state budget revenues, 2003-2012

The Oil Fund’s revenues came to a total of AZN 13 674.1 million (USD 17 405.4 million) in 2012. They consisted of the proceeds from sales of the Republic of Azerbaijan’s share of hydrocarbons, as well as transit fees, bonus payments, acreage fees, revenues from management of the Fund’s assets and other revenues. Chart 2.2.1. Structure of SOFAZ revenues, 2012 (USD million)



14

2.2. SOFAZ Revenues


ANNUAL REPORT 2012

At the same time, there was a reduction in the volume of export and import equal to 10% and more than 1% respectively, compared to the last year. This was mainly due to the reduction in crude oil production in 2012.

As one of the main courses of SOFAZ’s activity, in 2012 a part of the Fund’s assets was directed to financing major national scale projects in order to support socio-economic progress. In 2012 part of SOFAZ’s funds was allocated to implementation of state programs and activities aimed at reduction of poverty, as well as investing in infrastructure and development of human capital through financing the foreign education program. Foreign trade. The global economic crisis imposed downward pressure on the foreign trade volume. The position of the advanced economies in the world trade deteriorated compared to the previous year. Thus, the growth of export decreased from 5.6% to 2.1% in advanced economies and from 6.6 % to 3.6% in emerging economies during the last year.

Proceeds from profit oil and gas sales. In 2012, the State Oil Fund received a total of AZN 13 117.4 million or USD 16 695.8 million from sales of the Republic of Azerbaijan’s share of hydrocarbons (Chart 2.2.2.).



Chart 2.2.2. Proceeds from profit oil and gas sales by fields, 2012 (USD million)

Acreage fees. Another source of SOFAZ’s revenues in 2012 was acreage fees paid by foreign investors for the utilization of contract areas for development of hydrocarbon resources. Acreage fees received by the Oil Fund in the year under review amounted to a total of AZN 3.0 million or USD 3.8 million (Table 2.2.2.).

The State Oil Company of Azerbaijan Republic (SOCAR) deducts the costs of oil transportation, banking, customs clearances, surveying, marketing and insurance costs before transferring the proceeds from profit oil sales to the State Oil Fund. Revenues from SOFAZ’s asset management. SOFAZ asset management revenues amounted to AZN 544.0 million or USD 693.5 million, yielding 2.2% rate of return in 2012. Transit fee revenues. Revenues from transportation of oil and gas through the territory of Azerbaijan (transit fees), which amounted to AZN 7.9 million or USD 10 million, was another source of SOFAZ’s revenues in 2012 (Table 2.2.1.). Table 2.2.1. SOFAZ transit fee revenues, 2012 Transferor

Date

AIOC AIOC AIOC AIOC AIOC AIOC AIOC AIOC AIOC AIOC AIOC AIOC Total

12.01.2012 14.02.2012 02.04.2012 12.04.2012 24.05.2012 14.06.2012 12.07.2012 14.08.2012 13.09.2012 12.10.2012 14.11.2012 13.12.2012

Amount USD mln. 0.6 1.0 0.9 1.0 1.0 0.4 0.4 1.0 1.0 0.9 0.8 1.0 10.0

AZN mln. 0.5 0.8 0.7 0.8 0.7 0.3 0.3 0.8 0.8 0.7 0.7 0.8 7.9

Oilfield

Date

GDF SUEZ E&P ABSHERON B.V. Total E&P Azerbaijan B.V BP International

Absheron Absheron Shafag-Asiman Bahar and Gum-deniz

Bahar Energy Limited Total

Amount

28.06.2012 29.06.2012 29.06.2012

USD mln. 0.5 1.0 2.1

AZN mln. 0.4 0.7 1.7

10.10.2012

0.2

0.2

3.8

3.0

Bonus payments. Another source of SOFAZ’s revenues in 2012 was bonuses paid by investors for signing and fulfilling oil and gas contracts. The Fund received a total of AZN 1.6 million or USD 2.0 million in bonus payments in 2012 (Table 2.2.3.).

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Table 2.2.3. SOFAZ bonus payment revenues, 2012 Transferor

Oilfield

Date

UGE-LANCER Total

Balakhani

02.02.2012

Amount USD mln.

AZN mln.

2.0 2.0

1.6 1.6

Other revenues. In the year under review, assets (obsolete or unused metal scrap, pipes) received from investors (international oil companies) under oil and gas contracts were sold, bringing SOFAZ AZN 0.2 million or USD 0.3 million.

ANNUAL REPORT 2012


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Transferor


ANNUAL REPORT 2012

Table 2.2.2. SOFAZ acreage fee revenues, 2012


2.3. SOFAZ Expenditures


Chart 2.3.2. SOFAZ transfers to the state budget in 2003-2012 (AZN million)

The Oil Fund’s expenditures in 2012 amounted to AZN 10 573.6 million. The major areas of spending were: 1) Transfers to the state budget; 2) Funding social projects;

ANNUAL REPORT 2012

4) Funding human capital development program; 5) Administrative expenses. Chart 2.3.1. Structure of the SOFAZ expenditure in 2012 (AZN million)

Financing the improvement of the social and economic conditions of refugees and internallydisplaced persons. In 2012 the Fund allocated a total of AZN 300.0 million for these purposes. Total allocation to this project has been AZN 1 157.8 million since 2001. SOFAZ’s resources directed to the construction of 61 private house settlements for 20 778 families, along with multi-story buildings and a number of social and infrastructure facilities. The project aims to provide homes and appropriate social, cultural and other facilities to enable refugees and internally-displaced families driven from their homes by the conflict between Armenia and Azerbaijan over NagornoKarabakh to settle and improve their social and living conditions. Samur-Absheron irrigation system reconstruction project. In 2012 SOFAZ allocated AZN 200.0 million to this project. A total of AZN 895.5 million has been allocated to this project since 2006. AZN 82.9 million was allocated for construction of the Takhtakorpu water storage with hydroelectric station, AZN 80.8 million for the Takhtakorpu-Jeyranbatan water canal construction, AZN 35.8 million for the Velvelechay-Takhtakorpu canal construction and AZN 0.5 million for personnel expenses based on the request from OJSC “Melioration and Water Economy”, which is responsible for the program implementation. The project is designed to create a reliable water supply to Baku and Sumgait, enable energy efficient water transportation and create electricity generation capacity of 25 MW.

Transfer to the state budget. In 2012 the amount of transfers to the state budget from SOFAZ was AZN 9 905.0 million, which constituted 93.7% of the Fund’s total expenditures. Total transfers to the state budget from SOFAZ amounted to AZN 35 085.0 million since 2003.

New Baku-Tbilisi-Kars railway construction project. In 2012 SOFAZ provided AZN 119.0 million to finance this project. The total allocated amount to the project has been AZN 341.5 million since 2007. The main purpose of the project is to enhance the transit capacity of the region’s countries by building a railway line that goes through Azerbaijan, Georgia and Turkey connecting the TransEuropean and Trans-Asian railway networks. To this end, the project envisages building a KarsAkhalkalaki railway line, 76 km of which will pass through Turkey and 26 km through Georgia, as well as restoring and reconstruction the 160 km of Georgia’s Marabda-Akhalkalaki railway.



18

Funding of social and infrastructure projects. In 2012 SOFAZ continued to finance important infrastructure and social projects in the country, as well as the government program on the human capital development.


3) Funding infrastructure projects;


Financing the “State Programme on the Education of Azerbaijani Youth Abroad in the years 2007-2015”. This program helps to realize the idea of “transforming black gold into human capital”. A total of AZN 54.8 million has been spent to fund the program since 2008. SOFAZ allocated AZN 20.0 million to finance the program in 2012. Based on the request from the Ministry of Education of the Republic of Azerbaijan which is responsible for the program implementation, the Oil Fund allocated AZN 11.9 mln. for accommodation, AZN 6.6 mln. for tuition, AZN 0.8 mln. for travel, AZN 0.3 mln. for health insurance, AZN 0.1 mln. for visa and registration, AZN 0.3 mln. for the other expenditures and AZN 0.13 mln. for administrative and organizational costs of the partner organizations collaborating with the Ministry of Education. As of 1 January 2013, the education abroad of 1590 students, 370 of whom had already graduated, was financed through the Program. In 2007-2012 among the priority areas identified by the Ministry of Education for this Program medicine, public administration, engineering, information and communication technologies were the most popular choice among the students. Chart 2.3.3. presents a breakdown of graduates by countries of study.

The State Oil Fund’s administrative expenses were as follows: payroll/salary – AZN 2.35 million; procurement of goods and services – AZN 0.94 million; pension and social benefits – AZN 0.06 million; grants and other payments – AZN 0.04 million; other expenses – AZN 4.59 million; acquisition of intangible assets – AZN 21.64 million.

20

21


Chart 2.3.3. Distribution of graduates by countries of study

Administrative expenses. SOFAZ allocated AZN 29.6 million to the Fund’s Administrative Expenses in its 2012 approved budget, which constituted 0.3% of the Fund’s total budget expenditures.


ANNUAL REPORT 2012

Building human capital


ANNUAL REPORT 2012

Nasimi’s Humanistic Message n nfluenced by socio-philosophical accomplishments of the ancient world, the Islamic ideas of humanism reached a ttheir culmination in the literary and philosophical works bby Nizami Gan avi, an outstanding Azerbai ani poet th off th the 12 century. One may only regret that ust 15 years after Nizami’s decease, this humanistic legacy was flouted and consigned to oblivion for a good century as a result of violent foray by the Mongol hordes that had overtaken all of the Middle East as the divine scourge. Faced with unprecedented horror, people lost faith in themselves, even though for a short time. However, since virtue should always prevailed over vice in human nature, this domain of darkness did not last long, and the principles of humanity became dominant once again due to the efforts of the lucid minds of the day. E.g. profound philosophical ideas may be found in the works of Nasiraddin Tusi (1201-1274), a renowned intellectual, scholar and astronomer of Azerbai ani descent and a Vizier of Hulaghu Khan, one of the Mongol rulers. In his "Ahlaqi-Nasiri", N.Tusi offers the ways for moral perfection and presents a human being at the center of the Universe and the noblest creature ever. Inspired by this humanistic tradition, Islamic poets and philosophers of the 14th century appeared like Phoenix from its ashes to revive fading hopes and expectations, to dispel the sentiments of helplessness, and to bring about the belief in the ability of human beings to master their fate. Imadaddin Nasimi was one of those leading lights of the late 14th – early 15th centuries capable of conveying this humanistic message in the three dominant languages of the Islamic world, i.e. Arabic, Farsi and Turkic.

One of distinct elements featuring Nasimi’s humanism is probably the poet’s irrepressible talent, the harmony embedded in his nature, and his enormous affection towards human beauty. What makes this humanism ever more captivating is Nasimi’s tremendous love to human beings. This is the reason why, as a follower of the best traditions featuring the Azerbai ani poetry in preceding centuries, Nasimi managed to build upon the artistic images and poetic accomplishments of previous generations. While delving into Nasimi’s humanistic legacy, what should not be omitted is the capacious and multifaceted nature of his sentiment towards human beings. As it was the case with the Mediaeval Oriental and European Humanists, the anthropocentric nature of the Universe is dominant in the works of Nasimi. In other words, contrary to the dominant geocentric theory of the day, the endless World we live in is centered neither around the Terrestrial Globe comprising lifeless stones and earth with flammable gases, nor the Solar Star, but the world’s crown creature, i.e. the MAN. Meanwhile, what should be also noted in this respect is that Nasimi’s love towards humankind is far from being indiscriminate. Rather, it is selective in a sense that the human being revered to by the poet is the perfect man, the physiological and social entity worthwhile being considered a human being. Far not any humanlike entity stands to this definition. A person who succeeded in ascending to this top level is viewed as the Almighty’s messenger on Earth, so with a sense of enormous pride the outstanding intellectual admits that the only reason of his not being called The Truth (Allah) was the fear of mixing him with the Almighty. That being said, reaching the status of a perfect man requires tremendous efforts, torment, breadth of mind and soul, as well as sincere love to one’s neighbors and all creatures around.

Following ideas Nizami, Ibn Khaldun and other progressive intellectuals and poets of previous centuries who advocated equal rights for all people in the world and explained visual diversity among people by peculiarities of social and geographic environment, Nasimi was ardently promoting the ideas of equality for everyone under the Almighty’s protection whereby not a single religion or ideology was considered superior towards the others. Humanistic message of Nasimi and his sentiments towards the humankind may be sensed not only in the contents of his works, but in the very way they were written, i.e. the rhythm, the articulation, the harmony, and the alliteration. The rhythmics of Nasimi’s gazals beats in unison with readers’ hearts evoking love and oy with internal tranquility invariably accomplished. No doubt, what stands behind this is an enormous love to fellow-men featuring the poet himself.

Gazal For the yearning lover pains of love are sweet to bear. Heresy and Islam are the same to lover’s eyes.

Anguish the beloved causes always gratifies.

Like a prince the lover is wherever he abides. He in whose direction the beloved casts her eyes Since in all the world the one you love can have no like,

Insight gains – his name is the all-seeing one, the wise.

By this token your beloved you shall recognise. O full moon, your beauty into tumult throws the skies. He who views the Kaaba and the idol not as one,

Look up to the heavens and you’ll see there groans and sighs.

Though advanced in years, is yet unready to be wise. It’s for your sake Nasimi his being has renounced. You who tell my fortune, casting lots before my eyes,

See with what ma estic presence does the poor man rise!

Do not cast again! What you have forecast satisfies. That poor man, who in pursuit of love prostrated lies, With the name of King Khosrov the world shall eulogize. Man of power, be not tempted by the world of wealth, For it is of little worth. Such wealth you should despise. Keep away and wash your hands of this unworthy world, For its captive is the man whom riches tantalize. You who love the countenance of Kaaba, with a prayer Come to love’s arena where with silk the wild thorn vies.

Imadaddin Nasimi “Poems” translated by Peter Tempest 1973, page 31

INVESTMENT STRATEGY AND RISK MANAGEMENT

3. INVESTMENT STRATEGY AND RISK MANAGEMENT

2012 was marked by the deterioration of the economic growth rates in both developed and emerging economies. A slowdown in global growth at the beginning of 2012 was deeper than expected, as the growth equalled to 2.9% at the yearend vs. 3.4% forecasted. European growth amounted to -0.6% for the Eurozone vs. +0.2% expected at the beginning of the year. In general, the Eurozone, as well as the United Kingdom slid into recession. The GDP growth rate equalled 7.7% in China, 1.0% in Brazil in 2012. On the other hand, US growth was in line with forecasts at the beginning of 2012 equalling to 2.2% on average.

In general, global growth dropped by nearly one percentage point in 2012, from 3.8% (in PPP terms) in 2011 to 2.9% in 2012. After the inflationary shock in 2011, inflation tended to decrease in most countries. Chart 3.1.2. Inflation rates in the USA, Eurozone and UK (2006-2012, percentages)


ANNUAL REPORT 2012

3.1. Global economy during 2012

A deepening Eurozone crisis played a crucial part in deterioration of global economic environment. The global trade dropped from 4.5% in 2011 to 2.5% in 2012. Fiscal austerity in Europe, the ongoing deleveraging among private economic agents in developed countries, as well as the monetary tightening in 2011 played a significant role in a slowdown in growth in most countries. However, highly expansionary economic policies in 2012 of the United States have helped them to maintain stable growth rate. Japan was exception as well, as the latter benefited from the aftereffects of the Fukushima disaster.

Chart 3.1.1. Rates of growth in GDP in the USA, Eurozone and UK (2006-2012, percentages)

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ANNUAL REPORT 2012

Source: Bloomberg

Elections in the United States were the most significant event in the country. However, they did not change the political configuration that had prevailed in the previous two years and resulted in re-election of Barack Obama. Source: Bloomberg


The economic growth rates were in line with forecasted and equalled to 2.2% on average in 2012 after 1.8% in 2011. Highly expansionary economic policies in 2012 of the United States have helped them to maintain stable growth rate. Fiscal policy did not become restrictive and monetary policy continued to ease. As a result, the fiscal deficit declined to 6.7% in 2012 from 8.6% in 2011.


at the end of 2012. In general, the unemployment rate stayed on its upward trend, rising from 10.16% at the beginning of the year to 11.37% in December. However, in Spain unemployment rate increased sharply and amounted to 26.06%. Chart 3.1.3. Unemployment rates in the USA, Eurozone and UK (2006-2012, percentages)

ANNUAL REPORT 2012

About 1.8 million jobs were created during 2012 and country’s unemployment rate at 8.3% in January went down slightly to 7.7% in December. Real estate sector improved as well in 2012 as investment in structures and residential investment accelerated, prices returned to upward trend and inventories fell. On the other hand, household consumption dropped to 1.8% in 2012 against 2.5% in 2011. A deepening sovereign debt crisis continued to deteriorate social and economic situations in the Eurozone and was the main factor driving the economic slowdown in the region. The peripheral countries and other countries in the zone as well suffered from the ongoing fiscal austerity, even though due to interventions by the European Central Bank, financial environment gradually improved. Similar to 2011, the Eurozone economy was characterized by its heterogeneity in 2012 as well. Thus, while some countries showed positive growth rates, for instance growth rate in Germany equalled to 1% on average, other countries in the Eurozone gradually slid to recession, showing falling GDP. Italy and Spain have been facing severe problems since the second half of 2011 and continued to show signs of recession in 2012 as well. Hence, growth rate in Spain and Italy equalled -1.6% and -2.1%, respectively. France avoided recession, however, showed very modest growth rate amounted to 0.1%. The United Kingdom also showed signs of weakness in 2012 with a recession of 0.2%. The fiscal deficit in the Eurozone was reduced from 4.1% of GDP to 3.5% in 2012. Deleveraging among private agents, as well as the negative effects on growth created difficulties for some countries to keep their deficit commitments. Inflation remained relatively high in the Eurozone equalling to 2.5% at an annual average, before declining towards the end of the year. Similar to GDP growth, the significant cross-country variations were observed on unemployment as well. Thus, the German unemployment rate fell slightly from 7.05% to 6.83% while the French unemployment rate rose from 9.62% to 10.24%

31 Source: Bloomberg

The monetary policies of countries in 2012 aimed to counter the recessionary effect of the fiscal deficit and the private-sector deleveraging. While in emerging countries central banks eased their monetary policies in 2012 via rate cuts, developed countries continued unconventional policy tools, because rates there were already low. For instance, China lowered the reserve requirement ratio and twice (in July and August) cut the 1-year lending rate from 6.56% to 6%. India lowered its rates only marginally by 50 bp to 8%. The Russian central bank in particular was forced to hike its key intervention rate by 50 bp to 8.5% in September, owing to persistently high inflation. The Federal Reserve, the central bank of the United States continued its policy launched in 2010 of purchasing treasuries. In October 2011 the Federal Reserve made some changes in monetary policy namely Operation Twist, to amount to USD 267 bln. In order to drive down long-term interest rates the FED started selling short-term securities and buying long-term securities. In September 2012 it launched a third wave of quantitative policy by purchasing of Agency MBS for an amount 40 bln. per month. Furthermore, December 2012 meeting at the Federal Reserve resulted in an announcement of a new programme of purchase of Treasury securities for and amount of USD 45 bln. per month, starting in early 2013.

ANNUAL REPORT 2012


30


Unlike to the previous year when growing commodities prices led to increasing inflation, 2012 was marked by gradual disappearance of the sharp increase in commodity prices of preceding year. As a result, inflation fell noticeably over the year to 2.1% on average after 3.2% in 2011.


Chart 3.1.4. Leading countries’ central banks interest rates (2002-2012, percentages)


The Bank of Japan launched its government bond (JGBs) purchase programme in order to prevent the persistent deflation and in attempt to weaken the yen. Chart 3.1.5. 5-year Credit Default Swap (CDS) of named European countries (basis points)

ANNUAL REPORT 2012


Source: Bloomberg

In the reporting year European Central Bank (ECB) was very active in implementing of unconventional monetary policies to prevent widespread recession and growing liquidity crisis, as the interbank market seized up, and reduce sovereign risk. In July 2012 the ECB officially announced the closing of the SMP (Securities Markets Programme) and the launch of OMT (Outright Monetary Transactions). According to this programme, sovereign papers with short maturities up to 3 years should be purchased in secondary market. In 2012 ECB allotted unlimited amounts of liquidity to the banks with a maturity of 3 years. ECB also launched a next Very Long Term Refinancing Operation in late February which amounted to EUR 530 bln. In July 2012 the ECB also lowered the Refi rate by 25 bp to 0.75%. Consequently, this rate went below 1% for the first time since the creation of the ECB. As a result of the weakening economic growth short-term interest rates decreased during the year and reached very low level, reflecting the excess liquidity and the fall in banking risk. The Bank of England (BoE) extended its government bond purchase programmes, by purchasing Gilts for GBP 100 bln. in 2012 bringing the total amount held to GBP 375 bln. Additionally, in August it launched a new programme which aimed to help the banks to obtain cheap funding over a period of up to 4 years.

33 Source: Bloomberg

Equity market In 2012, coordinated efforts by central banks, especially by the ECB, contributed to positive performance of the major stock indices. The MSCI World Index, composed of stocks of 24 developed countries, ended the year with a +12.2% return, while MSCI EM Index, the stock market measure of developing countries, examined +15.1% return. Major US broad market index, S&P500 increased +13.4% over the year, mainly due to the strong positive earnings. The first quarter of the year which saw a monetary interventions by central banks and rise in stock prices, was followed by macroeconomic and political risks during the second quarter and consequently major declines in both MSCI World and MSCI Emerging Markets indices. Coordinated monetary easing measures by the ECB, the Fed and the People’s Bank of China resulted in major gains in European stock prices in Q3. Due to uncertainty with Spain, the fourth quarter was characterized by volatility in stock prices. Overall, European stock market gauge, Eurostoxx posted a positive gain of 15.2% during the 2012. In terms of individual country performances, German DAX showed the most significant increase of 29.1% over the year. France’s CAC40 gained 14.6%. Similar to previous years since the beginning of sovereign debt crisis, South European countries, Spain, Italy and Portugal were among the worst stock market performers in Eurozone, with Spanish IBEX, Italian MIB and Portuguese PSI posting annual returns of -5.1%, +7.8% and +3%, respectively. Exception was

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Greece; driven by the determination of EU member countries to keep the country in Eurozone, its benchmark index Athex gained 32.5%, following the severe decline of 2011 (-52%). In Asia, Japanese stock market gauge, Nikkei 225 Index, surged 23% during the year, the strongest return for the index since 2005. The strong results can partly be attributed to the newly elected government, which pledged to turn around the nation’s long-suffered economy and undertake more economy-stimulating measures.

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The leasing markets have been less resilient however, as corporates focus on productivity gains and cost savings, rather than on expansion. But even here, improvement in optimism is detected which should translate into renewed growth in leasing activity during 2013. Commodity market The fluctuations experienced by oil prices in 2012 can be explained primarily by market fundamentals and geopolitical tensions. In the first quarter of 2012, oil prices increased due to stronger Chinese demand. The announcement of an EU embargo on Iranian oil raised fears in March that Iran might close the Straits of Hormuz. Consequently, Brent prices increased to USD 126/bbl in March. In the second quarter, oil prices dropped by almost 28% (USD 90/bbl in late June) as increasing worries over the Eurozone debt crisis darkened the prospects for global demand. The downward trend in the price reversed again in July after the European embargo and US sanctions on Iranian oil came into effect on 1 July. Moreover, high seasonal demand in the US and EU helped to push oil prices back up in third quarter. During the fourth quarter, high oil prices were supported by disruptions in Nigerian oil output, as the country experienced a strong decline in crude oil production and export due to natural disaster.


Chart 3.1.6. MSCI World Index (2002-2012, index points)


Chart 3.1.7. Changes in crude oil price in months (2012, USD/barrel)



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Source: Bloomberg

Real Estate The global real estate market’s movement in 2012 was better than expected. Investment volume in 2012 slightly exceeded 2011 level by around 2%. An exceptional rally in 2012 has served to demonstrate the strength of investors’ appetite for core commercial property. The search for yield in the low interest rate environment, combined with perceived reduction in macro-economic risks and the selective improvement in debt markets, is supporting increasing investor activity. In this context real estate market expects investment volumes to grow more in 2013, with the best upside potential in secondary markets, which are now beginning to be attractive to investors with their more favourable yields.

Source: Bloomberg


Gold

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Chart 3.1.8. Changes in gold price in years (1972-2012, USD/ounce)

3.2. SOFAZ investment portfolio During 2012, SOFAZ’s investment strategy was modified to include several new asset classes and currencies in accordance with the amendments made into “Rules on management of foreign currency assets of the State Oil Fund of the Republic of Azerbaijan” in October 27, 2011. As a result, by the end of the year under review, portion of the Fixed Income securities was decreased to 94.36%, with new asset classes - Equities, Gold and Real Estate gaining 2.00%, 2.35% and 1.29% of the investment portfolio respectively. New currencies added into currency composition were Turkish Lira, Russian Ruble and Australian Dollar. SOFAZ targets maximizing returns and enhancing the diversification of its investment portfolio as a result of these changes. Chart 3.2.1. Breakdown of SOFAZ investment portfolio by asset classes (31.12.2012)



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Central bank demand, consumer demand from China and India and quantitative easing were major factors that affected gold prices during the year. Central banks from around the world significantly increased its gold reserves in 2012, as they sought to diversify reserves. Especially, the central banks of Turkey, Russia, Philippines, Korea and Kazakhstan substantially boosted their gold reserves during the year. Chinese gold imports from Hong Kong increased sharply, while India’s gold imports dropped significantly during the year. The main reason for this decrease was the efforts of Indian authorities to reduce gold imports due to the country’s widening trade deficit. Quantitative easing had also a significant impact on gold market. Ahead of the introduction of third round of this programme, gold prices rallied by 12% in Q3.


Fixed Income Investments Source: Bloomberg

During the year under review, the Fund’s fixed income investment strategy has not undergone significant changes compared to the previous year. As in 2011, it continued investing primarily in short-term fixed-income securities as well as commercial papers, and floating rate notes. The portion of the Fixed Income securities equalled 94.36%, in line with Fund’s Investment Policy, which implies that at least 85% of the overall portfolio should consist of debt obligations and money market instruments. The Fund sought to achieve the highest possible return with minimal risk in the prevailing low-interest-rate environment. The scope of fixed income investments was also broadened to include lower investment grade securities into portfolio with the aim to enhance the yield and secure greater diversification.



Chart 3.2.3. Breakdown of SOFAZ fixed income portfolio by currencies

Holdings of short term commercial papers in the Fund’s fixed income portfolio have increased to 24.74% of total portfolio by the end of 2012 compared to 12.76% a year earlier. On the other hand, proportion of the Fund’s sovereign debt holdings declined to 11.40% from 17.01% in 2011. This shift led to drop in the duration of portfolio to 0.36, resulting in less sensitivity to interest rate movements.

During the year under review, the Fund continued its strategy of achieving geographic diversification of the investment portfolio. As a result, emerging markets exposure was gradually increased to 13.07% compared to 9.5% a year earlier. In spite of these activities, Europe still remained the largest exposure of the portfolio by the end of 2012.

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Chart 3.2.2. Breakdown of fixed income portfolio by product types

In line with the changes into investment guidelines, new currencies - Turkish lira, Russian ruble and Australian dollar were added to portfolio in the year under review. In accordance with these guidelines, total amount of investments in new currencies is limited to maximum of 5% of total assets under management. The Fund got a mandate to invest in Australian government bonds in 2012 and this investment equalled to 0.65% of the portfolio by the end of the year. Turkish lira and Russian ruble denominated investments were in the form of deposits at the largest local banks and constituted to 1.43% and 0.31% of the investment portfolio, respectively. Thus, total exposure to new currencies was in line with the limits put forth by investment guidelines. Exposure to USD, EUR, and GBP has not experienced significant changes during 2012.

Chart 3.2.4. SOFAZ investment portfolio: Geographical distribution



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Promoting emerging market equity funds and making them more visible to investors is of growing importance. In the year under review, SOFAZ joined IFC by investing in the Catalyst Fund. The fund of funds is managed by IFC Asset Management Company, LLC, and is designed to stimulate the development of funds and projects focused on renewable energy and climate-friendly solutions in emerging markets.

Chart 3.2.5. SOFAZ investment portfolio bonds by credit rating

The IFC Catalyst Fund will invest in funds that provide growth capital to companies developing innovative ways to address climate change, and invest directly in those companies. The commitment period of the fund is 3 years for investee funds and 5 years for co-investments. At the first closing of the fund, SOFAZ committed USD 50 million of the USD 280 million raised.

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In 2010, SOFAZ also committed USD 100 million to the IFC African, Latin American and Caribbean Fund (ALAC). The Fund invested USD 1 billion in private sector growth opportunities in emerging markets. As of December 2012, SOFAZ has contributed USD 54.7 million of its commitment to the ALAC Fund.

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During 2012, the Fund also gradually decreased its exposure to high-grade bonds, while increasing its exposure to lower grade bonds. Thus, investments in ‘AAA’ and ‘AA’ rated securities declined to 32.96% and 10.98% respectively, down from previous year’s 36.44% and 14.30%. Increase in exposure to emerging markets and non-investment grade deposit investments in Turkey and Russia during the year under review, led to significant rise in the portfolio’s exposure to ‘A’ and below rated investments.

41 New investment policy adopted for year 2012 enabled SOFAZ to invest up to 5% of its assets into equities. In this area Fund has adopted the passive investment strategy by investing MSCI World Index, which is comprised of large/mid cap stocks of developed countries. At the initial stage, SOFAZ has opted to delegate the management of its public equity portfolio to external managers while building necessary internal capacity and expertise for the subsequent in-house equity portfolio management in the future. As a result, two financial institutions, UBS Global Asset Management and State Street Global Advisors, have been awarded with the mandates to manage the fund’s equity portfolio. Through external managers, fund has invested a total of USD 600 mln. into equities. At the year end, the equity portfolio of SOFAZ was comprised of more than 1600 stocks of the developed countries.

Real estate investments In 2012, SOFAZ made its foray into real estate market through direct property acquisitions in several key European cities. Fund’s strategy is aimed at investing in key business cities with high market transparency, depth, liquidity, landlord friendly laws and practice of very long leases. The investments were primarily directed into mixed use office space. SOFAZ made its first investment in London followed by Moscow and Paris: ● 78 St James Street, London, UK for 177,350,000 GBP (285,550,000 USD) completed in December ● Actor Gallery, Tverskaya 16, Moscow, Russia for 133,000,000 USD completed in December ● 8, Place Vendome, Paris, France for 135,000,000 EUR (180,000,000 USD) to be completed in March 2013

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Equity investments


These acquisitions are early examples of SOFAZ’s successful realization of its real estate investment strategy. The secure income that will be generated tied with strong fundamentals of prime office space in major world capitals are the defining factors in fund’s investment rationale. From 2013, the Fund will start broadening its investment geography outside the European market with global diversification of the real estate portfolio. This is in line with the strategy of diversifying away the risk of exposure to a single region.


The following information is used for performance measurement: The portfolio’s COB market value in local currency. The prices provided by the custodian bank and stored in the Oil Fund’s portfolio management system are used to calculate the portfolio’s COB market value in local currency. The prices provided by the custodian bank, audited and stored in the Oil Fund’s portfolio management system are used for calculating the portfolio’s month-end market value in local currency.

According to the investment guidelines, up to 5% of the SOFAZ’s assets can be invested into gold and Fund has been making this investment by purchasing the gold bars conforming to the requirements of the London Bullion Market Association (LBMA). In order to reduce the risks associated with price fluctuations, fund has scheduled to acquire the planned overall amount of gold on a weekly basis in equal amounts within two years. Starting from February 1, 2012, SOFAZ started the purchase of 25 gold bars conforming to the requirements of London Bullion Market Association (LBMA) per week (10,000 troy ounces) from the market-maker member banks of LBMA. As of December 31, 2012 14 934 kg of gold (480 146 troy ounces) was acquired. The gold is kept in JP Morgan’s London vault. In the next stage, it is planned to ship strategically important gold reserves to Azerbaijan and preserve it inside the country. Currently, in order to get extra return on the gold investments, some amount of the gold is invested in short-term deposits at the reputable banks operating in the international financial markets.

3.3. SOFAZ investment portfolio performance Performance measurement methodology. Returns on SOFAZ assets are calculated in accordance with the “Performance measurement methodology for the investment portfolio and subportfolios of the State Oil Fund” approved by the Resolution No. 5 of 21 April 2009. In accordance with this methodology, the AZN, USD or EUR is taken as the base currency in calculating the performance of the total investment portfolio. Performance is also calculated without a base currency, i.e. without taking currency exchange fluctuations into account. The performance of the sub-portfolios is measured in the respective (local) currency of each sub-portfolio and in the base currency, i.e. USD (provided the impact of the currency component is indicated).

COB net flows defined as the difference between inflows and outflows during the business day. Net flow figures are calculated by the SOFAZ portfolio management system on a daily basis. SOFAZ rate of return in 2012. The return on the SOFAZ investment portfolio was equal to about 4.2%, 4.5%, 3.8%, 3.3%, 1% and 0.8% in 2006, 2007, 2008, 2009, 2010 and 2011 respectively. The return from managing its investment portfolio was equal to 2.2% in 2012.

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Chart 3.3.1. SOFAZ investment portfolio: Rate of return

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The portfolio’s previous day COB market value in local currency. The prices provided by the custodian bank and stored in the Oil Fund’s portfolio management system are used to calculate the portfolio’s previous day COB market value in local currency.


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Gold


3.4. Restrictions on investment The Oil Fund’s investment portfolio is managed in accordance with the “Rules on managing the foreign currency assets of the State Oil Fund of the Republic of Azerbaijan” (“Investment Guidelines”), approved by Presidential Decree No. 511 of 19 June 2001. According to the Rules, SOFAZ assets may be invested in the following:

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● Debt obligations issued by the governments, government agencies, international financial organizations, for profit organizations and other institutions with long-term investment grade credit ratings (Standard & Poor’s or Fitch or Moody’s); ● Debt obligations with long-term investment grade credit ratings (Standard & Poor’s or Fitch or Moody’s) issued by governments, government agencies, international financial organizations, for profit organizations and other institutions; ● Investments in stocks included in major international equity indices; ● Shares of mutual and alternative investment funds;

SOFAZ currency assets are managed in accordance with the Fund’s investment policy which is approved by the President of the Republic of Azerbaijan on an annual basis. According to that policy: The Oil Fund’s assets must have reasonable liquidity in order to ensure that planned money and other transfers related to the Fund’s budgetary expenditures can be made in an accurate and timely manner. For this reason, a proportion of these assets, equivalent to no less than USD 100 million (minimum liquidity level) is to be held in cash or cash equivalents. If minimum liquidity level is breached, it must be restored within 7 (seven) working days. The Oil Fund determines the target duration (not exceeding 48 months) of its investment portfolio in line with the current status of the global financial markets. The maximum average weight of one specific security or one issuer (excluding depository banks) in the investment portfolio should not exceed 15% of the total value of the investment portfolio.

● Gold bars conforming to the requirements of the London Bullion Market Association; ● Real Estate; ● Non-investment grade debt obligations or deposits with credit rating of not less than BB- (Standard & Poor’s or Fitch) or Ba3 (Moody’s). Maximum capital, allocated to those investments should not exceed 5% of the total value. In this case, the counterparty banks of the Oil Fund providing custodian (depositary) services and holding correspondent accounts for Oil Fund may have non-investment grade credit rating (not less than BB(Standard & Poor’s, Fitch) or Ba3 (Moody’s)) (According to the “Rules on management of the foreign currency assets of the State Oil Fund of the Republic of Azerbaijan” (“Investment Guidelines”), approved by Presidential Decree No. 511 of 19 June 2001 as amended by decrees No. 607 of 21 December 2001, No. 202 of 1 March 2005 and No. 519 of 27 October 2011). Derivatives (i.e. swaps, forwards, futures, etc.) may be used for hedging or optimizing the currency composition and asset allocation of the Investment Portfolio.

45 External managers According to the “Rules on managing the foreign currency assets of the State Oil Fund of the Republic of Azerbaijan” (“Investment Guidelines”), approved by Presidential Decree No. 511 of 19 June 2001 as amended by decrees No. 607 of 21 December 2001, No. 202 of 1 March 2005 and No. 519 of 27 October 2011 an external manager engaged in managing the Fund’s financial assets, or its parent company, shall have an investment-grade credit rating (of no less than Baa3 (Moody’s) or BBB- (Standard & Poor’s, Fitch)), at least 5 years relevant experience of managing financial assets or experience of managing financial assets equal to or exceeding USD 1 billion. In February, 2012 SOFAZ announced the Request for Proposal for selection of managers for passive equity portfolio management. After a detailed due diligence of all the provided proposals, State Street Global Advisors (SSgA) and UBS Global Asset Management (UBS) were selected as the winners and in June, 2012 SOFAZ signed contracts with them. Besides, following the legal merger between Credit Suisse and Clariden Leu, on April 2, 2012, Credit Suisse assumed all the rights and obligations of Clariden Leu. Accordingly, from this date onwards, any existing or future reference to Clariden Leu in any documentation was to be read as a reference to Credit Suisse. The external managers handling SOFAZ financial assets as of 31 December 2012 are the World Bank, Deutsche Asset Management, Credit Suisse, SSgA and UBS.

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Investment policy


● Deposits in the central (national) banks, commercial banks and other financial institutions;



3.5. Risk management Risk management is an essential element of the Oil Fund’s operations. SOFAZ employs globally recognized, state-of-the-art models, procedures and indicators to handle this particular task. The Risk manager software application (developed by Riskmetrics) procured in February 2010 has greatly enhanced the Fund’s risk management capabilities. Its risk management practices are divided into two areas: financial risks and operational risks.

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Credit risk. Credit risk is the risk that a borrower will fail to repay the principal or interest on borrowed funds on time or fail to honour its contractual obligations. Credit risk stems from a number of sources, such as the borrower’s bankruptcy, credit rating downgrade, etc. As credit risks increase, investors tend to lend their assets at higher interest rates. Credit risk is an essential consideration when investing in fixed income assets and key credit rating agencies regularly assess the credit ratings of thousands of companies, agencies and financial institutions. The credit ratings of the securities in which SOFAZ invests, as well as their issuers, are regulated by the Fund’s “Investment Guidelines”.


46

Operational risks Operational risk is the risk of contingent financial or non-financial losses caused by internal processes, the human factor and external factors. Human risk. This is associated with the deliberate or unintentional failure of staff to comply with the organization’s rules and codes of conduct. SOFAZ closely monitors its staff to ensure strict compliance with its policies and procedures and to prevent any engagement in illegal market transactions and disclosures of the corporate commercial secrets. Furthermore, as part of the personnel’s skill development, staff from relevant departments regularly attend numerous training seminars and courses, held by investment banks with which the Fund cooperates.


Market risk. Also commonly referred to as systematic risk, market risk is the risk that a portfolio’s value will decline because of changes in market risk factors. These include security prices, interest rates, foreign currency exchange rates and commodity prices. Market risks are tightly controlled in all investment management companies and SOFAZ is continuously improving control of these risks. The Fund’s investment portfolio is dominated by short-term bonds. However, it constantly monitors the central bank interest rates of the countries to which it is exposed and adjusts the duration of the relevant fixed-income securities accordingly.

Reputational risk. Reputational risk is the risk that the organization may experience difficulties in maintaining past business relations, establishing new ones or gaining access to capital because it is perceived negatively by its stakeholders (customers, counterparts, shareholders, regulators, etc.). An organization might face reputational risk even without violating any law. SOFAZ pays particular attention to reputational risk and has been able to enhance its reputation and positive image both at home and abroad a great deal, especially thanks to its success in the Extractive Industries Transparency Initiative.


Financial risks


“Both Worlds within my compass come, but this world cannot compass me.” h gazal-fakhriyye is among Nasimi’s most recognized his works indeed. In ust sixteen couplets (beyt), in a very w ssuccinct manner, an intellectual poet succeeded in presenting the human as a driving force of the Universe, its source off power and beauty. Nasimi’s lyrical “self” implies not only an individual but the whole of mankind irrespective of language, faith or race. That being said, Nasimi’s image of a perfect man is not a statically shaped concept formed once and forever. In fact, an individual’s ever-lasting strive for perfection with no limit and ultimate point brings about the artistic expression like “this world cannot compass me” implying the infinite notion of knowledge and capabilities. This is the reason why a human being capable of encompassing the two worlds with his reason is in the meantime incapable to fit into the mundane framework of the day-to-day life. And this is exactly the drive behind the eternal quest for spiritual world. It is this endeavor towards perfection that should rescue the humankind from ignorance and oppression, murder and massacre, slavery and humiliation and lead it towards the world of ustice, enlightenment and universal love. It goes without saying that gazal penned in the socio-cultural environment of the Middle Ages is not devoid of religious and mystical images. As it was the case with all mediaeval poets, Nasimi was under an obvious influence of his milieu. However, the splendor of Nasimi, as well as other eminent figures of his time is that they were capable of being ahead of their time by conveying the message of eternal values for the generations to come. From this point of view, the mystical religious imagery and concepts they apply retain their value to this very day by supporting the vital and global ideas that never fade.

Even though the ideal ust world the outstanding Azerbai ani poet Imadaddin Nasimi was strongly striving for and believing in back 600 years ago, is far from being a reality today, the true meritocratic criteria are still oftentimes trumped over by considerations of confession and nationality, the double standards prevail world over with evil and violence unbridled on a number of occasions, the anthem to humanity passed over in Nasimi’s immortal verses is still valid, with the message of love, respect and mutual understanding still finding its way to human hearts.

Pay due regard to form, acknowledge content in the form, because Body and Soul I am, but soul and body cannot compass me. I am both shell and pearl, the Doomsday scales, the bridge to Paradise. With such a wealth of wares, this worldly counter cannot compass me. I am “the hidden treasure” that is God. I am the open eyes. I am the ewel of the mine. No sea or mine can compass me. Although I am the boundless sea, my name is Adam, I am man.

Both worlds within my compass come, but this world cannot compass me.

I am Mount Sinai and both worlds. This dwelling cannot compass me. I am both soul and world as well. I am both world and epoch, too.

Both worlds within my compass come, but this world cannot compass me.

Mark this particular: this world and epoch cannot compass me.

An omnipresent pearl am I and both worlds cannot compass me. I am the stars, the sky, the angel, revelation come from God. Because in me both earth and heaven and Creation’s “BE!” were found.

So hold your tongue and silent be! There is no tongue can compass me.

Be silent! For there is no commentary can encompass me. I am the atom, sun, four elements, five saints, and dimensions six. Both worlds are my inauguration. In your essence I begin.

Go seek my attributes! But explanations cannot compass me.

So know me by this token, though a token cannot compass me. I am the core and attribute, the flower, sugar and sweetmeat. Through doubt and surmise no one came to be a Friend of God and Truth. The man who honors God knows doubt and surmise cannot compass me.

I am Assignment Night, the Eve. No tight-shut lips can compass me.

I am the burning bush. I am the rock that rose into the sky. Observe this tongue of flame. There is no tongue of flame can compass me The honey and the sugar, too, I am. The sun and moon I am. The living spirit I bestow. The spirit cannot compass me. The bow and arrow, too, I am. I am both old in years, and young. I am eternal oy. The box for mirrors cannot compass me. Though I, Nasimi, am today a Hashimite or Kureishite, My praise is higher. Praise and reputation cannot compass me.


MANAGEMENT

4. MANAGEMENT

SOFAZ organizational structure

Investment Department (Front-Office)

SOFAZ Supervisory Board

The Investment Department is responsible for developing investment strategy, real estate, portfolio management and trading. The Department has 3 divisions:

The Supervisory Board, consisting of representatives of the state authorities and public organizations, carries out general oversight of State Oil Fund operations. The Board reviews and evaluates the Fund’s draft annual budgets, annual reports and financial statements, along with audit reports. Members of the Supervisory Board are approved by the President of the Republic of Azerbaijan. The Board members act on a voluntary (non-remunerable) basis. Presidential Decree No. 73 of 27 November 2008 approved the new composition of the State Oil Fund’s Supervisory Board as consisting of the following members: Artur Rasizade Prime Minister of the Republic of Azerbaijan Valeh Alesgerov Vice-Speaker of the Parliament (Milli Majlis) of the Republic of Azerbaijan Vahid Akhundov State Economic Policy Adviser of the Republic of Azerbaijan Samir Sharifov Minister of Finance of the Republic of Azerbaijan Shahin Mustafayev Minister of Economic Development of the Republic of Azerbaijan Elman Rustamov Chairman of the management Board of the Central Bank of the Republic of Azerbaijan Mahmud Kerimov President of the National Academy of Sciences of the Republic of Azerbaijan The Supervisory Board held 1 meeting in 2012. At the meeting on 7 June 2012, Fund’s 2011 annual performance report and the audit findings were discussed and deemed satisfactory. In addition, the Supervisory Board discussed and agreed on certain changes and amendments to the Fund’s 2012 annual budget. On 27 December 2012 Supervisory Board by the means of request discussed and approved the Oil Fund’s draft annual budget for 2013, its draft investment programme (including its investment policy), as well as the Fund’s draft administrative expenses. The Board resolved to submit the Fund’s draft annual budget to the President of the Republic of Azerbaijan for approval.

● the Fixed-Income Division; ● the Equity and Alternative Investments Division; ● the Money Market and Foreign Exchange Division. Risk Management Department (Middle-Office) The Risk management Department is responsible for conducting assessments of and preparing proposals for the Fund’s investment policy and strategic asset allocation (SAA), selecting benchmarks and risk budgeting. In addition, this department is also responsible for risk and performance measurement, performance attribution, modeling and research, compliance supervision and supervision of external managers. The department has 2 divisions:

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● the Strategic Asset Allocation/Risk and Performance Measurement Division; ● the External Asset Management/ Research Division. Settlements Department (Back-Office) Back-Office functions are performed by the Settlements Department, operating under the Fund’s Finance and Operations Administration. The Settlements Department is responsible for verifying trades with counterparties, for trade settlement with the custodian bank and correspondent banks, for reconciling cash and transactions with statements from the banks, and for reconciling external managers’ transactions and positions with information from custodians on a daily and monthly basis. Budget Forecasting and Projects Department The Budget Forecasting and Projects Department is responsible for forecasting SOFAZ revenue and expenditures, organizing its budgeting, its economic analysis, strategic research and macroeconomic modelling work, and for organizing and supporting the activities of the Fund’s Supervisory Board and the financing of fund-sponsored projects.

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The Oil Fund’s day-to-day activities are managed by the Executive Director who is appointed by the President of the Republic of Azerbaijan.


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SOFAZ’s investment activity is conducted by Front, Middle and Back Offices. Front and Middle office functions are performed by the Investment and Risk management Departments set up under the Asset management Administration.

MANAGEMENT

MANAGEMENT

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57


Figure 4.1. SOFAZ organizational structure

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Daryaye-Muhit (The Ocean) s the story goes, this masnavi (a distich-type verse with two lines rhymed together) was penned by w Nasimi as response to the poetic letter by his brother N tthat starts with the following couplet: Th The mystery of lords reveals me not The assets of elite are never the folk’s plot! Speaking of ‘the mystery’ what Nasimi’s brother implied is the secret esoteric knowledge available only to ‘the elite’. ‘The folk’ stands for the crowd, so he advises Nasimi not to reveal the science of the selected few to the masses. Back in the 14-15th centuries it was widely believed among some scholars that the secret learning required to accomplish perfection could not be grasped by each and every individual. Nasimi strongly disagreed with this prevalent view of the day, so he advocated the idea of disseminating esoteric knowledge of hurufism among broad masses. It was exactly this knowledge destined to make people better that together with his followers and disciples he was trying to promote to his very best through his gazals and other verses. As it was the case in a number of the poet’s other works, in this masnavi Nasimi promotes the theory of a perfect man. Elevating such a perfect person to the divine level, he coins the concept of ‘ana-l-haqq’ (I am the Truth) to be applied to such an individual. Meanwhile Daryaye-Muhit distich reveals Nasimi’s pantheist views presented in artistic and philosophical manner, with a number of images and symbols featuring figurative (irfani) poetry. The verse presents the Universe comprising the microcosm and the macrocosm through the unity of the nature and the society, as well as inseparability of individuals linked together on the organic level.

Daryaye-Muhit The mighty ocean in excitement stirs. All is in motion in the universe. The pristine source is patent to all eyes. How shall the sage accept a compromise? In every molecule appears the sun. Homage to earth by purity is done. The artist in his drawing you may scan. The ruby is revealed in Badakhshan. Sharp water has become a drink divine And every poison – candy crystalline. The antidote submits to poisoning. The rounded pearl becomes a medicine. All earth and heaven are Truth absolute. “I am the Truth!” say tambourine and flute. The men who laud are one with what they laud And the adorer is the true adored. Now every drop is the gigantic sea, Each speck of dust is Jesus and Mary.

The stone and clod are buds of eglantine, Ferhad and Khosrov – their sweet love Shirin. The lover and beloved are as one. Distinction between “no” and “yes” has gone. Belief and heresy as one combine. The sweet and bitter have become one wine. The fellowship of thought does toil create And unity has opened mercy’s gate. One Truth become the body and the soul. The Law and rival sects become one whole. Released each thing is from duality. The single whole wins immortality. O seeker after Truth, if you can see, Behold, all blessings flow from unity. The curtain moves and brings all things to light Save Allah, his eternity and might. The essence now remains, of all else purged. The sea is what was in the sea submerged. If insight be not blunted, see revealed The Truth within yourself – not far afield.

You are – if soul and body you observe – The aim and essence of the universe.

Alas, you did not hear the trumpet blast. You halt upon the bridge you have not passed,

A mirror likeness true believers share. The mirror watch and God discover there!

The scales are set. The Day of Judgement nears. It’s coming now. Believe me! God appears.

Beware of the accursed Satan, friend! An ear unto his pleading do not lend!

Since with a little you are not content, An alien you are and not a friend.

The man intoxicated by this wine Shall live forever, to the end of time.

Who shall have knowledge of the soul divine Shall to the world the worth of dust assign.

Who knows himself, the Lord God, too, he knows. The seeds of Ioving unity he sows.

A termite has come crawling from the ground. The secret of the ant I shall expound.

O you who stray from Truth, O ruffian, If Satan you are not, acknowledge man!

It bears an edict sealed. “That is to say,” The ant declares, “I’m Solomon today!”

It was in man God did himself display. So bow to man and be not led astray!

“I’m Moses. In my hand God’s staff I hold And in my belt God’s timeless sword behold!”

The trumpet blast of Judgement Day rings out, Do you not hear, O humble and devout?

“The faithful and the pagan recognise! And woe to him who manufactures lies!”

The Judgment Day has come. Awake, arise! If you still doubt it, open wide your eyes.

Into men’s hands the termite’s staff shall come And they discover equilibrium.

Wake up! It is already Judgement time. Observe the mass of wickedness and crime.

This equilibrium contains the Truth That owns all riches and is absolute.

From True God came the true road we survey And it is Fazlullah who shows the way. When you across this balance shall have passed You shall be free of grief and woe at last. He is both Paradise and its fair youth, He’s mercy and the throne of God and Truth, It’s in this sense we praise you to the sky, O Fazlullah, O grace from God on high! The face of man has now become the Truth. Bow to the one who merits it in sooth! Advance to Truth, if greatness you would find, And see to it you do not lag behind. Nasimi’s breathing is a soul divine, A mighty ocean and a ruby mine!


OIL FUND - TRANSPARENT SOVEREIGN WEALTH FUND

5. OIL FUND - TRANSPARENT SOVEREIGN WEALTH FUND

Today mass media, NGOs and independent experts appreciate Fund as the governmental organization replying to their requests on time and in details. Seminar for mass media representatives was held by the staff of the State Oil Fund of the Republic of Azerbaijan on 4 July, 2012.

SOFAZ information policy. The State Oil Fund’s public relations are managed in accordance with its Information Policy, as approved by the Order of Executive Director of SOFAZ, dated 20 April 2007. This policy was developed to properly coordinate and effectively manage the Fund’s public relations, ensuring it meets the public’s need for information and maintains and further develops its reputation of being a transparent public organization, in accordance with the Law of the Republic of Azerbaijan “On right to obtain information”. Instruments employed by the Oil Fund for public information and disclosure purposes include: ● Press-releases;


● Quarterly and annual reports; ● The official website; ● Press conferences; ● Disclosures and publications in the mass media. SOFAZ issues press releases about its assets, projects, revenues and expenditures through the periodical press on a quarterly basis. Furthermore, press releases are used to inform the public about various events and meetings held at the Fund. SOFAZ publishes quarterly revenue and expenditure statements, annual reports and reports on EITI activities through the press and its own website (www.oilfund.az). It ensures the transparency of the revenues from the management of the natural reserves and their utilization. Quarterly press conferences are held for media representatives in order to keep them updated of the Oil Fund’s activities. In addition, SOFAZ’s Executive Director gives interviews to reputable local and international media. Oil Fund always takes an interest in answering questions of public. SOFAZ replies to all verbal and written Fund-related requests directed to the Fund in the frame of time envisaged by the Law of the Republic of Azerbaijan «On right to obtain information».

During the seminar journalists were informed about SOFAZ, the organizational structure, Fund’s management mechanism, SOFAZ’s budget, financed projects, new investment policy, transparency activities, information about sovereign wealth funds and financial markets.

5.2. Extractive Industries Transparency Initiative (EITI) activities The Extractive Industries Transparency Initiative (EITI) is designed to promote transparency and accountability in the extractive industry. It was first announced in September 2002 in Johannesburg by British Prime Minister Tony Blair. The first EITI conference was held in London on 17 June 2003. A delegation, headed by the current President of the Republic of Azerbaijan Ilham Aliyev, attended the conference and announced Azerbaijan’s accession to the international initiative.

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The EITI Committee was set up by the Cabinet of Ministers of the Republic of Azerbaijan in its 13 November 2003 decree. The Committee, chaired by the Executive Director of the Oil Fund, consists of representatives of the ministries of Foreign Affairs, Economic Development, Industry and Energy, Finance, Taxes, Ecology and Natural Resources, the State Statistical Committee, the State Oil Company and the Ambassador of the Republic of Azerbaijan in the United Kingdom of Great Britain and Northern Ireland.

ANNUAL REPORT 2012

66

Transparency has been a key principle in the State Oil Fund’s operations since its inception. Regular auditing of the Fund’s financial statements by a global reputable auditor is used as the primary safeguard to ensure the transparency of SOFAZ operations. The State Oil Fund’s financial performance in 2011 was audited by Ernst&Young.

The purpose of the seminar was to enhance the awareness of mass media about the Oil Fund who carefully deals with transparency issues and is highly valued by numerous authoritative international organizations for its achievements, to disseminate professional information about the Fund and to cooperate with mass media on providing information to the population about SOFAZ.


ANNUAL REPORT 2012

5.1. SOFAZ public relations

The EITI is a voluntary initiative, supported by companies, governments, investors and civil society organizations. It provides the implementing countries with a significant capacity to demonstrate a completely transparent investment environment that is attractive to investors and to international financial institutions. The EITI acts as a major incentive to improve accountability and governance in a politically stable and rapidly growing country. This, in turn, helps to avoid any possible disagreements that may arise over the revenue distribution in the extractive industries. On 24 November 2004, the EITI Committee, local and foreign oil and gas companies and the Increasing Transparency in the Extractive Industries Coalition of NGOs signed a memorandum of Understanding on implementing the EITI in Azerbaijan. The government of Azerbaijan discloses its EITI reports about the mechanism as stipulated by the memorandum. In accordance with the memorandum, a competition is held to select a reliable international audit firm for each reporting cycle to analyze and reconcile government


and company reports. The successful bidder is selected by EITI multi-stakeholder Group (MSG), consisting of representatives of the parties to the Memorandum.

On 29 June 2012 the first annual report on implementation of Extractive Industries Transparency Initiative in Azerbaijan for the year 2011 was published.

All companies operating in extractive industries, as well as state enterprises are involved in EITI implementation process. The government has also ensured active participation of the civil society in development, monitoring and evaluation of the EITI implementation process.

The report is published based on new rules on EITI adopted at the V Global EITI Conference in Paris in 2011.

In 2012, the Oil Fund continued its activities within EITI.

ANNUAL REPORT 2012

On December 14, 2012, Moore Stephens, the audit company and the EITI Secretariat arranged a training session with the organizational support of BP for local and foreign companies operating in the extractive industry of Azerbaijan. The main purpose of the training was to eliminate inconsistencies and errors detected during the reconciliation of EITI reports in Azerbaijan, and the attempt to increase the quality of EITI reporting by reducing the number of such errors in reports for the next accounting period. Such training, which was held in Azerbaijan for the first time, allowed its participants to communicate with both employees of other companies, and directly with the auditors. Thus, the training participants managed to clarify various aspects related to the preparation of the EITI reports, get timely answers to their questions. Representatives of local and foreign companies participated in the training and they have increased their professionalism on preparation of EITI reports. The meeting of the Multi-stakeholder Group (MSG) on implementation of EITI in Azerbaijan was held on June 4, 2012. At the meeting Azerbaijan Government Committee on EITI announced the release of the Government’s EITI report (2011) audited by Moore Stephens, the independent Aggregator. The release is accompanied by the Aggregator’s opinion based on individual submissions of extractive industry companies participating in the EITI process in Azerbaijan. At the meeting held on July 17, 2012, the EITI NGO Coalition presented its opinion with regard to the 16th report on the EITI (for 2011 reporting year) – Government’s report and the Independent Accountants’ Opinion (IAO). In 2012, another innovation was implemented in the EITI process in Azerbaijan and the EITI report was issued on August 31 of in the form of an integrated document. This document includes a report on the aggregate revenues received by the Government of the Republic of Azerbaijan from the extractive industries, the Independent Accountants opinion and the opinion of the EITI Coalition of public organizations, which earlier were issued separately.

The last meeting of the MSG for the year 2012 was held on 21 December 2012. 2013 EITI Work plan was approved, other issues on EITI implementation in Azerbaijan were discussed and appropriate decisions were made at the meeting.

5.3. International Forum of Sovereign Wealth Funds

69 The International Forum of Sovereign Wealth Funds (IFSWF or Forum) was established by the International Working Group of Sovereign Wealth Funds, meeting in Kuwait City on 5-6 April 2009. IFSWF is a voluntary group of Sovereign Wealth Funds (SWFs), which meets, exchanges views on issues of common interest and facilitates an understanding of the Santiago Principles and of SWF activities. The State Oil Fund of the Republic of Azerbaijan is an active member of IFSWF and has systematically participated in its meetings. IFSWF held its first meeting in Baku organized by the government of Azerbaijan and SOFAZ on 8-9 October 2009. IFSWF met for its fourth annual meeting in Mexico City, Mexico on September 5–7, 2012. Hosted by the Mexican Ministry of Finance and Public Credit, the Forum advanced on its commitments made in Beijing in May 2011 by discussing the IFSWF Members application of the Santiago Principles, risk management and the investment environment, commitment to an open investment environment, as well as making progress on its internal governance issues. In accordance with Santiago Principle №24, SOFAZ published its first self-assessment report on its adherence to these Principles and the report is reviewed on an annual basis. The report is presented in the Appendix.

ANNUAL REPORT 2012


The delegation of representatives of Kyrgyzstan and Tajikistan visited Azerbaijan between March 6-30, 2012 and Afghani delegation visited Baku on 5 November, 2012. During the meetings the delegations had studied the experience earned by Azerbaijan in the management of revenues received from the extractive industries and the provision of transparency in this field.

On September 24, 2012, SOFAZ held a meeting with a youth delegation of the African Union. The African Union was represented by 16 countries in the meeting. During the meeting participants widely discussed the issues related to the situation in the oil and gas sector of Azerbaijani economy, national strategy, management of oil revenues, implementation mechanism and coordination structure of the EITI in Azerbaijan and associated problems and prospects, the significance of the EITI for our country and many other aspects. Young delegates received answers to their questions as to the EITI implementation and reporting in Azerbaijan.


The EITI International Board held 19th meeting in Sussex, England on 14-15 February, 2012. The delegation headed by the Chairman of the National EITI Committee, a member of the EITI International Board and the Executive Director of the State Oil Fund of the Republic of Azerbaijan Shahmar Movsumov participated at this meeting.

68


Nasimi’s Verbal Apologetics i ince very old times and throughout the Middle Ages, people, poets in particular, have always adored the power oof the word viewing it as the world’s greatest miracle. This was far not by chance, for it was the word that differed w hhumans other th animate beings due to the ability to convey the most intricate message through the combination of sounds and letters. It is by this very reason that the leading intellectuals of various periods were searching their minds out trying to figure out the mystery of the very emergence of the phenomenon of the word, with innumerable poems and philosophical treatises dedicated thereto. Nasimi was one of the strong believers in the word’s magic power and exceptional capacity in educating and bringing up a perfect individual. Therefore, in a number of his works the poet openly expresses his adoration of the word, the word of poetry in particular. This was the driving force behind Nasimi’s lines, stanzas, couplets and whole gazals eulogizing the ma or cultural and spiritual accomplishments in human history. "The Word", a gazal presented hereby, is one of the best examples of his legacy dedicated to this particular issue. According to Nasimi, the very concepts of flesh or spirit are nothing but words. This is the reason why the words are vested with divine force, i.e. the force to create. So those having command over words are capable of fully mastering this force. That being said, the words also differ depending on the might of those pronouncing them, thus the most potent word is the one delivered by the Almighty through His Prophet, i.e. the word of the Holy Qur’an. Creative individuals are striving to reach this unattainable point from time to time.

Numerous eulogies to the power of the word were written in the Azerbai ani literature both prior to Nasimi and afterwards, the most remarkable out of them, to our point of view, belong to Muhammad Fuzuli (1494-1556), a true genius of the Azerbai ani poetry. The following couplet by Fuzuli is particularly recognized in this respect: The human flesh is live with word, A wordless flesh is alien’s award. As a Hurufi intellectual, along with words, Nasimi attached an enormous value to the Arabic letters of the Holy Qur’an, reiterating their significance times and again in his works. Fazlullah Naimi, the founding father of Hurufism, claimed that once the almighty created the Universe with ust two letters in Arabic (Kainat, comprising the two basic consonants: ‘kaf’ and ‘nun’), and the whole of Qur’an was created with only 28 letters, then the letters are sacred in their nature. The number of letters in the Arabic and Farsi alphabets (28 and 32 respectively), as well as their interrelationship (28+4) presents a set of mysterious figurative symbols for the Hurufis. Through specific manipulations with letters and figures, the Hurufis tried to prove the level of sanctity of an individual together with the capacity to ascend to a certain level of divinity. Comparing the shape of facial hair and wrinkles to certain letters and figures they tried to read certain Qur’anic verses and thus identified an individual as a saint. It is true that the Hurufis used a great deal of mystical and cabbalistic elements, however their ultimate goal was to prove the divine origin of human beings and through this to put end to oppression, violence, misery and humiliation. Nasimi’s "The Word" is conveying this message.

The Word Come, heed this word, for is not soul – the word? High heaven is the dwelling of the word. From every angle grasp it and observe This fact: the world’s Creator is the word. Know that the Author and the Book are one, The Self-sufficing Cause explains the word. O sage, note well the legend, realise There can be no suspicion of the word. The prophet said the heart is mercy’s throne, Because he saw the heart breathes with the word. “I count on you,” Ali said, “Succour me!” On learning there was refuge in the word. The word cannot be made, so mark this well: No payment is exacted for the word. The universal reason, tablet, Pen, Four elements and Heaven are the word. What lies without, within, begins and ends, Is manifest and secret – is the word.

Of reason and our origin the proof, Enlightener of all – such is the word. The world was shaped by letters B and E. If this you grasp, then clear becomes the word. The blameless Jesus and the blest Mohammed, The Mahdi, Lord of Time – are the pure word. All this explains, if you would understand What kind of word it constitutes the word. “The Book of Eternity” you must acquire To learn that what most matters is the word. Is not the word sublime enough to say That Fazlullah, the wise one, is the word? Be sensible and check your wagging tongue, Nasimi, for unbounded is the word.


ANNUAL REPORT 2012

Since its inception, SOFAZ has cooperated closely with a number of economic organizations, financial institutions and banks, both in Azerbaijan and worldwide. Its economic relations with all its counterpart organizations are based on the principles of respect, transparency, mutual trust and reliable partnership.

The State Oil Fund’s budget for 2012 was approved by Decree No.570 of the President of the Republic of Azerbaijan on 29 December, 2011.

The great success the State Oil Fund has been able to achieve in a short period of time stems mainly from its personnel’s creative approach, hard work and, above all, eagerness to improve their qualifications and corporate culture. The Fund’s team consisting of highly qualified and competent young professionals values personal respect, responsibility and teamwork. The State Oil Fund assigns particular importance to solidarity, mutual trust, understanding, professionalism, conscientiousness and teamwork. It is through teamwork and joint efforts that it has been able to gain success and a good reputation, not only in Azerbaijan but worldwide, as well. Complete and accurate information about all proceeds from the country’s sales of each barrel of oil and each cubic metre of gas under production sharing agreements is freely available on SOFAZ website thanks to the Transparency Initiative. By making information on its revenues and income publicly available, the State Oil Fund strengthens the trust of the country’s citizens and international organizations in the transparency of its operations. As a highly specialized entity, the State Oil Fund operates in accordance with transparency principles and criteria. The Fund is highly praised at home and abroad as an example of credibility and transparency because of its transparent work with its staff, counterparties and external managers in line with best international practices. Azerbaijan’s complete compliance with the EITI principles and criteria and the Fund’s achievements in implementing the EITI brought SOFAZ the UN 2007 Public Service Award and the EITI 2009 Award.

In order to ensure timely implementation of arrangements related to socio-economic issues and settlement of refugees and internally displaced persons in 2012, changes were made to the budget of the State Oil Fund by Decree No.589 of the President of the Republic of Azerbaijan on 8 February, 2012. Based on the changes, the expenditures related to financing of arrangements related to social conditions and settlement issues of refugees and internally displaced persons was increased from AZN 110 000.0 thousand to AZN 300 000.0 thousand, and total budget expenditures of the Fund increased from AZN 10 561 304.0 thousand to AZN 10 751 304.0 thousand accordingly.

77 By Decree of the President of the Republic of Azerbaijan on 2 July, 2012 the budget of the State Oil Fund was amended again. One of the reasons for this amendment was expected additional revenues to Azerbaijani Government from Production Sharing Agreements due to high level of crude oil prices. Another reason was the need to specify the revenues of the budget of SOFAZ for 2012 related to the changes in the state budget of Republic of Azerbaijan for 2012. Based on these changes, net revenues generated from the sale of the Republic of Azerbaijan’s share of hydrocarbons was increased from AZN 10 365 432.0 thousand to AZN 13 388 644.0 thousand, at the same time revenues of AZN 1 572.6 thousand related to “Bonuses paid by investors when signing and fulfilling oil and gas contracts” was added and the total amount of revenues of SOFAZ was increased from AZN 10 697 030.6 thousand to AZN 13 721 815.2 thousand accordingly.

Revenues Effective use of the country’s resources by applying state-of-the-art technologies, utilization of the resulting proceeds and revenues to improve the welfare of the nation and the country, fair distribution of oil revenues between current and future generations are the primary goals and objectives of the State Oil Fund. Mutual respect, trust, teamwork and transparent operations provide the necessary foundation and favourable conditions for achieving these goals.

In 2012 the State Oil Fund’s revenues amounted to AZN 13 674.1 million, which compared to the amount indicated in the budget (AZN 13 721.8 million) was implemented at 99.7% level. Foreign currency translation gain was AZN 253.4 million. Differences in the implementation of each revenue item in 2012 SOFAZ budget are as follows:

ANNUAL REPORT 2012


7. 2012 STATE OIL FUND'S BUDGET EXECUTION


76

6. OUR VALUES: RESPECT, TEAMWORK, TRUST, TRANSPARENCY

2012 STATE OIL FUND'S BUDGET EXECUTION

In 2012 SOCAR, Total E&P Azerbaijan B.V. and SOCAR OIL affiliate company paid USD 1.5 million in accordance with the implementation of 28.2 Article of Exploration, Development, and Production Sharing Agreement for the Absheron Offshore Block in the Azerbaijani Sector of the Caspian Sea. Besides, SOCAR, BP (Azerbaijan) Exploration and SOCAR OIL affiliate company paid USD 2.1 million in accordance with the implementation of 28.2 Article of Exploration, Development, and Production Sharing Agreement for the Shafag-Asiman Offshore Block in the Azerbaijani Sector of the Caspian Sea. At the same time, SOCAR, Bahar Energy Operating Limited and SOCAR Oil affiliate company paid USD 0.2 million (due to less coverage of production area in Bahar and Gum Deniz Fields compared to initial forecasts, Bahar Energy LTD paid to budget less than USD 0.62 million) in accordance with the implementation of 31.2 Article of Exploration, Rehabilitation, Development and Production Sharing Agreement for the Bahar and Gum Deniz Fields in the Azerbaijani Sector of the Caspian Sea. Due to these, revenues under this item were executed 90% against the budgeted amount (AZN 3.3 million).

Other revenues and proceeds. In 2012, assets (obsolete or unused metal scrap, pipes) received from investors (international oil companies) under oil and gas contracts were sold, bringing SOFAZ AZN 0.3 million. This revenue item was executed at 28% level of the planned AZN 0.9 million. (The execution level of the budget is presented in Table 7.1.). Table 7.1. Revenues of SOFAZ in 2012

№

BUDGETED ACTUAL

1.

2. 3.

Revenues from transportation of oil and gas through the territory of Azerbaijan. Revenues from transportation of oil and gas through the territory of Azerbaijan (transit fees) amounted to AZN 7.9 million or USD 10.0 million in 2012. Transit fee revenues were fulfilled at 97% level of the planned AZN 8.1 million. A 3% gap for this revenue item is a result of lower crude oil production and a decrease in oil transportation through Baku-Supsa pipeline in 2012. Bonuses paid by investors when signing and fulfilling oil and gas contracts. In 2012 revenues from this source equaled to AZN 1.6 million or USD 2.0 million. The payment due in 2011 (to be paid within 30 days from the signature date) according to the Production Sharing Agreement between SOCAR, UGE-LANCER PTE LTD and SOCAR OIL affiliate company for Exploration, Rehabilitation, and Development of Balakhani-Sabunchu-Ramana and Kurdakhani Oil Field Blocks, was transferred to SOFAZ in 2012.

REVENUE ITEMS

AMOUNT OF THE REVENUES AZN MLN.

4. 5. 6.

Net revenues generated from the sale of the share of the Republic of Azerbaijan in hydrocarbons (excluding expenditures on transportation of hydrocarbons, customs clearance and banking costs, marketing, insurance and independent surveyor fees, as well as shareholder revenues of State Oil Company of the Republic of Azerbaijan from the investments in the projects where it is an investor, participant or a contracting party) Acreage fees paid by foreign investors for the use of contract areas for development of hydrocarbon resources Revenue from transporting oil and gas through the territory of the Republic of Azerbaijan Bonuses paid to the State Oil Company of the Republic of Azerbaijan or other relevant state bodies by investors when signing and fulfilling oil and gas contracts Asset management revenues of the State Oil Fund Other revenues and proceeds Total revenues Extra-budgetary revenues

EXECUTION PERCENTAGE

13 388.6

13 117.4

98.0

3.3

3.0

90.0

8.1

7.9

97.0

1.6

1.6

100.0

319.2 0.9 13 721.8

544.0 0.3 13 674.1 253.4

170.3 28.0 99.7

Expenditures During the reporting year, the State Oil Fund’s budget expenditures amounted to AZN 10 573.6 million which made up 98.4% of the planned expenditures (AZN 10 751.3) million.



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Acreage fees paid by foreign investors for the use of contract areas for development of hydrocarbon resources. Acreage fees received by the Oil Fund in the year under review was AZN 3.0 million, or USD 3.8 million.

Asset management revenues of SOFAZ. Revenues generated through asset management equaled to AZN 544 million (USD 693.5 million) which was over-fulfilled by 70.4%. In 2012 the SOFAZ’s investment portfolio yielded 2.2% rate of return.


ANNUAL REPORT 2012

Profit proceeds from sales of hydrocarbons. In 2012 the State Oil Fund received a total of AZN 13 117.4 million, or USD 16 695.8 million, from sales of the Republic of Azerbaijan’s share of hydrocarbons, which compared to the initially forecasted amount (AZN 13 388.6 million) was implemented at 98% level. The reason of lower level of implementation of this revenue item was production of crude oil at a level relatively lower than the volume planned in the budget of SOFAZ. On the other hand the revenues of USD 234.2 million from the sale of 2.1 million barrel crude oil on 30.10.2012 by SOCAR was expected to be included in the Oil Fund’s budget within 120 days (on 28.02.2013). Therefore, this amount will be allocated to 2013 budget.



The improvement of the social and economic conditions of refugees and internally displaced persons. In 2012 the State Oil Fund allocated AZN 300 million for this project. This expenditure item was fulfilled by 100% as planned. Transfers to the state budget of the Republic of Azerbaijan in 2012. Budget transfers of AZN 9 905.0 million constituted significant portion (93.7%) of the State Oil Fund’s budget expenditures in 2012. This expenditure item was fulfilled by 100% as planned.

Financing the State Program on the Education of Azerbaijani Youth Abroad. In 2012 the State Oil Fund allocated AZN 20 million to finance “The State Program on the Education of Azerbaijani Youth Abroad in the years 2007–2015” as adopted by Decree of the President of the Republic of Azerbaijan No.2090 on 16 April 2007. Administrative expenses of the State Oil Fund. Administrative expenses of SOFAZ totaled to AZN 29.6 million which amounted to 40.1% of its 2012 approved budget expenditure item (AZN 73.8 million). Under-fulfillment of this expenditure item can be explained by lower than the planned costs on the construction of the Fund’s new administrative building and management fees paid to external asset managers during the year.

ANNUAL REPORT 2012

№

EXPENDITURE ITEMS

The improvement of the social and 1. economic conditions of refugees and internally-displaced persons Transfers to the state budget of the 2. Republic of Azerbaijan in 2012 Samur-Absheron irrigation system 3. reconstruction project New Baku-Tbilisi-Kars railway construction 4. project Financing the State Program on the 5. Education of Azerbaijani Youth Abroad in the years 2007-2015 Administrative expenses of the State Oil 6. Fund Total

AMOUNT OF EXPENDITURES AZN MLN. BUDGETED ACTUAL

EXECUTION PERCENTAGE

300.0

300.0

100.0

9 905.0

9 905.0

100.0

200.0

200.0

100.0

252.5

119.0

47.1

20.0

20.0

100.0

73.8

29.6

40.1

10 751.3

10 573.6

98.4



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New Baku-Tbilisi-Kars railway construction project. In 2012 the State Oil Fund allocated AZN 119.0 million to finance the new Baku-Tbilisi-Kars railway construction project and the Oil Fund fulfilled this expenditures item by 47.1% of the planned AZN 252.5 million.

Table 7.2. Expenditures of SOFAZ in 2012


Samur-Absheron irrigation system reconstruction project. In 2012 the State Oil Fund allocated AZN 200 million to finance this project, fulfilling this expenditure item by 100%.


Separation Torment of Lyrical ‘Self’ a anegyric to the torment and ordeal of an individual sseparated from his beloved one constitutes the leitmotif oof Nasimi’s lyrics. This motif, known and widely used in tthe world literature and ancient philosophy since times iimmemorial, i l was particularly typical of pantheistic artists. E.g., the ancient Greek philosophers like Plato or Socrates used to resort to love-crazed characters neglecting their flesh and obsessed with the desire to merge with the whole of the world. Nasimi is not alien to the ‘platonic love’ motifs either. However, the way he approaches this motif is different from that of philosophers. For Nasimi, ‘platonic love’ evolves into human love whereby the hero is tormented by the love to a real beauty. The poet’s lyrical ‘self’ addresses the heart’s desire of his hero aspiring to put end to the torment of being apart and en oy the moment of reunion. Meanwhile, the fate itself is scaring the person in love who, nonetheless, is ready and willing to suffer from his beloved one’s nostalgia for the rest of his life. What is no less important is that despite the bitterness of being apart, the hero retains his faithfulness and dedication. So it is this lofty sentiment that makes the hero so ennobled and almost sacred for the reader. In fact, this torment and torture one voluntarily undertakes in the sake of love becomes one of the ways to accomplish perfection. It is a trial, and only those capable of meeting this test of love are the ones truly fallen in love. Nasimi’s love is not only addressed to the beautiful ones. It encompasses the whole of humankind, or, to be more precise, the people of spiritual beauty and rich inner world. Therefore the love shed by the outstanding poet makes no formal difference among the people, with wisdom and maturity being the ma or criterion. Needless to say, in this respect, Nasimi appears as a due successor of Nizami Gan avi (1141-1209), another genius of the Azerbai ani poetry who

also opposed to conventional discrimination by saying: “Knowledge is the only power, with no other way to gain advantage whatsoever!” In fact, Nasimi views those suffering from the grief of being apart as somewhat scholars in the field of love. An important issue not to omit is that despite all tortures and torment of those fallen in love, Nasimi presents his images with hope and optimism. This is the reason why a number of his gazals show the light in the end of the tunnel. “Where are you?” and “I have found” stanzas, hereby quoted, are quite typical in this regard.

Of my eyes you are light. For sight of you my soul is thirsting. Maiden fair, like Paradise your beauty charms me. Say, where are you? To your fragrant tresses’ chains Nasimi has his heart surrendered. So what need has he of other fetters and of ail? Where are you? Imadaddin Nasimi “Poems” translated by Peter Tempest 1973, page 65

Where are you?

I have found

Fires of love consume my soul, but you can make me whole. Where are you? Soul within my soul you are. My soul is seeking you. Where are you?

Let me give thanks to God that I today my friend have found, That dwelling in my heart a brave beloved I have found.

With the wine of assignation into ecstasy you threw me. Raging heat I feel within me. Cooling fount of life, where are you?

The world with all its wealth is not a farthing worth to me, For my own coin with an impress of beauty have I found.

O rich store of beauty’s favors, I am burning. Let me see you! For there’s none but you from whom this boon I can receive. Where are you?

I was on earth yet sunbeams did become my customers. Go tell the traders I today my own rich store have found!

Destiny that promised much has wrested from my grasp your tresses. Like Med nun I am distraught and bitterly I weep. Where are you?

I do not grieve no matter how much sorrow there may be, For grief with gladness and a sympathiser I have found.

O fair beauty, swept by passion strong my yeaning eyes are burning. Tears of blood I shed for you. O graceful cypress tree, where are you?

Go tell the zealot who is calling me to Paradise Not to expect me! Here my own rose-garden have I found.

O you of the rosebud mouth, the thorn of separation galls me. Come, for blood fills like a rosebud my deserted soul. Where are you?

And it is meet that Joseph should my servant here become, For in the Egypt of thy lips sweet sugar have I found.

My precious secrets to a stranger I shall not disclose. A trusty friend – a treasure-house of secrets – I have found. The sun of oy has risen. I have woken from my sleep. The meaning of this is: a wakeful treasure I have found. To Bagdad come, O zealot, and the oyful tidings bear: A nimble-witted, whimsical beloved I have found. What do I need a soul for, wherefore do I need this world, When without argument a true companion I have found? O you who give your all to scoundrels, sleepy, heedless one, The moon-faced beauty with beguiling tresses I have found. If I, as once Mansur did, should declare that “I am God!”, Do not blame me, O had a, that a gallows I have found. If you, like Moses, are enamoured of the face of God, Behold yourself within yourself and say: “God I have found!” Nasimi for her locks’ heterodoxy gave up faith. O you in the dervish shirt, a Christian hair-belt I have found! Imadaddin Nasimi “Poems” translated by Peter Tempest 1973, page 35

Contents INDEPENDENT AUDITORS’ REPORT 92

Consolidated statement of financial performance

93

Consolidated statement of changes in net assets/equity

94

Consolidated statement of cash flows

95

Statement of comparison of budget and actual amounts

96

ANNUAL REPORT 2012

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

The State Oil Fund of the Republic of Azerbaijan Consolidated Financial Statements Year ended 31 December 2012 Together with Independent Auditors’ Report

97

2. Basis of preparation

99

3. Significant accounting policies

99

4. Significant judgments and estimates

107

5. Cash and cash equivalents

109

6. Financial assets at fair value through surplus or deficit

110

7. Financial investments held-to-maturity

112

8. Gold bullions

113

9. Investment properties

114

10. Property and equipment

115

11. Other non-current and intangible assets

116

12. Capital contributions

117

13. Transfers by the Fund

117

14. Interest income

117

15. Foreign currency translation differences

118

16. Net gain/(loss) on financial assets at fair value through surplus or deficit

118

17. Operating expenses

118

18. Income taxes

118

19. Fair value of financial instruments

120

20. Risk management

120

21. Transactions with related parties

128

22. Commitments and contingencies

129

23. Events after the reporting period

130



88

1. Principal activities


Consolidated statement of financial position

Independent auditors’ report

Management’s responsibility for the consolidated financial statements Management is responsible for the preparation and fair presentation of these consolidated financial statements in accordance with International Public Sector Accounting Standards issued by the International Public Sector Accounting Standards Board of the International Federation of Accountants, and for such internal control as management determines is necessary to enable the preparation of consolidated financial statements that are free from material misstatement, whether due to fraud or error. Auditors’ responsibility Our responsibility is to express an opinion on these consolidated financial statements based on our audit. We conducted our audit in accordance with International Standards on Auditing. Those standards require that we comply with ethical requirements and plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are free from material misstatement. An audit involves performing procedures to obtain audit evidence about the amounts and disclosures in the consolidated financial statements. The audit procedures selected depend on our judgment, including the assessment of the risks of material misstatement of the consolidated financial statements, whether due to fraud or error. In making those risk assessments, the auditor considers internal control relevant to the entity’s preparation and fair presentation of the consolidated financial statements in order to design audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the entity’s internal control. An audit also includes evaluating the appropriateness of accounting policies used and the reasonableness of accounting estimates made by management, as well as evaluating the overall presentation of the consolidated financial statements. We believe that the audit evidence we have obtained is sufficient and appropriate to provide a basis for our audit opinion.

15 April 2013



90

We have audited the accompanying consolidated financial statements of the State Oil Fund of the Republic of Azerbaijan and its subsidiaries, which comprise the consolidated statement of financial position as at 31 December 2012 and the consolidated statements of financial performance, of changes in net assets/equity and of cash flows, and statement of comparison of budget and actual amounts for the year then ended, and a summary of significant accounting policies and other explanatory information.

In our opinion, the consolidated financial statements present fairly, in all material respects, the financial position of the State Oil Fund of the Republic of Azerbaijan and its subsidiaries as at 31 December 2012, and their financial performance and cash flows for the year then ended in accordance with International Public Sector Accounting Standards.


ANNUAL REPORT 2012

To the Supervisory Board of the State Oil Fund of the Republic of Azerbaijan

Opinion

CONSOLIDATED FINANCIAL STATEMENTS


Consolidated statement of financial position As at 31 December 2012 (Thousands of Azerbaijani Manats)

Consolidated statement of financial performance For the year ended 31 December 2012 (Thousands of Azerbaijani Manats)

1,182,309 24,127,399 57,523 624,735 12,986 7,528 1,028 26,013,508

771,095 22,282,480 57,143 9,407 10,710 23,130,835

456,969 338,057 4,485 77,117 876,628

326,959 2,611 52,393 381,963

26,890,136

23,512,798

4,757

429

Net assets

26,885,379

23,512,369

Net assets/equity Contributed capital Property revaluation reserve Foreign currency translation reserve Accumulated deficit Total net assets/equity

26,929,986 1,836 (185) (46,258) 26,885,379

24,343,928 1,836 (833,395) 23,512,369

Non-current assets Financial investments held–to–maturity Investment properties Property and equipment, net Other non-current and intangible assets Total non-current assets Total assets Liabilities Current liabilities

5 6 7 8

2011

7 9 10 11

The accompanying notes on pages 97 to 131 are an integral part of these consolidated financial statements.

Notes 14 15

2012 466,882 253,387

2011 540,261 (749,751)

16

77,110 857 798,236

(363,830) (573,320)

Operating expenses Surplus/(deficit) before income tax expense

17

(7,891) 790,345

(10,794) (584,114)

Income tax expense Net surplus/(deficit) for the year

18

(3,208) 787,137

(584,114)

Interest income Net gain/(loss) on foreign currency translation differences Net gain/(loss) on financial assets at fair value through surplus or deficit Other operating income Total operating gain/(loss)



92

Assets Current assets Cash and cash equivalents Financial assets at fair value through surplus or deficit Financial investments held–to–maturity Gold bullions Tax receivables other than income tax Current income tax asset Other current assets Total current assets

2012


ANNUAL REPORT 2012

Notes




Consolidated statement of changes in net assets/equity For the year ended 31 December 2012 (Thousands of Azerbaijani Manats)

Consolidated statement of cash flows For the year ended 31 December 2012 (Thousands of Azerbaijani Manats)

Contributions received Net surplus for the year Exchange differences on translation of foreign operations Transfers to the State Budget Transfers to the State Refugees Committee and Internally Displaced Peoples’ Social Development Fund Transfers for the reconstruction of SamurAbsheron Irrigation system Transfers for the construction of new Baku-Tbilisi-Kars railway line Transfers for the State Program on “Education of Azerbaijani youth abroad” 31 December 2012

12 10

12

18,441,696 15,451,696 -

4,441 (2,074)

-

(249,812) -

18,196,325 15,451,696 (2,074)

(9,000,000)

(531) -

-

531 (584,114) -

(584,114) (9,000,000)

(199,998)

-

-

-

(199,998)

(161,926)

-

-

-

(161,926)

(139,974)

-

-

-

(139,974)

(32,567)

-

-

-

(32,567)

(14,999) 24,343,928

1,836

-

(833,395)

(14,999) 23,512,369

13,130,042 -

-

-

787,137

13,130,042 787,137

(9,905,000)

-

(185) -

-

(185) (9,905,000)

(299,982)

-

-

-

(299,982)

(199,997)

-

-

-

(199,997)

(119,028)

-

-

-

(119,028)

(19,977) 26,929,986

1,836

(185)

(46,258)

(19,977) 26,885,379


Operating cash flows from interest received

2012

2011

790,345

(584,114)

10 11

125 48

101 88

16 15

(122,832) (296,384) (40,118)

331,381 695,520 (22,205)

(1,399,792) (130,390) (338,057) (624,735) (3,579) (1,028) 4,328 (2,162,069) (32) (2,162,101)

(5,419,139) (384,248) (7,165) 234 86 (5,389,461) (5,389,461)

10 11

(1,999) (145) (24,627) (26,771)

(78) (282) (39,027) (39,387)

12

13,130,042 (9,905,000) (199,997) -

15,451,696 (9,000,000) (199,998) (32,567)

(299,982) (119,028)

(139,974) (161,926)

(19,977) 2,586,058 14,028 411,214 771,095 1,182,309

(14,999) 5,902,232 (16,072) 457,312 313,783 771,095

507,001

518,056

5 5




94

31 December 2010 Contributions received Revaluation of building Depreciation transfer for building Net deficit for the year Transfers to the State Budget Transfers for the reconstruction of SamurAbsheron Irrigation system Transfers for the construction of new Baku-Tbilisi-Kars railway line Transfers to the State Refugees Committee and Internally Displaced Peoples’ Social Development Fund Transfers for the construction of Oguz-Gabala-Baku water pipeline Transfers for the State Program on “Education of Azerbaijani youth abroad” 31 December 2011

Notes Cash flows from operating activities: Surplus/(deficit) before income tax expense Adjustments to reconcile deficit to net cash used in operating activities Depreciation of property and equipment Amortization of intangible assets Unrealized (gain)/loss on change in fair value of financial assets at fair value through surplus or deficit Net unrealized (gain)/loss on foreign currency translation differences Change in interest accruals Changes in operating assets and liabilities: Increase in financial assets at fair value through surplus or deficit Increase in financial investments held-to-maturity Increase in investment properties Purchase of gold bullions Increase in tax receivables other than income tax (Increase)/decrease in other assets Increase in current liabilities Net cash used in operating activities before income tax Income taxes paid Net cash used in operating activities after income tax Cash flows from investing activities: Purchase of property and equipment Purchase of intangible assets Increase in other non-current assets Net cash used in investing activities Cash flows from financing activities: Contributions received Transfers to the State Budget Transfers for the reconstruction of Samur-Absheron Irrigation system Transfers for the construction of Oguz-Gabala-Baku water pipeline Transfers to the State Refugees Committee and Internally Displaced Peoples’ Social Development Fund Transfers for the construction of new Baku-Tbilisi-Kars railway line Transfers for State Program on “Education of Azerbaijani youth abroad” Net cash from financing activities Effect of exchange rate changes on cash and cash equivalents Net increase in cash and cash equivalents Cash and cash equivalents, beginning of the year Cash and cash equivalents, end of the year


ANNUAL REPORT 2012

Foreign Property Accumulated Total Contributed currency Notes revaluation Surplus/ net assets/ capital translation reserve (deficit) equity reserve

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Thousands of Azerbaijani Manats)


1. Principal activities

Statement of comparison of budget and actual amounts1 For the year ended 31 December 2012 (Thousands of Azerbaijani Manats) Annual budgeted amounts

Payments Transfers to the State Budget Reconstruction of Samur-Absheron Irrigation system Transfers to the State Refugees Committee and Internally Displaced Peoples’ Social Development Fund Construction of new Baku-Tbilisi-Kars railway line Education of Azerbaijani youth abroad Expenses for managing the Fund2 Total payments Net receipts

12

Final3

10,365,432 319,219

13,388,644 319,219

13,117,355 543,992

12

-

1,573

1,573

12

8,137

8,137

7,891

12

3,343 900 10,697,031

3,343 900 13,721,816

3,008 252 13,674,071

(9,905,000) (200,000)

(9,905,000) (200,000)

(9,905,000) (199,997)

(110,000) (252,484) (20,000) (73,820) (10,561,304)

(300,000) (252,484) (20,000) (73,820) (10,751,304)

(299,982) (119,028) (19,977) (29,622) (10,573,606)

135,727

2,970,512

3,100,465

1

The Statement of comparison of budget and actual amounts only refer to the State Oil Fund of the Republic of Azerbaijan and excludes its subsidiaries.

2

Explanation of material differences between the annual original and final budget for which the Fund is held publicly accountable, and the final annual budget and actual amounts are part of the annual report of the Fund.

3

According to the decree #570 of the President of the Republic of Azerbaijan on the approval of the budget of the State Oil Fund of the Republic of Azerbaijan dated 29 December 2011 and decrees #589 and #666 of the President of the Republic of Azerbaijan on the amendments to the budget of the State Oil Fund of the Republic of Azerbaijan dated 8 February 2012 and 2 July 2012 respectively.


In accordance with the Decree and the Regulations (discussed below), SOFAZ is an extra-budget state organization, formed as a separate legal entity, which is accountable and responsible to the President of the Republic of Azerbaijan. The consolidated financial statements include the financial statements of SOFAZ and its direct and indirect subsidiaries (together the “Fund”) listed in the following table:

% interest Date of Date of establishment acquisition

Subsidiary

2012

2011

Country

SOFAZ Re Ltd.

100.00

-

Jersey Islands

22-May-12

-

SOFAZ Re UK L.P.

100.00

-

Jersey Islands

6-Aug-12

-

SOFAZ Re Min Ltd. 78, St James’s Street Unit Trust

100.00

-

Jersey Islands

13-Aug-12

-

100.00

-

Jersey Islands

2-Oct-12

-

JSC Tverskaya 16 SOFAZ RE Europe Holding Sarl

100.00

-

Russian Federation

29-Jun-93

21-Dec-12

100.00

-

Luxembourg

31-Oct-12

-

SOFAZ RE Europe Sarl

100.00

-

Luxembourg

31-Oct-12

-

SCI 8 Place Vendome

100.00

-

France

14-Nov-12

-

Industry property management property management property management property management property management property management property management property management

SOFAZ’s subsidiaries are entities which own the investment properties located in United Kingdom and Russia as described in Note 9. Subsidiaries in Luxembourg and France are established to hold and own investment properties in Europe in the future. Contributions into the Fund are made in accordance with the Regulation of the Fund (“Regulation”) approved by Presidential Decree #434 dated 29 December 2000 as amended by Presidential Decrees #849 and #202 on “Amending Certain Legislative Acts Regulating the Operations of The State Oil Fund of the Republic of Azerbaijan” dated 7 February 2003 and 1 March 2005, respectively, and Article 2.3 of the “Regulations on Development and Implementation of the Annual Program of Income and Expenses (Budget) of the Fund” approved by Presidential Decree #579 dated 12 September 2001 as amended by Presidential Decrees #849 and #202 mentioned earlier. Pursuant to the Regulations of the Fund, contributions are received from the following sources:



96

Receipts Contributions received from sales of profit oil and gas Income from placement and management of assets1 The oil and gas agreements signature or performance bonuses paid by investors to the State Oil Company of the Republic of Azerbaijan or an authorized state body Income from transit of oil and gas through the territory of the Republic of Azerbaijan Acreage fees by the foreign investors for use of the contract areas in connection with the development of hydrocarbon resources Other gains and receipts Total receipts

Original3


ANNUAL REPORT 2012

Notes2

Actual amounts on a comparable basis

The State Oil Fund of the Republic of Azerbaijan (“SOFAZ”) was established by Decree #240 of the President of the Republic of Azerbaijan on the “Establishment of The State Oil Fund of the Republic of Azerbaijan” dated 29 December 1999 (the “Decree”). The purpose of SOFAZ is to ensure the accumulation, effective management, and use of income and other inflows generated from agreements related to oil and gas exploration and development, as well as, from SOFAZ’s own activities, for the benefit of citizens and future generations of the Republic of Azerbaijan.


a) Revenues generated from implementing agreements on exploration, development and production sharing for oil and gas fields in the territory of the Republic of Azerbaijan including the Azerbaijan Sector of the Caspian Sea, as well as other agreements on oil and gas exploration, development and transportation entered into between the State Oil Company of the Republic of Azerbaijan (“SOCAR”) or other authorized state bodies and investors, including: i. Net revenues from the sale of hydrocarbons related to the share of the Republic of Azerbaijan (net of expenditures incurred for hydrocarbons transportation, customs clearance and bank costs, marketing, insurance, and independent surveyor fees) excluding revenues related to the participating interest or investment of SOCAR in a project in which SOCAR is an investor, participant or a contracting party; ii. Price adjustment revenues under Shah Deniz Phase I;

ANNUAL REPORT 2012

v. Dividends and profit participation revenues related to the share of the Republic of Azerbaijan in connection with oil and gas agreements, excluding revenues related to a participating interest or investment of SOCAR in a project in which SOCAR is an investor, participant or a contracting party; vi. Revenues generated from oil and gas transported over the territory of the Republic of Azerbaijan with the use of the Baku-Supsa, Baku-Tbilisi-Ceyhan (“BTC”) and Baku-Tbilisi-Erzurum export pipelines; vii. Revenues generated from transfer of assets from investors to SOCAR and/or an authorized state body within the framework of oil and gas agreements. b) Revenues generated from investment, management, sale and other disposal of the Fund’s assets (including financial assets and assets contributed by investors within oil and gas agreements), other nonsale income or revaluation surplus of the Fund’s assets in its reporting currency (Azerbaijani manats), etc.; c) Grants and other free aids; d) Other revenues and receipts in accordance with the legislation of the Republic of Azerbaijan. Under the provisions of the Fund’s Regulations approved by the President of the Republic of Azerbaijan, SOCAR or an authorized state body implements the collection of the fees and revenues listed above and their transfers to the Fund. The Regulations exclude the following from the list of sources of the Fund’s revenue and assets:

The Fund’s registered office address is: 20, Bulbul Avenue, Baku, Azerbaijan, AZ1014. The actual address of the Fund is 24, Neftchiler Avenue, Baku, Azerbaijan, AZ1000. These consolidated financial statements as of and for the year ended 31 December 2012 were authorized for issue by the Fund’s Management on 15 April 2013.

2. Basis of preparation These consolidated financial statements have been prepared in accordance with International Public Sector Accounting Standards (“IPSAS”) issued by the International Public Sector Accounting Standards Board (“IPSASB”) of the International Federation of Accountants (“IFAC”). IPSAS are developed by adopting International Financial Reporting Standards (“IFRS”) to the public sector context. IFRS comprise standards issued by the International Accounting Standards Board (“IASB”), and Interpretations issued by the International Financial Reporting Interpretations Committee (“IFRIC”). The public sector refers to national governments, regional governments, local governments and related governmental entities. As permitted by IPSAS, the Fund follows the provisions of IFRS pronouncements in the absence of equivalent IPSAS. These consolidated financial statements have been prepared on the assumption that the Fund is a going concern and will continue in operation for the foreseeable future. These consolidated financial statements are presented in thousands of Azerbaijani Manats (“AZN”), unless otherwise indicated. These consolidated financial statements have been prepared under the historical cost convention, except for the measurement at fair value of financial assets at fair value through surplus or deficit, gold bullions, investment properties and buildings.

● The rental fees from the use of state property under contracts with foreign companies; ● Revenues from the sale of hydrocarbons related to the participating interest or investment of SOCAR in any project in which SOCAR is an investor, participant or a contracting party; and ● Other revenues generated from joint activities with foreign companies.

3. Significant accounting policies Changes in accounting policies The Fund has adopted the following amended IPSAS effective during the year. The principal effects of these changes are as follows: Amendment to IPSAS 1 “Presentation of Financial Statements”



98

iv. Acreage payments due to SOCAR and/or an authorized state body of the Republic of Azerbaijan from investors for the use of the contract area in connection with oil and gas exploration and development;

In 2012 and 2011, the Fund was a party to a custody agreement with the Bank of New York Mellon, and five (2011: three) investment management agreements with financial institutions with Deutsche Asset Management International GmbH, Credit Suisse (on 2 April 2012 Clariden Leu legally merged with Credit Suisse, who acquired all of Clariden Leu’s assets and liabilities and assumed all of its rights and obligations), the International Bank for Reconstruction and Development (IBRD – World Bank Group), State Street Global Advisors (SSGA) and Union Bank of Switzerland (UBS). Under the custody agreements the financial institutions hold securities purchased by the Fund, whereas in accordance with the investment management agreements the financial institutions manage the Fund’s investments based on general investment policies established by the Fund.


iii. Bonuses paid by investors under the production sharing agreements to SOCAR or an authorized state body in connection with oil and gas agreements;


The amendment to IPSAS 1 was issued in November 2010, and became effective for annual periods beginning on or after 1 January 2012. Main changes covered the current/non-current classification of convertible instruments which states that terms of a liability that could, at the option of the counterparty, result in its settlement by the issue of equity instruments do not affect its classification. These amendments did not have any impact on the Fund’s financial statements.

Recognition and measurement of financial instruments

Amendment to IPSAS 2 “Cash Flow Statements”

Financial assets and liabilities are initially recognized at fair value plus, in the case of a financial asset or financial liability not at fair value through surplus or deficit, transaction costs that are directly attributable to the acquisition or issue of the financial asset or financial liability. The accounting policies for subsequent re-measurement of these items are disclosed in the respective accounting policies set out below.

The amendment to IPSAS 2 was issued in November 2010, and became effective for annual periods beginning on or after 1 January 2012. Main changes covered the cash flows on unrecognized assets which states that only cash outflows that result in a recognized asset in the statement of financial position are eligible for classification as investing activities. Also paragraph 30 in “Reporting Cash Flows from Operating Activities” section of the Standard is amended and following text deleted “The impact of any extraordinary items which are classified as operating cash flows”. These amendments did not have any impact on the Fund’s financial statements. The following amendments to standards and interpretations did not have any impact on the accounting policies, financial position or performance of the Fund:

Derecognition of financial assets and liabilities Financial assets A financial asset (or, where applicable a part of a financial asset or part of a group of similar financial assets) is derecognized where: ● The rights to receive cash flows from the asset have expired;

● IPSAS 12 Inventories

● The Fund has transferred its rights to receive cash flows from the asset, or retained the right to receive cash flows from the asset, but has assumed an obligation to pay them in full without material delay to a third party under a ‘pass-through’ arrangement; and

● IPSAS 18 Segment Reporting ● IPSAS 21 Impairment of non-cash generating assets Basis of consolidation Subsidiaries, which are those entities in which the Fund has an interest of more than one half of the voting rights, or otherwise has power to exercise control over their operations, are consolidated. Subsidiaries are consolidated from the date on which control is transferred to the Fund and are no longer consolidated from the date that control ceases. All intra-group transactions, balances and unrealized gains on transactions between group companies are eliminated in full; unrealized losses are also eliminated unless the transaction provides evidence of an impairment of the asset transferred. Where necessary, accounting policies for subsidiaries have been changed to ensure consistency with the policies adopted by the Fund. For subsidiaries acquired and treated as an asset acquisition, no deferred tax is recognized by the Fund in respect of the asset i.e. property at the time of acquisition. If the Fund loses control over a subsidiary, it derecognizes the assets and liabilities of the subsidiary, the carrying amount of any non-controlling interests, the cumulative translation differences, recorded in equity; recognizes the fair value of the consideration received, the fair value of any investment retained and any surplus or deficit in statement of financial performance and reclassifies the parent’s share of components previously recognized in equity to statement of financial performance.

● The Fund either (a) has transferred substantially all the risks and rewards of the asset, or (b) has neither transferred nor retained substantially all the risks and rewards of the asset, but has transferred control of the asset.

101

A financial asset is derecognized when it has been transferred and the transfer qualifies for derecognition. A transfer requires that the Fund either: (a) transfers the contractual rights to receive the asset’s cash flows; or (b) retains the right to the asset’s cash flows but assumes a contractual obligation to pay those cash flows to a third party. After a transfer, the Fund reassesses the extent to which it has retained the risks and rewards of ownership of the transferred asset. If substantially all the risks and rewards have been retained, the asset remains in the statement of financial position. If substantially all of the risks and rewards have been transferred, the asset is derecognized. If substantially all the risks and rewards have been neither retained nor transferred, the Fund assesses whether or not is has retained control of the asset. If it has not retained control, the asset is derecognized. Where the Fund has retained control of the asset, it continues to recognize the asset to the extent of its continuing involvement.

ANNUAL REPORT 2012


The Fund recognizes financial assets and liabilities on its statement of financial position when it becomes a party to the contractual obligations of the instrument. A purchase or sale of financial assets is recognized using trade date accounting (Resolution #32 dated 13 June 2007 issued by the Supervisory Board of The State Oil Fund of the Republic of Azerbaijan). The trade date is the date on which the Fund commits to purchase or sell an asset.

● IPSAS 9 Revenue from Exchange Transactions ● IPSAS 13 Leases

100



ANNUAL REPORT 2012


Financial liabilities A financial liability is derecognized when the obligation is discharged, cancelled, or expires. Cash and cash equivalents Cash and cash equivalents include cash on hand, deposits with original maturity of three months, and short-term, highly liquid investments i.e. money market funds, readily convertible to known amounts of cash and subject to low risk of changes in value, with an original maturity of three months or less. Cash on hand, cash in banks and deposits are carried at cost plus interest, if any.


Financial assets at fair value through surplus or deficit

Investment properties

Financial assets at fair value through surplus or deficit comprise equity and debt securities, and are classified as held for trading. A financial asset is classified as held for trading if it is:

Investment properties are properties intended to earn rentals, or for capital appreciation, or both. Investment properties measured initially at cost, including transaction costs. The carrying amount includes the cost of replacing part of existing investment properties at the time that cost is incurred if the recognition criteria are met and excludes the costs of day-to-day servicing of investment properties. Subsequent to initial recognition, investment properties are stated at fair value, which reflects market conditions at the reporting date. Gains or losses arising from changes in the fair values of investment properties are included in the consolidated statement of financial performance in the period in which they arise. Fair values are evaluated annually by an accredited external, independent valuer, applying a valuation model recommended by the International Valuation Standards Committee.

a) Acquired principally for the purpose of selling or repurchasing it in the near term; b) On initial recognition part of a portfolio of identified financial instruments that are managed together and for which there is evidence of a recent actual pattern of short-term profit taking; c) A derivative (except for a derivative that is a financial guarantee contract or a designated and effective hedging instrument).

ANNUAL REPORT 2012

e) The financial asset forms part of a group of financial assets or liabilities or both, which is managed and its performance is evaluated on a fair value basis, in accordance with the Fund’s documented risk management or investment strategy, and information about the grouping is provided internally on that basis the entity’s key management personnel. Financial assets at fair value through surplus or deficit are initially recorded and subsequently measured at fair value. The Fund uses quoted market prices and valuation model to determine fair value for financial assets at fair value through surplus or deficit. The fair value adjustment on financial assets at fair value through surplus or deficit is recognized in the statement of financial performance for the period as part of net gain or loss on financial assets at fair value through surplus or deficit. The Fund does not reclassify financial instruments in or out of this category while they are held. Financial investments held-to-maturity Non-derivative financial assets with fixed or determinable payments and fixed maturity are classified as held-to-maturity when the Fund has the positive intention and ability to hold them to maturity. Investments intended to be held for an undefined period are not included in this classification. Heldto-maturity investments are subsequently measured at amortized cost. Gains and losses are recognized in the statement of financial performance for the period when the investments are impaired, as well as through the amortization process. Gold bullions The Fund is involved in purchase of gold bullions for investment purposes with the intention of diversification of the investment portfolio with ability to sell the gold in the future. The gold bullions are initially recognized and subsequently measured at fair value, and classified at fair value through surplus or deficit as part of current assets.

Transfers are made to or from investment properties only when there is a change in use. For a transfer from investment properties to owner-occupied properties, the deemed cost for subsequent accounting is the fair value at the date of change in use. If owner-occupied properties become investment properties, the Fund accounts for such property in accordance with the policy stated under property and equipment up to the date of change in use. Property and equipment The Fund’s property and equipment are tangible assets held for administrative purposes with an expected useful life of more than one accounting period and with the cost exceeding AZN 100 (full amount). Depreciation is charged on the carrying value of property and equipment and is designed to write off assets over their useful economic lives. Depreciation is calculated on a straight line basis at the following estimated useful lives:

Buildings Vehicles Office equipment Furniture Other property and equipment

Years 50 7 4 5 3

The carrying amounts of property and equipment are reviewed at each reporting date to assess whether they are recorded in excess of their recoverable amounts. The recoverable amount is the higher of fair value less costs to sell and value in use. Where carrying values exceed the estimated recoverable amount, assets are written down to their recoverable amount, impairment is recognized in the respective period and is included in operating expenses. After the recognition of an impairment loss the depreciation charge for property and equipment is adjusted in future periods to allocate the asset’s revised carrying value, less its residual value (if any), on a systematic basis over its remaining useful life.



d) Such designation eliminates or significantly reduces a measurement or recognition inconsistency that would otherwise arise from measuring assets or recognizing the gains and losses on them on different bases; or

Investment properties are derecognized when either they have been disposed of or when the investment properties are permanently withdrawn from use and no future economic benefit is expected from its disposal. The difference between the net disposal proceeds and the carrying amount of the asset is recognized in the consolidated statement of financial performance in the period of derecognition.


A financial asset other than a financial asset held for trading may be designated at fair value through surplus or deficit upon initial recognition if:

102



A building held for administrative purposes is stated in the statement of the financial position at its revalued amount, being the fair value at the date of revaluation, determined from market-based evidence by appraisal undertaken by professional independent appraisers, less any subsequent accumulated depreciation and subsequent accumulated impairment losses. Revaluations are performed with sufficient regularity such that the carrying amount does not differ materially from that which would be determined using fair values at the reporting date.

ANNUAL REPORT 2012

Depreciation on revalued buildings is charged to the statement of financial performance. On the subsequent sale or retirement of a revalued property, the attributable revaluation surplus remaining in the property revaluation reserve is transferred directly to accumulated deficit or surplus. Market value of property is assessed using any of the following three methods: ● The comparable sales method which involves analysis of market sales prices for similar real estate property; ● The income-based method which assumes a direct relationship between revenues generated by the property and its market value; ● The costs method which presumes the value of property to be equal to its recoverable amount less any depreciation charges. Intangible assets Intangible assets acquired separately are measured on initial recognition at cost. Following initial recognition, intangible assets are carried at cost less any accumulated amortization and any accumulated impairment losses. The useful lives of intangible assets are assessed to be either finite or indefinite. Intangible assets with finite lives are amortized over the useful economic lives of 10 years and assessed for impairment whenever there is an indication that the intangible asset may be impaired. Amortization periods and methods for intangible assets with indefinite useful lives are reviewed at least at each financial year-end. Taxation Income tax expense comprises current and deferred tax expense. The current tax expense is based on taxable profit for the year. Taxable profit differs from net profit before tax as reported in the statement of the financial performance because it excludes items of income or expense that are taxable or deductible in other years and it further excludes items that are never taxable or deductible. The Fund’s current tax expense is calculated using tax rates that have been enacted during the reporting period.

The carrying amount of deferred tax assets is reviewed at each reporting date and reduced to the extent that it is no longer probable that sufficient taxable profits will be available to allow all or part of the asset to be recovered. Deferred tax is calculated at the tax rates that are expected to apply in the period when the liability is settled or the asset is realized. Deferred tax is charged or credited to surplus or deficit, except when it relates to items charged or credited directly to the statement of financial performance, in which case the deferred tax is also dealt with in the statement of financial performance. No deferred tax is recognized and the initial recognition exception applies if the temporary difference arises in neither in a business combination nor in a transaction that gives rise to an accounting or taxable profit or loss. Deferred income tax assets and deferred income tax liabilities are offset and reported net in the statement of financial position if: ● The Fund has a legally enforceable right to set off current income tax assets against current income tax liabilities; and ● Deferred income tax assets and the deferred income tax liabilities relate to income taxes levied by the same taxation authority on the same taxable entity. The Republic of Azerbaijan also has various other taxes, which are assessed on the Fund’s activities. These taxes are included as a component of operating expenses in the statement of financial performance. Contingencies Contingent liabilities are not recognized in the statement of financial position but are disclosed unless the possibility of any outflow in settlement is remote. A contingent asset is not recognized in the statement of financial position but disclosed when an inflow of economic benefits is probable. Net assets/Equity As discussed in Note 1, in accordance with the Decrees and the Regulations, the Fund is an extra-budget state organization. All decisions regarding contributions to and transfers from the Fund are made based on the Decrees approved by the President of the Republic of Azerbaijan. Contributions/transfers received/ made by the Fund represent contributions/withdrawals and, accordingly, are recognized through net assets/equity at the fair value of the consideration received/paid. Transfers to the State Budget, as well as state institutions, state-owned entities and companies are recognized on the date of payment. All transfers are made within the approved budget of the Fund and transferred to the State Treasury of the Republic of Azerbaijan for payments to eligible budgetary beneficiaries (state institutions, state-owned entities and companies) based on their requests for payments.



104

An annual transfer from the revaluation reserve for property and equipment to accumulated deficit or surplus is made for the difference between depreciation based on the revalued carrying amount of the assets and depreciation based on the assets original cost.

Deferred tax is the tax expected to be payable or recoverable on differences between the carrying amounts of assets and liabilities in the financial statements and the corresponding tax bases used in the computation of taxable profit, and is accounted for using the balance sheet liability method. Deferred tax liabilities are generally recognized for all taxable temporary differences and deferred tax assets are recognized to the extent that it is probable that taxable profits will be available against which deductible temporary differences can be utilized. Such assets and liabilities are not recognized if the temporary difference arises from the initial recognition of other assets and liabilities in a transaction that affects neither the tax profit nor the accounting profit.


Any revaluation increase arising on the revaluation of such buildings is credited to the property revaluation reserve, except to the extent that it reverses a revaluation decrease for the same asset previously recognized as an expense, in which case the increase is credited to surplus or deficit for the period to the extent of the decrease previously charged. A decrease in carrying amount arising on the revaluation of such buildings is charged as an expense to the extent that it exceeds the balance, if any, held in the property revaluation reserve relating to a previous revaluation of that asset.




Recognition of income and expense Interest income is recognized on an accrual basis using the effective interest method. The effective interest method is a method of calculating the amortized cost of a financial asset or a financial liability (or a group of financial assets or financial liabilities) and of allocating the interest income over the relevant period. The effective interest rate is the rate that exactly discounts estimated future cash payments or receipts through the expected life of the financial instrument or, when appropriate, a shorter period to the net carrying amount of the financial asset. Once a financial asset or a group of similar financial assets has been written down (or partly written down) as a result of an impairment loss, interest income is thereafter recognized using the rate of interest used to discount the future cash flows for the purpose of measuring the impairment loss.

ANNUAL REPORT 2012

Expenses are recognized on accrual basis, i.e. when they are incurred.

2011 0.7865 1.0178 1.2123 -

Offset of financial assets and liabilities Financial assets and liabilities are offset and reported net on the statement of financial position when the Fund has a legally enforceable right to set off the recognized amounts and the Fund intends either to settle on a net basis or to realize the asset and settle the liability simultaneously. In accounting for a transfer of a financial asset that does not qualify for derecognition, the Fund does not offset the transferred asset and the associated liability.

4. Significant judgments and estimates

The consolidated financial statements are presented in AZN, which is the Fund’s functional and presentation currency. Transactions in foreign currencies are initially recorded in the functional currency, converted at the rate of exchange ruling at the date of the transaction. Monetary assets and liabilities denominated in foreign currencies are retranslated at the functional currency rate of exchange ruling at the reporting date. Gains and losses resulting from the translation of foreign currency transactions are recognized in the consolidated statement of performance as foreign currency translation differences. Non-monetary items that are measured in terms of historical cost in a foreign currency are translated using the exchange rates as at the dates of the initial transactions. Non-monetary items measured at fair value in a foreign currency are translated using the exchange rates at the date when the fair value was determined.

The preparation of the Fund’s consolidated financial statements requires management to make estimates and judgments that affect the reported amounts of assets and liabilities at the reporting date and the reported amount of income and expenses during the year ended. Management evaluates its estimates and judgments on an ongoing basis. Management bases its estimates and judgments on historical experience and on various other factors that are believed to be reasonable under the circumstances. Actual results may differ from these estimates under different assumptions or conditions. The following estimates and judgments are considered important in reflecting the Fund’s financial condition and financial performance.

Differences between the contractual exchange rate of a transaction in a foreign currency and the Central Bank exchange rate on the date of the transaction are included in gains less losses from dealing in foreign currencies.

Valuation of financial instruments

As at the reporting date, the assets and liabilities of the entities whose functional currency is different from the presentation currency of the Fund are translated into AZN at the rate of exchange ruling at the reporting date and, their statements of financial performance are translated at the weighted average exchange rates for the year. The exchange differences arising on the translation are taken to the separate component of net assets/equity. On disposal of a subsidiary or an associate whose functional currency is different from the presentation currency of the Fund, the deferred cumulative amount recognized in surplus or deficit in the consolidated statement of financial performance. Rates of exchange The exchange rates used by the Fund in the preparation of the financial statements as at year-end are as follows:

Financial instruments that are classified at fair value through surplus or deficit are stated at fair value. The fair value of such financial instruments is the estimated amount at which the instrument could be exchanged between willing parties, other than in a forced or liquidation sale. If a quoted market price is available for an instrument, the fair value is calculated based on the market price. When valuation parameters are not observable in the market or cannot be derived from observable market prices, the fair value is derived through analysis of other observable market data appropriate for each product and pricing models which use a mathematical methodology based on accepted financial theories. Pricing models take into account the contract terms of the securities as well as market-based valuation parameters, such as interest rates, volatility, exchange rates and the credit rating of the counterparty. Where market-based valuation parameters are absent, management will make a judgment as to its best estimate of that parameter in order to determine a reasonable reflection of how the market would be expected to price the instrument. In exercising this judgment, a variety of tools are used including proxy observable data, historical data, and extrapolation techniques. The best evidence of fair value of a financial instrument at initial recognition is the transaction price unless the instrument is evidenced by comparison with data from observable markets. Any difference between the transaction price and the value based on a valuation technique is not recognized in the statement of financial performance on initial recognition. Subsequent gains or losses are only recognized to the extent that it arises from a change in a factor that market participants would consider in setting a price.



106

Foreign currency translation

2012 0.7850 1.0377 1.2694 0.0258


Interest earned on assets at fair value is classified within interest income.

AZN/1 US Dollar AZN/1 Euro AZN/1 GB Pound AZN/1 Russian Ruble


The Fund considers that the accounting estimates related to valuation of financial instruments where quoted markets prices are not available are a key source of estimating uncertainty because: (i) they are highly susceptible to change from period to period because it requires management to make assumptions about interest rates, volatility, exchange rates, the credit rating of the counterparty, valuation adjustments and specific feature of the transactions and (ii) the impact that recognizing a change in the valuations would have on the assets reported in the statement of financial position as well as its profit/ (loss) could be material.

ANNUAL REPORT 2012

The Fund holds investments in companies, including those that do not trade in an active market. Future adverse changes in market conditions or poor operating results could result in losses that may not be reflected in an investment’s current carrying value, thereby requiring an impairment charge in the future. The Fund regularly reviews its investments to determine if there have been any indicators that the value may be impaired. These reviews require estimating the outcome of future events and determining whether factors exist that indicate impairment has occurred. Measurement of fair value of investment properties and property and equipment (building) Fair value of investment properties as well as at the property and equipment (building) is determined by independent professionally qualified appraisers. Fair value is determined using the combination of internal capitalization method (also known as discounted future cash flow method), sales comparison method and also based on the highest and best use method. The estimates described above are subject to change as new transaction data and market evidence becomes available. Deferred tax assets The management of the Fund considers that valuation allowance against deferred tax assets at the reporting date is considered necessary, because it is more likely that the deferred tax asset will not be realized.

Cash and cash equivalents comprise: Money market funds Bank accounts Deposits Total cash and cash equivalents

2012 475,826 262,286 444,197 1,182,309

2011 545,535 225,560 771,095

Money market funds Investments in money market funds represent share ownership in funds, payable on demand. Investments in money market funds are highly liquid. Money market funds invest their assets in short-term debt and debt related instruments, such as commercial paper, certificates of deposit, bonds bearing floating interests, US treasury bonds, Eurobonds and asset-backed securities. Interest and dividends payable to the Fund are reinvested. The Fund had the following investments in the money market funds with AAA credit ratings:

BlackRock ICS-Institution Liquidity Funds plc Royal Bank of Scotland plc, Global Treasury Funds plc Total money market funds

2012 475,826 475,826

2011 545,305 230 545,535

Bank accounts Bank accounts were denominated in the following currencies:

AZN USD AUD GBP RUB EUR TRY Total bank accounts

2012 156,525 101,629 2,155 1,672 279 22 4 262,286

2011 133,767 91,643 76 74 225,560

The Fund holds AZN accounts with the Central Bank of the Republic of Azerbaijan and the International Bank of Azerbaijan. At 31 December 2012 the Fund had AZN 156,506 thousand and AZN 59 thousand, held at bank accounts in the Central Bank of the Republic of Azerbaijan and the International Bank of Azerbaijan (2011: AZN 133,755 thousand and AZN 31 thousand), respectively.



108

Impairment of investments held to maturity

5. Cash and cash equivalents


Had management used different assumptions regarding the interest rates, volatility, exchange rates, the credit rating of the counterparty and valuation adjustments, a larger or smaller change in the valuation of financial instruments where quoted market prices are not available would have resulted that could have had a material impact on the Fund’s reported net surplus.




Other accounts originated in foreign currencies were opened with non-resident banks with long-term ratings BBB/Baa (Standard & Poor Fitch/Moody’s) and above. Deposits

110

T.C. Ziraat Bankasi A.S. Akbank T.A.S, Istanbul Turkiye Is Bankasi A.S. Istanbul Gazprombank, Moscow BNP Paribas, London VTB Bank JSC Jefferies Bache, London Total deposits

2012 137,261 136,890 91,312 78,536 86 66 46 444,197

2011 -

As at 31 December 2012, the Fund placed AZN 444,197 thousand in deposits with non-resident banks maturing in January 2013 with credit ratings of BBB/Baa (Standard & Poor’s/ Fitch/Moody’s) and above.

6. Financial assets at fair value through surplus or deficit

Foreign government debt securities Corporate debt securities Financial institution debt securities Equity securities Standard and Poor's Depository Receipt (“SPDR”) Trust Securities of USA agencies Total financial assets at fair value through surplus or deficit

Corporate debt securities Corporate debt securities are represented by investments in debt securities issued by corporations of Europe, Asia, Africa, Australia and America. These securities bear fixed interest ranging from 1% p.a. to 9.625% p.a. and USD LIBOR with the spread ranging from +0.20% p.a. to +1.4% p.a. (2011: from 1.25% p.a. to 11.875% p.a. and USD LIBOR with the spread ranging from +0.15% p.a. to +0.95% p.a.) and mature during the period from January 2013 to February 2017 (2011: January 2012 to December 2016). Discount securities are also included in this group. As at 31 December 2012 total accrued interest on these securities amounted AZN 52,913 thousand (2011: AZN 63,486 thousand). These securities were held in the portfolio managed both directly by the Fund as well as the Fund’s external managers, Deutsche Bank AG and Credit Suisse. Financial institution debt securities

2012 11,006,880 6,865,143 5,719,139 520,389 9,460 6,388 24,127,399

2011 11,087,696 6,434,710 4,726,843 11,614 8,348 13,269 22,282,480

As at 31 December 2012 the Fund held AZN 780,983 thousand (USD 994,882 thousand) under asset management agreements with financial institutions (“external managers”) including cash and cash equivalents (2011: AZN 210,364 thousand (USD 267,469 thousand)). The management fees in 2012 to these institutions were AZN 795 thousand (2011: AZN 969 thousand). During 2012 the Fund’s external managers were Deutsche Bank AG, Credit Suisse (on 2 April 2012 Clariden Leu legally merged with Credit Suisse, who acquired all of Clariden Leu’s assets and liabilities and assumed all of its rights and obligations), the International Bank for Reconstruction and Development (IBRD – World Bank Group), State Street Global Advisors (SSgA) and UBS. Whereas during 2011 the Fund’s external managers were Deutsche Bank AG, Clariden Leu Ltd. and International Bank for Reconstruction and Development (World Bank Group). All securities are held in the custodian - Bank of New York Mellon.

Financial institution securities are represented by investments in debt securities issued by various European, Asian, Australian and American financial institutions. These securities bear fixed interest ranging from 0.52% p.a. to 6.75% p.a. and USD LIBOR, GBP LIBOR and EURIBOR with the spread ranging from +0.13% p.a. to +2.5% p.a. (2011: from 1.875% p.a. to 6.75% p.a. and USD LIBOR, GBP LIBOR and EURIBOR with the spread ranging from +0.09% p.a. to +3.5% p.a.) and mature during the period from January 2013 to February 2016 (2011: from January 2012 to February 2016). Discount securities are also included in this group. As at 31 December 2012 total accrued interest on these securities amounted AZN 13,895 thousand (2011: AZN 18,755 thousand). These securities were held in the portfolio managed both directly by the Fund as well as the Fund’s external managers, Deutsche Bank AG, Clariden Leu Ltd. and IBRD.



Financial assets at fair value through surplus or deficit comprise:

Foreign government securities are represented by investments in debt securities issued by various sovereign and international organizations of Europe, Asia, Africa, Australia and America. These securities bear fixed interest ranging from 0.25% p.a. to 9.875% p.a. and USD LIBOR, EURIBOR, GBP LIBOR with the spread ranging from +0% p.a. to +1.2% p.a. (2011: from 0.25% p.a. to 9.875% p.a. and USD LIBOR, EURIBOR with the spread ranging from +0% p.a. to +1.4% p.a.) and mature during the period from January 2013 to June 2018 (2011: from January 2012 to January 2018). Discount securities are also included in this group. As at 31 December 2012 total accrued interest on these securities amounted AZN 49,651 thousand (2011: AZN 76,483 thousand). These securities were held in the portfolio managed both directly by the Fund as well as the Fund’s external managers, Deutsche Bank AG, Credit Suisse and IBRD.


ANNUAL REPORT 2012

The Fund’s investments in deposits comprise:

Foreign government debt securities



Equity securities

These are comprised of corporate bonds of:

Consumer Finance Telecommunication and information technologies Industrial Healthcare Energy Materials Private equity Utilities Total equity securities

2012 106,456 98,434 76,725 53,292 51,307 49,894 33,846 33,798 16,637 520,389

2011 915 252 475 100 504 160 239 8,969 11,614

SPDR Trust In its internally managed portfolio SOFAZ invests in S&P 500 stock index incorporated in the United States via SPDR Trust. S&P 500 index consists of a portfolio representing 500 large-cap stocks such as Apple Inc, Exxon Mobil Corp, IBM, Microsoft Corp, Chevron Corp, General Electric, Johnson & Johnson, Procter & Gamble, AT&T Inc, Pfizer Inc. The main sectors are Oil & Gas, Computers, Pharmaceuticals, Banks, Retail, Telecommunications and etc.

112 Securities of USA Agencies are represented by investments in debt securities issued by Freddie Mac and Federal Home Loan Banks in 2012 (2011: Fannie Mae, Freddie Mac, Federal Farm Credit Bank and Federal Home Loan Banks). These securities bear fixed interest rates ranging from 0.215% p.a. to 2.75% p.a. (2011: from 0.5% p.a. to 3.05% p.a.) and mature during the period from December 2014 to November 2015 (2011: from April 2012 to June 2015). As at 31 December 2012 total accrued interest on these securities amounted to AZN 15 thousand (2011: AZN 22 thousand). These securities were held in the portfolio managed by the Fund’s external manager IBRD.

2011 384,102 384,102

On 26 September 2012 the Fund purchased bonds of Mercury Investments and Holdings Ltd. (which is a 100% owned subsidiary of State Oil Company of Azerbaijan Republic) at face value of USD 200,000 thousand. As of 31 December 2012 amount of these bonds equaled to AZN 157,828 thousand (2011: nil). The maturity date of the bonds is 31 December 2027 and the coupon rate is 6-month LIBOR+1.335%. The purchase was made in accordance with the decree #519 of the President of Azerbaijan Republic dated 27 October 2011 on “Rules on management of foreign currency assets of the State Oil Fund of the Republic of Azerbaijan”. Main aim of the bond issuance is to improve and reconstruct the Ship Construction Plant of the Republic of Azerbaijan. On 5 July 2011 the Fund purchased bonds of AzACG Ltd. (which is a 100% owned subsidiary of State Oil Company of Azerbaijan Republic) at face value of USD 485,000 thousand. The purchase of the bonds was made under “The framework (program) of the main directions of utilization of Oil Fund’s assets for 2011” approved by the Decree of the President of the Republic of Azerbaijan dated 28 December 2010. According to the program SOFAZ may invest in the securities of oil and gas companies operating in the Caspian Sea basin. The issuer of these securities or its parent company should have a longterm investment grade credit rating. As of 31 December 2012 amount of these bonds equaled to AZN 356,664 thousand (2011: AZN 384,102 thousand). The maturity date of the bonds is 31 December 2024 and the coupon rate is 6-month LIBOR+1%. The custodian service for holding both securities is provided by the National Depository Center of the Republic of Azerbaijan. The management of the Fund has intention and ability to hold the bonds until the scheduled maturity date for the purpose of earning of interest income over the holding period.

8. Gold bullions In accordance with the “Rules on Holding, Placement and Management of Foreign Assets of The State Oil Fund of the Republic of Azerbaijan” approved by Decree #511 of the President of the Republic of Azerbaijan dated 19 June 2001 as amended by Decrees #607 dated 21 December 2001, #202 dated 1 March 2005, #216 dated 10 February 2010 and #519 dated 27 October 2011 gold bars conforming to the requirements of the London Bullion Market Association may be included in the Investment Portfolio of the Fund. The Fund bought 480,146 fine troy ounces of gold during 2012.

7. Financial investments held-to-maturity Financial investments held-to-maturity comprise: Current portion of Financial investments held–to–maturity Non-current portion of Financial investments held–to–maturity

2012 157,828 356,664 514,492

2012 57,523 456,969 514,492

2011 57,143 326,959 384,102

As of 31 December 2012 gold bullions deposited in foreign banks consisted of 325,000 fine troy ounces amounting to AZN 422,870 thousand (2011: nil).



Securities of USA Agencies

Mercury Investments and Holdings Ltd. Azerbaijan (ACG) Ltd (AzACG Ltd)


ANNUAL REPORT 2012

The carrying value of equity securities consists of the following at 31 December:



9. Investment properties

10. Property and equipment

Movement of investment properties:

Opening balance at 1 January Purchase of “Gallery Actor” complex Purchase of “78 St James’s Street” office complex Closing balance at 31 December

2012 102,677 235,380 338,057

2011 -

ANNUAL REPORT 2012

Rental income derived from investment properties Direct operating expenses Net profit arising from investment properties carried at fair value

2012 857 (250) 607

2011 -

Acquisition of JSC Tverskaya 16 On 21 December 2012, the Fund acquired 100% of voting shares of JSC Tverskaya 16. Its main activity is management of business and retail centre called “Gallery Actor” located in the Central Administrative District of Moscow, Russia. From the date of acquisition, the JSC Tverskaya 16 has contributed AZN 234 thousand of rental income and AZN 157 thousand to the net profit before tax of the Fund. The acquisition is accounted for as an asset acquisition. Establishment of 78 St James’s Street Unit Trust (the “Unit Trust”) The Unit Trust was established by the Fund on 22 November 2012 under the provision of the Trust Instrument. SOFAZ Re Limited in its capacity as general partner of the SOFAZ RE UK L.P. has a 99% holding of the Unit Trust. SOFAZ Re Min Limited has a 1% holding of the Unit Trust. SOFAZ Re Limited, SOFAZ Re UK L.P. and SOFAZ RE Min Limited are ultimately owned by the State Oil Fund of Azerbaijan. The Unit Trust invests in real estate located in the United Kingdom. The Unit Trust is established, resident and domiciled in Jersey, Channel Islands. From the date of acquisition, the Unit Trust has contributed AZN 623 thousand of rental income and AZN 450 thousand to the net profit before tax of the Fund. The Fund has no restrictions on the realizability of its investment properties and no contractual obligations to purchase, construct or develop investment properties or for repairs, maintenance and enhancements. As at 31 December 2012 investment properties are stated at fair value, which has been determined based on valuations performed by professional valuation company, an accredited independent appraiser. The appraiser is an industry specialist in valuing these types of investment properties. The fair value represents the amount at which the assets could be exchanged between a knowledgeable, willing buyer and a knowledgeable, willing seller in an arm’s length transaction at the date of valuation. The fair values of the properties have been primarily derived using prices for comparable properties, market information, discounted cash flow method (income approach) and the expert opinion of independent accredited valuators who have advised on current market levels.

Net book value As at 31 December 2010 As at 31 December 2011 As at 31 December 2012

Office equipment

Furniture

Other property and equipment

Total

4,350 (2,074) 2,276 2,276

330 22 (5) 347 1,232 1,579

400 45 (42) 403 138 541

156 11 (14) 153 18 171

5 5 611 616

5,241 78 (61) (2,074) 3,184 1,999 5,183

-

(80) (48) 3 (125) (72) (197)

(320) (40) 42 (318) (40) (358)

(127) (12) 14 (125) (12) (137)

(4) (1) (5) (1) (6)

(531) (101) 59 (573) (125) (698)

4,350 2,276 2,276

250 222 1,382

80 85 183

29 28 34

1 610

4,710 2,611 4,485

In accordance with Resolution #99 of the Cabinet of Ministers, dated 27 May 2002, the Fund received an administrative building from the Government. As at 31 December 2012 and 2011 the building owned by the Fund was revalued to market value according to the report of an independent appraiser. The following methods were used for the estimation of their fair value: discounted cash flow method (income approach), integrated cost estimation method (cost based approach), method of sales comparison (comparative approach). For the estimation of the final value, certain weights were assigned to the results obtained using different approaches, depending on the degree to which the estimates met the following characteristics: reliability and completeness of the information, specifies the estimated property and other. As a result, the carrying value of the buildings amounted to AZN 2,276 thousand as at 31 December 2012 (2011: AZN 2,276 thousand). The Fund engaged an independent appraiser to determine the fair value of its buildings. Fair value is determined by reference to market-based evidence. If the buildings were measured using the cost model, the carrying amounts would be as follows:

Cost Accumulated depreciation Net carrying amount

2012 559 (119) 440

2011 559 (119) 440



114

Accumulated depreciation 31 December 2010 Depreciation charge Disposals 31 December 2011 Depreciation charge 31 December 2012

Vehicles


Investment properties consist of “Gallery Actor”, mixed-use office and retail complex located in Moscow central business district at 16 Tverskaya Street and “78 St James’s Street” an office complex in London. Both properties are leased out on a commercial basis.

Revalued amount or cost 31 December 2010 Additions Disposals Revaluation 31 December 2011 Additions 31 December 2012

Building



11. Other non-current and intangible assets

12. Capital contributions

Other non-current and intangible assets comprise:

The movements in capital contributions to the Fund were as follows:

2012 76,281 807 29 77,117

Deferred costs Intangible assets Used equipment held for sale Total non-current assets

2011 51,639 710 44 52,393

ANNUAL REPORT 2012

13,130,042

101,666 66,784 15,451,696

The movements of intangible assets were as follows: Licenses

Total

At cost 31 December 2010 Additions Disposals 31 December 2011 Additions 31 December 2012

Computer software

13. Transfers by the Fund

241 280 (214) 307 135 442

761 2 (160) 603 10 613

1,002 282 (374) 910 145 1,055

During 2012 transfers to the State Budget, as well as to the state institutions, state-owned entities and companies were made in accordance with:

Accumulated amortization 31 December 2010 Amortization charge Disposals 31 December 2011 Amortization charge 31 December 2012

(135) (64) 160 (39) (37) (76)

(137) (24) (161) (11) (172)

(272) (88) 160 (200) (48) (248)

106 268 366

624 442 441

730 710 807

Net book value As at 31 December 2010 As at 31 December 2011 As at 31 December 2012

● Law of the Republic of Azerbaijan “On the State Budget for 2012” dated 6 October 2011; ● Decree #570 of the President of the Republic of Azerbaijan “On Ratifying the Budget of The State Oil Fund of the Republic of Azerbaijan for the year 2012” dated 29 December 2011, “Program on main directions of Expensing of Assets of The State Oil Fund of the Republic of Azerbaijan for 2011” as approved by Resolution #1266 of the President of the Republic of Azerbaijan dated 28 December 2010 “On some measures for execution of the budget of The State Oil Fund of the Republic of Azerbaijan for 2011”, and ● Decree of the President of the Republic of Azerbaijan #589 “On Amendments and changes to the Budget of The State Oil Fund of the Republic of Azerbaijan for 2012” dated 8 February 2012 and decree #666 dated 2 July, 2012.

14. Interest income Interest income on financial assets at fair value through surplus or deficit Interest income on assets carried at amortized cost: Interest on term deposits Income from financial investments held-to-maturity Income from money market funds Interest on demand deposits Total interest income

2012 425,455

2011 495,534

28,844 7,197 5,232 154 466,882

38,533 2,650 3,346 198 540,261



116

2011 15,257,482 7,502 1,346 15,730 1,186


As at 31 December 2012 deferred cost represent services and charges incurred in relation to the construction of administrative office building of the Fund.

Contributions received from sales of profit oil and gas Pipeline transit tariffs Acreage fees Bonuses Other Proceeds from implementation of the first phase of Shahdeniz oil and gas project Payments on Baku-Tbilisi-Ceyhan project Total capital contributions

2012 13,117,355 7,891 3,008 1,573 215



15. Foreign currency translation differences

Standard corporate income tax rates for companies operating in the Republic of Azerbaijan and Russian Federation comprised 20% for 2012 and 2011. Whereas the Jersey subsidiaries are subject to UK income tax at a rate of 0.2% on net rental income less any deductible expenditure and any adjustments for capital allowances. Luxembourg and French subsidiaries are subject to income tax at a rate of 29.22%.

Net foreign currency translation differences comprise of:

Net unrealized gain/(loss) on foreign currency translation differences Net realized loss on foreign currency translation differences Total net gain/(loss) on foreign currency translation differences

2012 296,384 (42,997) 253,387

2011 (695,520) (54,231) (749,751)

Deferred taxes reflect the net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for tax purposes. Temporary differences relate mostly to different methods of income and expense recognition as well as to recorded values of certain assets. The effective income tax differs from the statutory income tax rates. A reconciliation of the income tax expense based on statutory rates with actual is as follows:

ANNUAL REPORT 2012

118

Net gain/(loss) on financial assets at fair value through surplus or deficit comprises:

Unrealized gain/(loss) on change in fair value adjustment Realized loss on trading operations Net gain/(loss) on financial assets at fair value through surplus or deficit

2012 122,832 (45,722) 77,110

2011 (331,381) (32,449) (363,830)

Operating expenses are comprised of: 2012 (2,222) (2,003) (1,214) (983) (347) (490) (173) (459) (7,891)

2011 (1,957) (6,315) (462) (929) (303) (267) (189) (372) (10,794)

18. Income taxes

Financial assets at fair value through surplus or deficit Tax losses carried forward Accruals Property and equipment Intangible assets Other assets Net deferred tax (liability)/ asset Unrecognised deferred tax asset

2010

Origination and reversal of temporary differences In the statement of financial performance

Origination and reversal of temporary differences In the statement of financial performance 2012

2011

34,349 45,297 (632) (2) (14)

49,669 67,117 15 415 (22) 7

84,018 112,414 15 (217) (24) (7)

(84,018) (112,414) (15) 217 24 7

-

78,998

117,201

196,199

(196,199)

-

(78,998)

(117,201)

(196,199)

196,199

-

-

-

-

-

-

The Fund provides for income taxes based on the tax accounts maintained and prepared in accordance with the tax regulations of the Republic of Azerbaijan, Jersey Islands, Russian Federation and Luxembourg which may differ from IPSAS.

Deferred tax asset/ (liability)

According to the Presidential decree №- 509-IVQD dated 21 December 2012, and law of State Parliament regarding changes to the Tax Code of Azerbaijan Republic dated 29 December 2012 starting from 1 January 2013 SOFAZ is exempted from corporate income tax.

A temporary difference of AZN 20,457 thousand (2011: nil) exists between the carrying amount of investment property and their tax base for which no deferred taxation has been provided because of the initial recognition exemption in IAS 12.



2011 (584,114) 20% 116,823 (117,201) 378 -

Deferred tax assets and liabilities as of 31 December and their movements for the respective years comprise:

17. Operating expenses

Wages, salaries and employee benefits Bank commissions Professional fees Rental expenses Communication expenses Other employment expenses Depreciation and amortization (Notes 10 and 11) Other operating expenses Total operating expenses

2012 790,345 20% (158,069) 112,414 83,785 (41,338) (3,208)

Surplus/(deficit) before income tax expense Statutory tax rate Theoretical income tax benefit/(expense) at the statutory rate Utilized tax losses carried forward, not recognized previously Change in deferred tax asset not recognized Tax effect of permanent differences Income tax expense


16. Net gain/(loss) on financial assets at fair value through surplus or deficit



19. Fair value of financial instruments The Fund uses the following hierarchy for determining and disclosing the fair value of financial instruments by valuation technique: ● Level 1: quoted (unadjusted) prices in active markets for identical assets or liabilities; ● Level 2: techniques for which all inputs which have a significant effect on the recorded fair value are observable, either directly or indirectly; and ● Level 3: techniques which use inputs which have a significant effect on the recorded fair value that are not based on observable market data.

ANNUAL REPORT 2012

Level 1 20,015,182

Level 2 4,078,419

Level 3 33,798

Total 24,127,399

At 31 December 2011 Financial assets at fair value through surplus or deficit

Level 1 17,893,566

Level 2 4,379,945

Level 3 8,969

Total 22,282,480

Level 3 financial assets consist of investment in International Finance Corporation (IFC) Private Equity fund. IFC African, Latin American and Caribbean Fund has been set up with the purpose of making investments in businesses in Africa, Latin America and the Caribbean.

20. Risk management Management of risk is an essential element of the Fund’s operations. Risks inherent to the Fund’s operations are those related to credit exposures, liquidity, market and operational risks. A summary description of the Fund’s risk management policies in relation to those risks is discussed below. Credit risk The Fund is exposed to credit risk which is the risk that one party to a financial instrument will cause a financial loss for the other party by failing to discharge an obligation. The Fund is subject to credit risk from its portfolio of cash and cash equivalents and its investments. The Fund manages its credit risk in accordance with the “Rules on Holding, Placement and Management of Foreign Currency Assets of The State Oil Fund of the Republic of Azerbaijan” approved by Decree #511 of the President of the Republic of Azerbaijan dated 19 June 2001 as amended by Decree #607 dated 21 December 2001, Decree #202 dated 1 March 2005, Decree #216 dated 10 February 2010, Decree #519 dated 27 October 2011, as well as “Program on Expensing of Assets of The State Oil Fund of the Republic of Azerbaijan for 2012” as approved by Decree #570 of the President of the Republic of Azerbaijan, dated 29 December 2011. Credit risk is managed and controlled through proper selection of investment assets, credit quality of investment assets and setting limits on the amount of investment per investment asset.

The following table details the credit ratings of financial instruments held by the Fund. The credit rating is issued by internationally regarded agencies S&P’s and Moody’s. If the agencies have assigned different credit ratings to an asset, the highest one was used.

Cash and cash equivalents Financial assets at fair value through surplus or deficit Financial investments held–to–maturity

NonSecurities investment without rating rating

Total 2012

AAA

AA

A

BBB

478,257

-

103,373

600,679

-

-

1,182,309

7,936,878

2,481,712

7,675,411

5,211,403

292,230

529,765

24,127,399

-

-

-

514,492

-

-

514,492

AAA

AA

A

Cash and cash equivalents 545,535 91,761 11 Financial assets at fair value through surplus or deficit 8,240,732 3,154,050 6,369,922 Financial investments held–to–maturity -

BBB

Noninvestment rating

Securities without rating

Total 2011

133,755

33

-

771,095

4,495,473

22,303

-

22,282,480

384,102

-

-

384,102

As at 31 December 2012 and 2011, the minimum long term credit ratings of securities or of their issuers were Baa3 (Moody’s) or BBB- (Standard & Poor’s). Fund possessed three governmental securities issued by Eksportfinans ASA (Norway) and Portugal government that have carrying amount (fair value) of AZN 292,230 thousand in its portfolio that were classified as Non-investment rating:



120

At 31 December 2012 Financial assets at fair value through surplus or deficit

In accordance with the “Rules on Holding, Placement and Management of Foreign Assets of The State Oil Fund of the Republic of Azerbaijan” approved by Decree #511 of the President of the Republic of Azerbaijan dated 19 June 2001 as amended by Decrees #607 dated 21 December 2001, #202 dated 1 March 2005, #216 dated 10 February 2010 and #519 dated 27 October 2011, foreign currency assets of the Fund could be invested in debt obligations with investment grade credit rating not less than Ba3 (Moody’s) or BB- (Standard & Poor’s, Fitch) and up to 5% of foreign currency assets of the Fund could be placed into debt obligations that have credit rating not less than (Ba3 (Moody’s) or BB- (Standard & Poor’s, Fitch).


The Fund’s valuation approach and fair value hierarchy categorisation for certain significant classes of financial instruments recognized at fair value are as follows:

In accordance with Decree of the President of the Republic of Azerbaijan “Program on Expensing of Assets of The State Oil Fund of the Republic of Azerbaijan for 2012” dated 29 December 2011, the maximum weight of one financial institution or one investment in the investment portfolio is set at 15% of total amount of the investment portfolio.


Securities

ISIN

EXPT Fl 04/13 EXPT FL 10/13 Portug Fl 11/14

US28264QU939 US282649BY75 XS0467362223


Nominal value Currency (‘000s) 35,250 250,000 100,000

USD USD USD

Trade date

Settlement date

29.03.11 14.10.10 10.11.09

05.04.13 07.10.13 17.11.14

Rating as of trade date (Moody’s/ S&P) Aa1/AA Aa1/AA Aa2/A+

Rating as of December 31, 2012 (Moody’s/ S&P) Ba1/BB+ Ba1/BB+ Ba3/BB

In accordance with the “Rules on Holding, Placement and Management of Foreign Currency Assets of The State Oil Fund of the Republic of Azerbaijan” approved by Decree #511 of the President of the Republic of Azerbaijan dated 19 June 2001 as amended by Decrees #607 dated 21 December 2001, #202 dated 1 March 2005, #216 dated 10 February 2010 and #519 dated 27 October 2011, currency settlement accounts of the Fund may be held in banks with long-term credit ratings not lower than AA(Standard & Poor’s, Fitch) or Aa3 (Moody’s). The Fund is allowed to maintain funds in the Republic of Azerbaijan only in the Central Bank of the Republic of Azerbaijan and the International Bank of Azerbaijan. Depository services In accordance with the “Rules on Holding, Placement and Management of Foreign Assets of The State Oil Fund of the Republic of Azerbaijan” approved by Decree #511 of the President of the Republic of Azerbaijan dated 19 June 2001 as amended by Decrees #607 dated 21 December 2001, #202 dated 1 March 2005, #216 dated 10 February 2010, and #519 dated 27 October 2011, the Fund’s depository services may be provided by commercial banks and other financial institutions with long-term credit ratings not lower than A- (Standard & Poor’s), A (Fitch) or A3 (Moody’s). Financial market counterparties In accordance with the “Rules on Holding, Placement and Management of Foreign Assets of The State Oil Fund of the Republic of Azerbaijan” approved by Decree #511 of the President of the Republic of Azerbaijan dated 19 June 2001 as amended by Decrees #607 dated 21 December 2001, #202 dated 1 March 2005, #216 dated 10 February 2010, and #519 dated 27 October 2011, the Fund’s counterparties at international financial markets may involve commercial banks and other financial institutions with long-term investment credit ratings (Standard & Poor’s, Fitch or Moody’s). External managers In accordance with the “Rules on Holding, Placement and Management of Foreign Assets of The State Oil Fund of the Republic of Azerbaijan” approved by Decree #511 of the President of the Republic of Azerbaijan dated 19 June 2001 as amended by Decrees #607 dated 21 December 2001, #202 dated 1 March 2005, #216 dated 10 February 2010, and #519 dated 27 October 2011, when an external manager is engaged in management of the Fund’s currency assets, the external manager or its principal founder should have investment credit ratings (not lower than Baa3 (Moody’s) or BBB- (Standard & Poor’s, Fitch)) or have at least five years of positive history of management of assets, or be experienced in managing assets with a value not less than one billion USD.

“Program on main directions of Expensing of Assets of The State Oil Fund of the Republic of Azerbaijan for 2012” as approved by Decree #570, dated 29 December 2011, specified requirements for Investment Policy (investment trend) of the Fund for 2012 and currency basket of the Fund’s portfolio for 2012. In accordance with these requirements, 50% of the total amount of the investment portfolio of the Fund invests in assets denominated in USD, 40% in assets denominated in EUR, 5% in assets denominated in GBP, whereas 5% of the total amount of the investment portfolio can be invested in currencies specified in an article 2.2.1 of Presidential Decree #511 dated 19 June, 2001. In case of noncompliance the Fund is to rebalance the portfolio during 10 business days subsequent to the end of each quarter. As at 31 December 2012, 50.96% of the Fund’s investment portfolio was denominated in USD (2011: 52.28%), 41.81% in EUR (2011: 41.53%) and 4.27% in GBP (2011: 5.62%). The table below summarizes the Fund’s exposure to foreign currency exchange rate risk at the reporting date: 2012 AZN USD EUR GBP TRY AUD RUB Total Financial assets 394,350 170,289 14,710 365,466 2,154 78,815 1,182,309 Cash and cash equivalents 156,525 Financial assets at fair value through surplus or deficit 12,252,650 10,624,071 1,087,634 163,044 24,127,399 Financial investments held–to–maturity 514,492 514,492 Total financial assets 156,525 13,161,492 10,794,360 1,102,344 365,466 165,198 78,815 25,824,200 Financial liabilities Other financial liabilities Total financial liabilities Open position

67 67

2,318 2,318

Open position

1,098 1,098

-

-

1,196 1,196

4,757 4,757

156,458 13,159,174 10,794,282 1,101,246 365,466 165,198 77,619 25,819,443 0.61% 50.97% 41.81% 4.26% 1.41% 0.64% 0.30%

2011 Financial assets Cash and cash equivalents Financial assets at fair value through surplus or deficit Financial investments held–to–maturity Total financial assets Financial liabilities Other financial liabilities Total financial liabilities

78 78

AZN

USD

EUR

GBP

Total

133,767

472,799

52,706

111,823

771,095

133,767

11,396,608 384,102 12,253,509

9,679,982 9,732,688

1,205,890 1,317,713

22,282,480 384,102 23,437,677

103 103

268 268

58 58

-

429 429

133,664 0.57%

12,253,241 52.28%

9,732,630 41.53%

1,317,713 5.62%

23,437,248



122

Currency risk is defined as the risk that the value of a financial instrument will fluctuate due to changes in foreign exchange rates. The Fund is exposed to the effects of fluctuations in the prevailing foreign currency exchange rates on its financial position and cash flows.


ANNUAL REPORT 2012

Bank accounts

Currency risk



Currency risk sensitivity

Geographical concentration

The tables below indicate the currencies to which the Fund had significant exposure at 31 December 2012 and 2011 on its monetary assets and its forecast cash flows. The analysis calculates the effect of a reasonably possible movement of the currency rate against the AZN, with all other variables held constant on the statement of financial performance. The effect on net assets/equity does not differ from the effect on the statement of financial performance.

2012

AZN/EUR

AZN/USD

+11.49% -11.49%

1,240,263 (1,240,263)

AZN/EUR

AZN/GBP

+26.01% -26.01%

286,434 (286,434)

AZN/GBP

AZN/TRY

+21.46% -21.46%

78,429 (78,429)

AZN/AUD

+12.84% -12.84%

21,211 (21,211)

AZN/RUB

+20.97% -20.97%

16,277 (16,277)

Impact on surplus/(deficit) for the year 31 December 2011 +5.09% 623,690 -5.09% (623,690) +14.55% -14.55%

1,416,097 (1,416,097)

+10% -10%

131,771 (131,771)

Net position

2011

Commodity price risk The Fund is affected by the volatility of gold prices. The following table shows the effect of price changes in gold:

31 December 2012 Impact on surplus/(deficit) for the year

Financial liabilities Other financial liabilities Total financial liabilities

17.33% 108,267

AZN/XAU

-17.33% -108,267

Financial assets Cash and cash equivalents Financial assets at fair value through surplus or deficit Financial investments held– to–maturity Total financial assets Financial liabilities Other financial liabilities Total financial liabilities Net position

America

Asia

Africa

156,566

924,688

101,055

-

-

-

15,351,487

4,261,212

514,492

-

-

671,058

2,352,392 127,767 -

-

Australia International and organizations Oceania

Total

-

-

1,182,309

784,307

1,250,234

24,127,399

-

-

514,492

1,250,234

25,824,200

16,276,175 4,362,267 2,352,392 127,767 784,307

2,463

2,294

-

-

-

-

-

4,757

2,463

2,294

-

-

-

-

-

4,757

1,250,234

25,819,443

668,595

16,273,881 4,362,267 2,352,392 127,767 784,307

Azerbaijan

Europe

America

Asia

Africa

Australia and Oceania

International organizations

Total

133,786

546,436

90,873

-

-

-

-

771,095

-

15,452,916

3,467,644

1,355,347

193,108

568,832

1,244,633

22,282,480

384,102

-

-

-

-

-

-

384,102

193,108

568,832

1,244,633

23,437,677

517,888

15,999,352 3,558,517 1,355,347

429

-

-

-

-

-

-

429

429

-

-

-

-

-

-

429

193,108

568,832

1,244,633

23,437,248

517,459

15,999,352 3,558,517 1,355,347



124

AZN/USD

Impact on surplus/(deficit) for the year 31 December 2012 +3.82% 502,680 -3.82% (502,680)

Europe


ANNUAL REPORT 2012

Risk management and monitoring is performed within above set limits, by the Investment Committee and the Fund’s Management. All recommendations/decisions are proposed/made by the Investment Committee and subsequently are subject to the approval by the management of the Fund. Daily risk management is performed by the Risk Management Department.

Financial assets Cash and cash equivalents Financial assets at fair value through surplus or deficit Financial investments held– to–maturity Total financial assets

Azerbaijan



Interest rate sensitivity

Liquidity Risk

At 31 December 2012 deposits and debt securities were interest-bearing and, therefore, were exposed to the interest rate risk. Depending on the market conditions the Fund is managing this risk by gradually increasing or decreasing the duration of assets in the investment portfolio. Risk management and monitoring is performed within above set limits, by the Investment Committee and the Fund’s Management. All recommendations/decisions are proposed/made by the Investment Committee and subsequently are subject to the approval of the management of the Fund. Daily risk management is performed by the Risk Management Department.

Management’s guiding policies are to maintain conservative levels of liquidity to ensure that the Fund has the ability to meet its obligations under all conceivable circumstances.

ANNUAL REPORT 2012

Impact on surplus/(deficit) before tax:

Assets: Cash and cash equivalents Financial assets at fair value through surplus or deficit Net impact on surplus/(deficit) before tax

31 December 2012 31 December 2011 Interest rate Interest rate Interest rate Interest rate +1% -1% +1% -1% 13 (94,069) (94,056)

(13) 94,069 94,056

15 (81,843) (81,828)

(15) 81,843 81,828

126 The above tables demonstrate the effect of a change in a key assumption while other assumptions remain unchanged. In reality, there is a correlation between the assumptions and other factors. It should also be noted that these sensitivities are non-linear, and larger or smaller impacts should not be interpolated or extrapolated from these results. The sensitivity analyses do not take into consideration that the Fund’s assets and liabilities are actively managed. Additionally, the financial position of the Fund may vary at the time that any actual market movement occurs. For example, the Fund’s financial risk management strategy aims to manage the exposure to market fluctuations. As investment markets move past various trigger levels, management actions could include selling investments, changing the investment portfolio allocation and taking other protective action. Consequently, the actual impact of a change in the assumptions may not have any impact on the liabilities, whereas assets are held at market value on the statement of the financial position. In these circumstances, the different measurement bases for liabilities and assets may lead to volatility in net assets/equity. Other limitations in the above sensitivity analyses include the use of hypothetical market movements to demonstrate potential risk that only represent the Fund’s view of possible near-term market changes that cannot be predicted with any certainty; and the assumption that all interest rates move in an identical fashion.

Financial assets Cash and cash equivalents Financial assets at fair value through surplus or deficit Financial investments held– to–maturity Total financial assets Financial liabilities Other financial liabilities Total financial liabilities Liquidity gap

2011 Financial assets Cash and cash equivalents Financial assets at fair value through surplus or deficit Financial investments held– to–maturity Total financial assets Financial liabilities Other financial liabilities Total financial liabilities Liquidity gap

Up to 1 month

1 month to 3 months to 3 months 1 year

1 year to 5 years

Over 5 years

Maturity undefined

Total

1,182,309

-

-

-

-

-

1,182,309

2,127,141

3,904,496

6,178,959

11,334,804

52,234

529,765

24,127,399

30,329 3,339,779

3,904,496

27,195 6,206,154

155,641 11,490,445

301,327 353,561

529,765

514,492 25,824,200

(2,463) (2,463) 3,337,316

(2,294) (2,294) 3,902,202

6,206,154

11,490,445

353,561

529,765

(4,757) (4,757) 25,819,443

1 year to 5 years

Over 5 years

Maturity undefined

Total

Up to 1 month

1 month to 3 months to 3 months 1 year

771,095

-

-

-

-

-

771,095

2,017,784

2,461,882

5,157,833

12,200,388

424,631

19,962

22,282,480

29,897 2,818,776

2,461,882

27,246 5,185,079

136,233 12,336,621

190,726 615,357

19,962

384,102 23,437,677

429 429 2,818,347

2,461,882

5,185,079

12,336,621

615,357

19,962

429 429 23,437,248

Price risk Price risk is the risk that the value of a financial instrument will fluctuate as a result of changes in market prices whether those changes are caused by factors specific to the individual security or its issuer or factors affecting all securities traded in the market. The Fund is exposed to price risks of its products which are subject to general market and specific fluctuations. The Fund manages price risk through periodic estimation of potential losses that could arise from adverse changes in market conditions and establishing and maintaining appropriate stop-loss limits and margin and collateral requirements. Risk management and monitoring is performed within above set limits, by the Investment Committee and the Fund’s Management. All recommendations/decisions are proposed/made by the Investment Committee and subsequently are subject to the approval of the management of the Fund. Daily risk management is performed by the Risk Management Department.



Limitations of sensitivity analysis

2012


The following table presents a net impact of change of the fair value of securities, when market interest rate changed by 1%. Sensitivity analysis of interest rate risk has been determined based on “reasonably possible changes in the risk variable”. The level of these changes is determined by management and is contained within the risk reports provided to key management personnel.

An analysis of the liquidity risk of financial position items is presented in the following tables:



31 December 2012 1% increase in securities price

31 December 2011

1% decrease in securities price

1% increase in securities price

1% decrease in securities price

Impact on surplus/(deficit) before tax

240,802

(240,802)

221,237

(221,237)

Impact on net assets/equity

192,642

(192,642)

176,990

(176,990)

Related parties or transactions with related parties, as defined by IPSAS 20 “Related party disclosures”, represent parties that directly, or indirectly through one or more intermediaries: control, or are controlled by, or are under common control with, the Fund; have an interest in the Fund that gives them significant influence over the Fund; and that have joint control over the Fund. All government entities are considered to be entities under common with the Fund. Transactions with such entities are disclosed below as related party transactions:

State Oil Company of the Republic of Azerbaijan Azerbaijan Gas Supply Company Operating Companies The State Budget Ministry of Finance of the Republic of Azerbaijan “Azerbaijan Melioration and Water-sludge system” OSC

Ministry of Education of the Republic of Azerbaijan International Bank of Azerbaijan

119,028 161,926 299,982

-

-

-

-

-

2011 2012

-

139,974 -

-

-

156,506

-

-

2011 2012 2011 2012

-

32,567 19,977

-

-

133,755 -

-

-

2011 2012 2011

-

14,999 -

-

-

59 31

-

-

Transactions with related parties are described in Notes 5, 12, 13, 22 and 23.

21. Transactions with related parties

Related parties

“Azersu” OSC

-

Contributions Transfers Payables Year received from to related to related related parties parties parties

Receivables Bank Income Off-balance from accounts Tax sheet related with related expense transactions parties parties -

2012

12,772,844

-

-

2011 2012 2011 2012 2011 2012 2011 2012

15,019,238 287,161 288,834 57,350 51,076 -

9,905,000 9,000,000 -

-

20,117 -

-

-

277,225

2011 2012

-

199,997

-

-

-

-

276,107 -

2011

-

199,998

-

-

-

-

-

Key management personnel The senior management group consists of the Fund’s Executive Director and heads of administrations. The aggregate remuneration of members of the senior management group and the number of managers determined on a full-time equivalent basis receiving remuneration within this category are:

Aggregate remuneration Number of persons

2012 111 3

2011 87 3

22. Commitments and contingencies Off-balance sheet transactions On 11 August 2006 the Fund signed an Asset Management Agreement on “Granting free budget (balance) Funds to trustworthy management” with the Ministry of Finance of the Republic of Azerbaijan. According to this agreement free budget Funds of the Ministry of Finance of the Republic of Azerbaijan are to be transferred to and managed by the Fund within the asset management rules set in the agreement with the Ministry of Finance of the Republic of Azerbaijan. The Fund manages these assets free of charge, on its own behalf and in favor, at the expense and at the risks of the Ministry of Finance of the Republic of Azerbaijan. At 31 December 2012 assets received under the above agreement were AZN 277,225 thousand (USD 285,207 thousand, EUR 51,174 thousand and GBP 185 thousand) (2011: AZN 276,107 thousand (USD 284,687 thousand, EUR 51,068 and GBP 184 thousand)) including accrued interest.



128

Operational risk is the risk of loss arising from systems failure, human error, fraud or external events. When controls fail to perform, operational risks can cause damage to reputation, have legal or regulatory implications, or lead to financial loss. The Fund cannot expect to eliminate all operational risks, but a control framework and monitoring and responding to potential risks could be effective tools to manage the risks. Controls should include effective segregation of duties, access, authorization and reconciliation procedures, staff education and assessment processes, including the use of internal audit.

2012 2011 2012


ANNUAL REPORT 2012

Operational risk

The Ministry of Transportation The State Refugees Committee and Internally Displaced People’ Social Development Fund Central Bank of the Republic of Azerbaijan


Legal proceedings

ANNUAL REPORT 2012

The calculation of profit tax in Azerbaijan tax legislation can be subject to various interpretations and this may lead to certain possible additional obligations of the Fund, including additional taxes, penalties and interest. Tax years for the calculation of profit tax, Value Added Tax, personal income tax, withholding taxes and other taxes remain open to review by the tax authorities for three years. The last tax audit of the Fund was conducted by the Chamber of Accounts in 2010 and covered the calendar years 2008 and 2009. Management believes that the Fund has already made all necessary tax payments due, and therefore no provisions have been made in these financial statements for any other potential liabilities. Operating environment The Fund is established and operates in the Republic of Azerbaijan and its subsidiaries operate in Russia, Jersey Islands, United Kingdom of Great Britain and Luxembourg. Laws and regulations affecting the business environment in these countries subject to rapid changes and the Fund’s and subsidiaries assets and operations could be at risk due to negative changes in the legal, regulatory, and political environment.

23. Events after the reporting period Receivables and transfers In accordance with Presidential Decree #803 on “Ratifying the Budget of The State Oil Fund of the Republic of Azerbaijan for 2013” dated 30 December 2012, the Fund’s budgeted income and expenses for 2012 are estimated at AZN 11,482,040 thousand and AZN 13,403,099 thousand, respectively. The following main types of expenses for 2013 are budgeted: ● Transfer to the State Budget of the Republic of Azerbaijan – AZN 11,350,000 thousand; ● Financing of the measures for improvement of social conditions of refugees and internally displaced people – AZN 300,000 thousand; ● Construction of new Baku-Tbilisi-Kars railway line – AZN 138,275 thousand; ● Reconstruction of Samur-Absheron irrigation system – AZN 107,438 thousand;

● Financing of the construction of high speed fiber optic network providing an access to all settlements of Azerbaijan Republic – AZN 103,556 thousand; ● Financing of the share of Azerbaijan Republic in the construction project of the Oil-Gas and Petrochemical Consortium (OGPC) – AZN 211,950 thousand; ● Financing of the share of Azerbaijan Republic in the construction of the STAR oil refinery project in Turkey - AZN 596,600 thousand; ● Financing of the share of Azerbaijan Republic in the construction of the TANAP project – AZN 86,350 thousand; ● Financing of the share of Azerbaijan Republic in the construction of new driling rig in the Caspian Sea – AZN 388,575 thousand; ● Expenses related to managing the Fund – AZN 86,300 thousand. External asset manager One of five external managers - Credit Suisse has discontinued to provide external manager services to SOFAZ effective 28th of February, 2013. Income tax exemption Effective 1 January 2013 based on Presidential Decree #509-IVQD dated 21 December 2012, and law of State Parliament regarding changes to the Tax Code of Azerbaijan Republic dated 29 December 2012 starting from 1 January 2013 SOFAZ is exempted from Corporate income tax. Acquisition of 8 Place Vendome On 19 March 2013 the Fund has finalized the acquisition of 8 Place Vendome, an investment property comprising of an office, retail and residential building located in Place Vendome 8, Paris, France, for EUR 135,000 thousand.



130

Taxation

● Financing the State Program on Education of Azerbaijan youth in foreign countries during 2007-2015 – AZN 34,056 thousand;


In 2004, a legal action totaling approximately six million USD was brought against the Government of the Republic of Azerbaijan along with a number of Azerbaijan governmental institutions, including the Ministry of Communications of the Republic of Azerbaijan, the State Oil Company of the Republic of Azerbaijan and the Fund. This legal action was brought by First International Merchant Bank (the “Claimant Bank”) in the District Court of Rotterdam (the “Court”), the Netherlands. In an interim-verdict dated 24 December 2008, the Court ruled that the Claimant Bank should submit additional evidence supporting the major facts on legal proceeding. Further, in a verdict dated 17 February 2010 (the “Verdict”), the Court has rejected the claims of the Claimant Bank. Currently, the claim is at the court of appellate jurisdiction. The Management of the Fund believes that there is no possibility of any outflow in the settlement and there is no need for provision.


ùSANTIAGO PRINCIPLESú

APPENDIX SOVEREIGN WEALTH FUNDS GENERALLY ACCEPTED PRINCIPLES AND PRACTICES “SANTIAGO PRINCIPLES”

ANNUAL REPORT 2012

The key features of the SWF’s legal basis and structure, as well as the legal relationship between the SWF and other state bodies, should be publicly disclosed.

http://www.oilfund.az/en/content/25 http://www.oilfund.az/en/content/13

GAPP 2. Principle The policy purpose of the SWF should be clearly defined and publicly disclosed.

Narration of Principles / Sub-Principles

Responses

A. Legal Framework, Objectives, and Coordination with Macroeconomic Policies

132

GAPP 1.1. Subprinciple The legal framework for the SWF should ensure legal soundness of the SWF and its transactions.

SOFAZ was established for the purpose of accumulation and management of the revenues generated from implementation of oil and gas agreements. SOFAZ’s primary objectives are to help maintain macroeconomic stability in the country (neutralize negative impact of the currency inflows) and to generate wealth for present and future generations. http://www.oilfund.az/en/content/25/9 http://www.oilfund.az/en/content/3

Legal framework of SOFAZ is clearly defined in the “Statute of the State Oil Fund of the Republic of Azerbaijan” (hereinafter “Statute of SOFAZ”) approved by the decree of the President of the Republic of Azerbaijan.

GAPP 3. Principle

SOFAZ is a legal entity separate from the government or central bank. The Fund's operation is guided by the Constitution and laws of the Republic of Azerbaijan, Presidential Decrees and Resolutions, and the Fund's Regulations.

Where the SWF’s activities have significant direct domestic macroeconomic implications, those activities should be closely coordinated with the domestic fiscal and monetary authorities, so as to ensure consistency with the overall macroeconomic policies.

According to its bylaws, SOFAZ is not permitted to invest domestically. Expenditures of SOFAZ constitute part of the consolidated state budget which is approved by the Parliament. According to Budget System Law the consolidated state budget is being prepared in close consultation with all relevant institutions (Ministry of Finance, Ministry of Economic Development, etc.) and involvement of SOFAZ. http://www.oilfund.az/en/content/25/154 http://www.oilfund.az/en/content/25/156



GAPP 1. Principle The legal framework for the SWF should be sound and support its effective operation and the achievement of its stated objective(s).

All relevant documents related to the legal basis and structure and the legal relationships between SOFAZ and the other government agencies are publicly disclosed and they are available on the Fund’s website.


Self-Assessment April, 2013

GAPP 1.2. Subprinciple

APPENDIX


B. Institutional Framework and Governance Structure

GAPP 4. Principle There should be clear and publicly disclosed policies, rules, procedures, or arrangements in relation to the SWF's general approach to funding, withdrawal, and spending operations.

ANNUAL REPORT 2012

GAPP 4.2. Subprinciple The general approach to withdrawals from the SWF and spending on behalf of the government should be publicly disclosed.

The governance framework for the SWF should be sound and establish a clear and effective division of roles and responsibilities in order to facilitate accountability and operational independence in the management of the SWF to pursue its objectives.

http://www.oilfund.az/en/content/25/154 http://www.oilfund.az/en/content/25/156

GAPP 5. Principle The relevant statistical data pertaining to the SWF should be reported on a timely basis to the owner, or as otherwise required, for inclusion where appropriate in macroeconomic data sets.

SOFAZ submits statistical reports on a monthly basis to the President and Ministry of Finance and on a quarterly and yearly basis to the State Statistical Committee. SOFAZ also reports on its revenues and expenditures to the Parliamentary Chamber of Accounts and on other relevant information to the Ministry of Taxes, State Social Protection Fund and other relevant government agencies. Additionally, SOFAZ regularly provides the relevant information on its activities to the World Bank and International Monetary Fund. All relevant statistical data pertaining to the fund are available on the Fund’s website (audited annual reports, quarterly statements, etc.). http://www.oilfund.az/en/content/25/154 http://www.oilfund.az/en/account

SOFAZ has a three-tier governance structure, with the President of the country being a supreme governing and reporting authority for the Fund. SOFAZ's activities are overseen by a Supervisory Board which is headed by the Prime Minister and consists of the ViceSpeaker of Parliament, Minister of Finance, Minister of Economic Development, Governor of the Central Bank, the Economic Advisor to the President and the President of National Academy of Sciences. The operational management of SOFAZ is vested in the Executive Director. The relevant duties and responsibilities of the President of the country, Supervisory Board and Executive Director are clearly defined in the “Statute of SOFAZ”. http://www.oilfund.az/en/content/25/154

GAPP 7. Principle The owner should set the objectives of the SWF, appoint the members of its governing body(ies) in accordance with clearly defined procedures, and exercise oversight over the SWF's operations.

The objectives of SOFAZ are clearly defined in “Statute of SOFAZ” approved by the President of the Republic of Azerbaijan. President appoints the members of the Fund’s Supervisory Board and Executive Director. http://www.oilfund.az/en/content/25/154



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The source of SWF funding should be publicly disclosed.

GAPP 6. Principle



SOFAZ’s Funding and Withdrawal rules are clearly defined by the “Statute of SOFAZ” and "Rules on the preparation and execution of the annual program of revenues and expenditures (budget) of the State Oil Fund of the Republic of Azerbaijan" (hereinafter “Rules on the budget of SOFAZ”) which are publicly disclosed on the Fund’s website.

APPENDIX


GAPP 8. Principle The governing body(ies) should act in the best interests of the SWF, and have a clear mandate and adequate authority and competency to carry out its functions.

GAPP 11. Principle In order to ensure the adequate authority of the Fund’s Supervisory Board, the Board has to consist of representatives of the Parliament, Government and academic community. All roles and responsibilities of the Supervisory Board are clearly defined in the relevant legislation.

An annual report and accompanying financial statements on the SWF's operations and performance should be prepared in a timely fashion and in accordance with recognized international or national accounting standards in a consistent manner.

Since the start of its operations, SOFAZ has prepared annual reports and accompanying financial statements.

ANNUAL REPORT 2012

http://www.oilfund.az/en/content/25/154 http://www.oilfund.az/en/content/25/154 http://www.oilfund.az/en/account

GAPP 9. Principle The operational management of the SWF should implement the SWF’s strategies in an independent manner and in accordance with clearly defined responsibilities.

GAPP 12. Principle The SWF's operations and financial statements should be audited annually in accordance with recognized international or national auditing standards in a consistent manner.

Since the start of its operations SOFAZ has been audited by reputable international audit firms, and all annual reports and accompanying financial statements are available on the Fund’s website. SOFAZ also has an internal auditor who prepares periodic internal audit reports.

http://www.oilfund.az/en/content/25/154

http://www.oilfund.az/en/content/25/154

GAPP 10. Principle The accountability framework for the SWF's operations should be clearly defined in the relevant legislation, charter, other constitutive documents, or management agreement.

Accountability framework of SOFAZ is clearly defined in the “Statute of SOFAZ”, “Investment guidelines” and “Rules on the budget of SOFAZ” all of which are available on the Fund’s website. Fund produces and discloses audited annual reports and quarterly reports. Information about Fund’s activities is also disseminated by regular press conferences and published on the Fund’s website. http://www.oilfund.az/en/content/25/154 http://www.oilfund.az/pub/tiny_upload/ Inv_guide.pdf http://www.oilfund.az/en/content/25/156

GAPP 13. Principle Professional and ethical standards should be clearly defined and made known to the members of the SWF's governing body, management and staff.

Professional and ethical standards are clearly defined in the "Investment Guidelines". Management and staff of the Fund have to comply with ethical norms and rules of the International Financial Markets Association (ACI, Paris). http://www.oilfund.az/pub/tiny_upload/ Inv_guide.pdf



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“Statute of SOFAZ”, “Rules on management of foreign currency assets of the State Oil Fund of the Republic of Azerbaijan” (hereinafter “Investment guidelines”) and “Rules on the budget of SOFAZ” clearly define the role and responsibilities of the Executive Director. In accordance with these role and responsibilities Executive Director has independence in operational management.


All annual reports and accompanying financial statements which are prepared in accordance with IFRS standards are published on the Fund’s website.

APPENDIX


GAPP 14. Principle Dealing with third parties for the purpose of the SWF's operational management should be based on economic and financial grounds, and follow clear rules and procedures.

GAPP 17. Principle Fund’s activities related to third parties are based on economic and financial grounds. Fund’s "Investment Guidelines" and “Investment Policy” regulate SOFAZ’s dealing with third parties.

Relevant financial information regarding the SWF should be publicly disclosed to demonstrate its economic and financial orientation, so as to contribute to stability in international financial markets and enhance trust in recipient countries.

ANNUAL REPORT 2012

SWF operations and activities in host countries should be conducted in compliance with all applicable regulatory and disclosure requirements of the countries in which they operate.

Fund conducts its operations and activities in host countries in compliance with all applicable regulatory and disclosure requirements of those host countries.

GAPP 16. Principle The governance framework and objectives, as well as the manner in which the SWF's management is operationally independent from the owner, should be publicly disclosed.

Fund’s governance framework, objectives and its operational independence are clearly defined in the relevant legislation. http://www.oilfund.az/en/content/25/154

C. Investment and Risk Management Framework

GAPP 18. Principle

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The SWF’s investment policy should be clear and consistent with its defined objectives, risk tolerance, and investment strategy, as set by the owner or the governing body(ies), and be based on sound portfolio management principles.

Fund’s investment and risk management policies are defined by "Investment Policy" which is annually approved by the President after the review of the Supervisory Board and "Investment Guidelines".


Financial risk limits are set out in Fund’s Investments Guidelines which prohibits the use of any leverage. Derivatives (i.e. swaps, forwards, futures, etc) may only be used for hedging or optimizing the currency composition and asset allocation of the Investment Portfolio.

The investment policy should guide the SWF's financial risk exposures and the possible use of leverage.

ANNUAL REPORT 2012


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GAPP 15. Principle

http://www.oilfund.az/en/account http://www.oilfund.az/en/content/20/249


http://www.oilfund.az/pub/tiny_upload/ Inv_guide.pdf http://www.oilfund.az/pub/tiny_upload/ Inv_policy1.pdf

Audited financial statements are published in Fund’s annual report, which is publicly available. Quarterly reports and all other relevant financial information about the Fund’s activities are published on the Fund’s website. Disclosed financial information includes AUM, asset allocation, benchmark, annual rates of return, etc.

APPENDIX


GAPP 18.3. Subprinciple A description of the investment policy of the SWF should be publicly disclosed.

Fund's “Investment guidelines” and “Investment Policy” are available on its website.

GAPP 19.1. Subprinciple If investment decisions are subject to other than economic and financial considerations, these should be clearly set out in the investment policy and be publicly disclosed.

http://www.oilfund.az/pub/tiny_upload/Inv_ policy1.pdf

GAPP 19.2. Subprinciple The management of an SWF’s assets should be consistent with what is generally accepted as sound asset management principles.

GAPP 20. Principle The SWF should not seek or take advantage of privileged information or inappropriate influence by the broader government in competing with private entities.

http://www.oilfund.az/pub/tiny_upload/Inv_ guide.pdf http://www.oilfund.az/pub/tiny_upload/Inv_ policy1.pdf

“Statute of SOFAZ” does not allow the Fund to invest domestically. According to the “Investment guidelines”, SOFAZ makes investment decisions independently of the government. The legal framework of SOFAZ ensures that the Fund does not seek or take advantage of any privileged information. http://www.oilfund.az/pub/tiny_upload/Inv_ guide.pdf http://www.oilfund.az/en/content/25/154

GAPP 19. Principle The SWF's investment decisions should aim to maximize risk-adjusted financial returns in a manner consistent with its investment policy, and based on economic and financial grounds.

According to its “Investment Policy”, Fund’s investment decisions should aim at maximizing the risk adjusted returns. Fund’s all investment decisions are made purely on an economic and financial basis according to the sound asset management principles.

GAPP 21. Principle SWFs view shareholder ownership rights as a fundamental element of their equity investments' value. If an SWF chooses to exercise its ownership rights, it should do so in a manner that is consistent with its investment policy and protects the financial value of its investments. The SWF should publicly disclose its general approach to voting securities of listed entities, including the key factors guiding its exercise of ownership rights.

In 2012 SOFAZ started investing in public equities. At the initial stage, equity investments are done through external managers and with passive investment mandate. SOFAZ has chosen not to exercise its ownership rights at this stage.



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All aspects of dealing with external managers are clearly defined in relevant documentation about Fund’s activity. Fund's external managers can invest only in asset classes permissible by the Fund's “Investment guidelines”. Appointment of external managers is carried out in compliance with the current legislation of Azerbaijan Republic on “State Procurement”. External managers are selected on the basis of the criteria, such as credit rating of manager, assets under management, experience in the asset management industry, proposed rate of return and risk, proposed fees schedule etc. Compliance of the external managers’ investments to their mandate is monitored daily. Performance of external managers’ portfolios is monitored monthly.


ANNUAL REPORT 2012

The investment policy should address the extent to which internal and/or external investment managers are used, the range of their activities and authority, and the process by which they are selected and their performance monitored.


APPENDIX


GAPP 22. Principle The SWF should have a framework that identifies, assesses and manages the risks of its operations.

The risk management framework should include reliable information and timely reporting systems, which should enable the adequate monitoring and management of relevant risks within acceptable parameters and levels, control and incentive mechanisms, codes of conduct, business continuity planning, and an independent audit function.


http://www.oilfund.az/pub/tiny_upload/ Inv_guide.pdf http://www.oilfund.az/uploads/Inv_policy1. pdf

The assets and investment performance (absolute and relative to benchmarks, if any) of the SWF should be measured and reported to the owner according to clearly defined principles or standards.

Comprehensive reports on assets of SOFAZ (including information on breakdown by foreign currencies, asset class, credit ratings, maturities and geographic regions) are disseminated through the quarterly press releases. The performance of the Fund’s investments is measured according to best industry standards and reported on an annual basis. Annual reports and quarterly statements are posted on the Fund’s website. http://www.oilfund.az/en/account

GAPP 24. Principle A process of regular review of the implementation of the GAPP should be engaged in by or on behalf of the SWF.

This report was first published on SOFAZ’s official website in April, 2011 and it is reviewed on an annual basis.



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The general approach to the SWF's risk management framework should be publicly disclosed.

Identification, assessment and management of the risks of the Fund’s operations play crucial role in the Fund’s overall management framework. SOFAZ’s risk management system is supported with appropriate legal framework (“Investment Guidelines”, "Investment Policy”, etc), a specialized risk unit (Risk Management Department), internal and external audit functions and tools like RiskManager 4 by RiskMetrics and proprietary models. “Investment Guidelines” and "Investment Policy” set the main principles of risk management framework and clearly define limits on major factors for market, credit, concentration and liquidity risks. Certain pre-trade limits are set based on these factors. Furthermore, these risk factors are monitored on a daily basis via regular risk and performance reports. In addition to the factors set in the “Investment Guidelines” and “Investment Policy”, a more in-depth analysis and monitoring of the market risk is performed on a regular basis through: interest rate sensitivity analysis (key rate durations, PV01, etc.), risk concentration analysis (duration by groups, VaR by groups, marginal VaR, etc.), tail events (conditional VaR, stress tests) and scenario analyses. Operational risk is managed in accordance with Fund's Operational Manual and business continuity planning.


ANNUAL REPORT 2012


GAPP 23. Principle

24 Neftchilar Avenue, Dalga Plaza, Baku, Republic of Azerbaijan, AZ1000 +99412 498 77 53 www.oilfund.az