Business Statistics II

A statistical regression analyses of the impact of oil revenues on development of non-oil

sector of Azerbaijan
Ali Talibov
Murad Yadigar
Nurlan Huseyinli
Vusal Alili
Contents
Introduction 3
Theory 3
Hypothesis: 4
Data Description 4
Dependent variable 4
Independent Variable 1 6
Regression analysis with Time Series data 7
OLS Assumptions: 7
Regression Output 8
Interpretations of the slope 8
R-squared and Adjusted R-Squared 8
F Test 9
T test 9
How to address Multicollinearity problem? 10
Conclusion 10
References: 11

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Introduction
Azerbaijan is one of the oil producer country where the oil revenues constitute the lion share
of its economy, while non-oil sector of the country remains fragile. According to Martino
(2012), 95 percent of Azerbaijan’s export depends on the oil and gas industry. He also adds
that regarding the mentioned industries’ roles in GDP, in the last 3 years starting from 2009
to 2012, there has been a decline in the contribution of above mentioned sector from over 60
percent to less than 50 percent. Moreover, in accordance Ministry of Finance of Baku, in
2012, oil and gas sector made up 75 percent of Azerbaijan’s tax Revenue. The intense
dependency of Azerbaijan’s economy from oil sector demonstrated during the sharp decline
in the oil prices from 115 dollars per barrel in 2014 to under 35 dollars at the end of February
2016. The sharp decline started in 2014 displayed its impacts in the economy in 2015
February, when AZN depreciated by 34 percent from 0.78 to 1.05 per a dollar (Jafarli, 2016).
However, the impact did not end there and the devaluation in the currency reoccurred in
December 2015. During the second devaluation Azerbaijan’s Manat devalued by 48 percent
from 1.05 to 1.55 per a dollar (Jafarli, 2016). Since AZN exchange was fix rate exchange
rate, when the reserves of Central Bank declined due to lower oil revenue, the devaluation
was inevitable. In addition to that since the country’s non-oil sector was not developed, it was
importing majority of products abroad in the currency of dollar. Furthermore, declining in the
economy of Azerbaijan were making the foreign investment to the country riskier, which
resulted in the sudden withdrawal of investments from the country. Thus, the demand for
AZN were declining which was even worsening the devaluation process of the currency.

After the crisis which started in 2014, Azerbaijani government has realized once more time
that investment to the non-oil sector of the country is mandatory for sustainability of the
economy. Increased awareness of the topic due to the economic crisis has been a foundation
for many researches. While many papers have focused the dependency of budget revenue
from oil prices, there has not been any work that address the relation between oil prices and
budget revenue, there is less awareness of the relationship between the oil revenue and the
development of non-oil sector of Azerbaijan. Thus, a new study on the above-mentioned
topic is needed to shed a light on the question that how oil prices and revenue of Azerbaijan
affect the rate of improvement in non-oil sector.

Theory
To examine the paper from theoretical point of view, we are going to get more insights into
the variables needed to conduct the research. To estimate the development of non-oil sector
we first need the data that can represent the annual growth rate in non-oil sector. To define
which sectors particularly we mean by non-oil sectors we need to find data for each non-oil
sector and add them up to come to the specific number. Another way of doing that could be
finding the value of oil-related industries and overall the value the whole industries in
Azerbaijan. Subsequently, by subtracting the value of oil related industries from the overall
value of industries in Azerbaijan we get the numbers for non-oil sector. For independent
variables we need to first determine which industries are oil related sectors and then we need

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to use them as separate independent variable to check the overall relationship between the
revenue from those oil related industries and the development of non-oil sector in Azerbaijan.
Since the value of the revenue from oil related industries are going to be in million, we will
take logarithm functions of the two independent variables. Thus, the model that we are going
to build is the following:

Non-oil Sector=B0+B1 log (oil production) +B2 log (oil related products) + Error
To estimate the values of the variables we are going to build a regression Equation like
following:

Y(hat)= b0+b1log(X1) +b2log(X2)

Y(hat)= Estimated value of the development in non-oil sector, b0= estimated intercept,
b1= estimated slope of first independent variable, b2= estimated slope of second
independent variable

Hypothesis:
H0: b1=b2 = 0

Ha1: b1=b2≠0

Ha2: b1≠ b2=0

Ha3: b1=0≠b2

Data Description
The data that we are going to use in this paper has been derived from Azerbaijan Statistics
Committee’s website (www.stat.gov.az). In terms of the type of data, we are going to use
time series data to measure the tendency across the years starting from 2007 till 2017.
Overall, we have 11 observations for 3 variables which makes only 33 samples. Since we
take annual figures for each year, the number of observations and samples are not sufficiently
significant to come accurate outcome of regression. As a solution for this problem, we could
have taken monthly data for the variables. However, limited monthly data for oil production
and non-oil sector makes the accessibility of the data very challenging. Moreover, we expect
the multicollinearity problem among the variables of oil production and oil related products.
In the following sections we will analyze the outcome of regression and solution for the
problem.

Dependent variable
The independent variable for our study is the development of Non-oil sector. Thereby, we
have found the annual numbers that represent the non-oil sector of Azerbaijan and calculated
the growth rate per each year to find the development rate. As we have mentioned above the
numbers that we got for non-oil sector are the subtraction of the value of the oil related

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industries from the overall value of the industries in Azerbaijan. Moreover, these numbers
themselves are not sufficient to demonstrate the relationship. The reason for that the value of
non-oil sector mostly increase year by year (except in 2009) regardless of decrease or
increase in the independent variables. To address this issue, we have to find increasing rate of
the data compared to the previous year. Therefore, we will do the following mathematical
calculation for each time to get the growth rate or development rate of non-oil sector.

(Y(t)-Y(t-1))/Y(t-1)

Y(t) represents the value of non-oil sector at year t and Y(t-1) represents the value of
non-oil sector at year t-1
We will need the data of 2006 to find the growth at 2007. As a result, we will get the
following data for independent variable.

Growth rate in Non-

Years Oil Sector
2007 0.133212973
2008 0.253285917
2009 0.185844324
2010 -0.093127871
2011 0.186047493
2012 0.154621011
2013 0.147093731
2014 0.048884708
2015 0.060788132
2016 0.107737642
2017 0.196437137

The value of
Non-Oil
Years sector
2006 3101800000
2007 3515000000
2008 4405300000
2009 5224000000
2010 4737500000
2011 5618900000
2012 6487700000
2013 7442000000
2014 7805800000
2015 8280300000
2016 9172400000
2017 10974200000

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 Growth rate in Non-Oil
0.3
0.25
0.2
0.15
0.1
0.05
0

2007
2008
2009
2010
2011
2012
2013
2014
2015
2016
2017
-0.05
-0.1
-0.15

Independent Variable 1
As a first independent variable we will take the values of the oil production, in other words,
the annual revenue generated from oil production. Since the value of oil production is in
million manats, we will take the logarithm function of the revenue to get more accurate slope
of relationship. Thus, we will generate a new series in Eviews by the following steps. As seen
from the table of descriptive statistics the mean value of indep. var. 1 is 23.54 and the
maximum value is 23.98.

Loil_prod=log(oil_sector_production_)
Loil_pro
Years d
23.4941
2007 1
23.8210
2008 7
23.4946
2009 9
23.7288
2010 8
23.9834
2011 9
23.9319
2012 7
23.8869
2013 7
23.7666
2014 9
23.4126
2015 8
23.6599
2016 4

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 23.7049
2017 4

Oil Sector
Years (production)
2007 15972100000
2008 22149300000
2009 15981300000
2010 20198700000
2011 26055400000
2012 24747000000
2013 23658000000
2014 20977000000
2015 14723000000
2016 18853000000
2017 19774955245

Loil_prod
24.1
24
23.9
23.8
23.7
23.6
23.5
23.4
23.3
2006 2008 2010 2012 2014 2016 2018

Independent Variable 2

As second independent variable we will take the value of oil related

products produced in Azerbaijan. The underlying problem with this
variable is the high possibility of multicollinearity issue with the first
independent variable. As we did in the first independent variable, we will
also take logarithmic function of this variable as well and we will create a new series in
Eviews like following:

Loilproducts=log(oil_sector_oil_related_products_)

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As shown on the table of descriptive statistics the mean value of indep. Var. 2 is 21.45 and
the maximum value is 21.77.

Regression analysis with Time Series data

In this section we will run regression analysis which is a test to measure how much change in
one variable affect the other. In our case we will measure how much change in the
development of non-oil sector which is dependent variable is explained by the change in the
oil revenue which is the independent variable. We will use Least Square Method (OLS) to
estimate the slope coefficient of our regression model.
Y=B0+B1X1+B2X2+Errors

OLS means that in this regression model we will have such B1 AND B2 that the error terms
will be minimized.

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OLS Assumptions:
The expected value of the error is zero
Error terms are independent from the explanatory variables (independent variables)

There is no perfect multicollinearity problem meaning that no independent variable is a

perfect function of another independent variable.
Error terms are not serially correlated with each other
Error terms are normally distributed

Due to the limited number of samples there can be some assumptions violated. For instance,
to get the normal distribution of the variables we must have more samples than we have
which is 33. Moreover, our model could experience problem related to multicollinearity,
since our 2 independent variables correlate with each other. However, we will see whether it
is serious problem or not while getting the regression output.

Regression Output

Y= 0.6065-0.2364log(X1) +0.2370log(X2)

Interpretations of the slope

Since the function is Level-Log model specification, we can interpret the slope like 1 percent
increase in the value of oil production decrease the increase rate of non-oil sector by 0.0024
units which is quite significant number for the increase rate of the industry. Surprisingly,
there is a positive relationship between oil products manufacturing industry and non-oil
sector of Azerbaijan. In other words, 1 percent increase in oil related products manufacturing
industry increase the non-oil sector growth rate by 0.0024 units. However, when it comes to
test the significance of the result, the slope we got from the result are not significant to reject
the Null hypothesis. We will see in more details in F and T test section

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R-squared and Adjusted R-Squared
R squared and Adjusted R squared measure the percentage change in the dependent variable
that can be explained by independent variable. We usually have less Adjusted R square than
R square. The formula for the adjusted R square is the following:

Adj R square=1- (1-Rsquare) (n-1)/n-k-1

Based on the result we can claim that almost 31 percent of the changes in the development of
non-oil sector can be explained by the oil revenue of Azerbaijan. However, if we adjust the R
square to multiple regression through the formula we can conclude that it is only 14 percent.

F Test
F test in multiple linear regression model is used to test the existence of regression and
determine whether to reject or not reject H null. We can see from the output that F statistics is
1.870 which is not significant to reject H0 which was B1=B2= 0. Therefore, from the output
given above we cannot conclude that there is a significant relationship between the
development of non-oil sector and oil revenue.

T test
T test in multiple linear regression is to test the slope of each independent variable and
conclude whether it is significant or reject the H null or not. From the output given above we
can conclude that even 90 percent confidence interval does not include the test stat. In other
words, p value is greater than the alfa which implies that for both t tests of independent
variables are not significant to reject the H null. It means that the slope we got for each
independent variable is not significant.
So, what is the problem then? Is it because of Multicollinearity problem?

To check whether we have multicollinearity issue among two independent variable we need
to run regression between two variables and see the slope of their relationship. In this
regression we will take oil related products as dependent and oil production as independent
value.

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As we see from the output above there is a serious multicollinearity problem between two
variables.

Loilproducts= 6.55+0.63loil_prod
Since it is Log-Log function, we can interpret the slope like 1 percent increase in the value of
the oil production will lead to 0.63 percent increase in the value of the oil related products.

From the R squared above we can conclude that more than 80 percent of the changes in oil
related products can be explained by the value of the oil production. The respective number
for the adjusted R square is 78 percent which is enough to conclude that multicollinearity
issue in the regression is serious and needs to be solved. Overall, if R square is more than .70
in the regression between two independent variables, it is enough to conclude that
multicollinearity problem is serious and could lead to the wrong output.

How to address Multicollinearity problem?

One of the common way of solving Multicollinearity issue is to drop one of the variable
which is highly correlated with the other one. Therefore, in our model we will drop the oil
related products and run the regression again as a simple linear regression.

From the new output given above we can still see that p value is not small enough to reject
Null hypothesis. What does it mean? It simply implies that there is negative relation between
the value of oil Production and the development of non-oil sector. However, the given sample
data is not enough to reject the Null Hypothesis. In the beginning of the study we have also
mentioned the limits of this paper and stated that there some assumptions of OLS can be
violated in this regression. One of the assumptions was that error terms must be distributed in
normal distribution. However, from the sample data we can see that the number of samples in
our data is just 33 which is not high enough to create normal distribution.

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Conclusion
In conclusion, we can derive from this study that the relationship between oil revenue and the
development of non-oil sector is 0 which was the H0 in our hypothesis. While we got the
negative relationship from the output, we were not able to reject the null hypothesis which
was B1=B2=0. Therefore, we conclude that relationship slopes in our model:

Y(hat)=b0+b1log(X1) +b2log(X2) where b1 and b2 are zero, which means that the variables
are not correlated.

From the economic point of view, we can also justify the output and contend that oil revenue
does not necessarily affect non-oil sector of Azerbaijan. Even if we have high oil revenue, the
growth rate of the non-oil sector can be high depending on the sufficiency of the oil revenue
usage. In other words, we cannot confidently state that if the oil revenue in a country is high,
that county’s non-oil sector growth cannot be high. Depending on the policy of the
government non-oil sector can be improved regardless of the change in the revenue from oil
sector.

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References:
Balcani, Osservatorio, and Caucaso. “Azerbaijan's Oil Dependence.” Osservatorio Balcani e Caucaso,
www.balcanicaucaso.org/eng/zone/Azerbaijan/Azerbaijan-s-oil-dependence-123328.

Shepard, Wade. “What Azerbaijan Plans To Do When The Oil Runs Out.” Forbes, Forbes Magazine, 5
Dec. 2016, www.forbes.com/sites/wadeshepard/2016/12/03/what-azerbaijan-plans-to-do-when-
the-oil-runs-out/#28e87e3d3780.

Makroiqtisadi göstəricilər. (n.d.). Retrieved from https://www.cbar.az/lpages/statistics/key-

macroeconomic-indicators/

(n.d.). Retrieved from http://www.oilfund.az/index.php?page=hesabat-arxivi&hl=az_AZ

Huseynov, N. (2017, November 13). Azerbaijan's non-oil sector grows by over 3%. Retrieved from
https://report.az/en/industry/azerbaijan-s-non-oil-sector-grows-by-over-3

The Republic of Azerbaijan Ministry of Economy. (2012, September 24). Retrieved from
http://economy.gov.az/en/article/development-of-non-oil-sector/21322

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