Caspian Oil Gas

Development of Caspian Oil and Gas Sector: Role of FDI in Economic Development of Azerbaijan, Kazakhstan and Turkmenistan


This paper underlines the foreign direct investment strategy formulation process in the three energy-rich countries of the Caspian Region: Azerbaijan, Kazakhstan and Turkmenistan. The study comparatively analysis the investment climate in three selected countries and more specifically it examines the foreign direct investment in oil and gas industry and its role in economic development of each country. The research examines the investment climate in Azerbaijan, Kazakhstan and Turkmenistan and factors influencing the foreign investor’s decision-making in oil and gas sector.

The first part of this paper overviews the Caspian region and its oil and gas reserves. More specifically this part summarises the role of foreign direct investment in oil and gas industry and how it promotes economic development of Caspian basin countries, namely Azerbaijan, Kazakhstan and Turkmenistan. The second part presents the theoretical framework of foreign direct investment.

This part also reviews the previous empirical findings on types, determinants and motives of foreign direct investment. The part 3 comparatively analysis foreign direct investment performance in selected countries and factors which may influence the ability of a country to attract foreign investment. This part also overviews the investment climates in Azerbaijan, Kazakhstan and Turkmenistan. Part 4 concludes.

Key Words: FDI, Caspian Sea region, Oil and Gas, Azerbaijan, Kazakhstan, Turkmenistan.

1 Introduction

The Overview of the Caspian Sea Region

It is wide recognized that foreign direct investment (FDI) can play an important role in the development process of many countries and it is much required. Economies in transition, such as those in Central Asia and the Caucasus, are no exception as they realize the important role of FDI in strengthening their transition process. While some of them have sizable deposits of oil, gas and minerals which are major attractions to foreign investors, others, being less endowed, have more difficulty to attract FDI to their fledgling industrial and service sectors. But in even those countries which are well endowed with natural resources, there is a thrust to diversify their economies away from over-dependence on those resources and to develop viable value-added manufacturing industries and services. FDI can play a major catalytic role in this process.

Just a decade years ago the areas on each side of the Caspian Sea – Central Asia to its east side and the Transcaucasia to its west were largely unknown. These regions were provinces of the Soviet Empire important to the outside world neither politically nor economically. Now its is well known that the Caspian Sea is largest land-locked body of water on Earth, bordered by Azerbaijan, Russia, Kazakhstan, Turkmenistan and Iran – the Caspian basin countries (see Map 1). Amongst the five countries only Iran is a member of the Organization of Petroleum Exporting Countries. Kazakhstan, Azerbaijan and Turkmenistan became independent after collapse of Soviet Union in 1991.

Once a centre of global commerce, the Caspian Sea region has languished in obscurity ever since the rise of the sailing ship rendered the Silk Road obsolete a half millennium ago (Olcott, 1998). After discovery of oil and gas resources in the Caspian offshore and shore areas, this region became very important oil and gas sector in global context. Moreover, owing to energy security and geopolitical reasons, the Caspian region became very attractive for the West.

Azerbaijan became one of the world’s first oil sectors after crude oil production started in Baku in the middle of 19th century. The oil production in Central Asia started in the beginning of the 20th century. Azerbaijan recorded about 70% of Soviet oil production by end of 1940. The former Soviet Union controlled almost all natural resources in Soviet Republics. At the time of their independence, Soviet republics were quasi-states (Olcott, 1998). Each republic has its own president and prime minister, local and national legislatures. The political and economic liberalisation of the Soviet Union in the mid-1980s attracted foreign investors and oil and gas companies interested in exploration and production prospects.

The collapse of the Soviet Union gave further opportunities for the liberalisation of investment regulations. By the late 1990s the Caspian region was comparatively politically stable region, and a number of countries significantly improved investment regimes to their oil and gas sectors.

Historically, energy industry in Azerbaijan, Russia, Kazakhstan, Turkmenistan and Uzbekistan is very important sector for the economy growth of these countries. However, poor management of natural resources and poor investment climate in these countries lead to disparities emergent between the countries in socio-economic terms. Nowadays, it is well recognized that foreign investment plays a vital role in the development of the oil and gas sector for such countries as Azerbaijan, Kazakhstan and Turkmenistan and significantly stimulates social and economic development of each of these countries.

1.2 Research Questions

The presence of potentially vast oil and gas reserves is a part of the foreign investment attraction into the Caspian Sea region. On the other hand, it is important to note that while the quantity of proven reserves undoubtedly plays a significant role in estimating a region’s production and export potential, the other decisive factors for attraction foreign direct investment into this region are undeveloped market, cheap labour and cheap inputs and weak competition.

This paper focuses on foreign direct investment strategy formulation process in the three energy-rich countries of the Caspian Region: Azerbaijan, Kazakhstan and Turkmenistan; and on what foreign direct investment strategy in each country are based. The study comparatively analysis the investment climate in three selected countries and more specifically it examines the foreign direct investment in oil and gas industry and performance by each country.

The significant number of researches in regard to foreign direct investment mostly explains the investment strategy in the developed countries, when limited study has done on investment in less-developed countries or emerging countries. The selected countries - Azerbaijan, Kazakhstan and Turkmenistan are transition countries and to a certain extent new participants in the competition to attract foreign investment. These countries can offer many potential advantages to foreign investor, especially in oil and gas sector of business. The research examines the investment climate in Azerbaijan, Kazakhstan and Turkmenistan and factors influencing the foreign investor’s decision-making in oil and gas sector.

There is no much research which explores the determinants of investment in Azerbaijan, Kazakhstan and Turkmenistan, the stereotypes and perceptions that foreign investors have about these countries and what could be done to increase the foreign direct investment flow into these countries. This paper surveys these parts by investigating the multinational oil companies operating in Azerbaijan, Kazakhstan and Turkmenistan.

The data from different energy agencies were gathered for comparative analysis of oil and gas data as well as foreign direct investment in different countries. This would not only let one to have a picture of various state strategies related to foreign investment, but could also provide the valuable outlook of the most advantageous approach for transition countries in doing business with foreign investors.

1.3 The Legal Status of Caspian Sea

A large share of oil and gas reserves in Central Asia and Caucasus are thought to lie under he Caspian Sea. The question of the ownership of those resources, including the right to license and tax their development, is being argued by the Caspian littoral countries. The legal debate over the Caspian Sea can be tracked back to the 1921 Treaty to Moscow, reaffirmed in 1935, which declared that the inland Caspian Sea belonged to Russia (Kemp, 2000). Later Russia sent a note to the United Nations dated from 5th October 1994, where Russian Ministry of Foreign Affairs stated that the Caspian Sea should not be subject to the provisions of international maritime law (International Energy Agency, 1998).

The importance of the application of international law is that a “sea” under the 1982 Law of the Sea Convention would be subject to separation into national zones for the development of its mineral resources. Russia stated that until all five of the Caspian littoral states (Azerbaijan, Russia, Kazakhstan, Turkmenistan, and Iran) came to a common decision on some other arrangement, the legal status of the Caspian Sea was subject only to the provisions of the more general (Treaty of Friendship between Iran and the USSR of 26 February 1921 and Treaty between Iran and the USSR on Trade and Maritime Navigation of 26 March 1940).

Nevertheless, the ongoing legal uncertainty does not seem considerably decreased foreign investment in the Caspian Sea region. Advantageous geological prospects, with potential of a major oil and gas resource base, show significant motivations for companies to invest in this important producing region, preferably from the beginning of its development.

1.4 Current Production and Proven Reserves in Caspian Region

Caspian oil presents a lot of opportunities for world oil markets and for the region itself (Energy Charter Secretariat, 2008):

  • The appearance of new production sources would expand world oil supplies. Major quantities of Caspian oil would ease the pressure on the Persian Gulf production capacity and provide an additional hedge against oil supply disruptions
  • Profits from oil exports could stimulate economic growth and improve the standard of living in the Caspian energy-rich counties. The availability of Caspian energy supplies in world markets will likewise improve the prospects for economic growth and political stability in the Caspian basin countries.

Nowadays the Caspian Sea region is important, but not major supplier of crude oil to world markets, based upon estimates by British Petroleum (BP) and the Energy Information Administration (EIA). In 2005 the Caspian region produced 2.1 million barrels per day, or 2 per cent of total world production (see Table 1). Kazakhstan’s production rapidly increased since the late 1990s, accounted for 67 per cent and Azerbaijan for 22 per cent of regional crude oil production in 2005.

The Caspian Sea region’s comparative contribution to world natural gas supplies is larger than that for oil. Gas production of 3.0 trillion cubic feet per year in 2005 was 3 percent of world production (Energy Information Administration, 2006). Turkmenistan is the largest producer; with production of 2.0 trillion cubic feet per year, it accounts for almost two-thirds of the region’s gas production. (see Figure 1). Unlike oil, the region’s proven reserves of natural gas are a higher proportion of the world total than is its natural gas production. The estimate of proven reserves of natural gas in the Caspian Sea region for the end of 2006 published by Energy Information Administration is 232 trillion cubic feet per year, which represents 4 per cent of the world total (see Table 2).

Table 1Oil Production in the Caspian Sea Region

1. Proven reserves are defined by the EIA

2. Possible reserves

3. Other estimates (EIA/IEO 2006) - 3.45 million barrels per day, (World Oil, 10 March 2004) - 3 million

^Only Caspian area oil and gas production

Source: Energy Information Administration (EIA): Caspian Sea Region: Survey of Key Oil and Gas Statistics and Forecasts, July 2006.

Table 2Gas Production in the Caspian Sea Region

^Only Caspian area gas production

Source: Energy Information Administration (EIA): Caspian Sea Region: Survey of Key Oil and Gas Statistics and Forecasts, July 2006.

Figure 1 Gas Production in Caspian Sea region (1992-2004)

Source: Energy Information Administration (EIA): Caspian Sea Region: Survey of Key Oil and Gas Statistics and Forecasts, July 2006.

1.5 Role of Oil and Gas in the Economic Development of Caspian Region

The development of oil and gas resources in the Caspian region is mostly important for the development of economies in the Central Asian and Transcaucasia. In 1995 the energy sector’s share of gross domestic product (GDP) was an estimated 14.6 percent in Azerbaijan, 10.1 percent in Kazakhstan, 10.2 percent in Turkmenistan (International Energy Agency, 1998). Foreign investment attracted to the oil and gas sector in Caspian region could offer significant profits for the region’s governments and stimulate investment in other economic sectors.

The attract foreign investment the host Governments should take discreet measures to ensure the development of an sufficient legal and administrative infrastructure, including institution building and personnel training, to handle the inflow of oil related revenues and to help ensure the countries’ efficient and equitable development.

International Monetary Fund (2003) expressed concerns that unless regional governments introduce further administrative reforms, they risk being overwhelmed by new oil wealth. Particularly, corruption is a peril. Economic development motivated by foreign investment in the oil and gas industry helps to guarantee the financial independence of the Central Asian and Transcaucasian states.

The transition to the market economy and the economic dislocations originated by collapse of Soviet Union left Azerbaijan, Kazakhstan and Turkmenistan without adequate funds to develop oil and gas resources. Governments of these countries are looking for private investment (mainly from foreign companies) that would play significant role in the development of oil and gas industry. Besides financial capital, a foreign investor brings a modern technology to local industry, including environmentally sound production techniques and modern management approaches.

The Caspian Sea region countries are competing with each other for foreign investment. Oil and gas companies have a wide choice of where to make investment. The foreign investor considers the opportunities that offer the best financial returns. However, the investment climate is vital for company’s decision on where to invest. As a result, Kazakhstan and Azerbaijan took considerable steps in creating attractive investment climates. Kazakhstan concentrated on building a body of law applicable to all projects, while Azerbaijan focused primarily on modified production sharing agreements (International Monetary Fund, 2003).

By the beginning of 1998, cumulative foreign direct investment in the oil and gas sectors of Central Asia and Transcaucasia had reached an estimated 3 billion of American dollars, nearly one third of which was placed in 1997. Future investment commitments in the region from contracts already signed total over 40 billion of America dollars (International Energy Agency, 1998).

So far most foreign investment has been in Kazakhstan and Azerbaijan. Gas-endowed Turkmenistan started to attract foreign investment later than the others due to Government dictatorship and poor investment climate.

Caspian oil development has gained a great deal of political and commercial momentum since the first foreign companies came there at the end of 1980s (Ruseckas, 2000). Since then the most important external factor influencing Caspian oil development is the price of oil. Principally if oil prices remain at present high level it is possible the more optimistic projects will be started. The Caspian Sea region could possibly produce approximately 4 million barrels per day by 2010. In any case, the Caspian Sea states require a stable legal regime to develop, produce, transport and market its natural resources.

1.5.1 Summary data on Azerbaijan

Owing to extensive oil reserves, Azerbaijan is a major oil producer since the middle of the last century. Between 1990 and 1995 Azerbaijan’s gross domestic product dropped 58 percent (International Energy Agency, 1998). Oil production fell by only 25 percent mainly because of continuing oil product exports to neighbouring countries and an increasing use of heavy fuel oil in domestic power stations to alternative for imported gas. Due to the tightening of monetary and budgetary policies, the fiscal deficit dropped from 11.4 percent of gross domestic product in 1995 to less than 2 percent in 1996.

In 2006 Azerbaijan's real gross domestic product grew by 31 percent when the oil production in this region significantly increased. Azerbaijan's anticipate for sustained economic growth is in its managing of large oil and natural gas resources in the Caspian Sea region, through effective management of the resulting revenue stream, and non-oil sector diversification (Energy Information Administration, 2006).

During the beginning of transition most Azerbaijan onshore oil fields were in decline and required momentous new investment to develop large-scale offshore projects and to reconstruct existing fields. Since independence Azerbaijan signed several agreements with foreign oil companies. While maintaining full state ownership over energy companies, Azerbaijan was quick to invite foreign investors to assume a direct role in the development of its hydrocarbon reserves (Thompson, 2004).

In 1992 most of the Azerbaijan oil sector assets were merged in two state oil companies – Azerineft and Azneftkimiya. The new merger was called the State Oil Company of the Azerbaijan Republic or SOCAR. While Government organizations handle production and exploration agreements with foreign companies, SOCAR is body to all international companies developing new oil and gas projects in Azerbaijan.

After the first commercial oil flows through the Baku-Tbilisi-Ceyhan pipeline during summer 2006 and the increasing oil production from the Azeri-Chirag-Guneshli project, oil revenues are expected to contribute to a doubling of Azerbaijan’s gross domestic product by 2008 (Thompson, 2004). Energy Information Administration (2007) reports that though the oil sector represented around 10 percent of Azerbaijan’s gross domestic product in 2005, it is already projected to double to almost 20 percent of gross domestic product in 2007 (see Table 3).

To manage the revenues, former President of Azerbaijan Heydar Aliyev formed a State Oil Fund in 1999, which is designed to use money obtained from oil-related foreign investment for poverty reduction, education and raising rural living standards. As of the end of 2006, the State Oil Fund reported assets of almost 2 billion US dollars, but the fund’s assets are expected to increase to 36 billion US dollars by 2010 (Energy Information Administration, 2006).

Table 3Azerbaijan: Economy and Energy (in millions US dollars)







Oil Production

(thousand barrels per day)







Oil Exports

(thousand barrels per day)







Foreign Direct Investment







FDI in Oil Sector







Oil Sector Revenue







As share of total rev (%)







As share of total GDP (%)







Oil Fund Assets







Source: Energy Information Administration: Short Term Energy Outlook, 2007; International Monetary Fund (IMF), Article IV Consultation, Staff Report, No 07/191, June 2007

1.5.2 Summary Data on Kazakhstan

As it was the case in most other former Soviet Union countries, Kazakhstan’s first attempts at economic reform were effectively taken in response to Russia's one-sided price reforms in 1992. After Kazak oil production had suddenly declined for two years in the end of 1993, inflation had out of control. The efforts to create an economic union with Russia and other former Soviet Union countries didn’t meet expectations of the Kazakh Government. Looking at the dynamic Asian economies as a model, the Kazakh Government turned to market style policies.

However, the government increased hard budget constraints and restrictive monetary policies due to attempts to solve non-payment problem through state financing. The remained net debts after netting out inter-industry arrears were financed from Government budget and the central bank.

In 1993 International Monetary Fund (IMF) granted Kazakhstan a one-year standby package. To maintain IMF collaboration and to stop the decline in gross domestic product, the Kazakh government implemented a second stabilisation program in 1995. But this time hard budget constraints and monetary policy were strengthened by excluding of government financing of net positions in inter-enterprise debts and retreating government guarantees for loans granted by foreign and domestic banks.

In the middle of 1996, the International Monetary Fund approved an Extended Fund Facility (EFF) of 446 million US dollars for three years (IMF, 2003). According to International Monetary Fund (2003) the decision was made in light of a wide-ranging three-year reform programme submitted by the government, as well as the positive longer term prospects for production and exports of energy and non-ferrous metals. In 1996, Kazakhstan experienced its first positive economic growth since 1989.

1.5.3 Summary Data on Turkmenistan

Preceding the collapse of the Soviet Union approximately 8 percent Turkmenistan’s gross domestic product was generated by gas exports to the rest of the USSR mostly to Belarus, Ukraine and the Caucasus. Another 5 percent of gross domestic product was earned from cotton exports. Gas and cotton exports continue to be used to cover the import of considerable amounts of grain and capital equipment from other former Soviet Republics.

While estimates for the fall of gross domestic product between 1990 and 1995 vary depending on how adjustments to official gross domestic product are made, International Monetary Fund and European Bank of Reconstruction and Development agree on about -35 percent (IMF, 2003). This is much less than the 58 percent drop in Turkmen gas production. The rest of the economy is basically agricultural. The cotton industry has been less affected by the downfall of the Soviet Union.

The government gradually liberalised some prices beginning in 1992. A presidential decree of 1995 removed price controls on all products except for about 50 items, including energy. The government introduced the manat as the national currency in 1993. In 1995 it unified the previously separate official and commercial exchange rates, which subsequently became determined by inter-bank auctions for foreign exchange.

Between 1992 and 1995 the government compensated for the shortfall in revenue from taxes on gas production and exports by cutting expenditures and replacing subsidies to the economy with additional allocations of credit at largely negative interest rates.

Controlled prices were adjusted repeatedly but declined in real terms for natural gas and for oil products through 1994. The share of gas related revenues in the central budget declined from 60 percent in 1992 to under 20 percent in 1995, which lowered the share of total budgetary revenue in GDP from 40 percent to 10 percent during this period. Due to drastic expenditure cuts in government wages and investment, including maintenance, the central budget deficit remained fairly stable over this period. It also helped that new excise taxes were introduced in 1995 on petrol (55 percent) and diesel (60 percent). This resulted in some recovery of government capital spending.

The easy money policy was changed slowly in 1995 and 1996. During this time foreign exchange surrender requirements of state-owned enterprises to the Foreign Exchange Reserve Fund (FERF) were increased to 50 percent for gas and oil exports, and the money allocated directly to the central budget. Prior to that, this fund had been used to award credits to the economy, contributing to monetary expansion. In 1995 and 1996, bank credit allocation was reduced, real interest rates rose (due to credit auctions with deregulated interest rates), and reserve requirements for banks were increased. However, the pursuit of these policies was not smooth, in part due to the limited political autonomy of the Central Bank. Nevertheless, inflation decelerated by 50 percent towards the end of 1995 and is estimated to have been 445 percent in 1996, and 21 percent in 1997.

Despite plummeting gas exports in recent years, Turkmenistan’s current account was slightly positive in 1994 and 1995, as long as arrears owed to the country are not taken into account. If such arrears are counted the 1995 balance swings from an estimated surplus of 54 million US Dollars to a deficit of 289 million US Dollars. The situation has probably continued to deteriorate due to weak gas exports.

2 Theoretical Frameworks

2.1 Overview of Foreign Direct Investment Theories

There is variety of empirical studies on theoretical models explaining foreign direct investment (FDI) and its determinants. The various approaches from different disciplines such as economics, international business, organisation and management explain numerous characteristics of this phenomenon. The following dissimilar methods, explaining foreign direct investment as the location decision of multinational enterprises are mostly acknowledged in empirical literature on FDI:

  • Ownership advantages as determinants of foreign direct investment (including monopolistic advantage and internalisation theory) based on imperfect competition models and the view that multinational enterprises (MNEs) are firms with market power (Hymer, 1960; Buckley and Casson, 1979; Kindleberger, 1969; Caves, 1971 for ownership advantages)
  • Determinants according to the Neoclassical Trade Theory and the Heckscher-Ohlin model, where capital moves across countries due to differences in capital returns (for example Markusen et al, 1995,pp. 98-128; Aliber, 1970);
  • Determinants of foreign direct investment in Dunning’s ownership-location-internalization (OLI) framework, which brought together traditional trade economics, ownership advantages and internalisation theory (Dunning, 1977; 1979);
  • Determinants of foreign direct investment according to the horizontal FDI model or Proximity- Concentration Hypothesis (Krugman, 1983; Markusen, 1984; Ethier, 1986; Horstmann and Markusen, 1992; Brainard, 1993);
  • Determinants of foreign direct investment according to the vertical FDI model, Factor-Proportions Hypothesis or the theory of international fragmentation (Helpman, 1984; Dixit and Grossman, 1982; Deardorff, 2001; Jones and Kierzkowski, 2004 for models on international fragmentation of production).
  • Determinants of foreign direct investment basing on Knowledge Capital Model (Markusen, 1997);
  • Determinants of foreign direct investment basing on the diversified FDI and risk diversification model (Hansen et al., 2001; Grossman and Helpman, 2002; Ekholm et al., 2003 for studies on new forms of foreign direct investment, and Rugman 1975 for risk diversification)
  • Policy variables as determinants of foreign direct investment when foreign direct investment is seen as the result of a bargaining process between multinational enterprise and governments (Game-theoretic frameworks include Bond and Samuelson, 1986; Black and Hoyt, 1989; Barros and Cabral, 2001; Haaland and Wooton, 2001).

Foreign direct investment (FDI) is closely related to the transfer of capital, technical and managerial assets of a firm the host country from domestic country. Together with lending and portfolio investments, it is a type of international finance, but it is unlike to lending because FDI involves ownership, and it is dissimilar to portfolio investment because FDI involves control of financed activities over management and profits. In many cases portfolio investment is necessary for investment income, whereas foreign direct investment is to control a foreign enterprise in the host country.

The present analysis will cover the following basic three phases of foreign direct investment studies: macroeconomic, mesoeconomic and microeconomic levels. The macroeconomic theories founded on traditional trade and location theories, observe the national and international trend of foreign direct investment. The mesoeconomic theories, built on industrial organisation economics, highlight the competitive economic environment and mainly study the foreign direct investment on the industry level. The microeconomic theories based on the theory of the firm and focus on the competitive advantage of the firm.

The theories are shortly studied beginning from the macro-level and going towards the micro-level. This sequence reproduce the shift of focus of international business subject beginning from 1970s, from the international economy level to the firm level and even inside the firm, as in the case of milli-micro level of analysis. The shift of focus has not been straightforward, and it has aimed not only at progression into a more detailed level of analysis, but to more complete explanations (Bartlett, Ghoshal, 1991,p. 6).

The wide-recognized international trade theories were extended to foreign direct investment in regard to the international shift of factors of production. Examples include such extensions of the international trade theory, as factor endowment theory that contains factor mobility (for example Helpman, 1984) and specific factor models (for example Markusen, Venables, 1998). These two models are representatives of the new trade theory. They are relevant to foreign direct investment, because they tolerate product differentiation and imperfect competition. The Weber’s (1909) traditional location theory can be also considered in the context of foreign direct investment because it understands the least-cost location of production as the optimal location of the firm.

Hanink (1994) states that traditional location theory suggests that there is potential for foreign direct investment if the low-cost factor of production is located in a different country than the market. This relates to core-periphery investment, which is traditionally typical as the foreign resources of raw materials formed the major motivation of foreign direct investment. However, in the case of an imperfect market, where the market share is put before profit maximisation, foreign direct investment is likely to take place in an intra-core context. (Hanink 1994, p. 212)

Macro-economic investment theories comprise Dunning’s (1993) developmental model of international investment, which refers to the determinants of inward and outward investments to the developmental phase of the country. According to this model, outward investment surpasses the inward investment as the economy develops. The gradual shift from negative net investment to positive depends on a country’s factor endowments, politico-economic system and its interdependencies with the world economy. Investments develop through five phases.

In the first phase inward and outward investments of the developing country are at a low level. In the second phase market growth and enhanced human capital raise the inward investment while the outward investment still stays at a low level. In the third phase both inward and outward investments have a significant role in the economy, which has reached an intermediate level of industrialisation. In the fourth phase the outward investment exceeds the inward investment, because the domestic firms both pay off the location disadvantages of the home country by involving in outward investment, and complement the location advantages offered by the immobile factors of the host countries. At last, in the fifth phase outward and inward investments become balanced and are both at a high level. (Dunning, 1993)

In the literature on foreign direct investment, the increasing role of multinational enterprises (MNEs) is not easy to fit into a national level frame. Therefore, majority of theories are developed from the base that foreign direct investment is not an effect of the relative comparative advantage of a country, but an implication of the competitive advantage of the firm. Economics of industrial organisation is an application of microeconomics, which has broken the classical assumption of perfectly competitive markets and is interested in foreign direct investment as the MNEs way to use firm-specific advantages and survive in oligopolistic competition.

Hymer (1960, 1976), who gave foundation of theory of multinational enterprise (MNE) and is one of the best representatives of industrial organisation economics, showed that along with macro-theory of foreign direct investment (FDI) there is need of micro-theory of MNEs, namely capital flows, technology, marketing and management capabilities of firms. Hymer (1976) states that multinational enterprise has to gain a higher profit abroad than on the home market, because of the bigger risk involved and the additional costs resulted by operating at a distance.

Hence, the competitive advantage of multinational enterprise is both transferable over borders and difficult to acquire by local firms. While the industrial organisation economics stresses the firm-specific advantages and the strategies a firm can adopt for increasing and maintaining its market power, it also reminds that industries utilise a certain proportion of factors and therefore fit best to a country that offers the particular factor. However, industrial organisation economics focuses on strategic matters and firm-specific advantages rather than country factors.

The similar views to Hymer’s (1976) can be found in many other theories such as: the product-life-cycle theory, transaction cost theory, eclectic theory. The transaction cost theory introduced by Williamson (1975) with its basis in Coase (1937), disagrees that trade is beneficial for firms as they can evade costs occurring from the un-familiarity of the markets. However, if the transaction costs of exchange are lower within the hierarchy of the MNE, the market will be internalised. Consequently, foreign direct investment is not just a capital incentive but an international extension of managerial control over a firm abroad.

In 1966 Vernon published first classic Article on multinational enterprise (MNE) and efficiency-seeking motivation, where he presented the product-life-cycle theory, but developed it later to an explicitly oligopolistic interpretation. The theory explains the geographical process of locating the manufacturing units in the four common stages of maturity. In the first stage of the life cycle, new product is innovated by a firm that holds technological leadership in a location where it can enjoy agglomeration economies. Overseas demand is served by export. During the second stage the firm commences to establish production facilities abroad as soon as it finds an opportunity to reduce costs by doing so, or its market position is endangered. The first overseas production tends to be set up in the high-income market. In the third stage, the newly established plant serves the local market in the host country and dislocates exports from the home country. Consequently, home-country- based firms export directly to third countries. Ultimately, during the fourth stage the newly established plant in the host country enlarges its exports to third-country markets too. When the innovative lead is lost and the product becomes mature, the production facilities will be relocated to low-cost locations from where the products are exported to the home country as well (Vernon 1979, pp. 265-267).

The eclectic theory (or so-called OLI framework) is Dunning’s effort to join various theories on foreign direct investment (Dunning 1993). Eclectic theory is based on the idea that compared to local competitors; foreign firm does not have as good information of the local business environment. Therefore, multinational enterprise will engage in international production only if a set of particular advantages are present, namely ownership advantage (O), locational advantage (L) and internalisation advantage (I). The ownership advantage defines which firms will supply a particular foreign market. The ownership advantages comprise all the specific assets (often intangible), which a firm can either produce (e.g. knowledge, organisational skills) or purchase (e.g. patents, brand names), and which its competitors do not have. The location advantage explains whether a firm will supply foreign markets by exports or via local production. The location advantage (e.g. spatial distribution of inputs) makes it profitable for a firm to utilize its assets overseas. Failing that, it would serve a foreign market through exports from a home country base. Lastly, the internalisation advantage identifies why firms will internalise transactions inside their hierarchies rather than let transactions to be made within the market. The more ownership advantages a firm has, the greater the motivation to internalise their function. The eclectic paradigm establishes that enterprises will engage in international production if they possess ownership advantages in a particular foreign market; if the firm realizes the benefits of adding value to these ownership advantages rather than selling them to others – internalisation advantages; and “if location advantages make it more profitable to exploit its assets in a particular foreign location rather than at home” (Jones, 1996, p. 13).

Microeconomic theories of foreign direct investment consist of the internationalisation theory of the firm. Luostarinen’s (1979) model explicates the internationalisation process of the firm during the starting, development, growth and mature stages. Through these stages operational approaches of the multinational enterprise are displayed by the trade in goods, taking place in the earlier phase of economic interaction relative to international investment. This explains that exports arrange the way for investment by creating business contacts and sources of information and establishing a special knowledge of the market. After established, direct investment permits firms to gain a much better understanding of foreign markets, thus also facilitating further exports of the parent firm (Luostarinen and Welch, 1997). Foreign direct investment can also be spotted as a outcome of the growth of the firm. Luostarinen’s study (1979) has many resemblances with Hakanson’s (1979) five-stage model of the geographical model of a corporate structure. Hakanson’s model demonstrates how a firm extends from the home country to overseas and grows from a single operation plant to MNE. A firm expands slowly but surely by employing new international operations, commencing from a sales office and ending in an acquisition or subsidiary abroad. According to the model, the mode of operation is affected by transformations in the company’s environment and the company will choose the foreign direct investment mode only after it has succeeded a certain level of trade.

2.2 Microeconomic theories

Nowadays, economists have recognized that there will be additional costs involved at least initially for a firm investing in a foreign country where it is not familiar with local markets and institutions. At a theoretical level, economic analysis presents three key explanatory approaches, which challenge to show why, regardless of many disadvantages, firms may still wish to invest abroad. These approaches focus on different aspects, namely:

  • Ownership advantages (Hymer, 1976): advantages are thought to occur from economies of scale in regard to intangible assets such as skilled management capacity or organizational know-how which may also be exploited to even greater advantage by investing abroad.
  • Locational advantages (Vernon, 1966): these kind of advantages take place in part from the fact that, for many products, there is a production cycle involving several stages, with new technology first being produced and used in the home country and, once standardized, shifted abroad because either nearness to the final market or lower factor costs make this advantageous.
  • Internalization advantages (Buckley and Casson, 1976): advantages which may accrue to a firm from “internalization”, i.e. engaging in foreign production itself, rather than subcontracting or licensing it to a foreign firm. These authors drew on the general “transactions costs” theory of Williamson (1975) which provides a rationale to explain why it may be more advantageous to concentrate certain activities within the firm, rather than rely on the market mechanism to achieve the same objectives, say, by licensing or sub-contracting. The basic idea here is that there are transactions costs of various kinds involved in operating through the market mechanism. When such costs are greater than those arising from carrying out activities within the firm, internalization, that is, establishing an overseas subsidiary, will be preferred.

These mainstream theoretical approaches are not mutually exclusive; nor are they comprehensive. They do however encompass most of the practical reasons why firms may invest abroad (for example, access to markets, labor costs, proximity to raw materials, a more lax approach to the environment, and fiscal incentives). There are, however, other theories which explain multinational investment in rather different terms, such as oligopolistic rivalry between firms at the global level, the empire-building motives of managers of large corporations in advanced countries, or strategic entry deterrence, that is, the build-up of overseas capacity in order to stop potential rivals from entering any specific market or markets. Such theories may be better than the mainstream theories in explaining some of the observed facts concerning FDI, notably the existence of FDI surges.

2.3 Eclectic Framework

John H. Dunning in 1977 presented the eclectic framework, attempting to put together different partial ideas explaining multinational enterprises (organisation, firm, trade policy, financial theories) into analytical (eclectic) framework. John H. Dunning’s eclectic paradigm provides an organising framework, which incorporates different theoretical approaches and concepts and attempts to explain all forms of international production. Dunning’s main contribution was to assemble all these separate elements into an eclectic theory of international production.

As it was emphasised by Dunning (2001), the purpose of the eclectic paradigm was not to offer a full explanation but to provide a methodology and a set of variables, necessary for any comprehensive explanation of particular types of foreign value-added activity. He therefore used the ownership, location and internalisation “tripod in explaining the scope and geography of value added activities by multinational enterprises” (Dunning, 2001, p. 175). As noted by Corley (1992), Dunning assumed that the configuration of the ownership, location and internalisation advantages would vary according to the specific characteristics of each particular country and each particular firm as well as to the precise nature of the businesses involved, assuming that “the greater their competitive advantages and the higher the profits anticipated from exploiting these advantages in a foreign location, the more likely businesses would be to undertake overseas production in preference to the alternative modes” (Corley, 1992, p. 10).

Dunning’s eclectic framework was attempting to accommodate the most of micro-level and macro-level theories of international production and trade. His theory of the determinants of multinational enterprise activity covered the location of value-adding activities in conjunction with ownership and organisation of these activities. Classifying the multinational enterprises as multi-activity firms, engaged in foreign direct investments, Dunning (1993) noted that the nature of foreign direct investments undertaken by multinational enterprises is extremely varied, making difference in both motivations and determinants of international production. According to Dunning (1993), although the relevance and significance of the variables identified by each of the theories could differ, they “should be more properly viewed as complementary, rather than substitutable explanations for the cross-border activity of firms” (Dunning, 1993, p. 68).

Based on earlier studies in different related areas Dunning derived three types of advantages, which in combination were leading to the multinational enterprise. Firstly, Dunning (1993) came to a conclusion that firm must have some unique firm-level ownership advantages to compete with local firms in foreign countries. To explain this thesis he referred on to Hymer’s observation that the differences in national environments, pre-determined by the differences in labour markets, bureaucratic systems, taxation, legislation and many others, ultimately provides advantages to domestic firms. This in turn requires that any entering multinational enterprise should be strongly internationally competitive, possessing a unique firm-level ownership advantages, with a particular strength in technologies, management techniques or marketing capabilities: “for firms to own and control foreign value-adding facilities they must possess some kind of innovatory, cost, financial or marketing advantages – specific to their ownership – which is sufficient to outweigh the disadvantages they faced in competing with indigenous firms in the country of production” (Dunning, 1993, p. 69).

When formulating the ownership advantages, Dunning determined that “the capability and willingness of one country’s enterprise to supply either a foreign or a domestic market from a foreign location depends on their possessing or being able to acquire certain assets not available at such favorable terms, to another country’s enterprises” (Dunning, 1993, p. 77). The aforementioned assets were referred to as ownership advantages and included both tangible assets, such as natural endowments, manpower and capital, and intangible assets, such as technology and information, managerial and marketing skills and techniques, as well as to intermediate or final goods markets (Dunning, 1993, p. 77). As it was envisaged by Dunning, Hymer’s theory allowed a great variety and complexity in term of relevance and significance of different aspects and elements, whereas, for example, management itself, as one of the elements, comprised combination of both firm-level skills and network organizing capabilities.

Having identified ownership advantages as a firm-level capabilities in the industry within the country and location advantages as ability of the home-country to supply necessary inputs, Dunning then took into consideration the ideas, explaining the reasons why cross-border transactions of intermediate products are based on internal activities within the multinational enterprises, rather than determined by market forces (Dunning, 1993). He therefore turned his attention to the theory of internalisation advantages, developed by Buckley and Casson, according to which by opening own controlled operations in foreign countries firm keeps ownership advantages internally, not selling or sharing its ownership advantages to any local firm, because markets for intermediate products – intangible assets or skills, such as knowledge, technologies, trade-marks and others are very risky and expensive to be used effectively. As noted by Dunning (1993), Buckley and Casson explained why multinational enterprise does not sell ownership advantages as intermediate goods to local firm, which has some local experiences and advantages thereof, but goes for internalisation with all related additional costs and risks. This was seen as a result of imperfect markets for intermediate products with very high transaction costs and risks, making it economically efficient to transfer intermediate product between different parts of the firm rather that to transfer to any intermediate products to other independent firms.

The above allowed Dunning to conclude that firms were replacing market mechanisms by internal arrangements for value-added activities across the borders in response to the observation that “the net benefits of their joint ownership of domestic and foreign activities, and the transactions arising from them, are likely to exceed those offered by external trading relationship” (Dunning, 1993, p. 75). Internalisation theory studies the situations leading to internalisation of the markets for intermediate products by firms, which own and control value-adding activities outside their natural boundaries, focusing on “international horizontal and vertical integration of value-added activities in terms of the relative costs and benefits of this form or organisation relative to market transaction” (Dunning, 1993, p. 75).

It is necessary to emphasise that although appreciating the logic of internalisation theory, Dunning (1993) argued that it was not sufficient by its own to explain the level and structure of the production of a country’s own firms outside their national boundaries or of the production of foreign-owned firms inside country’s boundaries – without integrating location-specific variables with internalisation variables. And as with two other components of the eclectic framework, again it was observed that different types of internalisation leads to formation of different types of horizontally or vertically integrated multinational enterprises (Dunning, 1993).

As it could be seen, the eclectic paradigm offers a general framework for determining the extent and pattern of both foreign-owned value-adding activities undertaken by a country’s own enterprises and also that of domestic production owned by any foreign enterprises, prescribing “a conceptual framework for explaining ‘what is’ rather than ‘what should be’ the level and structure of foreign value activities of enterprises” (Dunning, 1993, p. 76).

For example Caves (1996) points out that arm’s length transfers of proprietary assets between firms are prone to the market failure, arguing that “these failures deter a successful one-plant firm from selling or renting its proprietary assets to other single-plant firms and thereby foster the existence of multiplant (and multinational) firms” (Caves, 1996, p. 4).

As noted by Cantwell (2000) the eclectic paradigm being a framework is capable of providing expression either to the internalisation approach, in which the firm grows by displacing markets that operate in a costly and imperfect way, or to the market power theory, whereby the growth of the firm causes market imperfection and failure. Thus, “the eclectic paradigm incorporates elements of both these alternative theories of the firm, since it allows that ownership advantages may act as barriers to entry and source of market power” (Cantwell, 2000, p. 23).

It could therefore be concluded, that by incorporating different theoretical approaches and concepts covering different aspects related the existence of multinational enterprises Dunning managed to assemble an eclectic framework, which provides a comprehensive methodology and a set of variables, explaining different types of foreign value-added activity. It was shown that the theory of multinational enterprise is based on interrelation of macro-economic theory of international trade and a microeconomic theory of the firm. As it could be seen, the eclectic paradigm uses much of traditional trade theory to explain the spatial distribution of some kinds of output and this in turn, involves consideration of market imperfections in order to explain the ownership of that output and the spatial distribution of other kinds of output which require the use of resources that are not equally accessible to all firms. It is therefore important that the eclectic paradigm being a framework is capable to match any of three elements, ownership, location or internalisation advantage in the context of relevant market imperfections and failures.

2.4 Motives and Types of Foreign Direct Investment

There are different types of foreign direct investment, which are differentiated based on the strategic motives, industry, target market, internal structure, mode of growth, ownership, and others. The local market-oriented investment relates to the case where the output of the production site in the host country is directed to fulfil the demand in the host country. Consequently, the international market-oriented investment refers to the case in which the host country is used as an export platform and the final product is directed at the international market. The latter is also called export-oriented investment.

It is perceptible that a main objective of a firm while making its investment decision is to meet the general motives of corporate strategy, particularly economic performance. A number of literatures on investment have studied multinational enterprises’s motivations to invest abroad widely from different perspectives: different firms, different industries, different host countries, and different periods. Consequently, enormous numbers of various motives has been listed. However, empirical literature on investment (e.g. Dunning, 1993, 1998; Buckley, 1988; Behrman, 1981) define the following predominant five types of direct investment in regard to strategic motives, though investment is usually not engaged due to the one single specific motive, but a combination of various motives (Eiteman et al.,1992, p. 436).

1. Resource-seeking investment – based on traditional locational advantages, such as costs of inputs, and transaction costs. Usually, this kind of investment extracts natural resources for export or for further processing and sale in the host country. Typical representatives of this type of investment are the petroleum or mining industries.

2. Market-seeking investment – based on strategic locational advantages to increase a company’s market power. The aim is to find better opportunities to enter and enlarge new markets by satisfying local demand or by exporting to third markets. Typically, investment is motivated by such aspects as market size, growth prospects of the market, market share, or competitive situation. Nowadays, this kind of investment is most common type of investment, where engagement with the host market is the greatest. A common example of market-seeking investment is foodstuffs, which have to be produced on the spot and can not be exported.

3. Production-efficiency seeking investment – helps to find production factors which are relatively cheap o their productivity. Investment may be motivated by labour cost advantages, low raw-material costs, low transportation costs, low energy costs, or the availability of a skilled labour force. It refers often to offshore production, which uses the special economic zones of the host countries. Typical representatives are thus the sourcing industries.

4. Knowledge-seeking investment (or strategic asset-seeking investment) – purposes to gain access to technology or managerial expertise in the host country. It has specific locational needs (e.g. technical knowledge, learning experiences, management expertise, and organisational competence) and is mainly focused on advanced industrial economies. The increase of Mergers and Acquisitions (M&A) emphasise the increasing role of knowledge seeking investment. (Dunning 1998, pp. 50)

5. Political safety-seeking investment – purposes to minimise expropriation risks and is conducted in the form of investment in countries unlikely to interfere with multinational enterprise (MNE) operations, or in the form of divestment from politically unsafe countries. (Dunning, 1993,1998; Behrman, 1981; Buckley, 1988; Eiteman et al., 1992, pp. 436)

Various types of investments can also be distinguished based on the investor’s internal structure, which classifies between horizontal, vertical, conglomerate and concentric investment. In the most common “horizontal investment” a company copies the whole production process, excluding the activities of headquarter in its subsidiary, which locates in the host country. The investor can enter the local market through the local production and increase its status with customers as products can be modified for the special requirements of a particular market. The vertical investment relates to the establishment of a subsidiary in the host country to serve at different stages of the value-added chain of the investor, notably the next stage forward or backward in production and sales (Larimo 1993, p. 47).

The concentric investment involves foreign units, which serve the same customers as the investing company via different production methods and research and development (R&D). It could also involve foreign units, which serve different customers through the same production methods and research and development (Larimo, 1993, pp. 47-48). Concentric investments can be also called horizontal diversification. This is still different from the conglomerate investment, which occurs when a company produces an internationally-diversified range of products.

The foreign unit differs from the investing firm in terms of all major characteristics, including production, technology, customers and distribution channels. (Larimo, 1993, p. 48) Due to the differences, conglomerate investment usually takes place by acquisition. In the case of mergers and acquisitions (M&A) the afore-described terms get different content to some extent.

Investment can be classified as an internal and external process, depending on the firm’s growth mode. Internal growth, or Greenfield investment, means investment in a new plant and equipment, which builds up knowledge and capability inside the firm, while external investment means the acquisition of existing plant and equipment (Luostarinen & Welch, 1997, p. 164). Greenfield investment is a most common type of foreign direct investment in developing countries (UNCTAD, 2004). The Greenfield strategy is applicable if the product or the production process requires unique technology, which creates a company’s competitive boundary and consequently can not be threatened by technology transfer to local firms in the host country. The Greenfield strategy is also applicable if the host government’s incentives are suitable in a particular geographical area where appropriate partners are not available. As a result, a particular location can have some important production factors, which results in a multinational enterprise to adapt the Greenfield strategy if there are no suitable partners (Luostarinen & Welch, 1997, p. 166).

A cross-border Merges and Acquisitions based on buying an existing company in the host country. This type of investment is the fastest way to enter a new market. It brings a readily-built market share and customer group with it, which considerably helps to avoid problems with hiring local personnel and entering rating local distribution channels. Due to this, the multinational enterprise needs relatively short time to pay back the investment. However, acquisitions usually face serious problems in integrating two previously separate organisations together (Luostarinen & Welch,1997, pp. 164-165; Root, 1994, pp. 164-166).

Merges and Acquisitions type of FDI is mostly used in the developed countries (UNCTAD, 2004). In regard to ownership, a multinational enterprise (MNE) may set an independent company or a joint venture. The advantages of independent company comprise a full control of operations, decision-making, profits, management and production decisions, and the security over the technological assets and know-how (El Kahal, 2001, p. 237).

The constraints are mainly related to the capital requirements and the shortage of management personnel with international experience. Success in a distant market without a local partner may also be difficult due to the different cultural backgrounds, different corporate or industry cultures, and different national or ethnic cultures, not to mention different legal, economic and political aspects.

In the form of a Joint Venture (JV), the investor has access to local partners’ specialised skills, knowledge of a local market, and government contacts. Therefore, a JV with a well-connected local partner is often considered as the best way of investment. In many cases, however, the contribution of partners have been uneven, as the local partner has provided only labour and local facilities, when the investor should provide capital, training, technology, equipment, and know-how (El Kahal, 2001, pp. 227-231).

A joint venture can be set with one or more local partners. In some cases, the partner or one of the partners is from the home country or a third country. If at least one of the partners is a Government-owned firm, the joint venture is called a Mixed Venture. A multinational enterprise can set a majority joint or mixed ventures, a 50/ 50 % joint or mixed venture, or a minority joint/mixed venture (Luostarinen &Welch, 1997, pp. 156-158). The entry mode is not always possible to decide according to the MNE’s decision, but may be regulated by the host country.

3. FDI In Caspian Oil and Gas Industry

A substantial body of literature has grown around the question of how inward foreign direct investment (FDI) affects host countries. On almost every aspect of this question there is a wide range of empirical results in academic literature with little sign of convergence. At the same time, policy-makers seem to have made their own judgments that inward FDI is valuable for their countries. The United Nations Conference on Trade and Development (UNCTAD) publishes annual data on “changes in national regulations of FDI” and reports that from 1991 through 2002 over 1,500 changes making regulations more favourable and fewer than 100 making regulations less favourable to FDI were made (UNCTAD 2003, p. 21, table 1.8). The same document reports that “the use of locational incentives to attract FDI has considerably expanded in frequency and value” (UNCTAD, 2003, pp.124).

According to Inward FDI performance Index …..

4. Conclusion

Developing countries have existed for a long time and the way of development is vary for each country. One of the main roles in development plays market, which is weak in the emerging countries, because of lack of resources. In case to enhance market potential and to be able to enter to the International markets, following strategies should be considered:

  • Export entry (direct and indirect)
  • Contractual entry modes (licensing, franchising, technology transfer, counter-trade, clearing, management contrast, turn-key and infrastructural project)
  • Investment entry modes, including marketing subsidiary (company owned sales, services and distribution network)
  • Joint ventures
  • Foreign direct investment (FDI), which includes merges, acquisitions, holding companies

Over the last decade, the study of FDI has become as a part of the main stream of academic research activity in the area of International business. In result, these researches have been distinguished different types of FDI in terms of its timing (initial investments), its strategic objectives (motivation) and its size (quantum).

FDI in most of the time provided by developed countries with strong market to emerging countries with weak markets. To reveal most effective conditions, which attract FDI in host countries have been done number of researches. In result of this, the prevailing mass of researchers concluded, those big impacts have market size, gross national product (GNP) and stability of host-country rather than investment incentives. However, these conditions are vary in each country, because all of them have weak and strong place of their market and therefore have different outcome of FDI.