GRM 2010 GRM 2011

Abstract Details

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Rehabilitation and Expansion of Iran’s Petroleum Industry post-Nuclear Deal: Official Plans, Problems on Ground and Uncertain Future
Paper Proposal Text :
With an estimated 158 billion barrels of proven crude oil reserves, representing almost 10 percent of the world’s crude oil reserves and 13 percent of reserves held by the OPEC, the Iranian return to the global energy scene post-nuclear deal is undoubtedly a big prize that oil companies have been waiting for decades. As a result of the nuclear deal between Iran and P5+1 powers, the US and EU removed several sanctions that had been impeding trade and investment vis-à-vis Iranian energy sector since 2010. In the changed scenario, the Iranian authorities are making an all-out effort to rebuild Iran’s energy industry. The plans to rehabilitate and expand the country’s petroleum industry – ageing production facilities and deteriorating infrastructure – fall into two basic categories intended to:

I. Attract international investment and technology to stem declines at mature (ageing) fields and target exploration of new fields to increase production capacity, by reformulating the oil contract model.

II. Regain market share in oil export lost during the period of the sanctions in order to maximize sales and revenue earnings.

International Investment and Technology in Old and New Fields

Since the 1979 revolution, a combination of various factors – the eight-year Iran-Iraq war, limited investment, near-absence of advanced western technology due to sanctions, and a rapid rate of natural decline in Iran’s mature oil fields – have prevented a return to a production average of 5.5 mbd of the 1970s. The vast majority of Iran’s crude oil reserves are located in giant onshore fields in the southwestern Khuzestan region near the Iraqi border and the Persian Gulf. Currently, Iran’s largest producing field is the onshore Ahwaz-Asmari field, followed by the Marun and Gachsaran fields, all of which are more than 70 years old. Having produced for decades, their decline is becoming difficult to contain without substantial investment and advanced technology.

Iran is also targeting its newer West Karun fields, discovered in the last 20 years, including the super-giant, multi-billion barrel North and South Azadegan and Yadavaran fields, which have faced setbacks and delays. Other new fields on the Iraqi border – Yaran, Darquain and Jofier – which are producing below their potential, would also be up for development. New discoveries, as recently as 2004, in the Kushk and Hosseineh fields in Khuzestan province, are also part of Iran’s capacity expansion programme.

Many analysts opine that Iran needs an immediate investment of $100 billion to prevent erosion of its crude oil production capacity. Iran’s oil fields need more investment than those elsewhere, due to the high natural decline rate of 8-13 percent and low recovery rate of 20-30 percent. More importantly, Iran is counting on Western technology and management expertise to raise the capacity of hydrocarbon fields, having depended entirely on local companies that have the limited know-how to reverse field decline rates in producing fields.

The New ‘Iran Petroleum Contract’

In order to attract major oil companies to its shores, Iran has formulated a new oil contract model – Iran Petroleum Contract (IPC) – to replace unattractive commercial terms of the ‘buyback’ model.

The buyback agreement had been so unpopular with the international oil companies (IOCs) that it dissuaded them from the Iranian market even before US and EU sanctions firmed up in 2012. Essentially a service contract, it required the foreign contractor to invest its own capital and expertise only during exploration and development phases of the project in collaboration with the National Iranian Oil Company (NIOC) or its subsidiary. At the onset of commercial production, the fields returned to the NIOC for subsequent operation. NIOC used revenue from the sale of oil to pay back the IOCs for the capital costs and remuneration. Some of the main criticisms of the buyback contracts include inflexible cost recovery mechanism and, in some cases, the NIOC’s limited expertise to prevent the decline in production to ensure reimbursement of foreign investor’s repayment and remuneration.

The IPC’s investment terms are similar to a production sharing agreement (PSA). Foreign companies would enter into a joint venture with the NIOC or its subsidiary to manage all the three levels of field operation – exploration, development and production, along with the possibility of participation in enhanced/improved oil recovery phases – in contrast to the buyback contracts. This modification aims to rectify issues of field decline once the national operator took over, by including the IOCs in the production and recovery phases, while also providing the opportunity for technology and knowledge transfers in the process. IOCs will be paid a share of the project’s revenue in installments once production starts. The fee will be based on the risk of the fields and allowing contracts to last for up to 25 years, which is more than thrice the amount of time permitted in the buyback contract, will provide foreign firms with better continuity.

Recapturing and Increasing the Market Share

Iran is aiming to boost production and regain customers lost to Saudi Arabia and Russia during the period of the sanctions. Iran claims, it has an immediate capacity to produce and export up to 500,000 bpd. Currently, Iranian oil production of 2.5-2.8 million barrels per day (mbd) is almost 2 mbd lower than the pre-sanction levels of 4.5 mbd, and far below the country’s peak of 7 mbd in the 1970s. Iran’s crude oil export has fallen to around 1 mbd from a pre-sanction level of 3 mbd in 2011.

Facing an over saturated oil market, ensuing from a record output and strategic price cuts from Saudi Arabia, shale oil exports from the United States, and a peak production level from Russia, Iran’s export strategy is to avoid aggravating pressure on the already depressed crude prices. Tehran might consider strategies such as longer payment windows and discounts, and investment in oil refineries to lock in buyers. Iran is banking on traditional buyers and voracious energy consumers in Asia – China, India and South Korea – to lift its crude, where the agreements for sales are already in place. The oil-rich country also expects to sell crude to Turkey, Greece, Spain, Italy and South Africa.

Problems on Ground

With official plans in the pipeline, several ground problems are already rearing their heads. The basic question is: Will the oil companies come rushing into Iran even if the contractual terms are good for investment?

Western companies remain wary of several issues – snapback sanctions, absence of banking channels, and sanction on conducting the dollar-based transaction with any financial institution in Iran – present immense hurdles for the oil companies. Moreover, sanctions on the Iranian Revolutionary Guard Corps that has deep connections in the Iranian oil industry, still remain in place – complicating the process of import of US-origin machines, equipment, and technology.

Oil multinationals are also apprehensive of the lack of an ‘investment infrastructure’ in Iran i.e. an independent set of auditors, lawyers, consultants, and courts that work within the framework of clear laws that outsiders can trust. They fear being hampered by the notorious maze of Iranian bureaucracy sustained by informal networks of perks and privileges.

In addition, information about Iran’s vast hydrocarbon deposits remains vague and scant, given that, there have been few exploration and production initiatives by foreign companies in last four decades. Given this, technical and geological barriers, such as, low field pressure and lost capacity hinder quick field rehabilitation even with financial and technological inputs. A good example is neighbouring Iraq, whose oil fields recovered rather sluggishly in the first year of the lifting of sanctions.

The next big question is how will Iran-Saudi rivalry play out in terms of OPEC quota and price. Saudi Arabia has been defending its market share, not only against possible Iranian supply but also against the shale oil producers, by pumping in excess of 10 mbd for a year since March 2015 despite a global glut. With the breakdown of diplomatic relations between Iran and Saudi Arabia, a possible agreement on supply management has been effectively buried. If the two countries inaugurate a price war to pursue sales, prices will tumble even further. A plummeting price might bring customers and the recapture some market share for Tehran, but that would not amount to higher revenue, crucial for state spending and economic recovery.

Officials of the IOCs have expressed their wariness over the tendency of Iranian authorities to emphasize the ‘resistance economy’ – the Iranian understanding of economic independence and self-sufficiency – thereby, highlighting the importance of Iranian participation in joint ventures under the IPC. While this certainly caters to allay concerns in Iran about foreign exploitation of the country’s natural resources, IOCs could also interpret it as an obstacle to autonomous business practices.

Uncertain Future

OPEC members have been unable to agree on production cuts that could eliminate excess oil in the market and stabilize the price now at a world average of $30/b, the lowest in a decade. In this scenario, major oil companies looking to reduce capital costs in the medium term, and wait for firming up of oil prices, could have a deleterious impact on capital investment in Iran’s oil sector.

Low prices oil also impacts Iran’s domestic oil policy. Till the IOCs move base in the country, Iranian authorities would need to invest considerably in production facilities and infrastructure. However, in an era of depressed oil prices, Iran is likely to continue with the strict monetary policies inaugurated by President Hassan Rouhani, which also tightened the purse on funding the reconstruction of oil infrastructure. Consequently, production capacity and trade could suffer major setbacks.

Oil production and export scenario in the Middle East have become intertwined with the sectarian crisis in the region. The Shia-Sunni divide has become much deeper with the proxy wars between Iran and Saudi Arabia in Yemen, Syria, Iraq and Bahrain. A possibility of direct confrontation between the two regional powers exists. While it could lead to prices going up, investors would be wary of putting money in a war zone.

For prospective investors, internal stability of Iran is still a big question. Many fear that reformist President Rouhani may not be elected for another term. The hardliners could reverse policy decision and make the climate unfavourable and unprofitable for foreign businesses.

In terms of market share, the current economic slowdown in China and India will depress demand for crude oil and impact negatively on Iranian sales.

Iran, Saudi Arabia, and other oil producers also face a threat of transition away from fossil fuels towards the renewables, mainly, solar and wind energy. As the cost of producing renewables goes down, oil, with its large carbon footprint, may not remain the fuel of choice for many consumers.

In the context of the above, this paper argues that:

a) Iran’s oil industry cannot reach its full potential without foreign investment and, more significantly, western technological expertise, to recover its production capacity.
b) The removal of energy-related sanctions has improved the investment climate in Iran and boosted investors’
c) IPC provides a well-founded opening for western oil companies to do business in the Iranian oil industry and appears to be the first step in the establishment of an ‘investment infrastructure’.
d) Banking and financial sanctions, if eased, will streamline the conditions for trade and investment. By expediting transactions, it will pave the way for the IOCs to operate securely in the Iranian market.
e) Much of the investment from the IOCs will depend upon how the prices of oil shape up in the medium-term for them to invest profitably.
f) The regrowth and resurgence of Iranian oil industry will also depend on the security climate in the region and Iran’s own internal stability.
g) While Iran will export more in the post-sanctions’ era, it will not be able to gain its entire market share in the medium-term with Saudi output in full swing. In addition, banking and payments systems will have to be aligned afresh to export volumes.
h) Iran as well as other oil producers face real threat from shrinking of demand due to economic slowdown and efforts to move away from fossil fuels.