To enter or not to enter: the IOC dilemma on Iran
While Iran steadily increases its production and exports, almost all non-American IOCs and oil and gas players have expressed interest to return or enter the Islamic Republic's promising hydrocarbon sector.
For the global energy sector, Iran has been the investor’s forbidden fruit, full of potential yet fraught with unknown risks.
A report published by A T Kearney shortly prior to the lifting of sanctions reminisces on the days when Iran’s upstream sector was a thriving one. The year 1976, authors of the report recall, marked a high point for the Iranian oil industry. Domestic oil production consistently exceeded 6mn barrels a day (bpd) and in November of that year it reached an unprecedented 6.68mn bpd.
Looking back over the past 35 years, Iran’s total oil output never reached two-thirds of that peak again. Meanwhile, the last 15 years alone saw the country’s reserves grow by nearly 70%, a much faster pace than any of its neighbours.
Even though the West supported the revolution of 1979 in various ways, the United States, European Union, and the United Nations soon changed their minds. Ever since, Iran has gone in and out of a series of sanctions, the last of which was in 2011, causing a significant setback in the Iranian energy sector.
Carrying the sanctions burden
Previous sanctions had not had an equally damaging effect as those implemented in 2011-12. As far back as the 1990s, Iran started applying the latest form of the buyback contracts, which, despite their disagreeable terms, attracted billions of dollars of foreign investment. What changed in 2011 was that the sanctions included the EU oil embargo and restrictions on financial institutions as well as shipping insurance, triggering nearly all foreign investors to leave the country. The exit of foreign investment, technology and expertise limited Iran’s ability to expand its oil and gas capacity.
This led the National Iranian Oil Company to cut production and shut down some fields. Since mid-2012, Iran has consistently lost between 600,000 and 800,000 bpd of crude oil production due to unplanned shutdowns. In total, production fell from 3.6mm bpd in mid-2011 to around 2.7mm bpd just a year later. According to the International Monetary Fund (IMF), Iran’s oil and gas export revenues dropped by 47% from $118mn in 2011-12 fiscal year to $63bn in 2012-13.
In addition to inflecting internal damage, Iran, as a result of these sanctions, also lost a lot of its market share in the West where it was restricted from doing business. Instead, Iran looked eastward to Asian markets.
A report by APICORP Energy Research published late 2016 summarises some of the trade activities of the energy sector at the time, “Iranian exports during sanctions were concentrated to the likes of China, India, Japan and South Korea who bypassed the US dollar by trading in local currency, trading oil for goods and allowed for the build-up of significant arrears. Iran found a lifeline in China and drifted away from its traditional partner in Europe – Germany – with an estimated $30bn worth of trade annually. The Bank of Kunlun was created specifically to ease Chinese oil payments to Iran, where up to 40% would be used to make cash payments elsewhere in Asia and the remainder used to finance projects in Iran and buy Chinese goods.”
Moving over the sanctions shadow
Now that the trade restrictions are lifted, Iran will continue to expand its reach within the Asian markets. Throughout 2016, Asian exports continued to increase steadily, reaching in excess of 1.7mn bpd in October.
According to APICORP’s report, Iranian exports to Asia’s four main customers reached 1.8mn bpd in August, the highest figure on record. Japan’s intake of Iranian Heavy grade more than doubled from 49,000 bpd to 106,000 bpd taking total exports to Japan from 210,000 bpd in the first quarter of 2016 to 268,000 bpd in the third quarter. Japanese trading houses such as Sumitomo, Marubeni, Itochu and Kanematsu, which had halted oil purchases totalling 50,000 bpd during sanctions, are already set to resume imports.
India has also significantly increased its intake of Iranian crude. In October 2016, the country took 2mn barrels for storage as part of their programme to build strategic petroleum reserves and bought a further 4mn in November. Further, the return of India’s Reliance Industries Ltd, which operates the world’s largest refinery complex at Jamnagar, took imports of Iranian crude up to 789,000 bpd in October, overtaking Saudi Arabia.
While it opens its doors to foreign investment, Iran will also have to stay weary of potential rivals. According to Vikas Handa, managing director of energy consultancy firm Beas DWC-LLC, “Iran will need major capital investment to develop the field and downstream processing plants, they are going ahead with both drilling as well as developing infrastructure to receive and process gas on priority. Given the scale, the development is expected to take years to finish even if the capital is in place. While on the other hand we see Qatar moving swiftly and trying to enhance relationship and ties with consumer nations like India beyond oil and gas to lock in the markets.”
Despite the remaining difficulties in making transactions with European banks, European companies also rushed to grab their share of Iranian oil. Exports of crude and condensates reached 700,000 bpd in September compared to the average 600,000 bpd it exported pre-sanctions. As in Asia, Iran has been trading with some European companies in Euros to reduce its dependence on the US Dollar, a deal which also benefits European firms happy to forgo the fee and inconvenience of acquiring US dollars for the transaction.
“Iran will try to deepen its economic and diplomatic engagement with Europe. Iran wants access to European oil and gas buyers, and broader inward trade and investment agreements with European companies. Given the likely hostility of the US administration to Iran, Europe will be an important diplomatic and business partner,” said Henry Smith, associate director at Control Risks Middle East.
Meanwhile, European refiners are equally keen to revive relations with Iran. ‘Greece’s Hellenic was amongst the first to secure long-term contracts with the NIOC accounting for 25% of the country’s crude imports’, confirms the APICORP’s report. ‘Cepsa of Spain also followed by booking Iranian crude for its refineries. Exports to France, Greece, the Netherlands, Spain and Turkey had reached 450,000 bpd in June. As well as renewing trade with some of its traditional partners, NIOC has also found new customers, having commissioned 140,000 bpd to Hungary in October and engaging in discussions for exports of both crude and products to Bosnia and Herzegovina’.
Throwing the doors open
In order to attract more investors, Iran has been working on introducing better contract terms that can encourage a larger number of International Oil Company (IOCs). Even though the initial Buyback contracts had not hindered foreign companies from entering the Iranian market in the past, the government introduced the Iran Petroleum Contracts (IPC) to attract more investments that it currently needs to rebuild the domestic energy sector.
IPCs provide more flexibility over companies’ reward structures and contract timelines. It can also potentially allow for a joint venture to develop an asset, which could allow foreign oil companies to book reserves.
“Cooperation with an Iranian partner remains a hurdle for the IPC but Iran is coming under pressure to make it more favourable for IOCs,” Ehsan Ul-Haq, senior analyst at KBC Energy Economics, said.
As part of these contracts, “IOCs are expected to develop fields and spend the money required both for OPEX and CAPEX. This is bound to kickstart the stagnating Iranian economy, and bring in much needed liquidity and also create thousands of jobs,” according to Handa.
Job creation is the need of the hour in the Islamic Republic in order to reinvigorate the Iranian market. However, Iran’s nationalisation targets will apply pressure to international operators entering or re-entering Iran. There is a need, for example, to submit a draft organisation chart to the Ministry of Labour for each project, showing the roles that cannot be filled locally. As Western companies re-enter Iran, compensation packages also need to be carefully considered. Managing expectations around infrastructure contribution within contract values will need to be managed thoughtfully.
According to Jon France, regional manager – EMENA, Petroplan, “The market for oil and gas workers in Iran is huge, but staffing is likely to pose a particular challenge for foreign firms. Iranian workers bring language skills, cultural understanding and willingness to the table, but the management methods and technical skills developed outside of the country during the period of sanctions may need to be part of the training.”
“This gap will need to be filled by expatriate workers for an initial period. The disciplines in which Iran is currently experiencing talent shortages are project management, commercial, strategy, health, safety and environment (HSE), deep water, and new technology roles,” France says. “Finding, vetting and securing the best candidates to fill these niches is another area where recruiters can add value and free up internal HR resource.”
Trump disruption possible?
Where these prospects will lead to is highly speculative as the future of the nuclear deal between Iran and the West remains unclear. US President Donald Trump has repeatedly expressed his discontent with the agreement, referring to it as a “really, really bad deal.”
Iranian President Hassan Rouhani responded to these comments, saying that the deal is not re-negotiable regardless of how Trump feels about it. According to Rouhani, going back on the deal was not possible as it is a multilateral agreement, rather than a bilateral one, that was also signed by other countries including Britain, China, France, Germany and Russia.
In a press conference commemorating the anniversary of the deal’s implementation, Rouhani said that re-negotiating the deal “is like saying that we should turn a shirt back to cotton.”
“The President-elect (at the time) has shown he is not happy about the nuclear deal, calling it the worst deal ever signed,” he said to reporters. “I don’t think he can do much when he goes to the White House.”
Meanwhile, Trump’s defence secretary, James N. Mattis said, “I think this is an imperfect arms control agreement — it’s not a friendship treaty. But when America gives her word, we have to live up to it and work with our allies.”