The Iranian economy has been hit by sanctions, mismanagement and now plummeting oil prices. Efforts to attract foreign investment were stymied by a lack of progress over its nuclear program but with sanctions lifted, Iran has the potential to offer attractive terms for world class oil and gas projects. But investment stability ultimately hinges not just on contracts, but the consistency of the regime behind them and the reversal of US financial sanctions.

The recent plunge in international oil prices is harsh medicine for OPEC member Iran. The country’s petroleum based economy was already being pushed towards collapse by international sanctions and government inefficiencies. According to the IMF, fiscal break-even for Iran in both 2014 and 2015 required oil at about $130/ barrel, more than quadruple current levels. Iranian oil production has never recovered to pre-sanction levels; the country was producing 3.68 million b/d in April 2011, but has not exceeded 2.8 million b/d since July 2012. Iran had 157 billion barrels of proved oil reserves and 33.8 Tcm in proved natural gas reserves at end-2013, according to BP data. Its gas reserves are the largest in the world, while its oil reserves are the fourth biggest. Iran also borders the Straits of Hormuz, the world’s busiest oil seaway, which brings millions of barrels a day of Gulf oil to international markets

Although pipeline capacity has been significantly expanded to circumnavigate the vulnerable strait in recent years, trade through the waterway and Iran’s capacity to disrupt it remain significant. It remains the oil market’s single most vulnerable choke point. The rehabilitation of Iran into the international community and the ability to invest in Iranian oil and gas therefore has a huge bearing on the future development of international crude and natural gas markets, both in terms of volumes and reserves open to development and in terms of security of supply.

Iranian oil and gas fields
Iranian oil and gas fields

Faced with an isolated and ailing domestic economy, the reform-minded administration of President Hassan Rouhani was keen to move forward with a historic decision to open up its upstream oil and gas sector to much-needed international investment. However, this investment was put on hold whilst international sanctions were imposed prior to an agreement on the country’s nuclear program with the P5+1 group, which consists of the five permanent members of the UN Security Council – the US, Russia, China, UK and France – plus Germany.

Investment regime

“There is little doubt about the high costs of the sanctions imposed on Iran’s economy as a whole and its oil and gas sector in particular,” Oxford Institute for Energy Studies Fellow Elham Hassanzadeh wrote in  Iran’s Natural Gas Industry in the Post-Revolution Period.

Hassanzadeh noted that sanctions have not been the only factor to hold back development. There have been a series of post-Revolution foreign investment regimes that international companies have widely viewed as unattractive. One of Rouhani’s major initiatives has been reform of that framework in a continuation of work started by his reformist predecessor Mohammad Khatami, who was Iran’s president from 1997 to 2005. Among Khatami’s boldest lasting achievements was the passage of Iran’s Foreign Investment Promotion and Protection Act (FIPPA), enacted in 2002, which has been recognized as providing a more investor-friendly legal framework that vastly improved upon the previous inefficient investment regime and its supporting regulatory framework.

The act gave permission for foreign investment within the framework of civil partnership and contractual frameworks, even though Iran’s constitution contained explicit provisions prohibiting private sector involvement in strategic industries such as oil and gas. It got around the constitution by invoking the Iranian concept of “Maslahat”, or “expediency”, which allows key policy issues that are recognized as unconstitutional or against Sharia (clerical) law to be referred to a national Expediency Council for arbitration.

To entice technically-competent investors back after sanctions are lifted, Iranian Oil Minister Bijan Zanganeh has proposed replacing the unpopular buyback deals with a new upstream contractual regime offering a vastly more flexible framework and greater incentives to invest. While detailed terms have yet to be revealed, much is known about the broad structure of the proposed Iran Petroleum Contract. The model is said to resemble the technical service contracts offered by Iraq, but could offer more lucrative and flexible legal and fiscal terms to attract long-term participation by foreign investors for periods extending for as long as 25-30 years. That is a major departure in intent from the restrictive buybacks, which were designed to minimize the duration of foreign company involvement in Iranian oil and gas projects seen in the pre-sanction period. Other notable features of the contracts.

Against this, contractors will be expected to pay taxes at a rate envisaged at around 30-35% of income. Signature bonuses, which were absent from buyback contracts, will also be a feature of the new contract model. However, investors will not be required to pay interest on their investment costs, increasing their incentive to improve cost savings. In another significant departure from the discredited buyback regime, foreign companies may be able to own produced oil. Even the booking of reserves may be sanctioned for exceptionally high-risk projects, as long as this does not entitle investors to claim ownership of Iranian oil and gas reserves, which the country’s constitution prohibits.

 

Iranian gas pipelines and processing plants
Iranian gas pipelines and processing plants
Buy how to pay?

While the U.S. government has agreed to lift the nuclear sanctions against Iran, it continues to impose other sanctions over Iran’s human rights policies and support for terrorism. These sanctions bar American citizens and companies from most forms of investment or trade with the country and whilst, in theory, those sanctions should affect only U.S. companies in reality, the law’s reach goes well beyond U.S. borders

The Treasury Department’s Office of Financial Assets Control has made it very clear that no payments linked to Iran may be processed through the U.S. financial system

That means foreign financial institutions doing business in the United States — and almost any bank of any consequence has substantial U.S. operations — must somehow segregate any Iranian money they hold from their U.S. assets. That’s difficult to do. Beyond this foreign financial institutions need to be very careful for whilst they may not be running afoul of the nuclear sanctions doing business with Iran in a particular set of transactions may run afoul of the counter-terrorism sanctions. Foreign banks are especially nervous about violating U.S. sanctions laws because they have sometimes been hit with hefty fines for doing so. In 2014, France’s largest bank, BNP Paribas, agreed to pay a $9 billion penalty for helping clients in Sudan, Cuba and Iran evade sanctions.

Thus, companies that want to do business in Iran have to first find banks that will work with them which means using small banks with no significant operations in the U.S. or even Iranian banks. However, Iranian market will ultimately prove irresistible to some businesses but these companies will first have to decide whether the allure of Iran is worth the risks they’ll face when they do business there.

Iranian oil – Contractual versus political risk

Whether the earlier mentioned contractual reforms will prove sufficient to enable Iran to restore lost productivity to its oil sector, while boosting development of the country’s massive gas reserves remains to be seen. Certainly international oil companies excluded by sanctions from Iran have been voicing interest in returning to the country when improved political relationships allow. In Iran, especially during Ahmadinejad’s presidency, governance institutions, including the judiciary and bureaucratic administrations, were severely weakened and strongly politicized, leaving them with little capacity to protect and enforce investor. Structural reforms aimed at increasing the transparency of Iran’s government institutions and curbing “systematic” mismanagement and corruption will also be required to get the country’s strategic oil and gas industry back on track.

Indeed, the prospects for a stable investment regime are by no means secure, despite the likely benefits to the hard-pressed Iranian economy, if judged by the political swings from reform to aggressive isolationism of the recent past. There is the ongoing friction between the republican and Islamic elements of the Iranian revolution that tends to produce administrations with very different foreign policy outlooks, as well as contributing to tensions within Iranian society. Clearly, the lifting of sanctions will enable the process of opening up Iran to foreign investment but reversing the damage done over recent years, the continued issues around funding and all this whilst a mauling bear market is ongoing is not to be underestimated. However, Iran offers a strong counterweight to Saudi Arabia, has traditionally strong ties to the West and is will welcome investment and capital, for whilst there are strong head winds, welcoming Iran politically, economically and commercially back onto the world stage is to be encouraged.

If you’ve found this blog helpful and would like other topics covered, please feel free to drop me an email with suggestions. You’re welcome to subscribe using ‘Subscribe to Blog via Email’ section and this will get you the latest posts straight to your inbox before they’re available anywhere else

I'd love to hear what your thoughts are...please feel free to leave a reply

This site uses Akismet to reduce spam. Learn how your comment data is processed.