The Fuse

Following a Tumultuous History, IOCs Consider a Return to Iran

July 01, 2015

Guest Post by Ari Sillman | @AriSillman

Ari Sillman is currently a masters candidate at Georgetown University and an intern for Securing America’s Future Energy. His studies focus on the intersection of energy and security issues in the Middle East.

Iran oil company map

With the conclusion of international negotiations on Iran’s nuclear program quickly approaching, the question of what an agreement means for Iran’s oil industry has grown more pressing. Iran’s long history of resource nationalism has made oil production politically risky territory for international oil companies (IOCs). Yet, given the country’s low production costs and expansive conventional reserves, IOC appetite to return to Iran appears extremely high. Future international involvement, assuming a deal is reached, will depend on Iran’s willingness to reinvent the terms of engagement in its oil sector that have previously discouraged international companies from dealing with the country.

A history of resource nationalism

Hostility toward international oil companies was a legacy of Iran’s long colonial history.

Following the Iranian Revolution in 1979, IOCs withdrew from Iran amidst political uncertainty and public hostility towards their work. This hostility was a legacy of Iran’s long colonial history, and quickly became manifest in the country’s new constitution. The new constitution, supported overwhelmingly by public referendum, allocated the country’s vast oil and mineral resources to the state, effectively outlawing foreign ownership of Iranian oil reserves. Iran’s oil production subsequently declined, and was further diminished by the outbreak of war with Iraq in 1980.

Production eventually recovered, though to levels far below Iran’s pre-revolution peak of more than 6 million barrels per day, and remained roughly constant until 1990, when the Iranian government made the decision to open the oil industry to IOC investment. Several factors were behind this decision, most importantly Iran’s desire to end its international isolation, its need to promote economic growth after years of war, and its acknowledgement that its aging oil fields required significant technical support.

Buy-back agreements

Given constitutional restrictions on IOC operations in Iran, the primary vehicles for IOC investment in the oil sector were buy-back agreements. Buy-back agreements allowed IOCs to fund the development and exploration costs of certain Iranian oil fields, and in return receive remuneration from the National Iranian Oil Company (NIOC) to compensate them for their services and offset their costs. The NIOC still controlled the oilfields, thereby circumventing laws against foreign ownership of Iran’s oil. In addition, the projects developed by the IOCs would revert back to Iranian control over time (contracts usually lasted around five to seven years).

Though buy-back agreements were initially unappealing to IOCs, improved terms and a changing political climate throughout the 1990s began to entice some of them to return to Iran. In 1995, for instance, Total and Bow Valley Canada signed the first major buy-back agreements to work parts of the Sirri, Balal, and South Pars fields. Other agreements soon followed.

However, Iran’s economic opening faced multiple setbacks. In 1995, the U.S. expanded sanctions on Iran to forbid U.S. companies from facilitating the development of the Iranian oil industry. This was quickly followed by the Iran Libya Sanctions Act (ILSA) in 1996, ostensibly in response to Iran’s pursuit of WMDs, which required the president “to impose sanctions against any foreign person, company or subsidy that invests $40 million or more in a year in Iran’s (or Libya’s) petroleum or natural gas sectors.” These sanctions discouraged many IOCs from actively pursuing agreements with Iran. In addition, IOCs found the improved buy-back agreements offered by Iran unenticing; the period of the contracts on offer was too short and the IOCs would be heavily dependent on the NIOC. Companies that had previously signed buy-back agreements had done so under the assumption that further reforms and privatization of the oil sector would take place. However, this was not to be.

Conservative legislators attempted to prosecute reformist oil officials for corruption, and Iran’s Guardian Council consistently ruled that buy-back agreements were un-Islamic and unconstitutional.

Structural reform of the NIOC and political disputes in the Islamic Consultative Assembly (Iran’s parliament, also known as the Majlis) during the early 2000s voided any possibility of significantly improved buy-back terms, as conservative elements in the government viewed these agreements with suspicion. Conservative legislators attempted to prosecute reformist oil officials for corruption, and Iran’s Guardian Council consistently ruled that buy-back agreements were un-Islamic and unconstitutional. Political meddling in the energy sector increased after the election of Ahmadinejad in 2005. Ahmadinejad’s victory underscored the rising clout of conservative factions in the Iranian government and many technical experts, fearing political retaliation, left the oil ministry and NIOC as a result. This led to a steep decline in government technical expertise during the mid-to-late 2000s.

Under Ahmadinejad, Iran found itself subject to increasingly restrictive international sanctions as a result of the country’s expanded nuclear activity. In 2006, the UN Security Council passed its first round of sanctions against Iran as a result of Iran’s failure to cooperate with the IAEA and continued enrichment activity. A series of more restrictive sanctions followed. Oil production in Iran became increasingly costly and by the end of 2010 most major IOCs that had been working in the country had suspended their activities or withdrawn from the country in expectation of further sanctions.

New contracts on offer

The Iran Petroleum Contract (IPC) will provide IOCs greater compensation for increased production, last longer than previous contracts, permit joint ventures, and allow IOCs to be involved in the actual production of oil.

Since the election of Hassan Rouhani as President of Iran in 2013, the Iranian government has worked hard to encourage international companies to return to the country. A major component of this economic push has been the creation of a new contract vehicle for IOC involvement in Iran’s oil industry. First proposed in 2014, the contract vehicle—known as the Iran Petroleum Contract (IPC)—will provide IOCs greater compensation for increased production, last longer (up to 20-25 years), permit joint ventures, and allow IOCs to be involved in the actual production of oil. The IPC will also, for the first time since the revolution, allow “the transfer of ownership of hydrocarbons to IOCs at defined delivery points,” though the IOC “will not have any ownership rights over the project assets.”

While Iran has yet to finalize the terms it will offer to foreign companies, it hopes that the IPC will prove attractive to western IOCs, which have already begun broaching the possibility of returning to Iran. IOCs are especially interested in Iran’s oil sector at present, as low oil prices have discouraged them from considering more capital intensive projects. The capital intensity of oil development in Iran, approximately $4 per barrel of oil equivalent over the last three years, is significantly lower than the global average, and as such makes it an appealing investment under the right contract. Moreover, Iran still possesses the world’s fourth largest oil reserves and well-developed refining and transportation capabilities.

IOCs, though clearly intrigued by the possibility of returning to Iran’s oil fields, maintain concerns about potential contract agreements. Eni CEO Claudio Descalzi recently commented that the previous buy-back agreement structure caused the company to lose money while operating in Iran. Critics of the buy-back contract arrangement complain that they were unable to record neither the reserves discovered in Iran nor the revenue gained from those reserves on their accounts. They add that the remuneration they received was inadequate in light of their expected contribution. Under previous buy-back agreements, for instance, IOCs that failed to discover any usable resources received no compensation for their work. Additionally, recording reserves and revenue on their accounts is especially important for IOCs, as their valuation is often based in large part on their revenues and proved reserves.

The new IPC seeks to address these concerns by both allowing the investor to participate in other projects if it fails to discover usable reserves and by permitting international investors to include at least revenues, if not reserves, from Iranian hydrocarbons in their annual financial reports.  These commitments seem to have piqued the interest of oil majors, as executives from Royal Dutch Shell and Eni met with Iranian officials in May and June to discuss investing in Iran’s oil industry. If these meetings are any indication, it seems likely that many IOCs will reenter Iran if sanctions are lifted.

While the IPC does not need parliamentary approval, conservative factions within the Iranian government could still influence the final shape of the contract.

Nonetheless, challenges remain. Most significantly, there is the lingering threat of opposition to the IPC from conservative lawmakers. While the IPC does not need parliamentary approval (it only needs to be approved by Rouhani’s cabinet), conservative factions within the Iranian government could still influence the final shape of the contract. Many experts believe that hardliners in the Iranian government could actually be empowered by the nuclear agreement. In recent months, Ayatollah Khamenei has curbed hardliners in order to prevent them from sabotaging the negotiations.

Once a deal is reached, however, the Ayatollah is likely to allow hardliners to reassert themselves in order to counter any clout that moderates may gain as a result of the accord. As such, certain changes made to make the IPC more attractive, such as allowing IOCs to record Iranian reserves on their accounts, may not make into the final contract as these changes are seen by hardliners as impinging on Iranian sovereignty.

Ultimately, the future of foreign involvement in Iran’s oil industry depends on the outcome of the ongoing nuclear negotiation, but given developments in the past few months it seems highly likely IOCs will return to the country in one form or another.