The Fuse

For Iran’s Oil Sector, Early Excitement Obscures Challenges Above and Below Ground

June 29, 2015

Guest Post by Matthew M. Reed | @matthewmreed

Matthew M. Reed is Vice President of Foreign Reports, Inc., a Washington, DC-based consulting firm focused on oil and politics in the Middle East.

Editor’s Note: To supplement this article, don’t miss the most recent Sanction Law podcast by Sam Cutler, Policy Advisor at Ferrari & Associates, P.C., featuring the author, Matthew M. Reed. Sam and Matt discuss Iran’s post-deal oil outlook.

June 30 is the putative but still uncertain deadline for the P5+1 nuclear talks with Iran. Success is by no means guaranteed but, if a deal is reached, Iran expects speedy sanctions relief. For some time, officials have been planning for the day after sanctions, which cut oil exports from about 2.6 million barrels per day (mbd) in 2011 (the year before meaningful EU and U.S. sanctions were imposed) to 1.4 mbd last year, a figure that includes lighter hydrocarbons called condensates.

Iranian officials have already met with customers old and new in order to discuss additional imports. They’re also meeting executives from international oil companies (IOCs), which Iran will need in order to hit future production targets. For the first time in a decade, there is genuine buzz about Iran’s prospects and its plans for the future. That said, between inter-OPEC tensions, the need for customers, downside price risks, unanswered questions regarding contract terms, and intense levels of investment required to rejuvenate the country’s antiquated fields, Iran’s oil sector faces no shortage of obstacles.

Oil Minister Bijan Zanganeh said last month that Iran will begin ramping up oil production within two weeks of reaching a deal with the P5+1.

As for the immediate future, Oil Minister Bijan Zanganeh said last month that Iran will begin ramping up oil production within two weeks of reaching a deal with the P5+1—in fact, he and others in the ministry are convinced that Iran can produce an additional 1 mbd in a matter of months. By contrast, industry estimates by outsiders tend to agree that an additional 400,000-800,000 barrels per day is technically feasible within six months of sanctions being lifted.

Setting the stage for a price war

Iran’s export plans depend on when sanctions are lifted and the availability of customers in an oversupplied market. Asia is Iran’s number one priority because of its demand growth potential. Iran is also intent on reviving deals with old customers, especially those in the EU, which banned Iranian crude in 2012, and other importers like South Africa, which were reliable until a few years ago. Lining up customers may not be as easy as it sounds. Iran wants annual term contracts that dictate volumes but it may have to settle for selling cargoes at a discount, most likely to customers filling storage, at least until it can negotiate new deals. It may thus take until 2016 before Iran’s export volumes gain pace.

Zanganeh has warned that Iran is determined to reclaim its market share, no matter how fierce the competition.

Iran’s oil minister expects OPEC to cut output and make room for Iran. Otherwise, prices will fall, perhaps dramatically. However, Zanganeh has also warned that Iran is determined to reclaim its market share, no matter how fierce the competition. According to him, Iran will reclaim its share even if prices fall into the $20-30 range. “It is our right to return to the market,” Zanganeh repeated on June 5.

Prices that low may be unthinkable today but Saudi Oil Minister Ali Naimi has also made it clear that his country and OPEC won’t cut production even if oil hits $20 a barrel. The stage is thus set for a nasty price war, most likely concentrated in Asian markets, but by no means limited to them. OPEC cuts can’t be ruled out, but it will likely take an extended period of exceptionally low prices to inspire action. OPEC is typically reactive rather than proactive.

Iran’s internal challenges

While Iran is desperate for revenue and eager to export more oil now, there is a limit to what it can achieve in the short and medium-term. Earlier this year, Zanganeh publicly said the industry was in a state of “catastrophe.” When faced with lawmakers who debated slashing his budget to just $3 billion in 2015-2016, Zanganeh asked members of the Majles: “How are we to manage the oil industry with such an amount?”

Because of sanctions, Iran’s oil revenues are currently stranded in those jurisdictions where Iran’s customers are located: Chinese refiners deposit payments into Chinese banks, Indian refiners deposit into Indian banks, etc. Iran then taps those accounts in order to pay for imports originating in those countries, like Chinese goods or Indian rice. With free access to its own capital and rising export volumes, Iran will invest some of that post-sanctions windfall into its aging oil industry, but the obstacles are huge and the potential for self-investment is modest.

There will likely be an interim period—between the lifting of sanctions and the realization of long-term investments—during which Iran’s production struggles to climb or perhaps even slips after the initial surge.

Shortly after sanctions are lifted, Iran could raise production quickly, from around 3 mbd today to maybe 4 mbd if there are no technical hitches and it is able to find customers. Producing much more than that would be a small miracle. Instead, there will likely be an interim period—between the lifting of sanctions and the realization of long-term investments—during which Iran’s production struggles to climb or perhaps even slips after the initial surge.

Iran’s oil fields are some of the oldest in the world. According to the EIA, most of Iran’s reserves were discovered more than 50 years ago and half of Iran’s current production comes from fields that began producing more than 70 years ago. The natural decline rate of these formations is tremendous. As a result, Iranian officials and politicians say the industry needs anywhere from $30 to $50 billion invested every year over the next decade. In order to revive old fields and develop new ones, Iran needs foreign capital and sophisticated technology. That’s why the Oil Ministry is excited to reveal its new model contract.

New terms for old partners

The Iranian or Integrated Petroleum Contract (IPC) is not final. All we know, from hints dropped by officials, is that the IPC will last longer and be more lucrative to foreign investors. Deals could last 20 or maybe 30 years and some will cover all project phases, including exploration, development, production and enhanced recovery. Predictably, foreign companies will be required to work closely with Iranian counterparts. Officials say they’re eager to replace Iran’s old buyback contracts and that the terms are “better than Iraq’s” tough service contracts. The final IPC will not be a production sharing agreement or PSA. Iran’s constitution forbids private or foreign ownership of natural resources.

One underappreciated factor regarding the IPC is the potential for delay. The new model contract will almost certainly spark a public debate and Iran is a country with a fierce resource nationalism streak. Like the pending nuclear deal, the IPC could rally opponents who think Zanganeh’s oil ministry is too generous to foreigners and President Hassan Rouhani is selling out the country. It’s up to Rouhani’s cabinet to approve the terms, but he and Zanganeh may have to defend them first. National debates in neighboring countries (Iraq, Kuwait, and Azerbaijan) took years to resolve.

Any new deals with Iran will likely include “escape hatch” clauses.

When it comes to Iran’s oil sector, don’t mistake excitement for urgency, especially if oil prices remain relatively weak through 2020. Foreign companies are excited by Iran’s geology but the industry is defined by caution and careful planning. Even those companies that are well-positioned to return to Iran’s oil fields—be they European, Russian or Chinese—are fully aware of the risks. If the nuclear deal falls apart years down the road, they may find themselves rushing to leave. Any new deals with Iran will likely include “escape hatch” clauses.

So much remains to be done before companies can get to work. Consider all the steps involved, some of which takes months—others can drag on much longer. Iran will open projects for bidding or enter direct talks with a pre-selected group of IOCs; authorities will then review their options and award contracts for certain blocks or projects; IOCs will then conduct seismic studies and other surveys; then they will present a development plan (or plans) for Iran to review; next the government will approve or negotiate those plans further; and then—only then—can IOCs place orders for equipment and material that needs to be fabricated. Once IOCs have people in place and materials clear customs, then they can start work. That work will take time, and once it’s finished there’s a testing period before going commercial.

If there’s a nuclear deal and sanctions are lifted, the surge might come soon but the flood is likely a long way off. If there is no nuclear deal, Iranian oil will stay in the ground.