The Biggest Obstacle to Iran's Energy Makeover Is Itself

Iran's energy sector may undergo a dramatic change if it can move beyond the country's difficult political and business environment. (ATTA KENARE/AFP/Getty Images)

Forecast

• The terms of Iran's new oil contract, once finalized, will be a significant improvement over the country's old buyback model.
• There is still an intense debate raging over the contract's details, including remuneration and profit allocation, but its framework appears to be settled.  
• Iran's various stakeholders will try to use the ambiguity to their advantage, furthering their own interests as the contract's remaining details are hashed out.

Analysis

Throughout the first half of the year, Iran's national oil company has been busily signing partnership deals with its international peers to secure its place in future Iranian energy projects. The agreements, the most recent of which was sealed on May 4 with Austria's OMV Group, come at a critical time for Iran's hydrocarbons sector. Over the past decade, the Iranian oil industry languished as Tehran largely shunned outside assistance. But now, in an effort to capitalize on the country's recent nuclear deal with the West and the lifting of sanctions, President Hassan Rouhani is trying to reinvigorate the sector by pumping in foreign cash and expertise.

The president's envisioned reforms will fundamentally change the structure of the Iranian energy industry. But they could also redefine the role and scope of the National Iranian Oil Co.'s activities — an outcome certain stakeholders in the company and the oil sector more broadly are determined to avoid. Despite the consensus among Iranian elites that some foreign investment and technology is needed to get the country's hydrocarbons industry back on track, they agree on little else. And as the disputes among Iranian policymakers persist, the appeal and efficacy of Rouhani's push for change will fade.

Creating a New Oil Contract

Revitalizing Iran's oil and natural gas sector has been a priority for Rouhani since he took office in 2013. The industry's deterioration under the weight of sanctions and the guidance of Rouhani's predecessor, Mahmoud Ahmadinejad, made it clear to many Iranian leaders that the country could not reach its production potential without help. Despite widely held political concerns about working with foreign partners, Rouhani has taken steps to make Iran's oil contracts more enticing to outsiders.

To that end, Iran discussed and unveiled some of the terms of its new Iran Petroleum Contract (IPC) model at a summit in Tehran last November. Though the details of the final version are still being worked out, the initial draft was clearly designed to address the biggest criticisms of Iran's former framework: the buyback contract.

Allowing Joint Ventures

The most important difference between the IPC and the buyback model is that the former allows international oil companies to play a much broader role in joint ventures with Iranian firms. Foreign companies have not been able to participate in the production stage of any Iranian oil field since the Iranian Revolution began in 1979. But under the terms of the IPC, international firms can serve as the operators of a block or field during the exploration phase. If oil is discovered and its extraction is deemed economical, then the foreign company and National Iranian Oil Co. (and potentially a third party) will establish a joint operating company and a joint venture, which acts as a contractor, to continue operating, developing and producing the field. Committees comprising members of each company then make strategic decisions for both joint entities.

Because Iran wants international companies — and their technology — to be present at every stage of its oil and natural gas projects, it has lengthened the time frame of the contracts outlining their responsibilities as well. The IPC framework makes room for contracts that can last up to 20 years, with the possibility of adding an extra five years if enhanced oil recovery techniques are needed. This is intended to draw foreign firms into managing declining fields, which often require more technologically complex methods to maintain high output levels as they age. Tehran also hopes that longer and more frequent partnerships with international companies will give its own firms a chance to access the best technology and expertise available.

Of course, there are a number of ambiguities about these joint ventures that the IPC has yet to address. For example, though the contract clearly states that international oil companies must assume all of their Iranian partners' risk in the exploration phase, it is not obvious whether they must do the same for partners from other countries. Moreover, the ownership shares of the various joint ventures, operating companies and committees involved in each partnership have not been defined, nor has a formula for figuring out if a field is economical. (Iran has said, however, that the latter will be included in the final draft of the IPC.)

Incentivizing Foreign Participation

Meanwhile, the Iranian government has also tried to solve many problems of the buyback model that endangered foreign companies' profits. Under the old contract, international firms received a fixed rate of return, usually between 15 and 17 percent, based on the sum they initially agreed to invest. The IPC replaces this rate with a much more robust mechanism that calculates revenues by taking into account the price of oil, the volumes produced and the complexity of the field. In so doing, it not only enables companies to benefit from higher oil prices but also incentivizes them to extract as much oil as they can, potentially exceeding production goals.

As an added bonus, the new contract model removes the rigid capital expenditure requirements of its predecessor and introduces a comprehensive cost recovery mechanism. Instead of having to eat any costs that exceed their initial budget estimates, international oil companies will now be able to get their work programs and budgets approved annually by a joint management committee. Furthermore, the cost recovery mechanism will allow them to recoup costs equal to as much as 50 percent of the project's annual revenues, carrying forward any outstanding costs into the following year. These changes will give companies the flexibility to make adjustments more easily in their projects' later stages, encouraging field redevelopment and the use of enhanced oil recovery techniques in the process. 

Like the joint venture terms, these areas of the IPC framework are still somewhat vague, and many of the finer details that are crucial for determining payment and financial feasibility remain unclear. Though some of them may eventually be set in stone in the IPC's final draft, a number of them will probably be left unresolved, giving foreign oil companies room to compete with one another in the event that Iran tries to strike up a bidding war. That said, the lack of clarity could also backfire by making potential investors at home and abroad uneasy.

Attractive Terms May Not Be Enough

As Iran tries to bring its petroleum contract more in line with industry standards, there are still a number of obstacles. For one, Tehran is bound by limits of the Iranian Constitution, which explicitly says all of the country's energy reserves belong to the state. This rule makes it impossible for international companies to own Iranian oil — a problem for firms whose reserves are vital to securing shareholders' support and financing from banks and other lending institutions.

The constitution's stipulations also rule out the use of several common contract terms, including those found in production-sharing contracts, which often give companies a share of output and reserves. Tehran is attempting to get around this roadblock, however, by including mechanisms that mirror the mechanics of production-sharing contracts while still adhering to Iranian law. The IPC's volume-based compensation structure, for example, is similar to the idea of paying companies with a share of their output. Iran has also promised to enter long-term supply contracts for the duration of the IPCs, arguing that they could be disclosed as assets to foreign firms' shareholders in a way that is comparable to booking reserves. (It remains to be seen how successful Tehran's argument will be, though.)

Either way, the new IPC framework could prove to be an attractive contract scheme, depending on the final details. Iran boasts many below-ground opportunities and an abundance of oil and natural gas that is fairly cheap to produce — two factors that will pull investors to the country. But generous terms and vast potential can do only so much to make up for the substantial political risk that investors would take on by entering Iran.

Consider the new 25-year contract the IPC offers. Though ideal in many ways, such a time frame would work out well for international companies only if Iran's stance toward the West does not sour substantially over the next quarter of a century. Yet in that time, Iran will likely experience several political evolutions and at least one new generation of supreme leaders. Coupled with the country's tumultuous history with the West, it is easy to imagine tension between the two rising once again.

Even if it does not, the receding effects of Tehran's protracted standoff with the international community will continue to make doing business with Iran difficult. Foreign companies will have to go to great lengths to ensure they do not partner with groups or individuals still under sanctions. In the meantime, 25 years is long enough to allow Iran's heavily politicized legal system, which often acts arbitrarily, to change the regulations governing Iran's oil industry. So while Tehran recognizes the importance of bringing in foreign know-how and funding to its energy sector, it may have a hard time convincing companies that the gains of operating in Iran outweigh the risks. In turn, international firms' hesitation will likely become a drag on Iran's production growth over the next five years or so.

The Debate Is Far From Over

Meanwhile, Iranian leaders continue to haggle over what the final IPC will look like. Despite the progress that has been made on some of the larger issues, the details have become a battleground for Iran's varied political groups, all of which will use the debate to further their own interests as best they can.

Chief among these groups are Iranian construction, engineering, equipment and contracting companies, many of which fear that their contracts and sales will be reduced by the new model. Iranian firms are not nearly as technologically proficient as their foreign counterparts, and they will struggle to stay competitive as they bid against international oil companies — especially since the primary contracts under consideration are for complex projects, including heavy oil, deep-water and mature oil fields. Having unveiled only 52 fields eligible for development under the IPC, Tehran could be setting aside other plays for domestic companies that are better tailored to their capabilities. It is also possible that Iran will create its list of approved Iranian partner firms with an eye toward ensuring certain companies have a chance to develop more advanced skills as they work with international corporations. But because it is unclear which companies will make the cut, the issue continues to be a source of heated debate.

Several questions about the IPC's constitutionality and its tariffs and customs requirements remain unanswered, too. Still, the ambiguity has given Oil Minister Bijan Namdar Zangeneh room to shift his rhetoric over the past two months, referring to the IPC as a buyback contract to alleviate the concerns of those who worry its successor introduces too much change for comfort. After all, the models are both service contracts at their core; they simply have very different structures. And regardless of terminology, it is unlikely that the IPC's initial draft would have been unveiled without at least the tacit support of Iran's supreme leader.

Yet even within the National Iranian Oil Co. and Oil Ministry there has been some pushback against the new contract. Both have their doubts about whether the state-owned company will in fact benefit from the IPC format and receive the technology it so desires. They question why a joint-venture contractor should operate projects, as opposed to the state company, and whether a 20-year time frame is too long. Moreover, uncertainties regarding remuneration and financial viability, among other areas, continue to make the two organizations uneasy.

All of these concerns aside, National Iranian Oil Co. Managing Director Roknoddin Javadi has said he hopes to have an IPC draft completed by July so that Iran can open tenders on its blocks. (International companies interested in investing in Iran will probably begin the prequalification process even sooner.) Whether his goal will be realized is another matter. The IPC's formal debut has been delayed indefinitely, though the contention surrounding it is centered less on the ideological question of whether foreign participants should be allowed in and more on domestic players' attempts to shape the contract's finer points to their benefit. Ultimately, this will probably mean that while some of the IPC's more attractive terms may get watered down, the model likely will not be blocked completely. Either way, Iran's energy sector appears to be on the verge of a dramatic change — but only if the country can get past its risky politics and difficult business environment.