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The IPC Terms Demonstrate a Big Improvement on Iran’s Old Oil Contract Model

Saturday, January 16, 2016

Iran Review’s Exclusive Interview with Richard Mallinson
By: Kourosh Ziabari

Iran’s Ministry of Petroleum has recently introduced a new set of contracts for its upstream projects to draw international investment and rehabilitate the country’s injured oil and gas industry.

The removal of sanctions placed on Iran over its nuclear program is imminent, and with the implementation of the comprehensive nuclear deal concluded in July 2015, international firms will be once more allowed to invest in Iran’s profitable energy projects.

Oil and gas experts believe the new formula for the energy contracts, known as Iran Petroleum Contract (IPC), boasts many enticing provisions and persuasive advantages, including the exclusion of “buyback system” that had been in place for about two decades. Under the buyback system, foreign firms involved in oil exploration and production in Iran couldn’t book reserves or own stakes of the Iranian firms. The IPC model allows for some limited reserve booking. Of the other benefits of the new contract is that it reduces the risk of investment by increasing the length of agreements to a maximum of 25 years, which would be certainly more encouraging for the foreign firms. The cost of operations will also be flexible and subject to negotiation.

A noted analyst specializing in the geopolitics of energy and Middle East energy affairs believes the new IPC terms demonstrate a major improvement on Iran’s old upstream contracts and definitely lures the European firms that previously did business with Iran, but left the country following the introduction of sanctions in 2012. Nevertheless, he believes these companies might start returning to Iran by “testing the water” and seeing if reinvestment would be safe and cost-effective.

According to Mr. Richard Mallinson, Iran will expectedly increase its oil production by around 3 to 400,000 barrels a day following the enforcement of the Joint Comprehensive Plan of Action, and can even surprise the global markets by overcoming the technical difficulties and producing more.

Richard Mallinson is a senior policy professional and works with the Energy Aspects. A member of the Royal Institute of International Affairs (Chatham House), he has published analytical papers and articles on international affairs and energy policies in such outlets as MEES and the Oxford Energy Forum.

Iran Review spoke to Mr. Richard Mallinson to explore the details of the IPC contract model unveiled by Iran freshly and the future of global energy markets in the wake of the much-anticipated lifting of the economic sanctions against Iran.

Q: The new model of Iran’s oil and gas contracts, IPC, has just been unveiled in a conference in Tehran. In what ways is the IPC model different from the contracts that were introduced in early 1990s following the conclusion of the Iran-Iraq War? It’s said that the new contracts don’t include the buyback financing deals. Do you consider it an advantage for the international investors?

A: Well, the outline of the new contract that has been shared certainly seems to address a lot of the concerns that oil companies had with the old buyback model. The first point is that the term of the contract is much longer, 20 to 25 years, which allows for more return on investment. And then the second is that in terms of the investment, there is more flexibility promised in this new contract model. So, for fields which are expensive to develop, companies can expect to recover all of the money that they have spent in that development phase when production begins, whereas the buyback contract had limits on that. I think the third important area for companies would be the promise that they will be able to book the reserves, so though the oil still in the ground will remain the property of Iran, the companies will be able to reflect that in their financial settlements and that is a very important feature for companies when they’re thinking about the benefits and the financial position of investing in a project.

So, those headlines look encouraging from the point of view of oil companies, but what’ve also heard from those companies is [that] they need to see more detail; they want to understand exactly what the terms will look like for individual projects, including the more geologically complex ones. They also have some concerns about the requirements to enter a partnership with a local Iranian firm. And this is in part because many of the U.S. and UN sanctions that limit or restrict business dealings with certain Iranian businesses will remain in place even under the nuclear deal, and they’re concerned about being caught by some of those sanctions if they’re forced to partner with certain organizations or businesses.

Q: You also talked about the UN and U.S. sanctions. Even though the sanctions lifting is expected to take place shortly, almost no American energy firm was represented in the recent conference in Tehran, which was attended by delegates from major international oil and gas companies. What’s your idea on the fact that the American firms still feel somewhat reluctant to bring their capital and technology to Iran?

A: It’s a really good question. The reality is that for U.S. oil and gas firms, even after the JCPOA is implemented, it will be almost impossible to do any business in Iran. And this is the case for most U.S. firms. The reason is that the JCPOA will not lift sanctions or restrictions on U.S. banks from allowing dollar-based transactions with Iranian businesses and that creates significant limitations and problems that particularly apply to U.S. businesses but could also affect other Western firms considering a return to Iran. So, the JCPOA lifts a significant number of sanctions that are directly linked to Iran’s nuclear program but what it leaves in place is a whole infrastructure of U.S. and UN sanctions that relate to other issues and other disputes between Iran and the international community. And that means that companies will still have to navigate a complex landscape in terms of compliance, in terms of legal restrictions and that landscape is much less appealing for U.S. businesses.

Q: But as far as the European Union states are concerned, they can invest in the Iran’s oil sector without any impediments. Isn’t it so?

A: Yes, that’s true on the surface. I think there are two things that they will still be wary of: one is these limitations around U.S. dollar-based transactions, and most international businesses even European ones will prefer to do lots of their trade and lots of their deals in dollars. And that may not be possible. We’re waiting for guidance from the U.S. Department of Treasury and depending on whether that guidance makes it clear that transactions and businesses can go ahead or remain restricted, that will have an impact. The other thing is the point that I’ve made about certain businesses and organizations within Iran remaining on sanctions list, and Western companies, European companies and others will still be cautious about ensuring they don’t have any business dealings with a company that is on one of those lists after Implementation Day.

Q: So with these restrictions which you talk about, do the European firms, especially from the countries that have had close ties and transactions with Iran prior to the imposition of the sanctions, find its market a lucrative and safe one so that they can undertake the risks of returning even if they are not able to do their transactions in U.S. dollars?

A: This is the question that is still under investigation. So certainly we’re seeing a lot of interest amongst the European countries in finding out more about the terms of the IPC and that exactly what projects will be available for them to bid on. But I think there is a gap between that interest and actual financial commitment to doing deals, and companies will only move from a level of interest to committing to deals if the return is seen to be attractive and if the wider market conditions also support it, because we are seeing Iran’s return against the backdrop of a very dramatic fall in oil prices, much lower investment plans amongst oil and gas companies globally. So, Iran is competing for smaller part of upstream investment and that’s why it needs to come out ahead of alterative locations that might have a lower political risk.

Q: It’s expected that China will become the main client of Iran’s crude once the sanctions against the country are lifted completely. Prior to the enforcement of the EU oil embargo, Italy, Spain, Greece, France and Belgium were the main importers of Iran’s oil in Europe. Greece used to buy 53.1% of its consumed oil from Iran, which is a very large figure. Now that they’ve turned to alternative suppliers, what can make Iran their foremost crude provider again?

A: It appears the Iranian Oil Ministry is already beginning the initial work to identify and reopen links with buyers who have stopped buying Iranian crude in recent years because of sanctions. And I think European countries and the European market will be a high priority target for Iran as it tries to widen its pool of costumers. There are two things that I think will be most important to buyers: one is the simplicity of transactions. That means that first and foremost, the EU and the U.S. sanctions preventing transactions are lifted, but also that associated issues like hiring tankers, making the transaction payments, getting insurance for cargos whilst they’re sailing, all of those are straightforward and easy, provided that the path can be cleared of impediment. Then the second question becomes how attractive is Iranian crude relative to alternatives that are available. So, for instance, we had seen the Kurdistan region in Iraq now exporting substantial volumes to the Mediterranean market by Turkey and reportedly offering discounts, offering favorable terms on some of that oil to find buyers. So, the buyers will have the option of considering different sellers and they’ll be looking for what’s the most competitive and attractive in terms of quality, in terms of the reliability of supply and in terms of price.

Q: So, do you consider this new model of IPC contracts adequately attractive and dependable so that these countries mostly from the Western Europe that purchased enormous deals of Iran’s oil and also companies such as Italy’s Eni, Royal Dutch Shell and British Petroleum that used to invest in the country’s energy sector enormously would be motivated to return to Iran’s market and resume their investment?

A: Let’s approach this in two parts. I think the first part is for buyers of crude; they won’t be too concerned about the terms of the IPC. The main question is, “is Iranian oil available?”, “is it easy to buy?”, and “is it well-priced?” And I definitely think we will see an increase in Iranian exports. I think we’ll see Iranian oil returning in some volume to European buyers. Potentially, there are a lot of key buyers such as South Africa, Singapore and Taiwan as countries that used to quite regularly purchase Iranian oil but have stopped in recent years. So, on that side, I think the question is more how much additional oil Iran can produce and sell and if it can make it attractive enough for buyers to pick up in large volumes.

On the upstream side, as to certain companies like Eni, BP, Shell and Total – companies that had been involved in the Iranian oil sector and gas sector before sanctions, I think we will see a slow process of them returning and deciding whether to invest. I think the IPC terms are a big improvement on the old contract model. I think they have done enough to keep the companies interested, but it may be some time before the very biggest companies from Europe decide to make substantial financial commitments. Perhaps, we will see smaller companies moving in first or we might even see the big companies starting with relatively small investments to test the water and understand better what the opportunities in the Iranian market now look like.

Q: The noted economist Anatole Kaletsky, who had once predicted that the oil prices might fall to $20 a barrel, has recently suggested that Iran is capable of producing oil at the cost of only $1 per barrel while the production cost is anywhere between $10 and $12 a barrel for Saudi Arabia. What’s your viewpoint about his observation?

A: Well, certainly some of Iran’s reserves are the kind of low-cost conventional crude reserves that made the Middle East a central source of global oil supplies over the last century. Iran has very large reserves and many of them are easy to access. I think that’s also true of Iraq and also true of Saudi Arabia and several other countries in the region. But for Iran, I know a couple of things: in some places, the geology is more complex. For instance, many of the reserves are offshore and that does add some costs. The second thing is that we’ve had a long period of underinvestment in the infrastructure to extract, move and export the oil and that will also add to the costs. So, whilst certain fields might have very, very low break-even costs at the wellhead, that’s just getting the oil out to the ground, we need to look at the full costs of bringing that oil to market. And I think for Iran, that does mean that it’s likely to be comparable or maybe even a bit higher than Iraq or Kuwait or Saudi Arabia on average.

Q: Do you have specific details on the quality of the crude that Iran offers? Some analysts used to suggest that Iran is providing high quality oil that is not usually available on the Saudi or Kuwaiti or Iraqi market and that’s why many European countries prefer to buy crudes from Iran rather than turning to the Arab countries in the Persian Gulf. Is it a well-substantiated assumption?

A: Iran produces a few different qualities of oil; the two main types are heavier grade of oil – certain Nowruz and Soroush grades, and I believe there are some discussions about introducing an Iranian heavy-grade. That is suitable for some refineries and attractive for some countries particularly in Asia to purchase, but it isn’t as appealing to European plants just because of its technical characteristics. The other type of oil that Iran produces is a lighter grade; it’s higher quality in that sense and that is better suited to European markets. However, I don’t think that gives it an advantage over all of the Arab countries. I think it’s similar, for instance, to some of Iraq’s lighter grade, similar to some of Saudi Arabia’s lighter grade. So, the reality is in 2016 and potentially beyond, we are going to see competition between the Middle Eastern suppliers. We’re going to see them all offering oil of quite similar qualities in a market that has substantial amounts of supply in it and that means buyers will be looking for competitive pricing; they’ll be looking for Iran to offer discounts or to offer other incentives to buy Iranian oil over oil from other suppliers.

Q: Well, you talked about the prices. What can Iran do to bring its export back to the pre-sanctions levels? It’s widely asserted that the global markets are saturated and OPEC has forecasted that prices won’t go back above $100 until 2040. So, is it reasonable for Iran to cut off prices further and boost the export in order to encourage the growth of demand?

A: Well, my expectation is over the course of this year, we’ll see the oversupply in the global market fades away because of lower investment in non-OPEC countries in oil production and because of rising demand. But the pace at which Iranian oil comes back following the lifting of sanctions will definitely affect that global market balance. I think the main challenge for Iran certainly this year is going to be a technical one: simply how much additional oil can they produce from existing fields until Western investment is returned, and we’ll start to see the effects of that investment on the Iranian production levels. But if Iran surprises, if it produces more oil quickly, then yes, that may add to the global oversupply and that could be negative for prices. But I’m certainly expecting oil prices to increase in the second half of this year and that’s even assuming more Iranian oil coming into the market.

Q: Iran’s Foreign Minister Javad Zarif has recently implied that the Implementation Day for JCPOA is approaching and it would be enforced in a matter of days, also confirmed by the Secretary of State John Kerry. How much would the removal of the sanctions affect the oil prices? Do you think it would further contribute to the downfall of the prices? What kind of fluctuations should we expect following the termination of the sanctions on Iran?

A: Well, the oil market has been closely watching each step of the JCPOA. So, it won’t come as a surprise to most market participants when Implementation Day is announced. And maybe it happens earlier than people were expecting last year, but it isn’t a substantial change; however, it’s worth noting that at the moment, the market is very boorish and the sentiment is very pessimistic and that’s why we’ve seen prices fall so far over the course of the first week of the year even with rising Middle Eastern geopolitical tensions. And so, I do think the day of the announcement of sanctions relief, you may see some further selling and some initial knee-jerk reaction in oil prices, but I think overall, Iran’s return has been factored in to the market for the year. It shouldn’t have a big impact; the question would only be how much more oil Iran will be producing by mid-year and how much more oil it will be producing by year end.

Q: What’s your prediction for the future of global markets following the implementation of the nuclear deal? What significant changes do you anticipate to happen in general, especially in terms of Iran’s exports to the countries that are already waiting for the resumption of oil trade with Tehran?

A: My predictions for the year is that if we start with Iranian production, I think following [the] Implementation Day, we’ll see Iranian production increase by around 3-400,000 barrels a day but I think it will be difficult for Iran to increase by more than that certainly in 2016, because of the technical challenges and because they need foreign expertise and investment to return and then some period of time for that to have its effect on fields. Looking at the wider market and including that extra oil from Iran, I think we are looking at a market where prices will remain very low in the first half of the year particularly in this quarter. I think as we’re going to the second half of the year, we are going to see the effects of lower investment in production elsewhere in the world and rising demand bringing down the size of the oversupply, tightening the market up and I think that’s going to prompt quite a significant re-pricing with oil prices going back above $60 a barrel late this year.

Q: To conclude, let’s discuss the recent Tehran-Riyadh diplomatic row, as well. What’s your perspective on the impact of these recent tensions between Iran and Saudi Arabia on the global markets? Do you think it would be going to complicate the international oil trade as both of them are OPEC member states and need to cooperate with each other within the framework of this international organization? Will these tensions affect the prices significantly?

A: I think the tensions between Saudi Arabia and Iran are definitely a concern for Middle East regional politics and in particular some of the conflicts that are going on in Syria, in Yemen, the situation in Iraq –I think all of these can feel some spillover from the heightened tensions between the two predominant regional powers. For the oil market, I think the effects are less significant at least in the near term. I don’t believe this will substantially change the oil policy of either Saudi Arabia or Iran, and OPEC is having a difficult period in terms of not being able to operate cohesively or collectively, but I think that was the case even before the increasing tensions and it won’t be changed very much by the current standoff. It’s notable that even with all the headlines and developments in the Middle East, oil prices have fallen this week quite dramatically. I think that probably reflects the lack of concern in the market about the risks to supplies, the risks to disruption. Well, that might be right in the short term; it’s probably too complacent in the medium term because an unstable Middle East, a politically-complicated Middle East is not good news for oil supplies and I think that could be a problem for oil markets and for the global economy in the future.

Key WordsIran, IPC, Improvement, Oil Contract Model, International Investors, UN, US, Sanctions, JCPOA, European Union, Impediments, European Firms, Risks  Eni, Royal Dutch Shell, British Petroleum, Investment, Oil Prices, Arab Countries, Pre-Sanctions Levels, Global Markets, Saudi Arabia, Mallinson

*Photo Credit: Mehr News

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