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Why oil investors won’t be rushing into Iran’s upstream just yet

Good reasons to invest in Iran’s energy sector abound. But for now discretion remains the better part of valour

The lifting of nuclear-related sanctions removed an important barrier to foreign involvement in Iran’s oil and gas industry, but attempts to attract investment and technology are unlikely to work as quickly as the government would like. Too many areas of uncertainty remain – beyond those associated with the oil price and geopolitics – including lingering financial sanctions and hostility to foreign investors within Iran.

Nonetheless, there are good reasons for optimism. First, Iran has considerable production upside, much of which depends on the application of capital, technology and expertise that only international oil companies (IOCs) can realistically provide – secondary and tertiary production techniques for its many ageing oilfields, for instance.

Second, the government has powerful motivation for attracting investment. “The oil industry is in a complete mess,” says Mehdi Varzi, an independent energy consultant. “There’s no way Iran can reach any of its production targets without a massive infusion of money and technology.” That is reflected in the size of the sums needed. President Hassan Rouhani has said Iran wants to attract as much as $50bn a year in foreign capital, much of which will be directed at achieving ambitious growth in oil-production capacity.

Third, there are – in theory – opportunities for a large number of firms, of varying sizes and in a wide array of domains; while the initial goal may be to recruit IOCs to upstream development, help is needed in other sectors too, including refining, petrochemicals, pipelines and, eventually, liquefied natural gas. “There is endless opportunity,” says Iman Nasseri, a senior consultant and member of the Iran team at Facts Global Energy (FGE), a consultancy.

Fourth, the oil ministry, under Bijan Namdar Zanganeh, has invested considerable time and resources in designing a new upstream licensing system, the Iran Petroleum Contract (IPC). The ministry’s assiduousness shows Iran means business.

Yet, these days, the terms of investment need to be as enticing as the geology. And, for now, Iran’s formidable hydrocarbons potential may not quite be enough to tempt IOCs to overlook the many risks. “If I were a big oil company, I wouldn’t be rushing to the front of the queue to put money in,” says Paul Stevens, a Middle East specialist at Chatham House, a think tank.

With prejudice

The biggest problem is that, despite the headlines, not all sanctions have been removed. So while doing business in Iran is now possible, it remains extremely difficult. The US has lifted its so-called secondary sanctions – those that apply to non-US individuals and companies. But primary sanctions – banning US nationals and companies from engaging in business with Iran – remain active. Among other things, they prohibit US banks from clearing Iran-related transactions in US dollars. Although the lifting of secondary sanctions technically frees non-US banks to manage Iran-related transactions in other currencies, most banks – as well as oil companies and contractors – are “petrified” of infringing sanctions still in force, says a British government official involved in developing commercial relations with Iran. Certainly, US companies will not be among the first investors, which are likely to be predominantly European.

“Any bank – even a European bank that might now technically be free of most of the previous sanctions – is going to be very wary of treading in Iran without a specific exemption or until the situation, and the application of the sanctions that remain in effect, become a lot clearer,” says Rob Patterson, a Middle East-based partner of Vinson & Elkins, a law firm. “We’re aware of a client that, while technically now free to carry out certain activities in Iran, is having great difficulty persuading its bankers that sanctions no longer apply.”

Ts and Cs

Investors need more assurances from Iran too. While Rouhani’s government recognises the country’s need for technology and capital, and the indispensable role of foreign companies in providing both, hardline conservatives continue to attack the nascent IPC as an unconstitutional loss of sovereignty over the country’s natural resources. Following February’s parliamentary elections, the Supreme Leader and parliament must quell that opposition by making unequivocal statements that the contracts are legal and not at variance with the constitution, says Varzi. “We need a political framework for these contracts to be seen as unbending.”

First announced two years ago, the IPC seems to be a big improvement – for private investors – on the buy-back, the unpopular and unsuccessful contractual model previously in use. The buy-backs were inflexible, capping cost recovery and remuneration. Developers couldn’t book reserves and didn’t benefit if production exceeded targets. Contract duration was too short. And developers had no control over production because state-owned Nioc took over the fields once they had come on stream.

The IPC appears to address these concerns, although the ministry probably won’t reveal the small print until a London conference planned for May (it had planned to do this at a London event in February, but pulled out, ostensibly because the UK couldn't issue visiting Iranians with visas in time.) So far, the basic information on the IPC that the oil ministry has made public suggests financial rewards will be linked to the size of discoveries, the rate of production and the complexity of developments. Their duration, up to 25 years, is reasonable, and they may even include mechanisms allowing IOCs to recognise revenues in their financial reporting that they couldn’t previously – akin to booking reserves, if not in name.

Still, considerable uncertainties remain. While some aspects of the IPC seem more in keeping with a production-sharing agreement than a services contract, companies will need greater visibility over likely rates of return, which were hard to predict under the buy-backs but mostly turned out to be unacceptably low. Dispute resolution is another grey area. Although the government has accepted the principle of arbitration – as opposed to disputes being handled in Iranian courts – the seat and rules of the arbitration body aren’t established.

Local partnerships will also make some investors fret. Local content is subject to a contractual minimum of 51%. FGE’s Nasseri points out that large pools of cheap skilled and unskilled labour, and know-how developed in spite of sanctions, may end up being useful. But although the oil ministry plans to provide a list of certified local contractors, the mechanisms for identifying financially solvent and technically competent partners – screened for bribery and corruption – still haven’t been spelled out. And, partnerships with some companies – those, for example, with links to Iran’s Revolutionary Guards – may constitute an infringement of sanctions.

Even Nioc may prove a weak partner. Its finances and skilled workforce were severely depleted during Mahmoud Ahmadinejad’s eight-year rule and it desperately needs a large, sustainable upstream budget. It also needs new scientists and engineers, and access to technology. Indeed, technology transfer is another IPC requirement – and yet another element of risk, since there is little information on what technology transfer will entail in practice and how it will be managed. 

Several other prominent country risks need to be considered, and may linger for years. Chief of them is the threat of “snap-back” sanctions: the possibility that Western governments might re-apply the embargo if Iran fails to comply with the nuclear deal. Oil firms are unlikely to commit themselves to large investments until they see consistent evidence of Iran’s commitment to the agreement, which will take time. Even geology – supposedly the big draw – might get in the way. Many of Iran’s producing fields were in a grim state even before sanctions and more than half of output comes from fields discovered over 50 years ago. Chronic underinvestment in and poor management of upstream assets and infrastructure – especially under the crushing weight of sanctions – could create operational bottlenecks and make upstream development more onerous than companies hope.

Ultimately, the considerable uncertainties concerning the state of geology and infrastructure, the contractual terms Iran is prepared to offer, and the country’s zeal in keeping to its side of the nuclear deal reflect an investment culture whose laws, processes, assets and institutions have scarcely been tested by foreign investors – and not at all for several years. Attempting to navigate such a labyrinth of uncertainty, while staying on the right side of residual sanctions, may be a risk too far.


Investing in Iran

New changes to the EU and US sanctions regimes for Iran have important implications for international investors in the energy sector, including:

EU persons may now import, purchase, swap and transport crude oil and other petroleum, gas and petrochemical products from Iran, as well as invest in and export equipment and technology for those sectors and provide technical assistance in relation to such items.

The EU no longer restricts financial transfers to and from Iran, and EU persons may now, among other things, provide export credit, guarantees, insurance or reinsurance in support of trade with Iran.

EU persons are now permitted to make funds available to a number of persons and entities, including the Central Bank of Iran and the NIOC, that have been removed from the list of designated persons subject to asset freezes and visa bans.

The US has waived so-called “secondary sanctions” applied against non-US entities and removed over 400 parties from the Treasury Department’s Specially Designated Nationals and Blocked Persons List (the SDN List).

However, US primary sanctions continue to prohibit involvement by US persons in Iran-related transactions and the supply of goods or services, including financial services, from the US to Iran. 

Many have pointed to the possibility of a “snap-back” of US sanctions depending upon the outcome of the 2016 US presidential election and instability within the Iranian leadership.

By Chris Caulfield and Ginger Faulk, Baker Botts LLP

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