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False dawn? Iran on the edge of the international oil market

Obstacles in the pipeline? A general view of the South Pars gas field, Iran. Abedin Taherkenareh

False dawn? Iran on the edge of the international oil market

In recent months, Iranian and foreign media have been abuzz with reports that a new generation of petroleum contracts aimed at foreign investors will be unveiled by the Iranian Oil Ministry later this year.

At first blush, it all seems positive enough. A discussion with international stakeholders at a London conference has been slated for September and a special revision committee has even been established to consult with domestic and foreign experts on how the new agreements can be structured. Iran wants to balance competing commercial and national interests in a more even-handed manner than the dominant buy-back model that prevails in Iran. The objective, as expressed by Iranian officials, is to arrive at a “win-win” solution for both foreign investors and Iranian counterparts.

However, it remains in doubt whether the new contracts can possibly avoid the strict limitations that are imposed by current Iranian law and complicated by the country’s fluctuating political climate. The revision committee’s work is, of course, further clouded by the ever-present doubts over Iran’s international political relations and the disincentive that gives to foreign investors. It is also unclear how Iran’s negotiations with the West over its nuclear program will affect the restrictions on foreign investment that currently isolate it from the international market.

Back in the fold

Assuming sanctions are lifted and Iran is able to achieve its real production capacity, then its re-emergence should lead to greater stability in international petroleum markets. That means we all have a stake in what happens next. It’s crucial to understand whether talk of a significant shift in the approach to oil and gas contracts will actually be backed up by action. The fear for foreign investors remains that all it amounts to is a spurious attempt to repackage the unpopular buy-back contracts which have endured for decades.

Under the buy-back system, international oil companies are permitted to enter into a contract in Iran through an Iranian affiliate. The agreement requires the international contractor to provide the necessary capital up front, and ownership reverts back to the National Iranian Oil Company (NIOC) or its subsidiary at the expiration of the contract.

This approach has been unpopular with international investors for a number of reasons. Consider the short timespans allotted for exploring and operating oilfields and the absence of production control despite the initial risk of operations. The impact of these deterrents is amplified by the financial structuring of buy-backs, which stipulate that assets acquired by the contractor will remain the property of the NIOC.

A representative of French oil giant Total stated in 2006 that buy-backs are “not the proper way for the transfer of know-how and technology.”

“In buy-back you develop fields and when it is finished you say goodbye to everything. You don’t know how it is produced. And it is exactly the problem,” he said.

In addition to such drawbacks, buy-backs are also vulnerable to the vicissitudes of domestic politics, as last-minute changes in the contract are often demanded by the local authorities. Conditions can ebb and flow with ever-changing international relations.

Legal obstacles

The trouble is that the origins of these buy-back agreements lie very deep. They can be traced to laws derived from Iran’s 1979 Constitution which continue to constrain the country’s commercial dealings over its natural resources. Specifically, Article 81 of the Constitution absolutely forbids the granting of oil and gas concessions to foreigners. That limits any significant changes to the existing model and precludes the reintroduction of Concessionary agreements, irrespective of the name given to the “new model”.

Other key provisions prohibit foreign “economic domination” over the country’s commercial life and stipulate that all large-scale industries be owned and controlled by the state, including oil and gas extraction.

In combination with restrictions in the 1987 Petroleum Act, it seems doubtful that foreign companies would be able to freely govern their operations. In essence, their ownership rights to petroleum resources and installations would remain vested in the government and the government would have the authority to manage them as they see fit.

This effectively limits any foreign ownership as we would normally see in production sharing agreements (PSAs) allowing the long-term granting of the use of oil fields, and which is one of the proposed amendments. Iran’s Ministry of Oil is also entitled to the ultimate ownership of all equipment, assets, property, capital investments including all installations used in Iran, according an article in the Petroleum Act.

The above law was drafted during the Iran-Iraq War, which influenced the definition of the government’s control over natural resources and “public wealth”. Against this backdrop, the current buy-back model was introduced to provide a degree of certainty to prospective international contractors and also negate the constitutional limitations. As this law was influenced by the necessities of the political climate during the war, it will in turn be necessary to reform the act in a manner that reflects the current political milieu.

The flaws in the buy-back system make it evident that these agreements must be fundamentally replaced with a new economically attractive model. Somehow, this must also be done in a way which preserves national sovereignty and public interest – and is politically palatable. While enthusiasm abounds for a new oil-rich entrant into the world energy markets, we should hold off on any premature celebration. The necessary modifications will not be possible without fundamental changes to the existing legal framework.