Re-engaging Iran's oil and gas sector

With the progress of the Iran nuclear agreement through the US and Iranian political establishments, the sector today stands on the edge of entering a new era, one that can benefit both Iran's economy and as well as worldwide stakeholders.

While Iran may be the 7th largest oil producer, it remains a sleeping giant within the global energy sector. Despite being home to the world's second largest natural gas and fourth largest oil reserves, Iran only produces 3.4million barrels per day (b/d) and exporting natural gas to a handful of neighbouring countries.

The heart of the issue lies in a lack of foreign investment due to a number of troubled relationships, namely the ongoing nuclear debate, which has seen Iran face four rounds of UN sanctions, and numerous additional sanctions imposed by the both US and the EU limiting its oil and gas output, as well as financial, shipping, and insurance institutions that are essential in supporting the sector

The election of Hassan Rouhani in 2013 as the new President brought a fresh approach to the nuclear issue, leading to the adoption of the Joint Plan of Action in November 2013. This subsequently resulted in the Lausanne Accord on 2 April 2015, and the comprehensive nuclear agreement signed on 14 July 2015.

One of the most important agreement outcomes for Iran will be the lifting of sanctions on its energy and banking sectors. This will enable Iran to access the international banking system and to restore and grow foreign investment into Iran. Iran has begun reviewing its approach to how international oil and gas companies, in particular those from Europe and the US, can return to Iran.

Iran's oil fields have relatively high natural decline rates and, due to the lack of investment, a low recovery rate. Iran's Petroleum Minister has said that Iran requires as much as US$200bn in the oil sector, as well as significant investment in its gas sector. Iran also lacks any LNG technology for export, and majority of the gas exported is through pipe lines.

As a result, Iran also requires significant investment and new technology to meet its potential as a major energy supplier to the world market. However, the recent history of the "buy back" contracts which Iran has favoured had a poor track record in encouraging the massive investment needed by the industry. Initial investment is likely to be focussed on those oil and gas fields which straddle borders with Iraq or Qatar.

The post revolution Iranian Constitution targets foreign economic "domination" over the country's economy and forbids granting concession to "foreigners". Accordingly, the Petroleum Act of 1987 considered petroleum as a public domain controlled by the government and forbid investment by foreign entities.

Such legal limitations restricted the international oil companies (IOCs) involvement in Iran to only buy-back contracts. Buy back contracts were a type of risk service contract, whereby the contractor received compensation for its investment but never gained equity rights in the oil. Under the contract, the foreign contractor (usually an IOC) funded all the investment costs and implemented the exploration and/or production operations on behalf of the National Iranian Oil Company (NIOC).

Once the field in question had reached its contractual production level, the field was then transferred back to the NIOC and the contractor recovered costs plus remuneration on the previously agreed rate of return. The length of these contracts was typically between five and seven years and shifted much of the risk for cost overruns back to the IOC, so that the actual rate of return for the IOC could be reduced to almost nothing.

IOCs returning to Iran will expect to receive greater financial return from what was offered in the buy-back contracts. Iran has indicated its intention to create an environment that is more attractive to the IOCs and is currently finalizing its draft new Iran Petroleum Contract ("IPC") which is currently planned to be presented in Tehran in November. This new contract is expected to be a marked improvement over the previous generation of buy-back contracts by offering 20-25 years contracts and greater coordination between phases of exploration, development and production. Iran also aims to offer a greater rate of return to IOCs based on the complexity of the projects, and the possibility of forming joint ventures.

Even though Iran's Constitution and Petroleum Act views the natural resources as public and state owned, the IPC is expected to contain provisions that should allow investors to incorporate revenue into their financing reports. Like similar contracts in the region, the IPC will have provisions on local content (likely to be 51% of the contract), transfer of technology, and social corporate commitment. Overall, the new IPC is likely to offer a greater flexibility and better terms than previous buy-back contracts.

There remains a significant amount of uncertainty around the timing of when the Iran sanction will be lifted and how companies will react to the new environment. After all, many sanctions will remain in place, and the amount of time out of the world market and the economic isolation it has experienced will mean many business relationships and the mutual understanding of business practices will be starting from a very low level. What is certain is that an economic race to re-enter Iran has begun, and those on the forefront stand to benefit from the significant business dividend Iran's oil and gas industry offers.