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Research & Analysis

By Salma Essam

Iran has been taking steps towards boosting its oil dependent economy after finally lifting international sanctions against its energy sector. Announcing the new scheme of the oil and gas contracts, known as Iran Petroleum Contracts (IPCs), has encouraged foreign investors to strike deals with the Islamic Republic. As the new contract model replaced the old buybacks scheme, it has also raised critics and concerns in Tehran, leaving the future of the new oil contract up for debate. These disputes over the new IPCs, nevertheless, proved misplaced and invalid.

Buyback: Inflexible Money Losers

The new era of petroleum contracts in the Persian state kicked off against the backdrop of the Joint Comprehensive Plan of Action, which led to the lifting and termination of several energy and financial sanctions against Tehran. Iran’s oil and gas industry requires huge investments and financial resources to reach production targets that come in line with the country’s field capacities. Thus, the dependence on international oil companies (IOCs) is deemed essential if not inevitable, yet the buyback system has been less enticing to them.

The buyback system was adopted since the breakout of the Islamic revolution in 1979. At the time, the Iranian oil ministry did not approve any contracts that provided a foreign entity with rights to ownership or co-ownership of the country’s hydrocarbon wealth. Even though these contracts were initially aiming to attract foreign investments, the three generations of the buyback contracts did not showcase successful trials.

The first generation of the contracts was a simple buyback agreement between the National Iranian Oil Company (NIOC) and a foreign company. In his research on Iran’s New Generation of Oil and Gas Contracts, published in the Journal Political Risk in 2015, Middle East Industry Expert at Corr Analytics, Reza YeganehShakib, wrote that under this agreement, the company, as a contractor, got paid for the services it provided with a fixed price. It was seen as problematic from the IOCs’ perspective that if the contractor found a commercial oil field during the exploration phase, it would not necessarily become the field developer. This condition prompted a degree of uncertainty, as Shakib elaborated in his analysis: “This may have caused a low level of interest among international companies since they could not be certain about recovering the operations costs and capital investments during exploration.”

The second generation of the oil buyback agreements also covered all phases of oil exploitation, from exploration to production, that were not necessarily assigned to the same contractors. An improvement was introduced when the contractor was able to successfully finish the exploration phase, which, under upgraded legal arrangements, qualified him to move to the development phase of a field directly, and without a new contract. Nonetheless, this shift would have occurred again at a fixed and predetermined price. But because operations costs are of volatile nature, this legal setting has significantly curbed the contractors from investing in the Iranian oil market.

Unlike the first and second generation contracts, the third contract was different in terms of that the exploration and development phases were already jointly included in a single contract. In addition, the cap on the price of the contract was agreed on in a public tender. The deals over oil operations turned into “an open tender contract, with an open capex or open capital expenditure,” according to Shakib’s report. The cap on the expenses was determined after the Front End Engineering Design (FEED) and the public tender phases. During different phases of the operation, the cap on expenses was subject to change depending on the operation cost. On the other hand, the contractor still did not have any rights to ownership of oil and gas inside the reservoirs.

According these buyback contracts, the IOCs got their costs covered and an agreed upon profit paid out of the oil and gas gross profit, assuming the field produces the volume as initially agreed upon and the international energy prices are high enough. The foreign investor was, therefore, often reliant on the NIOC to operate the field to a sufficient standard, in order to ensure that there would be adequate production to meet the foreign investor’s costs and remuneration requirements. Additionally, the IOCs had no share in the project’s profit after being repaid the activities’ costs.

Moreover, the IOCs were not allowed to book oil concessions and this added fuel to fire for foreign investments in the country, as Joanna Addison, Partner in Herbert Smith, and Mark Hatfull, Associate in Herbert Smith Freehills explained in their analysis – New Iranian Petroleum Contract Could Fix Buyback Issues, published by Law360.

The current trends in the global oil markets, especially the relatively higher supply and lower demand of crude, are clear indicators of fluctuations in the value of energy, based on which all the rewards and paybacks are calculated. Therefore, Iran had to bring forward a new contract model that would reflect upon these new developments, as the country is re-entering the global oil market.

Novelties of IPCs

As the Iranian government perceived it had to change its policy, Tehran has introduced the new model of contracts, the IPCs. These are addressing a number of key challenges and concerns with regard to foreign investments in the oil and gas industry. The lack of incentives to foreign capital was a cause of concern to many Iranian entities. Moreover, the country lacks improvements of its obsolete technology, the state is in dire need of developing its huge gas reserves, and the need for development of Iran’s riskier or more mature fields is seen as essential for the growth and independence of the country’s oil and gas sectors.

IPCs have thus launched a new beginning of the energy contract models for the country. The changes that IPCs bring relate to the ownership dilemma. According to the legalities of the newly devised contractual model, it is established that a national oil company (NOC) or its subsidiaries, along with international investors, will form a joint venture (JV) company to carry out operations in any of the three phases of exploration, development, and production of oil and gas reserves. The joint operating company can also take charge of the enhanced oil recovery phase in collaboration with another company in order to strengthen its technical and financial capacity. The foreign investor is thus able to participate in the production and it will not be subjected to the same level of operation risks as previously imposed by the buyback contract.

Article 2, Section 1 of the IPC states that if a contractor is successful in finding a commercial-scale field or reservoir, the consecutive phases of the operation contracts, including development and production, will be given to the same company. Contractors will be paid based on each barrel of oil produced. Besides the contract price, there will be rewards paid out for each extra barrel of oil, each 1,000 cubic feet of natural gas or each barrel of gas condensates produced in addition to the minimum agreed production amount, as stated in Article 1, Section 20 of IPC.

Another positive change seen in the contract is the longer duration of the deals for international companies. For the exploration and appraisal of greenfield projects, the term is anticipated to be four years. On top of that, IPCs have also introduced a potential two-year extension for exploration and a further two-year addition for appraisal activities. The development and production phases are to last 20 years plus a potential five-year extension for IOR/EOR operations is granted.

In the IPCs, 50% of the income from sales is allocated as “cost oil” for full cost-recovery purposes. In efforts to create incentives to drive down production costs of IOCs, a proportion of the saved cost will be paid to the investor in rebates. This will amount to as much as 5 to 10 barrels of oil for savings that equal to the cost of 1,000 barrels. There is also an incentive mechanism to encourage the investor to stick to the maximum efficient rate of production of the reservoir.

The IPC model also allows the investor to benefit from possible increases in oil prices over the span of the contract. In buyback agreements, the contractor’s remuneration fee was set based on the project’s rate of return, which is not present in the IPC model anymore. The recent model only indicates remuneration and payment conditions. In other words, instead of a constant figure as payment amount to the contractor, IPCs provide payments appropriated to the geographical conditions of the field or even the fluctuation in the global oil market, which may often add up to higher fees that contractors can receive. This change, in particular, is in the interest of international contractors and encourages them to invest in the Iranian oil and gas fields.

Middle East Industry Expert, Reza YeganehShakib, pointed out another incentive of the IPC model in his analysis – Risks and Benefits for Foreign Investors – published by Trend News Agency in November 2015. According to him, under Article 6, Section 2, Subsection 2, the contractor could be compensated with another exploration block in case the exploration is not successful in finding a commercial-scale field or reservoir.

IPCs have highlighted the need for attracting foreign investments that are essential for ramping up oil and gas production in the country and boost Iran’s floundering economy after years of sanctions and disinvestment. In this sense, changing the legal framework is paving the way for the Iranian oil industry to strike several deals with foreign investors.

Dispute over IPCs invalid?

The IPCs have, nonetheless, been exposed to criticism, along with the stricken deals. Oil officials disagree on whether foreign companies are required to develop natural gas and oil in the country or not. Others are in conflict over the way private Iranian companies should be involved in the activities despite little experience in managing exploration and production projects. Another group of critics view these deals as dispensing the country’s wealth, according to the Wall Street Journal’s analysis – Iran’s Political Battles Pose Risks for Oil Contracts – published in February 2015.

Iranian representatives appear to be sensitive about oil field ownership. For many in Iran’s predominantly conservative parliament, the IPC scheme effectively means that the state will be transferring partial ownership of the oil fields to foreign operators, which, they argue, is a violation of the national constitution. Internal tensions eventually led to the cancellation of a conference that was to unveil the IPC model to the international audience from among oil companies. The conference, scheduled to take place in London in February 2016, had already been postponed five times before it was eventually cancelled.

The IPC, according to Reza YeganehShakib, does not violate the constitution. The contract simply changes the way foreign oil companies are paid for their work on Iran’s fields—in crude extracted from these same fields or in money from the sale of the crude. No right of ownership is pledged in the new contract, as Shakib added in his analysis, “the Iranian oil ministry has not approved any contracts that provide a foreign entity with ownership or co-ownership.” Iranian companies are to take 51% in every joint venture agreed under the new contract.

In fact, YeganehShakib further argued, although the new generation of Iran oil and gas contracts is named Iran Petroleum Contracts, they resemble the buyback system, yet provide better legal frameworks for IOCs, with better incentives and more flexibility. The disputes over the new IPCs thus seem rather unsubstantiated, merely a fear for losing a parliamentary dispute or resistance to change.

While the dispute continues, Iran’s Oil Minister, BijanZanganeh, has explicitly stated that the country is aiming to attract investments that amount at $185 billion in oil and gas production, which will occur even despite any serious opposition from the parliament. Already in late November 2015, the Persian Gulf country pitched 52 oil and gas development projects worth more than $30 billion, including 29 new and currently producing oil fields, as well as 23 gas developments.

In a market where excessive supply of crude oil does not comply with the global demand, foreign investments become essential in revitalizing the industry. Iran is moving forward with a contract model that will secure the country with a huge market share and allow for further market competition against OPEC and non-OPEC states. The country, however, may later need to rethink some other obstacles related to the revival of its hydrocarbon industry, particularly those that forbid ownership of reservoirs, in case foreign investments decide to divert their interests towards other competing states.