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Omar Mawji

Omar Mawji

Omar Mawji was previously an investment analyst at Katusa Research in Vancouver. He also served as the lead oil & gas analyst for institutional investors…

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This Contract Could Help Iran Win The OPEC Oil War

Iran Oil

The mere mention of OPEC is almost instinctively accompanied by an automatic reference to the Kingdom of Saudi Arabia, as if the two are practically synonymous. As an oil producer, Saudi Arabia is in a league of its own within OPEC. It produces over 10 million barrels of oil per day, which is around the same amount of production coming from Iraq, Iran, and Kuwait combined.

Needless to say, Saudi Arabia has acted as the unofficial leader of OPEC. Its domestic oil production policy clearly influences and is invariably reflected in the decisions coming out of OPEC meetings. In the midst of the current continued policy of Saudi Arabia and OPEC to keep pumping in order to preserve market share, a developing dynamic within OPEC may cause a dramatic change in both its power and leadership.

Iran’s Recent Emergence

For several years Iran was subjected to sanctions, which not only prevented its oil production from reaching the U.S. and Europe, but also created dramatic declines in exports to China, India, and Japan.

(Click to enlarge)

Even as Iranian sanctions were lifted in 2015/2016, the country remains behind in production growth from its largest OPEC competitors Saudi Arabia and Iraq. While Saudi Arabia and Iraq increased production from 2010 by 15 percent and 90 percent respectively, Iran has lost 17 percent of its production. This meant that not only was Iran losing market share to its closest OPEC competitors, but the country was missing out on growing production in one of the highest priced oil environments from 2011 to 2014.

In a battle for market share, Iran has been struggling as it is only just beginning to regain market share around the world. Much of the global fight for market share is occurring in four key markets that make up 36 percent of global oil demand: the European Union (EU), China, Japan, and India. Sanctions imposed on Iran’s oil exports meant that it was unable to compete with its direct competitors within OPEC. This gave Saudi Arabia the opportunity to ramp up production and grow market share in those four key markets. Additionally, Iraq was able to almost double production from 2011 and gain significant market share in the EU, China, and India. From 2011 to 2014, Iraq increased market share in the EU from 3 percent to 7.5 percent and in China from 4.7 percent to 9.7 percent.

Iran Ready to Compete?

Since the lifting of sanctions in 2015/2016, Iran has been in the process of making critical oil and gas investment decisions that could not only change its position in the global market, but also make it a much larger competitive threat to the leadership of Saudi Arabia in OPEC.

In a departure from the past, a key strategy to building its oil sector back up has been a shift towards embracing foreign investment. Originally, Iran had tried to attract foreign investment in oil and gas fields through a “buy back” investment model for the exploration and development of Iran’s fields. Essentially international oil companies (IOCs) would explore and develop an oil and gas block and the IOCs would then hand over the project to the National Iranian Oil Company (NIOC) at production. If successful, the IOCs would be reimbursed for pre-determined funds spent on the project based on a rate of return of 15 to 17 percent, but would not be reimbursed for cost overruns, increases in production, or excess exploration risks.

The problem with the “buy back” model was that IOCs took on all the risk of exploration and development but had limited upside as they could not participate in the production of their projects. Additionally, these exploration and development contracts lasted only 3-5 years. IOCs would not get a stake in the project they explored and developed and could not book reserves on their balance sheet.

Iran’s New Iranian Petroleum Contract (IPC)

Iran introduced a new Iranian Petroleum Contract (IPC) model in November 2015 that will result in a major shift away from its original “buy back” contract model which has been employed for the past 20 years. The new contracting model structures investment in Iran’s upstream oil and gas sector by way of joint venture (JV) where the NIOC will own at least 51 percent of the JV. This model requires the involvement of the IOCs at the exploration, development, and production stages – leading to IOCs participating in the upside of their discoveries and development. Contracts between IOCs and the NIOC will last 20-25 years and provide payment flexibility on the risk taken to explore and develop difficult fields. Related: Utah Oil Sands Set For A Bright And Clean Future

Once the JV project is in production, the IOC will receive a payment for its service by a measured volume of production and the NIOC will repay costs during the exploration and development stage. A JV management committee, made up of members of the IOC and NIOC, will review costs from the exploration and development stage annually in order to approve any necessary cost overruns.

The participation of IOC’s in the production of projects brought through commercial development is a big step for Iran. The new IPC is a modified form of a production sharing contract (PSC) in order to abide by the Iranian Constitution, which does not allow production sharing. PSCs have been implemented in Iraqi Kurdistan, Oman, and Egypt where production is split between profit and cost oil. Profit oil is usually 40 to 60 percent of production and is split 70 to 85 percent toward the national oil company (NOC), with the remaining profit oil going to the IOCs.

Cost oil is used by the NOC to recover operating costs and is usually 40 to 60 percent of production – any surplus in profit from cost oil is usually shifted to be split from profit oil and any cost recovery shortfall can be recouped in the following years. For Iran’s new IPC, cost oil is expected to be covered through a maximum of 50 percent of annual production from the JV. Although there is no profit sharing under the IPC, the service fee paid through volumes of production annually can be considered the profit oil from a traditional PSC.

The IPCs from Iran are not without faults. The ambiguity of the IPC leads to many questions as it relates to base fees paid to IOCs, the oversight and qualifications of the JV management committee, clarity on the independent sale of production, and whether or not companies can book reserves on their balance sheet.

An important issue for IOCs is the booking of reserves as this gives companies increased value and the ability to leverage reserves for financing. Under the Iranian Constitution, all the country’s energy reserves belong to the state. The IPC, however, may maneuver around the Iranian Constitution, much like with the concept of production sharing, by using the long-term production contracts of 20-25 years as a way to book the contract as an asset similar to the booking of reserves – this is currently being done in Iraq.

Dichotomy within OPEC

While Iran’s IPC has certain ambiguities, the NIOC’s Managing Director, Roknoddin Javadi, hopes to clarify these issues as the NIOC plans to have an IPC draft completed by July 2016 so that Iran can open bids for its blocks. This transition from a “buy back” model to a virtual production sharing contract puts Iran in a unique position within OPEC. Iran holds the 3rd largest oil reserves in OPEC and would be the only country between the top three producers in OPEC to significantly open its markets to foreign investment.


(Click to enlarge)

Saudi Aramco, Saudi Arabia’s national oil company, has remained a sole proprietor of Saudi Arabia’s producing onshore fields and Iraq has opened itself to IOCs in a very limited form through service contracts that have seen IOCs reluctant to invest in Iraq unless contracts are changed.

Iraq pays its IOCs a fixed value fee equivalent to barrels of production for their service in Iraqi oil fields from the oil the Iraqi government sells. Part of the development costs is split between the Iraqi government and the IOC and both the Iraqi government and the IOC operate the field through a JV. Related: Oil Supply Disruptions Highest In Five Years

However, companies like BP and Royal Dutch Shell are requesting better terms on their contracts with Iraq as they prefer a model similar to a production sharing contract. The lower oil price and ongoing threat of Daesh in Iraq is forcing the Iraqi government to miss payment for services to IOCs, cut its oil budget and, in turn, force IOCs to cut their own development budgets. BP, Lukoil, Eni Spa, ExxonMobil, and Royal Dutch Shell were asked to cut their 2016 development capital by a cumulative 33 percent from 2015 levels. Based on these cuts, BP and Shell have indicated it will be difficult to ramp up production into 2016 and will require more attractive terms to keep investing in Iraq.

Iran’s preemptive shift to an IPC similar to a production sharing contract has put Iran in a unique position. If the IPCs are deemed successful in bringing in foreign investment by IOCs, Iran’s adoption of global technology and innovation in the oil and gas industry will directly compete with the efficiency of Saudi Aramco. OPEC could see a dramatic shift in power as Iran invites more investment into the country’s upstream, midstream, and downstream segments of the oil and gas industry.

The adoption and support of IOCs and the technology they bring to Iran’s aging fields and infrastructure could catapult Iran into direct competition with Saudi Arabia, surpassing Iraq, and encroach on Saudi Arabia’s established market share. This could push further opening of oil and gas markets in Saudi Arabia, Iran, and Iraq or see a globalized Iranian oil and gas industry as a competitive dichotomy to Saudi Arabia’s domestically insulated industry.

Just as OPEC lost control over global oil production with increased production, technology, and innovation from the U.S. in 2011, Saudi Arabia stands to lose its control over OPEC as Iran’s oil and gas industry opens to technology and innovation, resulting in increased production.

By Omar Mawji via Geopoliticalmonitor.com

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