Speed of Iranian Economic Recovery - The Role of Oil and Gas | Mehdi Varzi

The Nuclear Negotiations and the Speed of Iranian Economic Recovery - The Role of Oil and Gas

A Talk by Mehdi Varzi, Founder and Director, Varzi Energy Ltd

Held at The British-Iranian Chamber of Commerce, 20th June, 2014

Ladies and Gentlemen,

First of all, may I sincerely thank BICC, especially Martin Johnson, the Director General, for inviting me to speak at this august gathering today. Of course, I have been asked to focus on the nuclear negotiations and its potential impact on the speed of Iran's economic recovery, especially in the field of oil and gas. However, permit me to say just a few words about recent and ongoing developments which are affecting all the countries, including Iran, in the region.

As I speak, people are still reeling at recent developments. Still too early to grasp the full implications of what is happening and certainly too early to reach any conclusions

What appears to be happening - tear up of the famous or infamous Sykes-Picot agreement of 1916 which basically divided much of the Middle East between Britain and France along straight lines which crossed many ethnic and tribal groups.

The irony is that none of the states in the region today want the Sykes-Picot agreement to be revised, despite its inherent contradictions. It has become the status quo which is now under an unprecedented threat.

One could argue that the Middle East is going back to its former self, that is before the Imperial Age. Ever since commercial oil was discovered in Iran over 100 years ago, perhaps the biggest single theme in the region has been the interaction between outside powers and the governments and people in the area. The struggle has manifested itself in many ways, not least in the oil sector with constant attempts by Reza Shah to extract concessions from the British Government, and then the wave of nationalisations that began with Premier Mossadegh in Iran in the early 1950s and then spread to other countries. The establishment of OPEC in September 1960, which was and continues to be dominated by the producers in the Persian Gulf, was another significant development.

However, the threat represented by Isis goes way beyond the world of oil. If successful, it would result in a redrawing of Middle East boundaries more along sectarian and ethnic lines, with a kind of the bulk of Sunni Syria joining the Sunni areas of Iraq, a separate Iraqi Kurdistan and then a truncated Shi'ite Iraq in the south probably enjoying close ties with Iran.

Of course, nothing is inevitable. Today we see that Syria remains at least formally one country despite a horrendous civil war and Libya is still one country despite a virtual division between Tripoli and Benghazi. So, let us take nothing for granted. However, if the above-mentioned scenario comes to pass, a combined Iran-Shi'ite Iraq (much of Iraq's oil reserves are in the south) could provide a formidable challenge to Saudi Arabia in OPEC and the region. No wonder the Saudis are reported by a number of different sources to be in close contact and possibly even assisting the Sunni uprising in Iraq.

We now turn to the nuclear negotiations. However, before we do, the announcement just a few days ago that the UK was re-establishing its embassy in Tehran shows just how rapidly developments are taking place. Moreover, the repeated hints of Iran-US discussions over Iraq are significant. It appears that a combination of Ukraine, Syria and now above all the Iraq crisis is accelerating the desire on the part of the West to bring Iran in from the cold. This must surely be a welcome development for anyone who is in favour of establishing a lasting framework for peace and security in the region.

In my personal view which is no doubt shared by many other observers, this is perhaps a seminal moment in the post-war history of the Middle East. It is equally surely a seminal moment in the troubled relations between the West, especially the US, and Iran. Both governments have signalled their earnest intentions to try and solve their problems through diplomacy rather than conflict. Both governments have been reassessing their view towards the outside world. In Iran, there is no longer talk of spreading the Islamic revolution. Mr Rouhani's government is much more focused on solving domestic issues than the previous administration. In the US, the administration has been increasingly focused on how to establish a lasting economic recovery domestically. Besides the American public are war -weary and have no stomach for further military interventions in the Middle East.

There is also one other significant development that could be leading the US to reassess its Middle East policy - namely the incredible rise in US domestic oil production in the wake of the fracking revolution. I have researched a great deal on this issue - not one oil expert predicted in recent years that the US would become the world's biggest oil producer by 2015 - yes, if you take crude oil, condensates and natural gas liquids together, a bigger producer than even Russia and Saudi Arabia. It is no wonder that alarm bells about the US commitment have been ringing in Riyadh and real concerns have been expressed at the progress so far in the nuclear discussions with Iran.

But why is Iran so important for the West, indeed for the world. It possesses the entire eastern coast line of the Persian Gulf and straddles the Hormoz Straits. It is the only Persian Gulf country to border the Caspian states. It is the location of huge oil and gas reserves with huge export potential. Also, with a population of nearly 80 million, it has the largest domestic market in the region, about as big as Germany's in terms of total population and much bigger than either France or the UK. Last but not least, it has a large, well-equipped and experienced military machine which cannot be ignored by other states and actors in the region.

Here are some other facts that are worth noting. Did you know that Iran's GDP ($550 billion) is roughly the size of Switzerland, Sweden and Norway? Despite lack of rainfall, Iran's cultivated area is equivalent to France's and larger than Spain's. Iran's stock market is valued at around $140 billion, about the same as Poland's. Some 55 million Iranians own a mobile - roughly 70% of the entire population. Iran has some 200,000 kilometres of roads, equivalent to Hungary. Iran also has millions in higher education. In fact, some of Iran's brightest brains have won scholarships to universities such as MIT in the US.

I would also add that Iranians are probably more friendly towards the West, including the US, than any other people in the Middle East, despite all that has happened over the past three to four decades. This feeling permeates into the government (MY STORY)

Now to the nuclear negotiations. I have no doubt that both sides are deadly serious in wanting a successful outcome. My personal view is that the biggest danger to these talks is not Iranian intransigence but rather the adoption of strong anti-Iranian positions by some members of the US Congress who incidentally toe the Israeli line on every issue of importance to the Israeli government. In fact, if anyone has acted in bad faith, it was the US which slapped additional sanctions on Iran just weeks after the November 2013 talks. Yet, it is significant that Iran ignored this new move and acted as if nothing had happened. My question is, if a successful formula is arrived at, can President Obama overcome his domestic opposition?

Having said that, events are moving so fast (there are even rumours of preliminary discussions to re-establish an American embassy in Tehran) in favour of greater dialogue that surely the chances of a nuclear accord must have risen in recent days. I am also encouraged by the fact that there have so far been so few leaks by either side. Silence during diplomatic talks is generally a good rather than a bad omen.

There is currently talk about the possibility of extending discussions beyond 20th July. What I can say is that Iran is not using such a delay to play for time. In fact, the Iranian Foreign Ministry on the eve of a fresh round of talks with the world powers in Vienna released a paper on the religious foundations of the edicts issued by not just the Iranian Supreme Leader, but all Shiite jurists on the prohibition of the acquisition and use of the Weapons of Mass Destruction (WMDs), including nuclear weapons. Moreover, the Supreme Leader has on several occasions stated that the use of nuclear weapons is illegal and unacceptable in Islam. Such statements coming from the highest authority in the land should be taken seriously. Privately, senior Iranians have stated in the past that having one or two nuclear weapons would probably increase outside threat to Iran's security and independence. Moreover, in a recent article in the New York Times, Iran's Foreign Minister Zarif stated openly that Iran had no nuclear weapons programme and was years away from developing any such capability.

So why are the talks facing stumbling blocks? I believe there are two issues here; firstly the number of centrifuges Iran will be permitted to have following an agreement and defining what I call the end-game. On the centrifuges, the Group of 5+1 are apparently trying to limit the number to a few hundred while Iran is insisting on keeping several or many thousands. Obviously, at the end of the day this problem can be resolved subject of course to a schedule of continuous inspections and supervision by the IAEA. Iran incidentally has fulfilled the letter and spirit of the understandings achieved so far 100%, according to the IAEA. Moreover, Iran has already stopped further development of he Arak enrichment plant and has stated its readiness to re-configure it in a way that would be acceptable to the 5+1 Group. Taken altogether, Iran's concessions have been considerable well before the 20th July deadline for an agreement.

What worries me more is that diplomacy rarely succeeds if there is no mutually agreed end-game. Recently, we have been hearing increasingly that, largely on the basis of American insistence no doubt inspired by Israel and possibly Saudi Arabia, the Group of 5+1 are keen to include Iran's missile programme in the discussions as well. Iran's view, which can be perfectly understood, is where will all this end? From strategic missiles will it then proceed to tactical missiles, then to the make-up of the Iranian air force, army and navy and then munitions factories and so on. From everything I have heard so far, the issue of missiles was never agreed upon as a subject of the current nuclear discussions. If the end-game is moved, this will definitely in my view reduce the chances of a final agreement.

At the end of the day, it is impossible to predict the final outcome. We just have to hope that both sides will be ready to make painful compromises but in a balanced fashion.

Now, assuming the talks are eventually successful, what hope is there for the Iranian economy short and long term? For a start, the country faces a host of problems. These are high unemployment, high inflation, painfully high domestic subsidies even though they have been reduced in part and obstacles to much-needed domestic reforms. These problems are exacerbated by the fact that in the last year of the Ahmadinejad Presidency, Iran's GDP actually contracted. Moreover, this year it is unlikely to grow by much more than 3%.

The general view is that if high unemployment is to be tackled bearing in mind that at least a million young Iranians enter the labour force each year, the country must boost domestic growth to at least 7% per year for many years. This can in theory be achieved provided in my view real privatisation takes place in every field including the field of oil and gas. By real, I don't mean the semi-state privatisation that has taken place via the granting of huge chunks of the economy to state or semi-state organs. I mean real privatisation in which the people and private companies at large play an active role in the process.

We know that the Rohani government is trying to set the ball rolling. It has so far brought down inflation even though it remains in double digits; it has reduced subsidies in a variety of fields even though these subsidies are still a huge burden on state finances, and he is increasingly appointing "men of action" rather than ideologues in high ministerial positions. Above all, this can for example be seen with the appointment of Mr Zanganeh as Oil Minister and Mr Nematzadeh as Minister of Trade, Industries and Mines. Mr Rohani is also keen to encourage privatisation in various fields because he knows that the state is incapable of providing sufficient employment opportunities for such a vast and growing labour force. So, to sum up, a good start has been made, especially given the many domestic and international obstacles but there is a long way to go.

Now let's turn to the oil and gas sector. Iran as we know is the oldest oil-producing country in the Middle East. For many decades, Iran was not a master of its own destiny. I need not go into history as you are all no doubt pretty aware of what happened and the ensuing strong backlash during the Mosaddegh era. To this very day, this fear of foreigners controlling the oil and gas sector continues to drive government policy and the Supreme Leader has pointed to article 44 among others in the Islamic Constitution which specifically excludes foreign ownership of petroleum.

This legacy remains strong even today when the current government in Iran is trying to devise a model oil contract which eschews any form of foreign partnership in Iranian oil agreements.

However, before we go further, the question can be asked whether Iranian oil is needed, given the rise in US production and rises in capacity in recent years in Saudi Arabia, the UAE and possibly Kuwait. Towards the end of last year, a number of brokerage houses in London predicted a fall in oil prices owing to a combination of sluggish demand and rising supply. Such pessimistic scenarios - pessimistic from the view of oil exporters - are too bearish. They fail to take into account some salient factors.

For a start, all current indications are that the oil shale revolution which has occurred in the US is unlikely to be repeated to such an extent elsewhere. These events in the US are due to a combination of fairly exceptional petroleum geology and a legal system which encourages enterprise and technological change.

Secondly, scenarios which predict excess supply often fail to take sufficiently into account the risk of supply disruptions. Over the past several decades, almost every major OPEC country has witnessed such events and even non-OPEC exporters have not been immune to such incidents. In the 1980s, it was Iran, Iraq, Kuwait and Russia. In the 1990s, it was Venezuela, Iraq and Kuwait and since then it has been Venezuela, Iran, Nigeria and Libya. Moreover, this list is by no means exhaustive. In short, theoretical global capacity has consistently exceeded actual capacity.

Thirdly, OPEC's capacity to resist severe oil price falls has often been under-estimated. At certain times, Saudi Arabia with some help from the UAE and Kuwait, has adjusted production to prevent undue excess supply.

Finally, in terms of price, the remaining reserves of conventional, easily accessible oil are becoming increasingly difficult to replace. Its substitution by less accessible oil, often in deep water or severe climates, has increasingly become an important underpinning factor behind oil prices. There is also another factor worth reflecting about - if oil prices have remained fairly stable at around $100 per barrel during five years of the worst global recession since at least the Second World War, why should they now fall as global economic growth resumes? So my answer is that global supply potential is consistently over-estimated and that, all things considered, Iranian oil will be needed to maintain sufficient oil supply in international markets. However, can the Iranian oil industry meet the many challenges ahead?

Whether Iran can deliver in the event of a lifting of sanctions is another problem. The reality is that ever since the beginning of oil production in Iran, the oil sector has never really played its true role in the domestic economy. Emphasis has been placed on maximising short-term oil revenues rather than on the role that the sector can play in the wider economy. Moreover, the implementation of sanctions has served to widen the technological gap between Iran and many other major oil producers. Moreover, the sector has become heavily politicised in recent decades. Today, more than ever before there is an urgent need to reverse the fall in domestic oil production and implement far-reaching reform.

One of the key problems is that there has never been a truly objective and independent evaluation of proven oil reserves. By this I mean reserves evaluated on a similar basis to such evaluations in financial markets in the case of oil and gas companies. Without a correct evaluation, it will prove difficult for the NIOC to allocate priorities in terms of optimal exploitation of reserves in the ground. Today, such an objective reserve evaluation is more important than ever. Every single giant field discovered over the past fifty years is in steep decline - Ahwaz-Asmari, Marun, Gachsaran, Agha Jari etc. Moreover, the NIOC, as the minister himself has admitted, does not have sufficient funds of its own to boost output. The easy days of giant oilfield discoveries is over. Things have become more complicated. NIOC needs foreign technical assistance especially in exploiting heavy oil fields, and in enhancing secondary and tertiary recovery.

My strong personal view is that the current buyback schemes should be discarded in favour of production-sharing agreements. In addition, NIOC should be granted a long-term budget guaranteed by the Majless to boost domestic production.

Firstly, NIOC should introduce open competition among potential bidders. This would entail an open bidding process with the inclusion of a signature bonus and other potential forms of advance payment. This is a well-tested route to encouraging the movement of foreign capital and technology into upstream activities. Before former President Chavez reversed similar moves in Venezuela, the country earned nearly $2 billion in signature bonuses alone in the course of bidding rounds.

Secondly, NIOC should match the duration of each contract more closely to the expected productive life of each field with additional incentives to increase the rate of recovery. For example, an incentive should be given to find and tie small accumulations into the existing infrastructure of producing fields. On this point, I hear that NIOC is attuned to such issues and is trying to incorporate a more flexible structure into a future agreement. Moreover, a strategy is being developed given priority to existing fields and reserves which are shared with Iraq straddling the common border. Apparently there are well over 20 such areas.Thirdly, and as already mentioned, serious consideration should be given to the concept of production sharing in the upstream. Unfortunately, such a move appears already to have been dismissed by the Iranian authorities. The problem is that many Iranians associate all forms of upstream foreign investment with the former discredited regime of EMTIAZ or concessions. The two concepts, as explained below, are totally different from one another.

Concessionary agreements granted almost limitless powers to foreign oil companies to do virtually what they liked over tens of thousands of square kilometres of acreage granted to them for several decades. During the days of the former Shah, certain conditions were placed on these companies but these conditions remained fairly limited in scope.

Production sharing agreements (PSAs) are a completely different concept. Far from being colonialist or exploitative in design, it was Indonesia, then an OPEC member, which signed the first PSA in 1967. Over the years, other OPEC and non-OPEC countries signed similar agreements. Over time, PSA's have been significantly fine-tuned with the host country gaining additional benefits. The single most important principle is that the reserves in the ground remain 100% with the nation. Please note - we are not talking about reserve sharing. Only production is shared.

Moreover, exploration risk is borne largely by the foreign party. Exploration costs can be offset against future production. If there are no discoveries , the foreign party's costs are not reimbursed. Such a formula takes a big burden off NIOC's shoulders, especially at a time of severe budgetary constraints.

There is also the important principle of minimum obligation risk. During the exploration phase, the foreign company must undertake to fulfil certain minimum commitments, such as running seismic, drilling a certain number of wells and so on.

Also, the government can insist that all information acquired during the exploration phase together with any evaluation of the area's potential should be submitted to itself. The foreign partner may, moreover, be required to relinquish progressively during the exploration phase those parts of the acreage which it is not utilising. The government then has the choice of submitting those relinquishes to a new round of bidding.

One vital advantage of PSA's is that it can be used for the acquisition of advanced managerial and technical skills. The PSA can be used to insist on strict minimum targets for personnel training, replacement of expatriates and transfer of technology.

Moreover, the government can pursue a wide range of secondary objectives such as environmental protection, opening up new areas for exploration, encouraging exploitation of non-associated gas reserves, stipulating use of local goods and services.

Yet another advantage of PSA's is the ability to use the foreign party to secure loans. The state company may wish to seek foreign loans via successful bidders in order to finance its share of joint ventures, allowing NIOC to borrow at a cheaper rate than if it were to enter the market directly.

During the Shah's time, there was no petroleum ministry. The NIOC was essentially a state commercial organisation. However, since the establishment of the Islamic Republic, a Petroleum Ministry has been set up and is housed in the same building as the NIOC. In my personal view, this has been a retrograde step. It is difficult to distinguish between who is a bureaucrat, i.e. a government employee, and who is a technocrat. NIOC has become heavily politicised and should be physically separated from the Petroleum Ministry. When governments get involved directly in economic activity it leads to bureaucracy, inefficiency and corruption.

NIOC should be allowed greater autonomy to make decisions on a more commercial basis, of course within the framework of government regulation.

Moreover, the government should be more active in promoting the expansion of affiliated industries thereby keeping more of the economic value of the oil and gas sector in Iran.

In my view, reforms should go even further. For example, the entire country should be opened up to oil and gas exploration. There has been too much focus on Khuzestan. Opening areas such as Baluchistan would have tremendous benefits in terms of employment in the long term.

Also, NIOC should be permitted to look beyond its national borders, signing joint ventures with other companies. NIOC's foreign activities pale even when comparing it with many smaller state oil companies. Malaysia's PETRONAS has a tiny reserve base compared with Iran's; yet it has a much greater international profile than NIOC. Its foreign operations also form a huge source of revenue both for the company and the government.

Such an approach would give NIOC an unprecedented amount of flexibility for accessing additional funds. NIOC could access equity capital markets. Iranian joint ventures with foreign companies could raise funds via domestic and foreign equity markets, gaining access to a wide shareholder base with all its many benefits.

Moreover, the PSA should be used to achieve wider objectives domestically. The government could encourage the foreign partner to consider investing in ancillary operations such as pipeline construction, participation in downstream activity, establishment of associated plants etc. In this way, the PSC can be seen to have a multiplier effect on the rest of the economy, providing additional investment and employment opportunities.

My personal view is that the Islamic constitution should not be interpreted as automatically blocking PSAs. Article 44 of the Islamic constitution defines the border between private and public sector activity. Private sector activity has been specifically excluded from oil exploration and development. Personally I think this is a mistake. While reserves in the ground should always remain 100% the property of the state, equity ownership of production is another matter.

Private sector activity should be permitted in all sectors of oil and gas. Over time, this would help divert capital from the massive land and real estate speculation which has badly distorted the economy.

In Conclusion:

Iran's political leadership is very pragmatic. If it wishes, it can invoke the principle of "Maslehat", which can be translated as "expediency" or "doing things in the national interest."

However, one must remain cautious - Iran is in a state of flux. Even if sanctions are lifted, does the government have the vision and determination to adopt a more forward-looking and open-door policy towards the oil sector? Is the NIOC fit for purpose in its current form? The key task of attracting sufficient foreign investment and technology transfer could take longer than many may wish. Let us hope that the model agreement NIOC is hoping to establish in order to attract major international investment and technology transfer is fit for purpose.

The content of this talk does not necessarily express the views of The British Iranian Chamber of Commerce. The views and opinions expressed are those of the speaker.