The end of sanctions and Iran’s oil market

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This article originally appeared in Oil & Gas Agenda

For many in the oil industry, the news of the Joint Comprehensive Plan of Action and the lifting of economic sanctions against Iran meant only one thing: the country with the world’s fourth largest proven reserves was now open for investment. But several months on, what does the historic deal really mean for the oil market, and how quickly with Iran become a major player? Oliver Hotham talks it through with Eduard Gracia, principal at A.T. Kearney Global Energy Practice, and Michael Cohen, head of energy commodities research at Barclays.

It finally came after 20 months of arduous negotiations: the Joint Comprehensive Plan of Action, signed in Vienna on 14 July between Iran, the five permanent members of the United Nations Security Council, and the European Union, gives the country relief from UN sanctions in return for a slowdown in its nuclear programme.

The agreement had significance beyond the technicalities of the deal, the timings of the sanctions relief and the rhetoric from hardliners on both sides. In essence, it’s an agreement that means, for the first time since the 1979 Revolution, Iran and the West are back on speaking terms. The country, in the near future, would open for business – certain conditions applying.

The oil and gas industry, however, has a greater stake than anyone else in this new environment of openness. Iran is an energy superpower, with the world’s fourth largest proven reserves and immense potential for development. The presence of a major new player on the market, at a time of global glut and depreciated prices not set to rise anytime soon, looked like something of a mixed blessing, at least in the short term.

For the moment, insists Eduard Gracia, a Principal at the A.T. Kearney Global Energy Practice, a management consultancy, and co-author of a recent report Oil Supply and the End of Iran’s Sanctions, it’s difficult to say quite what the impact of Iranian oil will be on prices. The challenge, he argues, is assessing the time it’ll take for the market to get up to the level of its regional competitors.

“The reserves of Iran have been growing substantially since the year 2000,” says Gracia. “So it’s logical Iran would be trying to develop the resources as much as they can, but how fast can they develop them if the sanctions are lifted?”

There’s a lot going on in the international oil industry, and for Michael Cohen, who serves as head of commodity research at Barclays, the news of the deal with Iran affirms many of his views on the general direction the market is heading.

“We’re in the middle of a new rebalancing,” he argues. “We’re coming to the end of a cycle that saw very high prices as a result of geopolitical disruption.”

It’s no secret that Iran’s fortunes have long been tied, for better or worse, to its massive petroleum wealth. In 1908, it was first country in the Persian Gulf to strike oil, a discovery which led to the creation of the Anglo-Persian Oil Company and the beginning of the country’s petroleum industry. And it was reformist Prime Minister Mohammed Mossadeq’s fateful decision, in 1951, to create the National Iranian Oil Company (NIOC) and bring the country’s reserves under state control that led to his overthrow two years later in an American-backed coup and the restoration of the country’s absolute monarchy under the Shah.

It’s not as though the Shah was unaware of the immense power his country’s natural resources gave them. At the height of the 1973 oil crisis which saw prices soar as the OPEC cartel punished the West for its support for Israel – and at a time when Iran was the world’s second largest exporter of oil – he spoke to the New York Times about the rapidly rising cost of petroleum.

“Of course the world price of oil is going to rise….Certainly!” he said. “You buy our crude oil and sell it back to us, refined as petrochemicals, at a hundred times the price you’ve paid to us…; It’s only fair that, from now on, you should pay more for oil. Let’s say ten times more.”

Three years later, the Iranian oil industry was at its height: over 6 million barrels were produced a day. In November 1976 production reached a previously unseen daily level of 6.68 million barrels, a rate matched only by Saudi Arabia, the USSR, and United States.

“The experience of the 1970s still stands as a powerful reminder of what Iran’s petroleum industry might be capable of should the sanctions be lifted,” the AT Kearney report argues.

Despite this prosperity, however, the Shah’s days were numbered. In 1979, amid unprecedented popular protests against corruption, the authoritarianism of his regime and its perceived acquiescence to American commercial and geopolitical interests, he was overthrown and the monarchy replaced with an Islamic Republic bitterly opposed to foreign interference in the country’s politics. In the aftermath of the revolution, the country’s oil was returned to state control under the NIOC, and Iran’s agreements with international oil companies were cancelled. Iran’s oil production, since then, has never surpassed its 1976 peak. Whether or not it’ll ever reach these levels again will have to wait and see.

Iranian oil production did not stop simply because of the trade sanctions imposed by the United Nations, the USA, and the EU in 2011. China, India, and others continued to buy Iranian crude. But the limitations placed by the rules on technology imports and the EU’s ban on the provision of tankers’ insurance for Iranian vessels, for example, meant that the country’s ability to maintain its upstream facilities took a hit. The country suffered a total loss of 18 to 20% of potential output – amounting to a loss of 800,000 barrels a day.

“Where the oil market goes from here will depend to a large extent on how much (and how rapidly) crude supply is expected to increase once the sanctions have been lifted,” the AT Kearney report argues.

There are two schools of thought as to how quickly this is going to happen. On the one hand, Iran has the 800,000 spare capacity. But on the other, the Energy Information Administration (EIA) argues, with the assumption that sanctions come to an end in the first months of 2016, the figure will be closer to 300,000 – this estimate puts a greater emphasis on the effect that the sanctions had on infrastructure, and as the AT Kearney report points out, since mid-2012 600,000 to 800,000 barrels of oil have been lost a day due to “unplanned shutdowns”.

Predictions are a risky business, and with so much going on in the oil market – from the shale gas boom in the United States to the rise of the Islamic State in Iraq and Syria – it’s very difficult to say exactly what the impact of all this will be. The analysts at Kearney decided to use the model of Iraq’s recent opening up post-invasion as a model for how, once sanctions are fully lifted, Iran’s oil market could work and at what rate they could be expected to develop their reserves.

“One estimate we took is we thought that Iraq had been in a similar situation,” says Gracia. “On average, in the last five, six years its production grew by about five, six percent. So that seems a logical estimate for Iran, which would also be investing heavily in that development.

Of course, it’s possible that Iran might grow faster than its neighbour. It’s far more stable than Iraq was in the aftermath of the American invasion, of course, and as such can offer a far less risky investment environment.

“Remember two things: number one is that these investments always take time, so you know there’s a limit to how fast you can drop back,” says Gracia. “The second thing is they would also need to attract foreign investors. Iraq had internal instability, but at the same time you know there are limits to how fast you can grow.”

But in the long term the return of Iran to international oil markets is undoubtedly going to be huge. As AT Kearney notes, the last few years have seen numerous reserve findings in Iran, but the sanctions have limited its ability to develop them.

“As a result, not only is Iran’s crude oil production tracking behind its historical record, but its proven reserves level is the highest in its history,” the report argues. “At the same time, current production levels are nowhere near where they need to be to cover government expenditures.”

There’s also political difficulties and a complex regulatory environment to navigate for foreign investors hoping to capitalise on the coming “gold rush”, as one report calls it. The country’s constitution, for one thing, bans foreign ownership of natural resources, production sharing agreements are prohibited, and it’s obvious that the oil is going to stay firmly in the state’s hands. Michael Cohen thinks that, despite the country desperately needing the investment to bring its energy sector up to scratch, foreigner investors will be understandably cautious.

“Major banks have been cognisant of the risks of getting involved in Iran,” he argues. “The use of US dollars is still prohibited, regardless of what happens after implementation day.”

“If the Iranian energy sector needs hundreds of billions of dollars, or even tens of billions of dollars just to get to that next level of production, it’s going to be very hard for the money to flow easily.”

Nevertheless, none of the rules necessarily make it impossible to invest in the technology needed to maximise Iran’s potential, and with the government in the fiscal state that it’s in, it’ll be firmly in their interest to encourage oil market growth as quickly as possible. Whether or not that’ll happen, of course, remains to be seen. But the future of energy in Persian Gulf, and the effect its growth will have, will be monumental.

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