Western attitudes towards Iran are shifting towards tougher unilateral and multilateral sanctions as the energy-rich country continues with its nuclear ambitions. International pressure on Iran has partly focused on restricting oil exports and investment in Iran’s oil-related projects. How will its oil industry cope?

IRAN is today the world’s fourth largest oil producer after Russia, Saudi Arabia and the US. In 2011, it produced around 4.2 Million barrels per day (Mb/d), the equivalent of 5.2 per cent of world supply.

Expanding domestic demand has threatened oil and gas exports and therefore revenues. Because of artificially low energy prices, more than 40 per cent of Iranian oil production is consumed domestically

But with nearly 10 per cent of world proven oil reserves (third after Saudi Arabia’s 19 per cent, and Venezuela 15 per cent), Iran ought to be producing more given that in 1974, Iranian oil production reached a peak of 6 Mb/d.

Four factors have hindered Iran’s production capacity: the relentless increase in domestic consumption, OPEC quota, limited investment and, to some extent, sanctions.

Oil production and consumption in Iran from 1965 to 2010 (Data source: BP Statistical Review of World Energy, 2011)
Oil production and consumption in Iran from 1965 to 2010 (Data source: BP Statistical Review of World Energy, 2011)

Ninety nine per cent of energy production in Iran comes from oil and gas and only one per cent from renewable energy resources. Meanwhile, a continually growing population and generous energy subsidies have encouraged wasteful consumption and caused budgetary problems.

Expanding domestic demand has threatened oil and gas exports and therefore revenues. Because of artificially low energy prices, more than 40 per cent of Iranian oil production is consumed domestically, the rest (2.4 Mb/d) is exported. In a country that is highly dependent on oil income, this has a detrimental effect on the economy. Currently, however, this effect is somewhat countered by the high international prices of oil.

Gas sector

Although Iran sits on the world’s second largest gas reserves after Russia, its gas sector is under-developed. Domestic demand has been increasing rapidly, and some regions have run out of gas during peak winter periods, fuelling debates over supply priorities: domestic versus export markets.

Iran is an important member of the Organization of Petroleum Exporting Countries (OPEC). It is the organisation’s second largest oil producer after Saudi Arabia.

However, unlike Saudi Arabia which produces more than 10 Mb/d and sits on a spare capacity of 2 Mb/d, Iran is unable to expand its production capacity under existing conditions.

Despite the disagreements that have repeatedly emerged between the two countries at various OPEC meetings, Iran wants to keep its quota within the organisation in order to maintain influence on the international oil market, and therefore acquire some degree of geopolitical advantage. But its position is threatened by the re-emergence of Iraq as a potentially major OPEC oil producer.

Investment and sanctions

Iran’s upstream oil and gas sectors have suffered from years of limited investment since the Islamic revolution in 1979.

Although the oil industry was nationalised in 1951, Iran remained open to foreign investment. Following the 1979 Islamic revolution and until 1995, international investment in oil and gas was prohibited, in line with the Iranian Constitution.

The Iran-Iraq war in the 1980s left the oil industry in dire need of rehabilitation. As a result, the Iranian Government revised its attitude towards foreign investment and introduced a new type of contractual arrangement, called buyback. This type of contract allows an international oil company to invest in Iran’s oil sector up until production starts. It then hands over the project to the National Iranian Oil Company (NIOC) and receives, in return, an agreed fixed fee. Overall, such terms are very tough from an international investor’s perspective.

Buy-back contract

American based Conoco Oil Company was the first to sign this type of buyback contract with Iran. But that coincided with the US Government imposing in 1995 unilateral sanctions in response to Iran’s stepped up nuclear programme and its support of terrorist organisations. It was called the Iran and Libya Sanctions Act – ILSA, which later became ISA after the sanctions on Libya were lifted. The sanctions prevented mainly American companies from investing in Iran. The Conoco contract was subsequently cancelled and the French company Total SA took over the deal.

Up until 2010, the US sanctions on oil companies have either been waived by the US president or just ignored.

Norwegian Statoil, Italian Eni, Austria’s OMV, China’s CNPC and SINOPEC, and Russia’s Gazprom, have all invested in Iran’s oil and gas sectors. Some companies found ways round ISA controls and, in the case of non-American companies, were actively supported by their governments in doing so. They believed the sanctions were unilateral and extra-territorial, applied by the US and attempting to extend domestic American law, which made others doubt their legality in international law.

But the situation has since started to shift as the international community imposes a new wave of sanctions. The US, the United Nations, the European Union, some Asian and other OECD countries have targeted the Iranian energy sector with new sanctions of differing degrees of stringency. The EU sanctions are effective from July 2012.

Effectiveness of sanctions

Some companies are already feeling the pressure and have had to pull out of upstream projects in Iran. In 2010, Japan’s Inpex withdrew from an oil project and in 2011, both Belarus’ Belarusnafta and Gazprom followed suit.

But can Iran cope? Amid increased international pressure, Iran is now facing a bigger hurdle to overcome if it wants to sustain its oil production. But experience shows that the effectiveness of sanctions is questionable.

Iranian exports will not suddenly disappear from the market as supplies will be absorbed by buyers, like China and India, who are not bound by the sanctions and have been tempted with easy credit and discounts.

Iran knows that, by threatening to close the Strait of Hormuz, it will create enough anxiety in the market to increase the price of oil and therefore generate higher oil revenues for itself.

The Strait of Hormuz is a major route for oil and LNG exports, both from Iran and Arab Gulf countries. Around 20% of oil traded worldwide and almost a third of world LNG passed through the strait every day in 2011

Higher oil prices can compensate for a reduction in exports for Iran, but for the major oil consuming nations, they can be detrimental to economic growth. This explains the disagreement among EU member states about the ban on Iranian oil imports. Countries like Greece, which imports around 14 per cent of its crude oil from Iran, want to delay the decision as long as possible.

Some benefits

However, some major oil consuming countries, like the US and the UK, are also oil producers. In this case, higher prices can bring some benefits. They boost oil activity, generate higher export revenue, and produce higher profits for oil companies, generating higher taxes. So the net effect may not be as destructive as often reported.

The Strait of Hormuz is a major route for oil and LNG exports, both from Iran and Arab Gulf countries. Around 17 Mb/d of oil (20 per cent of oil traded worldwide) and almost a third of world LNG passed through the strait every day in 2011.

It could be manageable to ban just Iran’s exports, as the market witnessed following the Libyan war in 2011. But the problem in this case is that the closure of the Strait of Hormuz would cause bigger disruptions to oil and LNG supplies coming from other Gulf producers. This in turn could send the oil price rocketing.

But even then, would this automatically trigger the global disaster, the ‘Armageddon’ of the oil market, which some fear? Even if Iran implements its threats, the Strait would only remain closed for a short period and the spike in oil price would not be sustained. Besides, the oil market has experienced many episodes of severe volatility. Although in the short term these caused a major increase in the oil price, they subsequently led to unlocking new oil reserves, hence brought new supplies on stream, and modified consumption habits.

Current situation

In summary, while Iran may seem to be thriving in the current situation where oil prices are high, in the longer term, its oil industry and economy will suffer most. While some in Tehran may continue calling for extreme measures, wiser minds may see the dangers ahead to Iran itself.

The question is, which set of pressures in Iran’s complex and turbulent political community will ultimately prevail?

In future reports, Dr Nakhle will consider whether or not other producing countries compensate for any potential loss in Iranian oil; how will the market react under different scenarios; and can consuming countries cope?

Iran oil facts

  • At its narrowest point the Strait of Hormuz is 21 miles wide
  • The Iran-Libya Sanctions Act (ILSA) of 1996 authorised the US President to act against persons or companies investing more than US$20 million in the Iranian oil and gas industry
  • In 2009, the Iranian government spent more than US$ 66 billion on fossil-fuel subsidies – the equivalent of over 20% of the country’s total budget for that year
  • In 2010, Iran was the third-largest exporter of crude oil globally after Saudi Arabia and Russia
  • On average, 60% of the Iranian government revenues and 90% of export revenues originate from oil and gas resources
  • Oil activity started in Iran in 1901, when D'Arcy Exploration was awarded a 60-year oil concession. This gave English-born William D'Arcy and his team exclusive rights to prospect for oil in most of Persia (now Iran). The deal was signed between Mr D'Arcy and Shah Mozzafar al-Din

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