Production-Sharing Contracts Could Help Renew Iran Oil Market

For the first time since the Islamic Revolution in 1979, Iran is offering production-sharing contracts (PSCs) for investment in its upstream energy field, which involves exploration and production stage of the hydrocarbons industry.

The contracts, which allow oil companies to more quickly recoup their investment expenses than the buy-back arrangements Iran had previously favored, could help the Islamic Republic attract desperately needed new cash and expertise and alleviate the impact of draconian sanctions and competition from its neighbor, Iraq.

The National Iranian Oil Co. has offered such a contract to an Indian consortium of three companies: ONGC Videsh Ltd. (OVL), Indian Oil Corp. Ltd. and Oil India Ltd. This contract is for developing the offshore Farzad B gas field in the Farsi block in the Persian Gulf. Negotiations over developing the Farzad B gas field had been in process with the Indian consortium since early 2009.

It is estimated that the block possesses up to 21.68 trillion cubic feet (tcf) of natural gas, with recoverable reserves of about 12.8 tcf. The target production for the field's first phase would be about 1.1 billion cubic feet per day (bcf/d). In the second phase, this figure would be 1.65 bcf/d, and in the third, 2.2 bcf/d.

The required investment for exploration and production in this field is estimated at $5.5 billion, with an extra $8 billion to $9 billion for developing the field, constructing a liquefied natural gas (LNG) terminal and for transport. This gas could go directly to India in the LNG form and have a significant place in India’s energy-security calculations. OVL officials have been quoted as saying, “Why should we leave it [this offer] for others? We should take it, as we have currently been made this offer by Iran.”

Although sanctions and limitations on investment in Iranian energy are much tighter now than four years ago — even Chinese companies have more or less halted new investment in Iran — the magic of PSCs may finalize this deal between India and Iran despite concerns about US sanctions.

Originally the Indian consortium was guaranteed a 15% return on investment at the time it was awarded development rights. But this came with no ownership rights. However, the PSC now offers Indian investors a guaranteed share of the production. Moreover, in response to the high investment risks in Iran caused by sanctions, Indian officials have been quoted as saying, “We are taking [the offer]” and “There are methods to do it.”

Since 1979, the Iranian constitution has forbidden foreign companies from ownership stakes in hydrocarbon projects. Therefore, typical PSCs have not been offered since the revolution. In order to attract foreign investment, Iran used what are known as buy-back contracts — a kind of a service agreement that reimburses companies gradually as oil and gas are produced.

Since the buy-back system is uncommon for high-risk upstream energy investments, shifting toward PSCs while under historically unprecedented sanctions seems like a wise move. However, the most important question is: Will these types of contracts help Iran attract much-needed foreign investment? The answer will take time to emerge, but there is no doubt that substituting a buy-back system with production sharing markedly increases the attractiveness of investment in the Iranian energy field.

Numerous sanctions on investment and technology transfers have placed a growing strain on Iran’s energy sector and prevented it from growing under normal market conditions. As a result, Iran’s oil production has dropped under 3 million barrels a day and its exports have plummeted to less than 1 million barrels a day. Clearly, the buy-back contracts Iran has used are not profitable enough for foreign investors to risk incurring the wrath of the US government.

Sanctions against Iran, along with its problematic investment regulations, have also put this country at a major disadvantage for investment in comparison to its neighbors, particularly Iraq. At a time when Iran’s production has plummeted and there is almost no foreign investment in its fields, the International Energy Agency expects Iraqi oil production to double from roughly 3 million barrels a day to 6.1 million by 2020, and to even reach 8.3 million by 2035.

Assuming there are no further sanction limitations and risks, PSCs could increase desperately needed investment levels in Iran. With Iran’s market position rapidly eroding, reviewing its investment regulations and offering a more attractive contract is a practical, if forced, decision. This could not only attract foreign investment but is also a good strategy for Iran to compete with its up-and-coming neighbor Iraq.

The change coincides with presidential elections that may also improve Iran’s prospects. The election of Hassan Rouhani, a former nuclear negotiator who won the backing of former presidents Hashemi Rafsanjani and Mohammad Khatami, has raised hopes for successful diplomacy and more transparent negotiations with West over Iran’s nuclear program. If Rouhani succeeds in winning relief from sanctions, Iran’s new contracts will increase the country’s ability to attract foreign investment and to regain some of the market position it has lost in the past five years.

Sara Vakhshouri is the president of SVB Energy International and a former adviser to the director of the National Iranian Oil Co. International. On Twitter: @SVakhshouri