Following the subsequent removal of sanctions, Iran announced its ambition in becoming a regional economic hub.
Combined with its political ascendance over the past several years, Iran’s clout in the region is shaping up to be unparalleled. With the recent announcements of $18 Billion of Italian deals and $600 Billion of Chinese trade over the upcoming decade, investors are lining up their money to enter Iran. At the heart of Iran’s economy is the oil and gas industry, where political risk has remained a significant barrier to foreign investment. The political risk involved in Iran is deeply intertwined with the country’s energy sector. The country could reintroduce itself as an exploration frontier as Iran offer 52 new blocks for foreign investors.
Over the last decade the Iranian Rial depreciated significantly against the US dollar. In 2013 the US targeted the demand side of the Iranian Rial economics by penalizing transactions and reserves of Iranian Rials globally[i]. The weak currency created a burden on the economy. Servicing foreign debt becomes an expensive settlement – $5.5 billion, in the case of Iran by Q3 2015 – and leads to inflation, an internally destabilizing force. The Iranian economy suffered from inflation during the presidency of Ahmadinejad with annual rates of 32%[ii]. Iran’s central bank targets to curb the inflation rate to a record 25-year low by 2017[iii] provisional on the sanction removal. The Rouhani government thus far has managed to control the inflation rate from approximately 32% under the helm of the previous government. With that being established as a track record it is very likely than that single digit inflation could be achieved by the current administration. The currency outlook is still speculative, and a weak Iranian Rial could still signal negative political one. A possible scenario by the Iranian central bank would encourage cheap exports; this is detrimental if the future of the currency will be based on the Chinese model to avoid a strong currency by diverting future revenues into foreign markets[iv]. This strategy discourages investors involvement in the Iranian energy sector. The Rial will steadily appreciate in any case albeit slowly overtime. Appreciation of the Iranian Rial will encourage foreign oil companies to invest, driven by higher investor confidence and creation of wealth outlook. This is a target that Iranian officials are pursuing on another front. Iran’s deputy oil minister revealed that Iran is planning to secure $165 billion worth of investment in the Iranian oil industry by 2021[v].
The sanctions imposed on the Iranian economy have limited its capital resources. Iranian companies as a result cannot seek raising capital from foreign investments. This has presented the Iranian economy with its own set of challenges. The Iranian banks are overburdened by their role[vi]. In 2016, when Iran reconnects with the global market, domestic companies and banks would be able to acquire debt at lower yields of around 7% compared to 22% from banks locally, according to Hans Humes, CEO of Greylock Capital. The Iranian government is also looking to acquire capital by raising Islamic T-bills (Sukuk). The risk to the buyer will be mitigated by a sovereign guarantee. The lack of capital investment in the Iranian oil industry has limited the production potential of Iran. The oil companies themselves are said to be looking to raise capital through their own issued Sukuk. Iran’s internal stability, being part of general turmoil in the Middle East, could affect the demand on these Sukuk and foreign investors could hesitate in investing. To mitigate the risk, Iran would hope for a couple of stable years on the market in foreign funds and rating agencies accreditation to restore confidence.
Iran’s current oil production stands at approximately 3.1 million barrels per day[vii]. The sanctions on Iran have curbed its production to a maximum point of around 4 million barrels. Iran’s dependence on oil revenues has facilitated the potency of the sanctions on the industry[viii]. The sanctions deprived Iran of $30 billion of frozen revenues overseas. Iran has also announced that they plan to increase output by 500,000 barrels per day, and 1 million by March 2016[ix]. These commitments require capital investment, and foreign oil companies can significantly contribute to developing the efficiency of the operational fields in the Iranian industry. Ensuring brownfield efficiency will drive higher capital expenditure requirement. Higher capital requirement for greenfields makes Iran’s existing fields more attractive in a low price environment. The country has the second largest gas reserve in the world after Russia. Iran’s largest gas field is the South Pars/North field, which is shared with Qatar[x]. Due to the lack of technological investments in the gas sector Iran has a slow extraction rate, and does not compare with Qatar’s ability to produce. This could shape itself as an incentive to foreign companies especially with a predicted trend in the near future where oil consumption could gradually be edged by gas.
The role of the IRGC and Bonyads in the oil industry
The position of the Iranian Revolutionary Guard Corps (IRGC) within the Iran’s political structure gives it significant authority. This legitimacy translates into an over involvement in the Iranian economy. The IRGC report directly to the supreme leader and as a result has no governmental barriers to expropriate, or terminate contracts for any reason under the umbrella of national security. Autocratic regimes in the market negatively affect the confidence of external investors. Neighboring Turkmenistan is a similar example where autocracy has stood in the way of opening the development of oil and gas fields to foreign producers. The IRGC is directly invested in the oil and gas sector of Iran as ‘Khatam Al-Anbia’, the IRGC’s construction company, has signed $25 billion worth of contracts with Iran’s National Oil Company as of 2011, for infrastructure development in the oil industry[xi]. Not only do foreign companies have to compete with the IRGC, they face a risk of contract termination by an IRGC influenced Ministry of Oil[xii]. According to IR Diplomacy, the previous minister of oil, an Ex-IRGC General, Rostam Qassemi has on occasion threatened Chinese companies to terminate their contracts and replace them with IRGC owned companies[xiii]. Furthermore, the IRGC being an exporter of Iran’s Islamic revolution throughout the Middle East is expected to maintain its influence in the economy. It has to depend on a strong financial backbone to maintain its role domestically and empower its sphere of influence regionally in areas like Syria, and Iraq.
The Bonyads have been labeled by many as the inefficient link in the Iranian economy, and creates more complications than it actually solves. However, in contrast to the IRGC the Bonyads are limited in their capabilities over foreign investments [xiv] and do not have the same clout as the IRGC. A more likely scenario is Bonyads seeking to capture a higher share of the revenue from a certain project. Iran has introduced more favorable fiscal terms to promote the Iranian upstream prospect. The new fiscal regime recently introduced could mean a weaker influence of external parties in the negotiations processes.
Explicit political risks
Nationalization and expropriation
Historically Iran has set precedent for this occasionin 1951 and again in 1971, as a result for oil companies it is never a distant scenario to consider. Nationalization in the Middle East has always been conceived as a symbol of national strength and defiance in facing western imperialistic interests, best highlighted by the Suez Canal nationalization in 1956. Furthermore, the risk of an ideological conflict would always be present. Political tensions between Middle Eastern countries and the west have always promoted this divide. There is always a popular case for autonomy over the natural resources in the Middle East. This will be an ongoing ambition for Iran’s hardliners. However, as Iran looks to integrate with the global economy the only risk arising in this field would be awarding contracts to preferred companies to the Iranian regime or creep nationalization. Direct expropriation is very unlikely.
Already restricted by the trade embargo, the Ahmadinejad administration further strained the government revenues with populist policies. The administration has faced it popular protest and as a result these policies work to maintain public order, considering the high inflation in Iran. Even as the newer government reduced the subsidies it still finds itself obligated to transfer the excess revenue in financial aid to the Iranian household. However, the removal of the trade embargo would contribute to a more efficient economy, which would mitigate the risk of civil unrest. Previously, financial institutes such as HSBC and Standard Charted have been fined heavily for financially breaching the trade embargo on Iran[xv]. The removal of sanctions will allow a stronger presence of financial institutes, with normalized dollar transactions. This will be a crucial step forward for the oil and gas industry. Any commitment by international oil companies has to consider the nature of Middle Eastern geopolitics as an active risk.
Regional risk and the Middle East premium
Geopolitically, Saudi Arabia and its Arab allies continue to escalate their efforts in what is seen as an expanding Iranian influence; notably in Syria, Iraq, and Yemen. The execution of the Shi’ite cleric Al-Nimr, and the attacks on the Saudi Arabian embassy in Tehran and consulate in Mashhad led to the termination of diplomatic ties between Saudi Arabia and Iran. The removal of sanctions would open a new economic frontier between the Middle Eastern adversaries to be contested on. The low oil prices remain a tool that Riyadh will continue to use to curb Iran’s resurgence. Saudi Arabia and its OPEC allies will maintain production to limit Tehran’s market share on the international market. Iran is willing to contribute another 1 million barrels per day to OPEC’s daily quota. This will add to OPEC’s over producing 30 million barrels per day quota that it confirmed in November 2015[xvi]. It is not likely that Iran will be pressured by its OPEC counterparts to curb production. Iran itself as a result could be reluctant to invest heavily from its fiscal budgets in a low price environment, given its $130 per barrel breakeven point[xvii]. A high capital investment commitment requirement makes an investment in the Iranian oil industry not an attractive prospect against the risk profile of the country and a 4% decline in base production per year[xviii]. Conversely, Iran is willing to attract a longer operation period for foreign companies that could reach up to 25 years and in all three sectors of the oil industry to guarantee consistency in high production.
On the other hand, Israel is another regional rival that is concerned with Iran’s prospects. In many occasions Netanyahu and the cabinet voiced their opposition to the nuclear deal. In recent leaked recordings CNN reported that the Israeli administration has planned military attacks on Iranian establishments[xix]. Although this option seems more distant with the current deal being signed. Any military action against Iran will most likely provoke strong retaliation by the Iranians. The question of risk in this case would be how safe are foreign interests in Iran if the possibility of expanded military operations took place. Israel’s long-term ally, the US continues to ensure Israel has the upper hand politically and militarily. The US imposed sanctions in 2016 on entities and individuals involved in Iran’s ballistic missile program, after Iran’s recent ballistic missile test. Iran’s ongoing commitment to militarization will continue to attract scrutiny from the west.
Being the oil trade’s most important waterway, the Hormuz straight is central to the geopolitical concerns by the international markets. There is no likelihood that Iran would shut down the Hormuz straight without the consent of the Omani authorities, of which both have a deep interest in keeping the straight open. Unlike its Gulf Cooperation Council (GCC) counterparts, Oman maintained good ties with Iran in recent years. Oman’s role has been paramount for Iran, and the west as a diplomatic mediator. This comes after successful attempts by the Omani government in normalizing ties between Iran and the west, after successfully negotiating prisoners’ exchanges for both sides. Diplomatic breakthroughs would have been unlikely had it been for Muscat’s role on several occasions, in 1999, 2009, and finally in 2014, simultaneous with Oman and Iran’s gas pipeline deal agreement.
Iran aims to become an active regional player in several theatres that affects the inner stability of the country. Once Iran integrates with the world economically it will have strong interests in the security of the oil and gas supply through the Hormuz straight. According to Saudi Arabia’s oil minister, the markets have reached a level of comfort with the Middle East risk premium. It does not pose as abig concern anymore, because of the oversupply in the oil markets[xx]. Additionally the Iranian deal has previously worked to reduce the risk premium in 2013 at the beginning of the nuclear talks[xxi]. Continuing on the previous trend the markets reacted to the removal of sanctionswith a slump in the oil prices and the Middle East risk premium seems less prominent.
The Rouhani administration has targeted corruption and will continue to advance on the index of economic freedom. However, the structure within the Iranian political hierarchy makes it difficult to tackle corruption. Authorities that are furthest from the centralized authority are the hardest to prosecute and as a result are more likely to be corrupt, such as the Bonyads. The sanctions have introduced and developed corruption networks in Iran and this would take years to fully dismantle[xxii]. Furthermore, Iran ranks poorly in corruption indices. In the 2015 index of economic freedom Iran ranks 171 out of 178 countries, categorized within the ‘repressed’ economies, and ranked as the lowest in the Middle East [xxiii]. Iran ranks poorly in the 2014 transparency international’s corruption index at a 136 out of 176 countries [xxiv]. Foreign companies in Iran would easily be exposed to reputational risk, as this could be a slow transition into market transparency.
The case of the IRGC’s and the Bonyads’ power and interference in the oil industry highlight the risk from muddy regulation. In both cases the supreme leader appoints the heads of these entities. The government authority on them is lacking and is not properly defined. Parties such as the Bonyads and the IRGC are institutions that thrive in the lack of well-defined regulations. This enables these structures to maximize their personal benefit. According to the index of economic freedom, the regulation efficiency in Iran is lacking and forming operations are ‘burdensome’[xxv]. Iran as a destination to invest could be more expensive than the initial operating expenditure accounted for.
Various aspects within the Iranian industry have different degrees of riskiness. The main risk trends are those expected from an economy that has been operating under a trade embargo: corruption, high capital requirement and a low oil prices. There are high reputation risk implications, most active International Oil Companies (IOCs) are registered in countries that are strongly opposed to Iran’s political involvement and militant financing across the Middle East. It is established by several sources that a portion of the ISIS oil is smuggled through Sulaymaniya, Iraq to Iran [xxvi]. Before venturing in the Iranian industry, more transparency needs to be presented by the Iranian administration and well-defined regulation for authorities that are politically strong domestically, to protect foreign investors. Building relations with the Iranian government is the most effective and efficient tool to mitigate this risk. Economically the Rouhani administration are cutting inefficiencies and improving the market condition. The outlook for the Iranian market should look more stable two years down the line, with the nuclear deal being a great boost. Iran has an incentive to comply with its nuclear obligation as it seeks to raise capital at a lower sovereign bond yield. Endorsed from both negotiating sides including the Iranian supreme leader, the deal is a ‘golden page’ as stated by Rouhani.
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Author: Nabegh Al Sabbagh is currently a Master’s degree student at New York University, focusing on Energy Policy. His graduate thesis is on the effect of the Iranian nuclear deal on energy markets in the Middle East. Other research interests focus on Middle Eastern geopolitics, nuclear energy and proliferation. Nabegh is currently interning at Oman Oil Exploration and Production, and has a background in corporate banking. He is fluent in Arabic, English and Italian.
Source: International Security Observer