Oil Markets Have Little To Fear From Iran For Now

After Iran and the P5+1 group of international mediators signed the framework for an interim agreement in Lausanne, there was a surge in reports from the international media, predicting a shock to the global oil market when it is flooded with Iranian oil later this year.

But what are the realistic prospects for such a sudden boom in exports from Iran?

Proved reserves of very impressive size lie under the surface of Iran. According to the Oil & Gas Journal, the country's oil fields contain 157 billion barrels of petroleum and 33.8 trillion cubic meters of gas, comprising 10% and 17% of world's reserves, respectively.

But despite these substantial resources, Iran's exports are limited. Under the yoke of Western economic sanctions, Tehran stopped selling oil to the US in 2012, and the next year petroleum deliveries to the EU ceased as well. In addition, the International Group of P&I Clubs that offer maritime insurance to shipowners has imposed sanctions on the insurance and reinsurance of oil shipments from Iran. This will negatively impact exports of Iranian fuel to Asia.

It is worth noting that India, Japan and South Korea have found an alternative way to obtain insurance: these countries have begun to issue sovereign guarantees to vessels carrying Iranian petroleum. However, even these potent measures have been unable to return the country's oil exports to their pre-sanctions level. Related: ISIS Still Hampering Iraqi Oil Industry Progress

Before the embargo, Iran produced over 4 million barrels of oil per day and shipped approximately 2.5 million barrels to overseas markets. Today exports have fallen by more than half, to only 1.2 million barrels per day. Production has plunged to 2.9 million bbl/d. The Iranians are doing their best to keep up appearances while struggling to fill in the many chinks in their oil sector after years of sanctions.

Wherein lies the root of the problems in Iran's oil industry?

It would be a gross oversimplification to blame everything on the sanctions, because there are plenty of other reasons for the drop in Iran's oil output.

It should be kept in mind that most of Iran's deposits were discovered for commercial purposes long ago. According to the statistics, about 80% of the proved reserves were identified prior to 1965. Many Iranian oil fields have been depleted after decades of exploitation, and thus production there has rapidly declined.

According to the Arab Oil and Gas Journal, Iranian fields have natural decline rates of 8% to 11% (which is relatively high), coupled with a recovery rate of 20% to 25% (which is low). On top of the continuous depletion of its production capacities, the previously discovered fields in Iran lack the tools and technology to inject any "new blood." The country has not brought a single new oilfield on-stream since 2007, despite announcements of a number of individual new exploration and development blocks.

Iranian-Chinese cooperation

In fairness it should be noted that Iranian experts, along with their Chinese partners, are developing several deposits and sites (with mixed success), but this work is proceeding much more slowly than was originally planned.

The Azadegan field contains between six and seven billion barrels of oil, and was Iran's biggest find in 30 years when it was discovered in 1999. That field is divided into two parts. China's CNPC is developing North Azadegan in a two-phase process, with ultimate total production estimated at 150,000 bbl /d (75,000 bbl/d for each phase). The first phase is planned to be on-stream this year or next, at a cost of $1.8 billion. Related: Punitive Tax Regime Is Crushing Ukraine's Oil And Gas Sector

Nevertheless, the Chinese company, which has not escaped the sinking ship of the Iranian economy, has still heard complaints from the Iranians. Last year, the National Iranian Oil Company announced that it was canceling its contract with CNPC because of persistent project delays as the Chinese had drilled only seven of the 185 wells they had planned.

The Yadavaran field is another promising upstream project, with 3.2 billion barrels of recoverable oil reserves. China's Sinopec signed a buy-back contract at the end of 2007, promising to invest $2.2 billion. That oil field produced 25,000 bbl/d in 2013. Iran's plans might seem bold, but the experience of CNPC, whose contract with Tehran was canceled, shows that it may not be possible to bring all those plans to fruition, even after the potential lifting of the sanctions. But the question still remains: Why?

Legal obstacles

Iran's constitution prohibits foreign or private ownership of natural resources. As the journal Neftegazovaya Vertikal rightly notes, the production-sharing agreements (PSAs) so beloved by many contractors are also forbidden. Iranians use buy-back contracts (in which the state purchases oil from a company) that allow foreigners to take part in exploration and development projects through subsidiaries of Iranian state-owned companies.

Using funds from the export of raw materials, the Iranians repay a foreign contractor's capital costs, and the annual repayment rate is based on a predetermined percentage of the field's production and the rate of return on the invested capital. According to FACTS Global Energy, the rate of return on buy-back contracts varies between 12% and 17%, with a payback period of five to seven years.

Thus, a clear drawback to such contracts is the lack of flexibility of cost recovery.

In an attempt to learn from these lessons and attract greater interest from foreign players, Iran is developing a new oil contract model called an Integrated Petroleum Contract (IPC), the terms of which will be similar to a PSA.

Under the draft IPC, the Iranians will pay foreigners a share of the project's revenue in installments once production begins at a field. According to the Middle East Economic Survey (MEES), the payment terms can be adjusted as the project progresses. IPCs are intended to encompass a longer period - between 20 to 25 years - which is double the amount of time permitted under a buy-back contract. Related: How Shale Is Becoming The .COM Bubble Of The 21st Century

Geopolitics and economics

There is much to preclude any optimistic predictions about large quantities of Iranian oil flooding the market anytime soon.

First, the United States, which likes to play the Iranian card in its Middle Eastern geopolitical games, is unlikely to applaud once Tehran begins to sell impressive quantities of oil on international markets (prior to the sanctions, the Iranians sold petroleum to more than 20 countries), thus replenishing its own coffers. An influx of petrodollars would allow Iran to provide financial support to the regime of Bashar al-Assad in Syria, who has long been a thorn in the White House's side. In addition, the greater availability of Iranian oil might raise serious doubts about the prospects for many oil shale projects in the United States.

Second, it is important to realize that Iran is a member of OPEC, although, like Iraq and Libya, it is allowed to operate outside the production-quota system for now. However, as soon as Tehran begins to show its teeth and increase its export capacity, the cartel will immediately intercede in a regulatory capacity to respond to that situation.

Third, the preliminary agreement itself that was signed in Lausanne is worded very broadly and leaves the United States room for inconsistent maneuvering, which is something that the administration of Barack Obama - and before him, George W. Bush - has done a lot.

By Eldar O. Kasayev for Oilprice.com

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