By Mr. Bijan Khajehpour

Oil export income has been the backbone of Iran's economic development in the past few decades. As a result, Iran's economic conditions have been heavily dependent on international oil prices and the country's ability to export oil. Nevertheless for the past three decades, every government in Iran has talked about the promotion of non-oil sectors in order to reduce the economic vulnerability that results from a dependence on oil. However, these past experiences have failed and Iran's economy is still suffering from oil domination.

Interestingly, there are a number of indications that Iran has learned from past experiences and is trying to re-define its actual approach to utilizing the country's oil and gas resources. This article will discuss the most significant policy shifts, as well as the current bottlenecks affecting the development of Iran's hydrocarbon sector, by shedding some light on government plans.

Identifying New Approaches 

The following initiatives and policy changes could be considered the most significant moves to redefine the role of oil and gas in the Iranian economy:

· The policy of attracting foreign capital and technology through the concept of buy-back contracts;
· Part-privatization and decentralization of the oil sector;
· The creation of the Oil Stabilization Fund;
· Capacity building in related local industries;
· Increasing the domestic added value in the chain activity of the hydrocarbon sector.

These initiatives are discussed below in more detail by identifying the actual objectives as well as the obstacles and prospects in each case. In addition, a decree by Supreme Leader Khamenei in March 2001 underlined the macro picture in this sector by declaring the following as the core objectives:

· Expansion of exploration activities in oil and gas;
· New capacity building in oil production in order to increase Iran's political, economic and security capabilities;
. Increase in gas production, specifically to cover domestic requirements;
· Attraction of the necessary financial resources (domestic and foreign) through legal channels;
· Value addition in the exportation of oil and gas products; 
· Optimization of energy consumption. 

Attracting Foreign Investment

Historically, the Iranians have had a tense relationship with the concept of attracting foreign capital into sectors concerning natural resources, especially oil. The paranoia of foreign companies' exploiting and undermining national interests is a prevalent historical element in the Iranian psyche. In spite of this, since the mid-1990's, Iranian authorities have tried to attract foreign investment into this crucial sector, albeit very gradually. 

It can be seen that, as part of the domestic opposition to the concept of foreign investment in this sector, Iran initially mainly offered its offshore resources to foreign investors. In fact, the first wave of buy-back tenders (introduced in November 1995) were exclusively offshore projects. Only during the second wave, offered in July 1998, were major onshore projects also included. In other words, the re-entry of foreign companies into oil and gas operations had to happen in a controlled and staged development. Notwithstanding, the pace has been much slower than the Iranian authorities had initially hoped. The main obstacles have been:

· The unsuitability of the legal framework due to restrictions defined in the Iranian Constitution: Government authorities have so far interpreted the ban on "concessions to foreign companies" in Article 81 as a legal impediment to Production Sharing Agreements, which are the norm in international oil contracts. Consequently, Iran has tried to use the concept of buy-back agreements, which essentially presents a service contract with very limited rewards for International Oil Companies (IOCs). Though the National Iranian Oil Company (NIOC) has tried to amend the buy-back models to respond to the expectations of foreign companies, the risk-reward ratios of this contract remain unrealistic. This is particularly significant since NIOC has introduced a "performance guarantee" for the post-development phase of the field when the foreign party has no influence over the field operations;

· The multiplicity of decision-makers on the Iranian side is another key impediment. Though the Ministry of Petroleum and NIOC are the actual Iranian parties in negotiations, it is clear that many other stakeholders are influencing the decisions. The consensus-building process on the Iranian side is not only time-consuming, but also discourages the foreign party;
· Furthermore, the pressure from domestic stakeholders to increase local content ratios has translated into a frustrating exercise for both sides to find an appropriate and feasible formula for utilizing local content. This obstacle will be discussed later;

· Finally, Iran's focus on the giant South Pars gas field as the main field for foreign participation is faced with a practical issue. Many foreign entities are still uncertain what Iran will do about creating a market for its vast natural gas resources. Consequently, the commercial viability of some of Iran's gas projects is under question.

All in all, the process of including IOCs in Iran's oil and gas sector has been slow and difficult, and in the course of debates and considerations, many challenges have come to light with which Iran has to deal over the next few years if she wants to seriously attract foreign capital and technology.

Restructuring of the Oil and Gas Sector

While in an isolated state, and with no input from international oil companies, the Iranian oil apparatus arguably lacked the needed push to overcome its inertia. Ever since the sector was reopened to foreign entities, it has become clear that the Iranian oil industry needs to undergo considerable structural reforms to be able to cope with the new developments, i.e., with the large number of parallel negotiations and consideration of project proposals, as well as managing the operations in the hydrocarbon sector.

The most crucial element in the structural reforms seemed to be a decentralization plan for NIOC, in order to achieve three objectives:

· Creating the necessary infrastructure to be able to negotiate with a large number of foreign companies on many current projects, as well as to manage the same projects once the deals were signed;

· Generating more flexibility by creating smaller entities as opposed to the huge centralizes structure of NIOC; and finally,

· Make the structures more transparent for foreign firms.

In line with this necessity, a Restructuring Plan was initiated in 1999 and regional companies were established. However, differences of opinion, a lack of political and commercial mandates, as well as changing priorities led to the fact that the regional entities never became more than a legal document. Negotiations, decisions and policies remained in the hands of the central authority of NIOC and its affiliate, PEDEC.

However, feeling the need for a clear separation between the regulatory and policy-making functions of the Ministry of Petroleum on the one side, and the operations responsibilities of NIOC and its affiliates on the other, in December 2001 the Oil Minister appointed Mehdi Mirmoezzi as the new Managing Director of NIOC. Mirmoezzi is the first individual to lead this important entity since 1985, which for the past 16 years had been directed by a Board of Directors. The move was understood as a positive signal that the Ministry would gradually distinguish between the regulatory functions and the operations responsibilities. While separating the responsibilities, the Ministry and NIOC are also pushing ahead a decentralization plan with the following objectives:

1. Forming a firm structure to create competitive, commercial, ministry-affiliated units, while considering national benefits;
2. Promotion of efficiency; 
3. Creation of systems that would bring transparency to the different functions of companies as well as in costs and reasonable prices on products; 
4. Reasonable optimization of management systems and services;
5. Accessibility to new structures that are suitable for the national economy

Clearly, this process will require a comprehensive medium-term plan until the current structure is developed into a more transparent, competitive and efficient set of companies and functions. From policy drafts, especially the Third Five-Year Development Plan, it can be deduced that the authorities are resolved to improve the structural realities, however the process will certainly take a few years.



The Oil Stabilization Fund

Another significant shift has evolved around the fact that the government considers Iran's hydrocarbon resources as an "asset" and not as "income". This thinking evidently led to the creation of the Oil Stabilization Fund in the Third Five-Year Plan. The continuation of this approach, namely a focus on considering oil and gas as actual assets, will have two clear consequences for the Iranian economy:

· In line with the fundamental nature of the Oil Stabilization Fund, the fact that oil income is taken away from the state treasury for current budget purposes means that Iran has to find alternative sources of income for the state budget. These could partly come from taxation but also from a diversified oil and economic structure, i.e. more focused on downstream and value added activities;

· Furthermore, the fact that the President insists on turning the "underground asset" into an "over-ground asset" means that funds will be available for infrastructure and job creation schemes in Iran.

The plan is already underway, and since March 2000 only a pre-determined proportion of the oil income per barrel flows into the state treasury. This figure was $13.80 per barrel from March 2000 to March 2001, and increased to $16 per barrel in the last 12 months. The remainder goes to a special Stabilization Fund under the control of the Central Bank of Iran (CBI) and the supervision of a Board of Trustees. This fund has already accumulated some $10 billion - money that the government can only use for investments that are approved by parliament. About $4 billion of these funds have already been allocated to a number of projects.
The initial debate on how to spend the excess funds evolved around two contradicting views:

· One group believed that Iran should spend these funds on developing the oil and gas sector and consequently reduce the dependence on foreign companies;

· The other group argued that the money should be invested in job creation schemes and light industries in order to respond to the direct needs of the country. They underlined that oil and gas projects can finance themselves.

Actual parliamentary decisions on the utilization of the Stabilization Fund indicate that the second group has won the debate, as job creation is currently the Iranian government's highest priority. The fact that in the future a considerable portion of the oil income will be spent on improving the country's capabilities in the non-oil sectors, especially in job-creating schemes, will be very significant for the country's economic development.

Local Content Issues

As mentioned above, the role of local companies has been an important point of debate in the developments of the energy sector. The debate has two distinct but interrelated dimensions:

· On the one side, there is a push for the creation of Iranian oil companies that can take over projects as prime contractors in projects. It is in line with this plan that companies such as OIEC, PetroPars, PEDCO and others have been created and also awarded projects. The vision among Iranian authorities is that such companies will in the future be awarded projects as prime contractors and then they would enter into negotiations with foreign partners and/or service contractors;

· On the other side, the local industries are using their muscle to make sure that foreign contractors are obliged by law to utilize Iranian subcontractors for their projects. Interestingly, the level of local content has been pushed up from 30% in 1998 to 40% in 2000, and 51% in 2001. 

The actual bottleneck in this process is not the fact that Iran is trying to optimize local content on all fronts. In reality, none of the key foreign players have a problem with the essential concept. The problem is that local players in Iran have limited capacities in carrying out major oil and gas projects, especially when more advanced technologies are required. The deficiencies are not only technical, but also in management skills as well as legal and financial issues. Furthermore, a obstacle is created through the fact that the actual hardware capacities of Iranian industries have been relatively overstretched in responding to the current needs of the sector.

In order to respond to this gap, Ministry of Petroleum authorities have put emphasis on capacity building in local industries by obliging foreign companies involved in subcontracting and equipment manufacturing to transfer their technologies to their Iranian partners. Similarly, NIOC is seeking opportunities to improve the project management capacities of its own companies. As a result, Iran is hoping to increase the capabilities of local entities, however this process also will require time - an element that Iran is short of - if the country wants to achieve its own set objectives regarding the production capacity of oil and gas.

Focus on Gas and Downstream

Another important fact clearly reflected in government plans and directives is the need for value addition as a means of increasing the actual potential of the hydrocarbon sector for the Iranian economy. In light of this, the current emphasis on gas resources and downstream activities can easily be understood. In the face of potential losses in the oil production as a result of depleting production capacities, NIOC feels that finding suitable solutions to utilize the country's gas resource base could act as substantial compensation.

The Gas Utilization Study carried out in 2000/2001 by a number of foreign companies has shed some light on how Iran can utilize gas in the future to add value to the economic chain. Furthermore, the potential of getting gas to international markets through cross-border pipelines, and new technologies such as LNG and Gas to Liquid, have all been on the Iranian agenda. However, Iran is still going through the learning curve of acquainting itself with the international gas market realities - a market that is very different to that of oil, as Iranian authorities are finding out. Nonetheless, the focus of Iran's efforts in attracting foreign investment remains South Pars and the signing of a number of defined phases in this giant gas field.

Downstream, the Third Five-Year Plan introduces a new approach both with regard to privatization efforts as well as the structure of this sub-sector. By offering a host of downstream activities to the private sector, the authorities are hoping to increase efficiency and move towards more market-oriented sector activities. However, the main obstacle to any constructive development here is the heavy subsidies that are still indicative of the country's fuel prices.


The success story on the downstream side is the level of development in petrochemicals. Here, the Ministry of Petroleum affiliate NPC has managed to develop a strategic plan and gradually increase the actual potential of the petrochemical sector for the Iranian economy. Incidentally, one of the success parameters has been the fact that most of the petrochemical projects were new initiatives as opposed to old projects that needed to be revamped. Today, the various petrochemical complexes are not only meeting most of Iran's own needs for petrochemical materials, but are also a major contributor to Iran's non-crude oil export performance. 

Conclusions

Iran's oil and gas sector has gone through a number of very distinct development phases since the 1979 Islamic Revolution. In the 1980's, the main focus of this sector was inward orientation and overcoming the damage caused by nationalization, to say nothing of the negative effects of the Iran-Iraq war. In the post-war era, the oil sector was a mere cash cow for the reconstruction of the country, and was used to fund other strategic industries (such as steel, automotive etc.). However, it seems that the government has come to appreciate the importance of this sector for the overall economic development of the country. In order to realize the true potential of the hydrocarbon sector, Iran has been undergoing major policy and structural shifts, however, to become effective, these shifts will require more time. In other words, after two decades of difficulties, the Ministry of Petroleum is now focusing more on the structural and legal reforms that are needed to benefit from a more efficient and internationally competitive oil and gas sector. The realization of the real value of the hydrocarbon sector for the Iranian economy will require many more reforms and restructuring processes, which, due to the slow pace of reform, will take a few more years. In that light, it will be extremely difficult for the authorities to achieve the goals that have been set in the Third Plan.

In the meantime, one will witness many debates and policy-making processes that will aim to overcome the bottlenecks in achieving the above stated objectives. The maximization of the oil and gas sector's potential for job creation will be the core of all new policies. Therefore, foreign companies should take the debates on local content very seriously and try to respond to the Iranian expectations in that field by creating joint ventures and transferring technology to Iran.

On a different front, the Oil Stabilization Fund will mean that the government's dependence on oil exports for revenue will be reduced. Notwithstanding, the financial significance of oil exports will remain a given fact in Iran, no matter whether the funds are used for the treasury or as a source of loans for industrial development.