Emerging privatization in Iran’s energy sector deserves a second look

Bourse and Bazaar|Esfandyar Batmanghelidj: The recent news that Austrian oil firm OMV has signed a preliminary agreement with Dana Energy, Iran’s largest and perhaps most capable private oil exploration and production firm, heralds the future of Iran’s energy sector. The agreement between an international oil company (IOC) and a private Iranian energy company is a significant development, given Iran’s long-held promise to privatize its oil and gas industries. The goal of privatization has been a constant feature of the Iran’s five-year economic plans since the 1990s.

As economic sanctions were tightened beginning in 2011, investment dwindled and policymakers focused on promoting self-sufficiency in the oil and gas industries. Without access to new equipment, new technology, or best-in-class expertise, Iran’s production collapsed. This decline threatened government budgets as Iran lost global market share. Very quickly, Iranian authorities realized that achieving self-sufficiency actually required foreign investment– there were too many technologies and management practices yet to be mastered in Iran’s oil and gas industries.

Iran’s reentry into global energy markets has been one of the most heralded aspects of the sanctions relief afforded as part of the JCPOA nuclear deal. Within the larger scope of economic reform, there was a strong expectation that the Rouhani administration would push for a greater role for the private sector in Iran’s oil and gas industry, finally getting the program of privatization back on track. The commitment is evidenced by the several private companies included in the Ministry of Petroleum’s list of approved local E&P partners for new tenders.

However, the first oil production contract under the new Iran Petroleum Contract (IPC) framework was awarded to Persia Oil & Gas Industry Development, a quasi-state company affiliated with Setad (the entity decreed by Supreme Leader Khomeini that encompasses both publicly and privately held assets, including various industries, companies, and real estate holdings.) The awarding of the contract in October, 2016 raised concerns that Rouhani’s support for private enterprise in the energy sector was being blocked by entrenched interests. A recent report by Reuters examined the range of contracts awarded since Implementation Day. The report concluded that state-owned enterprises were winning the lion-share of the new business, including oil and gas sectors. Of the 110 major contracts examined (collectively valued at USD $80 billion), only 17 contracts, worth USD $14.6 billion, were granted to private sector businesses.

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The primacy of state enterprise has raised concerns among policy groups in Europe and Washington that the economic benefits of the Iran nuclear deal are not driving economic liberalization. The concern is particularly acute in the energy sector, given the immense importance of oil and gas revenues to government budgets and the significant involvement of state entities such the IRGC in the extractive industries.

There are, however, several reasons why critics should remain optimistic about the prospects for privatization. The Reuters report overlooks important context for the evaluation of post-sanctions contracts, particularly in the energy sector. First, state enterprise was better positioned than the private sector to win the early post-sanctions contracts. The initial wave of economic interest in post-sanctions Iran was marked by delegations led by economic ministers. Naturally, these government-to-government efforts focused on deals in sectors where government-involvement remains high both in Iran and in Europe. While it is widely known that companies like Iran Air, MAPNA, and Iran Khodro are state owned, it is worth remembering that their potential foreign partners like Airbus, Siemens, and Renault count European governments among their major shareholders. In the short term, while political uncertainty remains high, economic activity will naturally favor state-owned or state-backed enterprises in both Europe and Iran.

Second, concerns about awarding contracts to state entities ignore the matter of the actual contractual obligations of the parties. This is particularly important in the oil and gas industry, where the new IPC contracts enshrine clear provisions that support privatization in the long term. While the former “buyback” contracts treated the IOCs as contractors who handed off exploration and production projects to NIOC for operation, the new IPC contracts call for joint-ventures between IOCs and a local exploration and production (E&P) partner at the contracting stage, with a similar joint-venture managing operations when the project is production-ready. Two such examples are the Shell and NIOC oil exploration agreement and Total’s gas deal with Chinese state oil firm CNPC and NIOC subsidiary Petropars. In both cases, the state ownership interests represented by Iran’s NIOC or China’s CNPC will be diluted in the exploration and operation joint-ventures through the participation of Shell and Total, major private sector shareholders. In effect, the next wave of companies that will own Iran’s production capacity will include foreign, private sector ownership, even if domestic private firms are frozen out. This aspect of the agreements represents a significant shift that is missed when merely identifying the signatories to the contract. The obligation of the signatories to own and operate the assets is paramount.

Another provision in the IPC contracts that supports the agenda of privatization hinges on the question of technical and managerial knowledge transfer. In this sense, privatization can be understood as the propensity to behave in a manner consistent with the norms of private enterprise. While Iranian state-owned enterprises may be winning the majority of oil and gas contracts in the near term, the means by which they are defining their cooperation with foreign energy companies has moved to new ground. The new IPC contracts took long to develop, not simply because of the terms that were being offered to foreign companies in Iran’s energy sector, but also because of the new obligations being placed on Iranian energy firms.

The new joint venture companies established as part of IPC contracts will need to operate to the standards of the major shareholders, namely companies like Shell, Total, and Norway’s DNO. When compared to the companies previously operating Iran’s oil and gas fields, these newly-minted JV firms will need to conduct business more transparently, all the while reacting to market forces and adopting the global best-practices on which foreign partners will insist. Indeed, the IOCs working in Iran are required by the IPC framework to “gradually transfer” managerial positions to Iranian nationals in order to “facilitate the process of know-how and managerial skills transfers to the Iranian party.” While it might be unreasonable to expect oil companies to transfer ideas like corporate social responsibility and environmental protection, more fundamental skills like corporate governance, robust accounting, and compliance and risk management will be critical to the successful operation of the new JVs and will therefore have to be transferred to Iranian managerial teams. The significance of this shift cannot be overstated. It would be meaningless to privatize companies that would continue the bad habits and poor management typical of Iranian state-owned enterprises. Moreover, a well-operated and responsible state-owned oil company is compatible with Western business practice. Italy’s Eni and Norway’s Statoil are good examples.

Overall, the privatization of Iran’s oil and gas industry is proceeding at a greater pace than what a cursory look to the active players would suggest. Given that the redevelopment of Iran’s energy sector is only at the nascent stages of a decades-long process, it is far too early to sound the alarm.