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posted on 16 May 2016

Iran's Oil Sector Returns To Form

from STRATFOR

-- this post authored by Matthew Bey

Oil and geopolitics crossed paths repeatedly throughout the 20th century. And perhaps nowhere were the political effects of their intersection more pronounced than in Iran. For nearly five decades, the Anglo-Persian Oil Co., later renamed Anglo-Iranian Oil Co., the forebear of what would eventually become British Petroleum, enjoyed near total control over Iran's oil sector.

When Iran nationalized the sector in 1951, the United States and United Kingdom responded by overthrowing its architect, Prime Minister Mohammad Mossadegh, just two years later. Those events heavily influenced the 1979 Iranian Revolution, a foundational element of which was resource nationalism.

And now it appears that BP is returning to its roots. During the week of May 2, the head of Iran's national oil company announced that BP will soon open an office in Tehran. Meanwhile, the country is opening up its energy sector and considering admitting foreign oil companies to set up joint ventures and operate oil fields there for the first time since 1979.

But Iran faces new challenges. To revive his country's economy after years of sanctions, President Hassan Rouhani is now driving an initiative to reinvigorate the oil sector. To do so, Rouhani will have to break what has become a steady cycle of backlash - aimed at foreign and domestic actors alike - over the distribution of oil revenue in Iran.

Iran's Paradox: Nationalism and Pragmatism

The Islamic Republic of Iran is a country built on oil. Despite attempts to reduce the country's economic reliance on the industry, oil remains Tehran's lifeblood - supplying roughly 40 percent of the government's revenue in 2015 - as well as its largest export. Even so, oil production in the country has never returned to the pre-revolution levels of the 1970s. Since then, Iran has sought to balance its revolutionary ideals with the pragmatic understanding that it needs foreign investment and technology to develop its oil sector and, in turn, to finance its government.

Pragmatism notwithstanding, several restrictions, including a ban on foreign ownership of oil reserves, have deterred foreign partners, who may be difficult to lure back. Like Rouhani is now trying to do, former President Ali Akbar Hashemi Rafsanjani attempted to introduce liberalizing reforms to rebuild Iran's economy following the Iran-Iraq war of the 1980s. At the time, Iran's political system was much different from what it is today. Foreign investment into the country's hydrocarbon sector was anathema to many politicians, who showed little interest in attracting foreign investors, and Iran became embroiled in a bitter ideological war between its more isolationist Islamic left and a more capitalist conservative clerical base.

This dispute raged on until the mid-1990s, yielding very strict foreign investment terms. Under the terms, Iran offered contracts, whereby international oil companies would develop a field that, once completed, would be sold to Iran for a fixed fee. Because payments were not based on production volume or price, international oil companies had no incentive to exceed production targets. Furthermore, given their high risk and limited scope, the contracts were poorly suited to maintaining aging fields or developing complex fields, projects for which Iran most needed foreign technology. Even from Tehran's perspective, the model made it difficult to ensure optimal and continued production. But it was the best Iran's political system would allow for at the time.

A New Political Landscape

Since then, however, Iran's socialist and isolationist left has all but disappeared from the political scene, leaving in its place reformists who support re-engagement abroad. In fact, a broad consensus has been reached in Iran in favor of reviving economic ties with the outside world. At the same time, of course, the country's various political factions will try to turn the opportunity, each to its own advantage. Nonetheless, the ongoing disputes between Iran's hard-line conservatives, pragmatic conservatives, traditional conservatives and reformists depend more on the distribution of wealth in the country and less on the ideological rifts that characterized the debate 30 years ago.

Iran's new investment terms, though not yet final, differ fundamentally from their forerunners and represent a significant evolution in the way in which Tehran interacts with foreign companies. According to the new terms, international oil companies (IOCs) may enter joint ventures with Iran to work on projects and form joint operating companies to run them. Ownership of the reserves, the backbone of the revolution, will still be off-limits to foreign companies, but IOCs will be involved in the exploration, development and production stages for up to 25 years. Iran has promised, moreover, to enter long-term supply agreements with IOCs, which Iran hopes will be able to disclose to their shareholders as assets. Despite its plan to establish joint ventures and operating companies with IOCs, Iran explicitly distinguishes between joint operations and decision-making, hoping not to replicate past experiences in which foreign operators - mainly BP's predecessors - called all the shots.

However different from previous models the new one may be, it remains to be seen how attractive IOCs will find it. A number of its details, including factors that will determine fiscal allure, have yet to be hammered out. Although factional disputes over revenue shares will almost certainly curb the plan's appeal, the question is just how much. To offset their diminished role in the oil sector, the Islamic Revolutionary Guard Corps (IRGC) and others who benefited under the administration of former President Mahmoud Ahmadinejad will expect compensation from other areas of the economy. And they will likely retain a high level of involvement in the oil sector all the same: Khatam al-Anbiya and other IRGC-linked contractors remain among the country's most prominent construction and engineering firms.

Nationalism Will Strike Back

Besides this, the prospect of increased foreign participation in oil faces a more daunting challenge in Iran. The past 70 years of Iran's history have been characterized by sustained discontent among Iran's general populace that oil revenues never trickle down. At its heart, this is a problem of geopolitics. Iran is a populous country with a prohibitive landscape. While inland development and industrialization depend on oil revenue, Iran's large population far outstrips its petroleum wealth, making the country inherently poor. Moreover, the country's many disparate ethnic and religious groups require a strong central government and a strong security and military apparatus to manage. Consequently, whoever controls Iran's oil wealth tends to funnel it into the country's security apparatus, and any industrialization efforts follow the lines of political patronage. This makes it nearly impossible for Iran's oil wealth to reach the general population, leading to frequent unrest over who controls the oil revenue.

Prior to the revolution, the public directed their frustration at foreign oil companies, but it has since focused on domestic political figures. Even though Iran moved toward greater economic liberalization under Rafsanjani and former President Mohammed Khatami, the concomitant spoils went to their key political allies. In the oil sector, where several private companies were set up and often headed by those close to the political elite, this was glaringly true. As a result, Ahmadinejad's campaign to eradicate the "oil mafia" and distribute oil wealth struck a chord among Iran's electorate. But Ahmadinejad fell into the usual pattern: The IRGC became his biggest support network, and it saw its economic position rise as a result.

In many respects, Iran is at a critical point in its history. The revolution is nearly 40 years old, and many of the key political figures that have since shaped the country are aging. Indeed, in the next decade, Iran's third supreme leader may come to power. Roughly two-thirds of Iranians, meanwhile, were born after the revolution, and the country faces a 25 percent rate of youth unemployment. And although a political consensus on economic reform exists, there is no such agreement on social and cultural issues, where stark ideological differences divide Iran's various factions.

Furthermore, there is no consensus on amending the relationship between the state and the oil sector and allowing for greater social liberties. This means that Rouhani, and his successors, will ultimately struggle to reform Iran's system so that oil revenue is not siphoned off by various political actors. The core factional dispute over Iran's oil sector is not an ideological disagreement, but rather a fight over which political groups get what. Ultimately Iran's security imperatives - which make the country's judicial and legal system somewhat arbitrary - create a restrictive investment climate, despite the significant measures to open up its energy sector.

But unlike in previous attempts to liberalize the oil sector, the question of reserve ownership, which is so central to Iran's revolutionary identity, at least, is settled. Iran remains focused on ensuring that foreign powers - historically the United States and United Kingdom - do not manipulate the country's oil sector against it. In the pre-Mossadegh era, the Anglo-Iranian Oil Co. was known for calling the shots in Iran's oil sector, turning its role in exploration into a tacit co-ownership of Iran's most precious resource. Now, BP can never claim ownership, but, as long as it respects that boundary, its expertise is needed and welcome.

No matter who wins its presidency next year, and no matter how many foreign companies enter its oil sector, Iran will forever safeguard its most valuable natural resource: oil. Iranians would not have it any other way. And as the country fights itself over oil revenue management, Iran demonstrates that sometimes this protection comes from within.

"Iran's Oil Sector Returns to Form" is republished with permission of Stratfor.

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