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Flagging output from its vast reserves could diminish Tehran's influence

Few countries can match Iran in its ability to generate angst among Westerners. It appears determined to become a nuclear power. Tehran's Islamic leaders aid radical groups across the Middle East. And as the U.S. gets bogged down in Iraq, Iran's influence in the region is on the rise, fueled in large part by its vast energy wealth.

Yet Iran has a surprising weakness: Its oil and gas industry, the lifeblood of its economy, is showing serious signs of distress. As domestic energy consumption skyrockets, Iran is struggling to produce enough oil and gas for export. Unless Tehran overhauls its policies, its primary source of revenue and the basis of its geopolitical muscle could start to wane. Within a decade, says Saad Rahim, an analyst at Washington consultancy PFC Energy, "Iran's net crude exports could fall to zero."

That's not to say Iran doesn't have abundant resources. The country's 137 billion barrels of oil reserves are second only to Saudi Arabia's, and its supply of gas trails only Russia's, according to the BP Statistical Review of World Energy. Getting it all out of the ground, though, is another matter. Iran has been producing just 3.9 million barrels of oil a day this year, 5% below its OPEC quota, because of delays in new projects and a shortage of technical skills. By contrast, in 1974, five years before the Islamic Revolution, Iran pumped 6.1 million barrels daily.

The situation could get even tougher for the National Iranian Oil Co. (NIOC), which is responsible for all of Iran's output. Without substantial upgrades in facilities, production at Iran's core fields, several of which date from the 1920s, could go into a precipitous decline. In September, Oil Minister Kazem Vaziri-Hamaneh suggested that with no new investment, output from Iran's fields would fall by about 13% a year, roughly twice the rate that outside oil experts had expected. "NIOC is likely to find that even maintaining the status quo is a mounting challenge," says PFC Energy's Rahim.

STATE HANDOUTS

Iran's looming crisis is the result of years of neglect and underinvestment. As in other oil-producing countries such as Venezuela and Mexico, the government treats the oil industry as a cash cow, milking its revenues for social programs. It allocates only $3 billion a year for investment, less than a third of what's needed to get production growing again.

Compounding the pressure are policies that encourage profligate energy use. Gasoline prices are set at 35 cents a gallon, which has helped fuel 10%-plus annual growth in consumption, PFC Energy figures. The national thirst for gasoline far outstrips domestic refining capacity, so Iran will import about $5 billion in gasoline this year, or about 40% of its needs. The government is planning a $16 billion refinery building program to boost capacity by 60%. But unless Iran raises fuel prices, the new plants will just mean more consumption.

An oil squeeze could spell trouble for President Mahmoud Ahmadinejad. The populist leader has won backing at home through generous handouts. Ahmadinejad has ratcheted up public spending this year by 21%, to $213 billion, on everything from aid to rural areas to housing loans for newlyweds. He has also promised some $16 billion in outlays from a special $30 billion fund set up to tide Iranians through future hard times. Without a healthy oil sector, Iran's social spending could bust the national budget--and reignite inflation.

Iran badly needs fresh foreign investment to shore up the oil industry. Tehran has attracted some $20 billion in funding for oil and gas projects since 1995 from overseas companies including Royal Dutch/Shell Group (RD), France's Total (TOT), and Norway's Statoil. But new investment has largely dried up in recent years because of lingering worries about the risk of war with the U.S. and disenchantment with Iran's tightfisted terms. Outsiders are offered contracts only to drill wells--rather than operate fields--and get just a small share of profits from output. For instance, Italian oil giant ENI (ENI), a fixture in Iran since 1957, produces about 35,000 barrels per day but doesn't expect to get any bigger. "Unless international sanctions are imposed on Iran and the Italian government directs ENI to abide by them, we are committed to staying," says ENI Chief Executive Paolo Scaroni. "However, in order to increase our presence there, contractual terms for oil companies need to change."

Endless haggling and delays have set back some of Iran's biggest oil initiatives. One top priority had been the Azagedan field in southern Iran, which is expected eventually to produce 260,000 barrels a day. But in October, Tehran scrapped a $2 billion contract, agreed to in 2004, with Japan's Inpex to develop the project. And Shell's $800 million Soroush/Nowrooz project in the Persian Gulf has been plagued by cost overruns and technical glitches. In January, meanwhile, Statoil wrote down the entire $329 million book value of its South Pars project because of "productivity and quality problems" with a local contractor.

GLACIAL PACE

It's not just oil that Iran is failing to exploit. The glacial pace of negotiations is also making it fall behind neighboring Qatar in exploiting the huge offshore gas field that the two countries share. While Qatar has signed up the likes of ExxonMobil (XOM) and Shell to develop the site, Iran's talks with Total and Shell have progressed far more slowly. Iran is now a net importer of gas, a situation not expected to reverse before 2010.

Foreign energy companies are lobbying the Iranians to change. Executives say they would like longer contracts, which would give them more control and might boost returns. But progress is slow as many Iranian officials are reluctant to give foreigners terms that might be judged too favorable. "There are indications of movement, but how far and how deep it goes is anyone's guess," an oil executive says.

Can Iran fix its energy conundrum? Some experts are betting Tehran will get its act together sooner rather than later. Iran was able to boost production from 1.2 million barrels a day during the 1980-88 war with Iraq to nearly 4 million barrels with almost no foreign help, notes Bijan Khajepour, chairman of Tehran's Atieh Bahar Consulting, which advises oil companies. He thinks Iran should be able to sustain current production for the next decade. Even so, if Tehran doesn't face up to the woes of its oil industry, Iran may find itself in the unusual position of sharing the West's angst over growing dependence on imported oil.

with Babak Pirouz in Tehran


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