|Iran petroleum contract and the missing link - pre-pay||
At the recent 2-day conference in Tehran on February 22 and 23 Iran outlined a new form of contract to replace the unpopular and complex buy back scheme.
Looking forward to a post-sanctions environment, Iran’s oil ministry has unveiled its new thinking in what they have termed IPC…Iran Petroleum Contract.
The logic of the thinking can best be described in four straightforward terms:
2. Competitive terms
4. Booking of reserves
Iran aims to implement the best and latest technology to extract its oil and gas reserves, and requires international oil and gas partners who have this technology. So Iran is proposing a joint venture arrangement with International Oil Companies (IOCs) to develop existing known fields, find new ones, and drive efficiency in already producing ones. On top of this, Iran is actively engaging with IOCs to discuss and develop the new IPC, a classic piece of collaboration.
The competitive terms outlined in the new IPC are designed to lower, or perhaps more evenly share the risk for the foreign participant in the JV (Joint Venture) IPC. Where cost over runs under the old buy back scheme were borne by the International partner, under the terms of the proposed IPC any cost over runs in the development phase will be shared by the JV partners, meaning Iran and their International partner.
Similarly, fields or proposed developments will be essentially graded with a risk rating. Harder to develop fields will attract a higher return to the International JV partner, and those fields which are lower risk and easier to develop, will attract a slightly lower return. This of course makes perfect sense and fits with the age-old risk return model easily understood by everyone involved.
Lastly, Iran wants to agree more competitive terms than its oil-producing neighbors in the region, such as Iraq. Quite simply they want to attract IOCs.
Pricing of oil and gas between consumers and producers globally remains somewhat of a conundrum. Therefore pricing between the parties to the proposed IPC is also somewhat difficult. Market manipulation in the oil markets is an open secret. Oil is traditionally priced based upon the Brent/BFOE (Brent Forties Oseberg Ekofisk – North Sea Oil) oil contract, and also WTI (West Texas Intermediate).
Manipulation is routine around the Brent/BFOE contract because the number of cargoes per month under which this pricing benchmark is based is declining to such an extent that it is no longer reflective of the true state of demand or supply in the global market. Add to this the fact that a small number of oil traders dominate the Brent/BFOE pricing contract, and then unfortunately, manipulation is inherent in the market.
The second issue with pricing is that oil is priced and settled in USD. Since the volatility in currencies has raised sharply in recent years, due to the so called currency wars, non-dollar nations, which is most of the world, have to factor in the price movement of their domestic currency against dollars.
So to use a current example, it can be expected that the $/Rubble (Russian Currency) rate and the $/Renmimbi (Chinese Currency) rate will sooner or later diverge to such a degree that a long term contract priced and settled in dollars will sooner or later be repudiated by the losing participant.
This issue of sustainability is insoluble under the IPC other than in the short term. In the medium and long term, price security must be addressed, and must be adaptive to the effects on exchange rates of physical supply and demand in the global economy.
Booking of reserves
Oil and gas reserves fall into three categories: proven, probable and possible. Naturally proven reserves have the most value, simply because they are known to be there and are extractable; probable are worth slightly less because we think they are there; and possible because we hope they are there.
International oil companies wish to book reserves to their balance sheets, to replace oil, which once produced and sold is replaced on their balance sheets by cash, which is simply adding new assets for old ones. The reserves are generally booked using a DCF (discounted cash flow) model against the future expected price.
Under the proposed IPC there is no means for reserves to be booked, because under Iranian law oil and gas in the ground belongs to the Iranian people, and ownership of it cannot be transferred. This means that the financing to develop new fields and the ongoing funding of producing fields essentially becomes more expensive, because International oil companies cannot use the booked reserves, which are assets on their balance sheets, to raise capital. The capital return only occurs when the oil or gas is actually produced and sold to the consumer.
There is a solution: Pre-pay.
Pre-pay is a radical, yet simple, credit instrument which is 'asset based' upon the use value of a productive asset. It is issued by a producer at a discount in exchange for value received and then accepted and cancelled by the issuer when presented by a consumer in payment for supply.
Pre-pay has been around a long time – in fact it pre-dates modern banking – and is also Sharia'h (Islamic) compliant at a deep level. But now that conventional financing and funding are scarce, Pre-pay has been re-emerging in use. For instance, Russia's Rosneft and China's Sinochem recently entered into an $85bn 10-year crude oil prepay agreement
Energy Pre-pay is an undated energy prepay credit or promissory note returnable in payment for energy supplied by the issuing producer. Energy Pre-pay enables direct financing and funding of all types of energy production or even energy savings. Most importantly it provides a direct ('Peer to Asset') energy loan to the asset, not to the owner.
What is the relevance of Pre-pay energy to an IPC? Simple! Rather than absolute ownership of energy – which few sovereign states, and certainly not Iran, will accept - the investor may own the economic interest of energy which remains in the custody of the producer.
So, rather than transferring absolute ownership of reserves to the International partner, NIOC, as the Iranian member of a JV, simply issues prepay energy credits at an agreed price in $ (or other acceptable unit of account), equivalent to the value of the investment made by the International partner in the JV.
The Pre-pay energy credit is priced in the same way as reserves normally are on a balance sheet, which is to apply a DCF (Discounted Cash Flow) type model. Simply put, the Pre-pay energy credit is issued to the JV partner at a discount to the expected physical market price. Since the unit is returnable in payment for the underlying oil or gas, and priced by reference to the dollar, then currency or price movements do not matter because it is an asset, in this case oil or gas.
This simple solution of Pre-pay gives both partners of the JV what they need. NIOC need not give up sovereignty by transferring ownership of oil and gas in the ground to foreign partners: while the economic interest in oil and gas may be booked as reserves by their foreign partners to their balance sheet.
The outcome is a simple but radical form of energy co-operation achieved by empowering the private sector. Iran achieves security of demand while IOCs achieve security of supply and crucially – Back to the Future – the innovative use of tried and tested credit instruments in the 21th Century energy markets enables IOCs to secure their financial position in a simple but radical way.
Chris Cook is a former director of the International Petroleum Exchange. He is now a strategic market consultant, entrepreneur and commentator.
Mahmood Khaghani is a former Director General of Caspian Oil and Gas at the International and Commercial affairs at the Iranian Ministry of Petroleum. He is now retired and is a business development and joint venture advisor.
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