Experts elaborate on gas to power and energy swap

April 28, 2015 - 0:0

TEHRAN - The second South Caspian Petroleum & Energy Summit held recently in the Grand Palais Hansen Kempinski Hotel in Vienna attracted many involved in the petroleum and energy industry, particularly those interested in Iran’s upstream oil & gas industry.

Mahmood Khaghani, the former director general for Caspian Oil & Gas Affairs who was involved in Iran’s energy swap at the Ministry of Petroleum, chaired the summit.

Tehran Times asked him and Chris Cook, an oil market analyst, to explain about the outcome of discussions, particularly in respect to Iran’s ability to access international upstream investment.

Following is the text of the interview:

Q: Mr. Khaghani, please explain about the most important issues raised in the conference.

A: Since the Summit was held under Chatham House Rules I can share with your readers what was said, but I cannot say who said it. But what I can say is that there was a very clear focus on the hopes and expectations of major upstream oil investors, including – as has been reported in the Wall Street Journal – at least one U.S. major oil company.

Q: The new Iranian Petroleum Contract (IPC) has been under development for many months, and it is generally understood that it will be on more attractive terms for oil majors than historic buyback contracts. What was the view of summit participants?

A: It was generally recognized that no international company active in Iran had been able to develop oil profitably and that this must be rectified. So it has been indicated that the IPC will have characteristics of both a buy-back and a production sharing contract, tailored specifically for Western oil companies with an enhanced focus on profit-sharing.

One of the key themes which emerged was the importance of strong and credible legal structures which promote investment and protect the interests of the people and the state.

Professor Khawar Qureshi QC, head of McNair Chambers international lawyers gave a presentation in Vienna based upon his long experience of acting for and against many states in contractual and investment disputes. He emphasized that it is crucial for Iran to ensure it has effective contracts and an internationally acceptable arbitration available for dispute resolution.

Q: I observed that there must always be a conflict between oil producing nations and oil companies in relation to the correct form and mechanism for dispute resolution. After all, what nation would admit that its legal system may be inferior to another’s?

A: It appears to be a matter of general agreement that disputes should be kept out of courts wherever they may be. However, the governing law of a contract and the seat of any arbitration proceedings remain controversial, although one or two jurisdictions have become internationally trusted as centers of excellence as seats of arbitration. Regrettably Iran has not yet attained this happy state of affairs.

In fact, Chris Cook, who is an expert in market regulation, advocates the creation of a global institute for international energy arbitration, governed by a market-specific agreement which transcends any specific jurisdiction. I understand that Scotland has already made a step in this direction, and I am trying to raise the possibility with the vice president for legal affairs.

Q: Was there any distinction between the positions of the U.S. and other Western oil companies?

A: Perhaps the most important contribution of the summit was when a major U.S. oil & gas player was asked to set out his company’s expectations of the proposed IPC. In simple terms, he explained that there are two key criteria which attract upstream investors like his company: the primary criterion is financial return (which, being negotiable is a soluble issue at least in the short term) and the secondary criterion is reserves. In addition to this there are less important criteria, such as dispute resolution, which in my experience of negotiating such contracts, while of lesser importance may nevertheless be a ‘red line’ which prevents agreement.

---------------Financial returns

Q: So what sort of financial return does such a major company expect?

A: His company expects a ‘reasonable and fair return on investment commensurate with the risks’ and naturally, a higher return on investment is expected for a new ‘frontier’ investment than that for reactivating or refurbishing an existing field.

Q: Did he say what he regarded as reasonable?

A: He said that a range from 12% per annum to 25% pa is “a range the industry can work with”. Of course, it remains to be seen whether this is a range which Iran can work with!


Q: My understanding is that one of the greatest problems in negotiating such contracts, in Iran or anywhere else, is the question of ownership of reserves. Why?

A: Indeed so. In many countries, including Iran, resources such as oil belongs to the people, through the government, and it is not possible to sell ownership of them to anyone. But of course, for investors in oil companies it is ownership of crude oil or natural gas which underpins their ability to finance development.

Q: Could you be more specific?

A: U.S. companies such as our respondent must comply with the rules of the U.S. financial regulator - the Securities and Exchange Commission (SEC) - which aims to safeguard the interests of U.S. investors, and these rules specify provisions in relation to reserves which I shall set out for your readers.

1: Clear economic interest (revenue) in a project;

2: Responsibility for physical operations to produce a field’s oil and gas reserves;

3: The right to take volumes in kind, rather than currency, as reward for operating a field;

4: Exposure to the risk of both price fluctuation and production performance.

So in order to ‘book’ reserves in their financial results, all of the above SEC tests must be met without undermining or conflicting with Iran’s constitution, under which ownership of resources vests in the people of Iran through their sovereign government and may never be sold.

Q: Is that actually possible?

A: Chris Cook, who was director of what is now the leading global energy exchange with responsibility for market regulation and development believes that there is a fundamental and irreconcilable conflict of interest.

The key issue is the nature and basis of the SEC’s first ‘economic interest’ criterion: the other three criteria may all be resolved through suitable contractual wording in the agreements/protocols which define the relationship within which investment is made. This investment uses either the instrument of ownership (equity shares in a company) or financing through debt instruments, usually through bank borrowing.

Q: So do I have this straight? You are saying that the Western model of absolute ownership rights over assets, on the one hand, and the temporary secured rights of the banks who finance development of these assets on the other hand, are fundamentally irreconcilable?

A: Mr. Cook and I agree that this is the case and that any solutions to the conflict can only be short term before the interests of the two counterparties diverge. However, we agree that there is in fact a way of resolving this conflict, and with your permission I will outline the substance of our respective presentations at the summit.

Q: What about independent oil companies?

A: U.S. & European independent oil, gas and energy (power generation) companies were also present in the summit and they completely supported my suggestion that being more agile and adaptable, independent companies are perhaps better placed to lead development of Iran’s petroleum industry while the majors, who are not so flexible, prepare themselves.

Q: What about energy swaps?

A: During my career I was instrumental in the introduction of energy swaps as a means of energy trading. Perhaps best known is the Caspian Oil Swap whereby crude oil is delivered into the North of Iran for refining and the oil supplier receives in exchange cargoes of crude oil in the Persian Gulf.

Other energy swaps included the exchange of Iranian gas for Armenian hydropower and so on, but this simple energy swap technique is not limited to Iran and is today becoming routine. Moreover oil producers and refiners will often agree oil for product swaps which may take several different forms.

Q: Surely that is a barter transaction. There is no sale of oil and gas in such swaps.

A: That is a very astute observation. As Mr. Cook puts it, the use of energy swaps essentially transforms the oil and gas market model from energy as a commodity to energy as a service. Or as I prefer to think of it, from oil sale transactions to oil supply relationships.

Q: That’s all very well, and you are to be congratulated on these ingenious swap initiatives, but is it not the case that oil and gas suppliers will often be either unable to take delivery, or to use some or all of their entitlements to products or output.

A: Indeed so; and this is where Mr. Cook’s simple prepay credit instrument provides the necessary additional flexibility and liquidity.
Q: Mr. Cook can you please explain what prepay credit instrument mean? Our readers like to know about it.

Cook: It means that an energy prepay credit instrument is issued by an energy producer in exchange for value he receives from the acceptor of the credit instrument. It is the issuer’s promise which he will accept in payment for supply as an alternative to (say) dollars or other currency. So by way of example the holder of a crude oil prepay credit instrument issued by the National Iranian Gas Company (NIGC) cannot demand payment of money from NIGC – that would be a debt instrument. Similarly, a holder has no right to demand delivery by NIGC -that would be a forward contract -a derivative instrument. Finally, and most importantly, he has no absolute ownership right to Iranian natural gas - an equity instrument.

Q: Mr. Khaghani, so the acceptor of NIGC’s credit instrument would hand over value to NIGC because he trusts that NIGC will be good for the supply of natural gas in due course, either to him, or to someone to whom he subsequently sells the instrument. Is that an accurate summary?

A: That was an excellent summary. Mr. Cook and I believe that the combination of suitable energy swaps of oil and gas supply, and prepay credit in respect of energy consumption by end users will allow Iran to implement His Excellency Bijan Zanganeh’s energy diplomacy through establishing energy cooperation agreements.

Q: Could you give examples?

A: The potential is limited only by the imagination of market participants. Iran could supply crude oil to (say) Greece and Scotland, and receive in exchange entitlements to products which could either be collected physically or as prepay product credits which could be sold not only in Greece and Scotland but also to neighboring countries to which products are supplied.

Q: What are your examples, Mr. Cook?

A: Both eminent academics active in the energy field and downstream energy sector officials said in Vienna that they intend to examine very carefully the possibility of financing and funding domestic and international gas to power infrastructure using energy swap and prepay credit instruments. In particular there was great interest in the concept of new Caspian Energy Grid infrastructure as first suggested by Mr. Ramazani in Ashgabat in December 2014 at the UN sponsored Energy Charter conference on Reliable & Stable Transit of Energy.

A: Thank you for your time. May I finally ask you, Mr. Khaghani and Mr. Cook, what do you think are the realistic chances of such agreements being implemented?

A: The answer is simple. These agreements are routinely, but quietly, already in use in energy markets simply because they work when conventional funding methods do not. For instance, Russia’s Rosneft and China’s Sinochem have entered into an $85 billion prepay deal. The proposal is that Iran, in dialogue with other nations should develop and codify an international market of supply through energy swaps and a new asset class of generic energy prepay credit instruments.