COMMENT: Sanctions would help Iran solve its gasoline problems

A close analysis of energy markets and refining capacities in Iran strongly suggests sanctions against gasoline sales to the country—such as have been proposed by bills passed by the US House last Dec. 15 and by the Senate on Jan. 28—would not be effective. In fact, imposition of the sanctions would turn into a blessing for the Islamic Republic.

Important statistics must be considered when weighing the merits of sanctions. Iran is the fourth largest oil-producing country in the world and, after Saudi Arabia, the second largest in the Organization of Petroleum Exporting Countries. In addition, Iran's natural gas reserves have been estimated at 948 tcf or more, second in the world after Russia.

On the world market, Iran exports about 60% of its oil production of 4 million b/d and controls 5% of the global oil supply that has a measure of influence over international oil markets. Iran also has strong influence in the Strait of Hormuz: About 17 million bo/d passes through it.

Iran's oil policies

After 1979, the year of the Islamic Revolution, all policies regarding crude oil production and marketing were greatly changed. Previously, international oil companies were responsible for almost 90% of Iran's crude oil exports under long-term agreements. After the revolution, National Iranian Oil Co. (NIOC) quickly found itself in charge of both petroleum sales and exports and came to prefer short-term contracts and a wider, more diverse customer base.

The Islamic Republic immediately announced it would reduce production from a pre-1979 level of over 5.5 million b/d to 3.5-4 million b/d in order to save resources for the future. Also, because of the sharp reduction of supply in the market, each barrel of oil generated more revenue than ever before. In fact, by September 1980, Iranian oil production dropped (largely due to the Iran-Iraq war) to less than 700,000 b/d.

At the same time, the US imposed the first of numerous economic sanctions in response to the hostage crisis of 1979-81. Although the US stopped buying oil from Iran, the exporter quickly found new costumers. During the 1990s, US concerns about Iran's nuclear program led to an additional round of sanctions. The Iran and Libya Sanctions Act (ILSA) of 1996 supplemented these measures with restrictions on foreign companies, targeting new foreign oil field investments in Iran. Still, other industrialized countries continued to trade extensively and invest in Iran's petroleum industry.

The absence of an American business presence in Iran has, ironically, created a noncompetitive market for other countries. Total was the first European company to ignore US sanctions. The company argued that European companies were not subject to US legislation and signed a deal to develop offshore Siri oil field. Other companies followed suit: Eni of Italy and major Chinese, Indian, Russian, and Malaysian companies undertook large investments in Iran's petroleum industry.

In general, while sanctions aimed to put Iran under pressure to renounce the use of terrorism or the acquisition of nuclear weapons, they also had an unintended business effect: American companies could not compete in the Iranian market and were losing ground to non-US competitors.

Nevertheless, the ILSA sanctions did persuade some foreign companies to postpone and cancel bidding on new contracts.

Contract problems

But Iran's problems in attracting new investment had less to do with US sanctions and more to do with its own domestic policies, particularly rules on investment.

Legal restrictions on investment in Iran's oil and gas industry—as laid out in the new Constitution, specifically the Budget Act—have limited the flow of much-needed foreign investment and technology. The problem is the "buyback contract" system. NIOC effectively purchases a foreign contractor's services, including funding of the investments. Buyback licensing agreements have played a key role in Iran's oil and gas projects over recent decades.

The buyback contract system prevents any foreign ownership of the Iranian oil industry while still allowing scope for foreign investment. This type of contract revolves around what could be called a repurchase agreement, in which a foreign investor is responsible for funding the project, installing facilities, and transferring the technology and agrees to transfer the project to the host country once it is launched. Capital return and capital gain are achieved by selling products. The investor deals with administrative and engineering affairs, ordering, construction and installation, technology transfer, education, launching, and delivery of the oil field to the host country upon completion.

All these stages are supervised by the host country, technically and financially. This system ensures a profit by guaranteeing a share from the production and sale of oil and gas. Yet the investor forgoes any potential for profit after completion of the project.

The amount of return on the investment depends on the oil or gas production rate specified in the contract. But the contractor earns a return on investment only by selling oil and gas. These technical and legal issues largely make buyback contracts less attractive than more traditional schemes of foreign investment.

In spite of this, the Islamic Republic was able to attract over $20 billion of foreign investment in oil and gas during 2004-09. At the same time, domestic Iranian companies have become capable and independent in developing a number of oil fields. For example, Petropars Ltd. and Oil Industries' Engineering & Construction are two Iranian companies that, after the close of buyback agreements, successfully worked in the upstream business with other foreign companies.

US sanctions were effective in discouraging investment in Iran's petroleum industry to the extent that Iran suffers from underinvestment and older petroleum technology and cannot compete with its rivals in the shared offshore oil and gas fields near Qatar and in South Pars. Yet US sanctions were not completely effective. Iranian oil production has grown modestly over the past decade rather than being completely strangled.

Iran's vulnerability

Iran remains in a vulnerable position, nevertheless. With a population of more than 70 million, Iran uses 1 l./day/person of gasoline, which is heavily subsidized, and overall consumption is rising by more than 11.4%/year. Because Iranian refineries cannot meet demand, the country imports 40% of its gasoline, buying an average total of about 130,000 b/d from Vitol, Glencore, Trafigura, Total, BP, and Reliance Industries.

Recognizing the vulnerability, Tehran imposed rationing 2 years ago in a system based on a "smart card." Each car has a fixed quota of subsidized gasoline. If the car's gasoline consumption exceeds the quota, the owner must purchase gasoline at the international market price.

In a country with large petroleum reserves, the system caused much unrest and anger; many Iranians see cheap gasoline as their birthright. There were riots in Tehran.

Iranians found ways to get around the quotas. Many simply purchased an extra car for its quotas. Others participated in an informal market, selling and buying quotas.

Rationing consumption reduced neither traffic nor pollution in Tehran. Most significantly, it generated inflation. This not only hit ordinary people hardest but also spawned a lucrative black market for smuggled gasoline.

Much of this vulnerability relates to the important question of Iran's refining capacity.

According to Oil & Gas Journal, Iranian refineries have total distillation capacity of 1.45 million b/d, with projects announced that would expand capacity to 2 million b/d. In addition, Iran has discussed eight new refineries, which would raise this figure to 3.4 million b/d.

Upgrading processes associated with gasoline manufacture represent small shares of total distillation capacity: catalytic cracking 35,000 b/d, catalytic reforming 164,700 b/d, and catalytic hydrocracking 136,500 b/d.

Major refineries in Iran and their capacities are Abadan 350,000 b/d, Isfahan 284,000 b/d, Bandar Abbas 232,000 b/d, Tehran 220,000 b/d, Arak 170,000 b/d, and Tabriz 100,000 b/d. Smaller refineries are in Kermanshah, Shiraz, and Lavan Island.

Hobbling for investment

Upgrading refineries to increase gasoline yields has been difficult since the revolution. Before 1979, Iran had access to US technology and was able to undertake massive projects such as the Abadan complex.

Since then, Tehran has had to hobble around to solicit investment from a consortium of foreign companies in completing the Arak refinery in 1993 and from Chiyoda Corp. and Snamprogetti in building the Bandar Abbas complex in 1998. Tehran also received help this year from China Petroleum & Chemical Corp. in upgrading the Arak refinery.

These efforts have not been enough to fully renew Iran's refining capability. In 2007, Iranian oil officials announced that the country's refining industry required investment totaling $15 billion. They mentioned construction of a 300,000 b/d refinery at Bandar Abbas and a 180,000 refinery at Abadan. They further announced a project to build three 120,000-b/d condensate splitters at Bandar Abbas.

In December 2008, the government announced plans to construct seven oil refineries at a cost of $27 billion by 2013. This massive undertaking would increase the industry's output capacity for gasoline by 1.9 million l./day and for gas oil by 1.8 million l./day.

While the grassroots refinery construction plans have been met by doubt because of financial challenges, Iran has been making progress in the upgrade and expansion of existing facilities. The FACTS Global Energy consultancy has noted delays in construction of the Bandar Abbas condensate splitters but says they probably will be completed by 2012-13. Designed to yield little naphtha, the facilities will produce an estimated 200,000 b/d of gasoline.

If other projects to upgrade the Arak, Abadan, and Isfahan refineries proceed, it is quite possible that Iran will cease to be a gasoline importer by 2010. It may even become a net exporter by 2013.

Effect of sanctions

Iran's refinery capability has undoubtedly been hit by US sanctions. Lacking upgrading capacity and having to run crudes that are predominantly heavy and sour, Iranian refineries yield mostly middle and, especially, heavy distillates.

Yet Iran can get around this problem. From condensates produced in supergiant offshore South Pars gas field, it can produce increasing amounts of gasoline as more splitting capacity comes on line. It is upgrading its refineries, however slowly. And it has little problem exporting heavy distillates.

Achievement of gasoline self-sufficiency in a few years would be important politically. Imposition of sanctions on gasoline sales to Iran, as proposed in the bills before Congress, might help it meet this goal in at least two ways: by focusing government attention and investment on projects essential to increased gasoline production and by making further movement toward market pricing of gasoline more acceptable to Iranians.

Sanctions thus might relieve the Iranian government from one of its biggest headaches: being dependent upon gasoline imports. Gasoline, it seems, may not be the Achilles' Heel of Iran, but rather its Sword of Excalibur.

The author