Demand is strong and prices are soaring so these should be profitable times for National Iranian Oil Company (NIOC), already the world’s second largest exporter of crude, and also charged with development of the world’s second largest reserves of gas.

But the troubled state of Iran’s international relationships - the EU has toughened its sanctions on the Islamic Republic because of the dispute over its nuclear programme - is a powerful deterrent to investment by IOCs. Their participation would be crucial to any successful liberalising reforms and expansion of the hydrocarbons sector.

Iran is more open to the principle of foreign investment in upstream oil and gas than many of its regional neighbours. NIOC’s insistence on ‘buy-back’ service contracts may be restrictive in comparison with the policy of producer countries outside the Middle East, but it still offers more scope for foreign involvement then is available in Kuwait or the Saudi oil sector, for example.

Technology gap

However, while the likes of Shell and France’s Total are upfront about their continuing interest in Iran, they are holding back from committing to new joint venture projects.

This is restricting the pace of development because NIOC lacks access to the latest technologies in areas such as enhanced oil extraction, which would help to maximise the output from ageing fields.

In 1974, Iran produced 6 million b/d; today, NIOC claims total output capacity of only 4 million b/d. The government has decided to push output back up to 5 million b/d or more by 2010, and the 4.2 million-b/d mark was passed earlier this year. But estimates of the extra investment required to achieve the 5 million-b/d target range between $25bn and $100bn, and NIOC has begun to withdraw from a firm commitment to expansion.

Apart from money, the Iranian parastatal also needs foreign technology and expertise to revive old fields and develop new ones.

The greatest potential for expanding out-put is in the 26-billion-barrel geologically complex Azadegan zone, where extraction will be difficult.

At the recent annual conference of the independent Ravand Institute thinktank in Tehran, there was confirmation of the progress that NIOC has made in restarting production at old fields, and using gas and water injection to tap into heavy-oil deposits.

Western companies are involved in some upstream developments. Italy’s Eni is in a joint venture in the Darkhovin field, while Total is due to hand over gas injection facilities at the Doroud 3 field on Kharg island. However, in the current climate, Western companies are holding back from major new joint ventures.

A contract was recently agreed with Sinopec that will bring the Chinese group into the Yadavaran field in the southwest. India’s ONGC also appears interested in participating in the Farzad or North Pars gas projects. But it is not yet certain that interest from Asian investors will continue on a scale sufficient to maintain output growth.

Western caution is particularly marked when it comes to gas, where key phases of the giant South Pars development have stalled because of the reluctance of selected partners to put development plans into action.

While upstream investment falters, NIOC has at least begun to press ahead with internal changes that will leave it better adapted to the demands of liberalisation and partnership with foreign companies when conditions improve. Outside observers have for some time argued that NIOC needs to be broken down into more specialist units - for example, by separating its exploration and production of non-associated gas. There have even been suggestions that local private sector interests could be allowed to move into the upstream oil sector, as is now happening in Nigeria.

NIOC is already a holding company, with operations largely carried out by specialist subsidiaries, and plans have been drawn up to move towards a simpler but more liberalised structure that could eventually mean many companies are at least part-privatised.

Traditionally, the boundary between the Petroleum Ministry and NIOC has been barely visible. In 2006, President Mahmoud Ahmad-inejad appointed NIOC managing director Gholamhossein Nozari as oil minister. But today, the roles of the two institutions are more distinct, although Nozari’s appointment has helped to smooth the working relationship between the president, the government and the company.

Yet structural reforms will really only show results once Iran’s international position has improved, and major foreign investors feel more confident about investing.

The same applies to financing options. Under former president Mohammad Khatami, Iran successfully launched two Eurobond issues, to set a benchmark for future capital market financings by Iran’s major companies. NIOC or its offshoots could have been among the first to use this tool. But the subsequent imposition of US banking sanctions has rendered such issues much more difficult.

Meanwhile, NIOC faces some major challenges at home. Despite its huge output of crude oil, a shortage of refining capacity
means Iran is also the world’s second largest importer of gasoline. And with domestic fuel prices still heavily subsidised, this supply of energy to the local market is a heavy burden on the government.

Revised budget

Surging world energy prices will force Iran to revise its budget for the import of refined petroleum products. The $3-3.3bn budget originally earmarked for the current Iranian year - which began on 21 March 2008 - will be exhausted by August, forcing a probable revision.

Although a major programme of refinery upgrades is gradually reducing the need to rely on imported supplies, it is likely that the budget will have to be increased to the equivalent of at least $6bn to ensure domestic fuel needs are met, says Hojatollah Ghanimi Fard, executive director at NIOC.

Domestic fuel subsidies need to be phased out to encourage more efficient domestic energy use, but gradually to protect the interests of socially vulnerable groups. More careful use of energy is also a concern for environmental reasons. Excessive consumption would have disastrous results for future generations, says Ghanimi Fard.

But price alone will not control petrol use. NIOC has also been seeking to produce cleaner fuels, to reduce their polluting impact. All the gasoline sold in Iran is now unleaded. Refineries, starting with the newer plants at Bandar Abbas and Arak, are being upgraded to bring the quality of fuel up to EU standards.