Oil production slumps as sanctions tighten in Iran

14 August 2012

With sanctions now directly targeting its oil exports, Tehran is seeing its pool of customers shrink. As a result, it is being forced to cut back on production, while investment in the sector is under threat

The latest round of international sanctions against Iran targeting its lifeblood oil exports have been the most devastating yet for the Islamic republic’s economy.

Its oil exports have slumped since the EU enforced a ban on the insurance of vessels carrying Iranian crude. The shipping sanctions have proved especially damaging as more than 90 per cent of the world’s oil tankers are covered on the London insurance market.

The EU and South Korea, which respectively consume 18 per cent and 19 per cent of Iranian crude exports, both ceased buying from Tehran before the ban came into place. Concurrently, Iran’s three largest customers – China, Japan and India – developed new strategies to maintain the flow of oil.

Reduced imports

Japan is faced with a difficult situation as it is under pressure from the US to reduce crude supplies from Iran. At the same time, the country has a thirst for oil, having shut down most of its nuclear power capacity in the wake of the Fukushima earthquake and tsunami in March 2011.

Tokyo passed a bill on 20 June making provision for a domestic insurance fund of up to $7.8bn to provide cover for vessels carrying Iranian crude. While oil imports jumped 60.5 per cent in June ahead of the ban, Japan is still expected to significantly reduce buying activity.

UK-based investment bank Barclays forecasts that Japan will reduce imports of Iranian crude to about 120,000 barrels a day (b/d), compared with a normal volume of more than 350,000 b/d as it increases purchases from other Middle East oil producers. Tokyo received a US waiver on financial sanctions against Iran in return for agreeing to cut oil imports along with another 19 countries.

The Iranian government can insure its own cargo, but no one really trusts Iran’s government in insurance commitments

Fariborz Ghadar, Centre for Strategic and International Studies

India, which also has a waiver, looks set to import crude from Tehran using a mixture of Iranian and India-backed insurance. Iranian tanker firm NITC has reportedly secured insurance cover from a domestic provider, as has Indian refiner MRPL. Meanwhile, the Shipping Corporation of India has agreed to provide as much as $100m a voyage to Iran, according to Iranian state press.

“The Iranian government can insure its own cargo, but no one really trusts the Iranian government in insurance commitments,” says Fariborz Ghadar, a senior adviser at the Centre for Strategic and International Studies in Washington. “The question is what happens when the ship docks … and that port wants insurance in case something goes wrong. And if the port does not accept Iranian insurance, then they will have to accept somebody else’s. There will be insurance companies that will come out of the woodwork.”

The limitations caused by the EU insurance embargo is likely to force Iran to sell oil at a discount to attract buyers wary of less reliable coverage and possible repercussions from the US.

China, the destination for 20 per cent of Iran’s oil exports and its largest buyer, also received a waiver from the US. The waivers are renewable after 180 days if countries can show they have made “significant reductions” in volumes of oil from the Islamic republic.

“Sanctions have really shortened the client list of Iran, making it exposed to a small number of buyers, particularly China,” says Samuel Ciszuk, analyst at UK-based consultancy, KBC Energy Economics. “They are over-reliant on China and what it does in the future will be extremely crucial for Iran. China is in a very good position to negotiate discounts and they have shown they are willing to do this.”

What is clear is that the embargo on insurance has exacerbated the impact of existing sanctions against energy-related transactions with the Central Bank of Iran in hitting the country’s crude production and exports.

Iran produced an average of 4.3 million barrels a day (b/d) of crude during 2011, according to UK oil major BP’s Statistical Review of World Energy. The country’s output has been in a steady range of 4.2 million-4.4 million b/d since 2006, and last year it was the world’s fourth-largest producer after Saudi Arabia, Russia and the US.

Market shift

But by mid-July, Iran’s crude output was thought to have dropped under 3 million b/d to a 20-year low. Its production levels have now been surpassed by its neighbour Iraq, which is slowly recovering from war and decades of sanctions. A predicted further decline would see Iran’s output drop below other major Gulf exporters Kuwait and the UAE, which produced an average of 2.86 million b/d and 2.6 million b/d respectively last year.

Barclays estimated in mid-July that the start of the EU’s sanctions on shipping insurance had been accompanied by a fall in Iranian exports to 1 million b/d or below, less than half the 2011 average.

“Iran is making some adjustments by storing some of its oil, making some barter deals and trying to insure its own tankers,” says Hossein Askari, Iran professor of international business and international affairs at the US’ George Washington University. “But there’s absolutely no doubt that if this continues, and given the state of the global economy, Iran is just going to be selling less and less oil because refineries can adjust and can reconfigure [to use crude from other sources].”

Even if sanctions against Iran were to be lifted in the near future, the shift in the market to replace Iranian crude would leave the country facing a challenge to rebuild its customer base.

Oil prices

Due to the significance of Iran as a global oil producer, the sharp reduction in its crude exports has had an immediate effect on prices.

“Long term, exports could pick up again, but I think they are largely gone for a number of months now,” says Colin O’Shea, head of commodities at UK-based Hermes Fund Managers. “I think it is just going to take a period of time to get this situation up and moving again. I can’t see a lot of these reinsurance companies taking on commitments that would lead to a rise in exports in the short term.”

The Opec Basket Price rallied to above $103 a barrel on 4 August, from just under $89 a barrel on 22 June before the EU shipping sanctions were enforced.

“Through the course of July, the tightness from Iran and some other areas led to a bid to the market, which was potentially undervalued coming to that point in time, when it was sold down off the back of European macroeconomic weakness in June,” says O’Shea.

Whether Iran is forced to reduce its exports further or sell at an increasing discount to maintain its sales volumes to Asian countries, the sanctions are hitting the Islamic republic’s oil revenues hard. US secretary of state Hillary Clinton said in a statement at the end of June, citing the International Energy Agency that the drop in Iran’s oil exports would cost the country about $8bn in lost revenues each quarter.

The Iranians really have nowhere to turn to this time; if the Chinese won’t help them, then who will?

Samuel Ciszuk, KBC Energy Economics

This loss of income creates further problems for an Iranian oil and gas industry already suffering from chronic underinvestment. Masoud Mirkazemi, Iran’s former petroleum minister, estimated in May 2011 that the country required investment of $25bn a year to maintain production at what was then more than 4 million b/d.

The threat of renewed sanctions and the unattractive terms offered by Tehran have caused nearly all Western companies to leave Iran’s energy sector. The government has increasingly looked to Asian national oil companies to step in and invest in its projects.

China National Petroleum Company (CNPC) agreed to take on a $4.7bn contract to develop Phase 11 of the offshore South Pars gas field after French oil major Total exited the scheme. On 30 July, however, Iran’s Mehr news agency reported that CNPC has now pulled its workers out of the country.

The oil ministry in Tehran has blamed the Chinese group for delays in buying equipment and starting preparatory works, while National Iranian Oil Company has said domestic companies are on standby to replace CNPC as the development partner.

Contrasting reports suggested CNPC had not pulled out, but was struggling to finance the project, which was planned to increase the South Pars field’s gas production by 2 billion cubic feet a day and its natural gas liquids output by 70,000 b/d.

Either way, the scheme has clearly stalled at the pre-production stage.

“It is not surprising that the Chinese have been as unwilling as Western companies to commit larger sums of money. When the Iranians kicked out the Western companies and the Chinese came in, the first thing the Chinese start to do is the same thing – stalling and carrying out more studies,” says Ciszuk.

“The project was looking like a millstone round the neck of CNPC, which has business worldwide and risks being sanctioned in the US for having a project in Iran. The Iranians really have nowhere to turn to this time; if the Chinese won’t help them, then who will?”

Gas potential

Iran’s gas reserves are the second-largest in the world, but output has fallen far short of its potential. The Islamic republic shares the world’s biggest gas field with Qatar, but the difference between the two countries’ gas production and export infrastructure is staggering.

Long-standing US sanctions have prevented Iran from developing export projects, including a planned pipeline through Pakistan to India, the extension of an existing Iran-Turkey pipeline into Europe, and the building of liquefied natural gas (LNG) facilities in the Gulf port of Assaluyeh, close to the South Pars field.

Underinvestment and wasteful domestic consumption mean Iran has little presence in export markets; some volumes are sent to Turkey, but Tehran also imports from Turkmenistan. Sanctions have prevented Iran from getting the technology to develop LNG capabilities, which could be used to export large volumes of gas to Asia.

As US sanctions tighten further, they are likely to hit oil production infrastructure, leaving Iran with significant long-term challenges to regain its lost status as an exporter. When the Islamic regime took over in 1979, Iran’s oil exports were around the same as Saudi Arabia’s at 4 million to 5 million b/d. Now, the contrast between the economically isolated republic and the Western-allied kingdom has never been so stark.

Key fact

Iran’s crude output has dropped to below 3 million b/d in July, from an average of about 4.3 million b/d in 2011

b/d=Barrels a day. Source: BP

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