World Marketplace
Running on Empty
Lionel Beehner
06/01/2007

Iran is swimming in oil and gas. The country’s known oil reserves are second only to Saudi Arabia’s, its gas reserves second only to Russia’s. Yet even with such vast subterranean wealth, Tehran must now rely on oil imports for up to one-third of the nation’s energy needs and may soon begin rationing gasoline. The country’s oil fields lie in disrepair because of a lack of development and outside investment. Coupled with a domestic spike in demand for oil spurred by artificially low gas prices, petroleum exports have plummeted.

The Islamic republic’s neglect of its energy industry has considerable economic, political and diplomatic consequences. On the economic front, the Iranian government relies on high global energy prices to underwrite generous domestic gas subsidies. A precipitous drop in energy prices, as some analysts predict, could have dire economic effects and require Tehran to dip further into its foreign exchange reserves or seek loans from Russia or China. Yet Iran’s leaders do not appear willing to make the long-term investments needed to kick-start the nation’s pipeline and production capacity. "For the mullahs, the short-run political return on investment in oil production is zero," Johns Hopkins University professor Roger Stern wrote in a January 8 opinion-editorial piece for the International Herald Tribune.

Some analysts, including Stern, estimate that Iran’s oil and gas exports could dwindle to zero within a decade, barring a major influx of foreign capital or a spike in domestic gasoline prices. Even Iran’s own oil minister, Kazem Vaziri-Hamaneh, said last September that production could fall by 13 percent annually unless there is a surge of investment. The International Energy Agency estimates an additional $165 billion will be needed for Iran to meet its growing domestic demands and energy production goals set for 2030. Iran’s current energy crunch has important implications for the global oil and gas markets. A drastic cessation of its oil and gas exports, either because of poor economic planning or in response to recent UN Security Council action, could disrupt world markets and send the price of oil skyrocketing, which would hit Western economies hardest.

TOP VIEW
Years of mismanagement by ruling mullahs have left Iran’s oil sector diminished and underperforming. Their negligence, combined with increasing domestic consumption, has led to a steady decrease in exports. Some analysts estimate that Iran’s natural gas and oil exports—5 percent of the world's oil total now comes from Iran—could dwindle to zero within a decade. Tehran sees little domestic political incentive to address this situation. Meanwhile, global oil markets watch nervously as a nation with 10 percent of the world’s known oil reserves squanders its production potential.

Economists blame Iran’s dilapidated infrastructure for millions of barrels lost in production each year. For example, the South Pars field, which lies in southwestern Iran, houses roughly half of the country’s natural gas, but has yet to be fully developed. Red tape stymies progress as well. Bureaucratic hurdles, including restrictions on production-sharing agreements and buyback contracts, make investors uneasy. Recently, the Japanese company Inpex withdrew its bid to develop Iran’s Azadegan field after seven years of frustrated negotiations. Credit Suisse stopped taking new Iranian clients in late 2005 to safeguard its reputation, according to a spokesperson for the Swiss firm.

Foreign investors are skittish about doing business with Tehran, given the raft of punitive sanctions imposed by the Security Council and the cloud hanging over its nuclear program. A number of energy firms, including BP, have decided against investing in Iran for fear of disrupting their business ties with the United States. The U.S. Treasury has pressured financial institutions abroad, particularly in Europe and Asia, to forgo doing business with Iranian firms with ties to Tehran’s atomic energy program. The prospect of additional Security Council sanctions, not to mention the heated political rhetoric between Tehran and Washington and the threat of military escalation, has created what Conflict Securities Advisory Group’s Adam Pener calls a "cooling off of the business environment."

Petrol for the People
Iran sits atop 10 percent of the world’s proven oil and gas reserves, and its economy is almost entirely dependent on energy. Sales of oil and natural gas account for roughly two-thirds of the country’s income and three-quarters of total exports—its fields produce 3.8 million barrels of oil per day, or 5 percent of the global supply. But a number of factors—both internal and external—have recently contributed to sagging energy exports and sliding production levels.

Tehran’s bloated subsidies of gasoline also have cooled investment and contributed to the nation’s energy woes. Iranians pay just 40 cents per gallon for gas at the pump. Cheap energy has spurred domestic consumption, which in turn boosts demand for cars. Iranian manufacturers churn out around 1 million automobiles each year, resulting in crowded streets and rising air pollution. But the effects of these massive subsidies on the country’s economy have been grave. Energy subsidies cost the government an estimated $35 billion per year—or one-fifth of its annual gross domestic product.

The trouble with this surge in gas consumption is twofold. First, Iranian production cannot keep pace with demand, resulting in drastic cuts in energy exports to meet its growing domestic needs. Iran’s imports of oil now surpass its exports. The country has consistently failed to meet its export quotas set by OPEC. Second, bulging population leads to greater demand. A population of 68 million increases by 500,000 annually, which contributes to the country’s imminent energy crunch. In recent years, the government has dipped into its rainy-day stabilization fund—despite higher-than-average global oil prices—to pay for its generous gas subsidies. According to Stern, last year Tehran even dipped into its foreign exchange reserves for the first time to offset diminishing profits from its oil exports.

Iran’s ruling mullahs have shown little willingness to reinvest in dilapidated oil and gas fields.

Iran’s energy prospects look so grim that the government has even rolled out an unpopular new rationing plan for consumers to curb their gasoline intake. The aim of this austerity measure is to stabilize domestic prices, while reducing consumption of gasoline and diesel products. The country shelved an earlier push to ration gasoline last summer amid fears of a public backlash.

Yet the rationing scheme may be a tough pill to swallow for Iranians already struggling with double-digit inflation and unemployment. Little of Iran’s $50 billion in annual oil revenues ever trickles down to the masses. Moreover, according to Iran’s Karafarin Bank, the cost of housing is up 14 percent, medical care is up 18 percent and food prices are up 33 percent. Officially, unemployment hovers at 12 percent, but some economists say it may be as high as 25 percent. The World Bank calculates that given Iran’s growing labor force and demographic strains, the economy will need to produce 700,000 new jobs annually to absorb these fresh entrants into the labor force. Per capita income levels are 25 percent lower than those under the shah in the 1970s.

Ahead of Iran’s fiscal year, which began in March, the government’s budget provided for a lowball estimate of oil prices at below $30 a barrel, versus the actual price of roughly $50.

President Mahmoud Ahmadinejad has repeatedly called on his country to reduce its dependency on oil revenues. His most recent speech on the topic came in response to Saudi Arabia’s decision earlier this year to drop oil prices to around $50 per barrel. Ostensibly, the move was meant to boost the global economy, which in turn would spur demand for their oil, but Iranian leadership suspected something more sinister was at play. "We assume our enemies want to damage us by decreasing the price of oil," Ahmadinejad said in a February speech. Ahead of Iran’s fiscal year, which began in March, the government’s budget provided for a lowball estimate of oil prices at below $30 a barrel, versus the actual price of roughly $50 a barrel. This estimate takes into account the possibility of an "extraordinary" incident—a U.S. military strike or an all-out civil war in Iraq—that would disrupt its energy exports and further depress Iran’s oil revenues. In a recent speech, the president also pledged to develop more fuel-efficient cars and expand public transport systems to curb Iran’s dependency on oil revenues.

Ahmadinejad’s failed energy policy holds important political implications. Rationing is not only unpopular among Iranians, but also among many conservatives in power. A number of influential newspapers have run editorials panning the president’s misguided economic policies. Last summer, 50 Iranian academics and economists sent an open letter to Ahmadinejad criticizing his inefficient system of gas subsidies. And results of local elections in December, in which candidates aligned with Ahmadinejad fared poorly, demonstrate the popular discontent of the president’s economic and energy policies.

Eastern Exposure
To soften the blow of UN sanctions and combat its image as an international pariah, Iran is assiduously working to strike deals with energy-thirsty countries to its east. Last September, Iran signed a pipeline deal with Kazakhstan worth $3.5 billion—and followed it in November with an energy deal with China worth some $100 billion. The agreement with China would provide annual exports of some 10 million tons of natural gas over the next 25 years and guarantee China’s state oil company various exploration and drilling rights. More recently, Beijing and Tehran signed a $3.6 billion deal to develop the South Pars gas field. The Islamic republic also intends to ink a $7 billion pipeline deal with India and Pakistan by June, though some analysts remain skeptical that Iran will be able to deliver on the agreement without reforming its energy sector.

Iran also wants stronger energy ties with Russia. Between the two countries, they hold half the world’s proven natural gas reserves. Moscow has helped Tehran build an $8 billion civilian nuclear reactor at Bushehr (located in southern Iran on the Persian Gulf), set to go online later this year. Last February, Iran floated the idea of forming a miniature version of the OPEC with Russia and Qatar to strengthen energy cooperation. The plan would give states like Russia and Iran greater control over global energy prices and complicate efforts by the Security Council—of which Russia is a permanent member—to punish Iran for its defiance.

No one is watching the nuclear standoff between Tehran and the Security Council more closely than foreign investors. Iran, after all, is an energy bonanza in their eyes. Its underdeveloped oil and gas fields, the world’s second largest, scream for outside expertise, capital and technology. But Iran remains a risky investment target, given its uncertain political climate, Soviet-style subsidies and inefficient energy policies. If the dust ever settles from the nuclear issue, sanctions lift and Tehran eases restrictions on foreign investors, Iran could see its economy soar to new heights. Perhaps the opening of Iran’s energy sector and the influx of businessmen to its borders could make the country more liberal and Western-friendly, a preferable outcome to the current course of brinksmanship-style politics.

Lionel Beehner is a writer for the Council on Foreign Relations’ website.