Changes bring new attention to Iranian buyback contracts

Alexander Brexendorff, Christian Ule

Recent legislative changes have improved but not totally repaired the buyback contract covering exploration and production by foreign investors in Iran. Because further change is possible, companies interested in Iranian projects need to understand current investment conditions and areas requiring further improvement.

The Iranian buyback agreement takes the form of a short-term version of the common risk-service exploration and production contract and would normally be negotiated between National Iranian Oil Co. (NIOC) and an international oil company (IOC) or group of companies. The IOC contractor would provide certain E&P services in return for which its costs and a reward would be reimbursed out of a share of project revenue.

A buyback service contract consists of two separate parts: the exploration and development service contract, which covers the development phase of a field, and the volume-based, long-term export oil sales agreement (LTEOSA), which regulates the reimbursement of costs and a return in the form of oil or gas, not cash. While the contractor develops the field, NIOC repays the capital expenditure, operating expenditure, and accrued bank charges. The contractor also receives an agreed remuneration fee, normally by way of an entitlement to an amount of produced hydrocarbons. The IOC gains lifting rights to a portion of crude and a contractual right to equity oil, which helps its balance sheet. The LTEOSA continues until the contractor has fully offset its petroleum costs and the remuneration. The IOC is usually committed to a development period of 2-3 years and a 5-8-year operation period.

Commercial terms

In the Iranian buyback agreement the contractor completes either an agreed scope of work for a full-cycle E&P project or a development-and-production project only. If the agreement involves a full-cycle E&P project and the contractor makes a discovery judged commercial, NIOC and the contractor must agree on the terms and conditions before development can proceed. If an agreement is not reached or no discovery is made, the contractor may withdraw and receive repayment of costs plus an uplift from NIOC. Under the latest negotiated buyback contracts, the contractor will be paid a negotiated fee that includes taxes paid, expenses and bank charges, plus a remuneration fee based on an internal rate of return of 15%.

If a buyback agreement involves the development of an existing discovery (or appraisal and discovery), the contractor bids for the project on the basis of a submitted work program. If the bid is accepted, the contractor completes the agreed scope of work, and after commissioning NIOC becomes operator. Out of the total period of the buyback agreement, the actual amortization period starts just after the development of an oil discovery and its commissioning. During the following 5-8 years the contractor must secure its payback. During this buyback period the contractor receives its costs plus interest at the London Interbank Offered Rate (LIBOR) plus an agreed uplift. In addition, the contractor receives a monthly remuneration fee.

The Model Buyback Contract provides for a delay fine for the contractor in case of lateness in completing the project. The contractor would not receive the banking interest of the delay period. The contractor is responsible for any increase in costs above the agreed level, except where a change in function has taken place with the approval of NIOC and is unavoidable. In the event that the petroleum cost and remuneration fee are not fully paid during the amortization period pursuant to Article 22.4 of the Iranian Model Buyback Contract, the contractor would be entitled to receive crude oil or gas from the field until the costs and remuneration fees are recovered.

Investment law

Of importance for investment in the Iranian oil and gas industry is the new investment law, the Foreign Investment Promotion and Protection Act (FIPPA), which came into effect in October 2002. The law retains most of the provisions of its predecessor, the 1956 Law for the Attraction and Protection of Foreign Investment (LAPFI). However, it goes further in providing for coverage of "investment" by including investment schemes not covered under LAPFI. FIPPA provides coverage for virtually all activity by foreign investors, whether as direct investment or through nonequity participation and provides coverage for civil partnerships; build, operate, and transfer (BOT) schemes; and service contracts such as buyback agreements (Article 3[b] of FIPPA).

However, the main shortcoming of the new investment law remains the strict reading of the constitution. It essentially allows foreign firms to invest only in areas where private Iranian companies can invest (Article 3[a] of FIPPA). A strictly academic reading of Articles 44 and 45 of the Iranian constitution leaves not more than 5-10% of the economy open to the private sector, with the public sector having the lion's share. Even though such a strict approach has never in fact been applied and Iranian companies have had little problem in entering many areas that are not designated as the private-sector sphere in the constitution, foreign investors should be aware that the new bill is not explicit with regard to whether foreign firms can count on legal protection in areas where private Iranian firms are widely and openly involved despite constitutional restrictions.

As a result, the legal consequences for IOCs investing in the Iranian oil and gas sector through buyback service contracts are still nebulous. Article 3(b) of FIPPA, by putting foreign investments in all sectors within the framework of "civil participation" and "buyback" arrangements under its protection, seems to be in direct conflict with constitutional provisions concerning "mother" industries such as oil and gas exploitation, exploration, and export, which are supposed to be strictly state-dominated.

However, a sharp look at FIPPA and its implementing regulations (IR-FIPPA) suggests that up to a certain limit even foreign investment in the state-dominated oil and gas E&P industry falls under the protection of FIPPA. Article 2 (d) of FIPPA declares that the fields in which foreign investments are made and the amount of foreign capital to be invested must comply with regulations to be approved by the Council of Ministers. The relevant IR-FIPPA, in referring to Article 2(d) FIPPA, explicitly mentions "crude oil and natural gas (exploration, extraction, and transfer)."

Furthermore, Article 3(d) of FIPPA states that the value of services and commodities resulting from the foreign investments compared to that of the services and commodities supplied to domestic markets in every economic sector and in every field should proportionally not exceed 25% and 35%, respectively. These proportions should be seen in the light of Article 2(b) and (c) of FIPPA highlighting the main fear of Iranian political and religious influential circles that foreign investments could threaten Iran's national security and public interest. The article makes clear that foreign investment should not involve concessions to be granted by the government to foreign investors. By "concessions" it means special rights or exclusive privileges that may entitle foreign investors to a monopolistic position. Therefore, exemptions from the proportions provided for foreign investments relate to the production of services and commodities for export purposes—but explicitly not for crude oil.

So far the legal situation for oil and gas downstream projects seems to be clear: Their capital would come under FIPPA's protection. The law would protect their investment, and if there was nationalization the IOCs would be compensated and, more importantly, would be guaranteed to take their profits in hard currency. The situation seems to be entirely different for upstream oil and gas projects as they could be viewed as potentially conflicting with the Islamic provisions of the Iranian constitution.

Under the present buyback service contract the situation remains nebulous. According to Article 16.2 of the Iranian Model Buyback Service Contract, the IOC is the operator for the design, construction, installation, commissioning, and start-up of all facilities but only acts on behalf of and in the name of NIOC (Article 3.1 and 7.1 of the Model Buyback Service Contract). After commissioning and start-up the operatorship moves to NIOC (Article 16.1 of the Model Buyback Service Contract).

Under a buyback scheme the question remains how a foreign investor or contractor would enjoy FIPPA protection for a project. As the law specifically refers to deprivation of national assets and property, and in buybacks the foreign company does not own anything other than its right to develop that specific field, it is not clear under FIPPA whether an act by the government that would terminate the buyback contract prematurely could be deemed a nationalization within the definition in FIPPA.

This leads to the issue of FIPPA's dispute resolution, which is also subject to constitutional restriction. Specifically, whenever the government or a state-owned entity intends to undertake an arbitration proceeding, it must first obtain Majlis approval. This is a reference to Article 139 of the Constitution, which provides that the referral to arbitration of any case involving state property where one party is a foreigner requires the approval of the Council of Ministers and the Parliament. Hence, a foreign investor would be assured of the validity of any arbitration article only after a conflict had actually arisen and been referred to the Majlis for permission to arbitrate. However, while the new law allows for arbitration, there are limitations. For example, the foreign investor's home country must have a bilateral investment treaty with Iran. Not all countries have this treaty in place. So as a precondition, only if an IOC's country has a bilateral investment treaty between the two governments can a company ask for arbitration to be included as part of the dispute resolution.

In summary, FIPPA is an improvement from the previous foreign investment law, although ambiguities remain concerning investors' protection in oil and gas buyback arrangements.

Risks

From the contractor's perspective, a major risk with the buyback contract is that the oil or gas field might not move into production. The contractor then would be denied the opportunity for recovery of petroleum costs and remuneration as a consequence of the contract's referral to the ministry for the exclusive determination of what represents a "commercially viable discovery." Furthermore, the duration of the investment recovery period of around 5 years is too short for foreign firms hoping to secure long-term involvement in the Iranian oil and gas sector; but the contractor could theoretically transact a series of successive buyback agreements timed so that maximum return of the previous project guarantees the stream of investment into succeeding projects.

Pursuant to Article 11 of the Model Buyback Contract, all lands and assets acquired by a contractor would be the property of NIOC. The only thing the contractor would get in return for handing over all its assets would be a right to buy an agreed amount of oil at a certain price at a certain time, subject to a cap. This makes buyback projects akin to a construction contract but with the important difference that payment is not made until after the contractor has lost possession and control of what is being built. As a result, the financial structuring of buyback contracts is difficult.

Moreover, there is a serious risk concerning the rate of return (ROR). If costs prove larger than originally planned, the IOC bears the extra costs under the contract, which increases investment risks and lowers potential return on investment below an already low ROR. If the oil price drops to a level lower than forecast, problems could arise because the amount of oil available from the project might be insufficient to meet the costs of the project and the agreed return. No provision of the Model Buyback Contract deals in detail with the procedure in case such a situation occurs. As a result, IOCs have to take all the relevant factors into account before they enter the contract. In buyback projects, expenditures are estimated prior to implementation. Hence the figures, obtained through approximation because of a lack of sufficient information on reservoir characteristics, reserves and productivity rates, for example, are prone to high risk. In the case of very complex oil fields, it is very difficult to foresee the exact level of spending and the time required.

The contractor regularly faces a cap on the quantity of oil to be lifted. Given the length of the service contract and the LTEOSA, and the recent volatility of oil prices, the most obvious area of risk in purely commercial terms is the cap on the quantity of oil that can be lifted to remunerate the contractor. Obviously, as the price falls, the quantities of oil required to meet the agreed payment schedule increase. The effects of this can to some extent be mitigated by carry-over provisions, which allow a greater quantity of oil to be lifted in an agreed period if the provisional amount is insufficient, with correspondingly lower quantities being lifted in succeeding periods.

Compared with production-sharing agreements (PSAs), buyback contracts cannot offer the fiscal and legal certainty investors require. Under buybacks, an IOC's position is more vulnerable to legislative initiatives resulting from changing government attitudes. The coverage of upstream oil and gas buybacks by FIPPA is vague. The complexity and sluggishness of the decision-making process within NIOC are not always compatible with the need to take operational decisions as and when necessary. And if a dispute arises between NIOC and the IOC, the matter might be taken out of the hands of the disputant by an Islamic court, which could rule that the whole agreement is unlawful.

From the Iranian viewpoint, a major disadvantage of buybacks is the perception that the contractor does not bear real price risk, regardless of oil price fluctuations. Furthermore, the fixed ROR encourages inefficiency as there is no benefit to the contractor in ensuring that it operates in the most economic manner. This could cause problems if the oil price drops because the amount of oil available from the project might be insufficient to meet the costs of the project and the agreed return.

The buyback contract furthermore provides insufficient time for NIOC to acquire as much new technology from the foreign partner as it would like. The IOC gains a project payback and its ROR out of the most profitable part of the field's production. If the guaranteed level of production is maintained, the IOC is relieved of most of its technical risk through its withdrawal from the project before the field enters its most severe decline phase. During the decline phase of the project, when the application of new technology could have its greatest impact, the foreign partner is no longer around to help.

The future

Recently, Iran appears to have had second thoughts about buybacks and is reportedly considering substantial changes to the system. The addition of a limited risk-reward element under a revision to the buyback contract has not attracted the flood of foreign energy investment that Iran both needs and wants. As a result, Iran reportedly is considering a further modification, possibly extending the length of such contracts from the current 5-7 years.

So far, Iran's Ministry of Oil has stressed that Iran will continue with buyback contracts to develop its oil and gas fields, arguing that the buyback agreements are the best method of serving the interests of Iran and attracting foreign investment. The numbers do not seem to confirm this position. Although Iran has during the past few years attracted more than $14 billion in foreign investment, from which buyback contracts account for $12 billion, further negotiations for buyback contracts are progressing slowly.

Besides economics, new oil and gas deals with foreign companies were slowed in 2002 by an investigation by the conservative judiciary into Iran's oil ministry. The probe was looking into alleged improprieties in $21 billion worth of oil and gas deals signed between 1997 and 2001. However, in January 2003 the Majlis joint commission assigned the oil ministry to conclude further buyback deals with foreign contractors to launch oil and gas exploration and implementation projects, including those in underdeveloped areas such as Makran, Jazmourian, Sistan and Baluchestan, and Tabas.

In general, Iran is seen to be moving towards a more open society and improving its relations with the West and Arab countries, not least to enable external investment, as the country recovers from the economic effects of postrevolution isolation. Putting aside religious and constitutional obstacles to investment, the country has a comparatively stable regime and rule of law. However, it remains to be seen whether, in the current political environment, Iranian oil negotiators can agree to real changes in buyback contracts, especially changes designed to provide a greater flexibility for coping with situations not foreseen in the originally negotiated contract.

The major drawbacks of investing in the Iranian petroleum industry through buyback agreements as outlined in this analysis make it clear that the buyback scheme does not present a reasonable alternative to the concession and PSA schemes used commonly worldwide. The main goal of the Iranian government, to avoid foreign control of oil and gas resources, could also be achieved through more investor-friendly alternatives.

This analysis is an abridged version of a detailed report entitled "Investing in the Iranian Oil & Gas Industry - From a Business and Legal Perspective," by the authors. The full report is available for sale in the Oil & Gas Journal Online Research Center at www.ogjresearch.com.

The authors