Chapter 10 - Assessing the potential of Iran's investment prospects: Oil and gas and beyond

The implementation of the nuclear accord, or Joint Comprehensive Plan of Action (JCPOA), has allowed Iran to return to several key global markets, especially through crude oil exports, and regain access to some of its frozen overseas assets. However, Iranian authorities and some trading partners have pointed to concerns about the limited benefits from the deal so far. This paper identifies the sectors in which Iran is likely to attract foreign investment and those in which the country might play a significant role. It also assesses some of Iran’s relative strengths and vulnerabilities that might facilitate or impede its ability to take advantage of these opportunities.

Bottom line

The energy sector (oil and gas, as well as related sectors like petrochemicals) is likely to provide the fastest pathway to Iran’s foreign currency earnings. However, other sectors such as manufacturing will also determine some of those investment prospects. Assuming the Iranian government is able to follow through on some of the reforms mentioned below, the economy is likely to expand at a pace of 3 to 4 per cent in the current fiscal year, reaching 4 to 5 per cent in the following years.

Let us first assess some of the short- and medium-term strengths and vulnerabilities that will condition Iran’s ability to take economic advantage of the JCPOA and attract investment. We will then look at specific sectors. 

Iran has several sources of resilience

• Low debt. Lower levels of total and government debt than its oil-exporting peers and indeed many other emerging and frontier markets. Iranian entities have little external debt. Although this largely reflects restrictions on borrowing due to sanctions, it nonetheless reduces the risk of a sharp adjustment.
• More resilient fiscal position. Economic sanctions forced Iran to front-load some of the fiscal adjustments that its peers among oil exporters are only now beginning to make (eg, cuts to domestic fuel and food subsidies, increase in domestic retail fuel production and decreases in overall spending patterns).
• Macro-policy improvements. Iran has already made some of the fiscal and monetary policy changes needed to adjust to a lower oil price environment, including allowing the domestic currency to adjust to such prices, something many peers like Ecuador, Nigeria and the GCC countries have avoided, forcing them to spend their reserves. However, Iran has not fully adjusted. Even if oil prices were to remain above or near USD 50 a barrel, we would expect to see further currency depreciation and modest fiscal cuts. We would also expect to see some room for Iran to cut interest rates, reducing borrowing costs domestically.
• Quality of officials and policy-making improving. There has been improvement in the quality of the bureaucracy as technocrats are gradually replacing some of the previous political appointees, particularly in some of the critical ministries including the Petroleum Ministry, the Central Bank, and the Ministry of Finance. There are still significant political appointees and it remains to be seen whether these technocratic ministers will be able to push unpopular reforms through given the persistence of those with vested interests who are reluctant to liberalise political or economic institutions.
• The oil fundamental surplus is gradually wearing off globally. A series of recent outages have reduced oil supply growth, allowing Iran to re-enter the global oil market without meaningful further price declines. Although oil markets may remain in surplus for most of 2016, especially if some of these temporary outages wear off, the market is likely to tighten in 2017, which should allow for a further rally in oil prices.

Structural challenges impair Iran’s investment and growth

• Obstacles to doing business remain high. Iran continues to rank in the bottom quintile in global competitiveness rankings, and in the World Bank’s Doing Business study. It remains particularly difficult for businesses to gain access to credit without collateral; intellectual property protections are low; and overall regulatory quality is poor. Although the formal regulatory process for starting a business is similar to and even better than the average among regional peers, in practice, persistent rule-of-law and corruption problems have created obstacles. These factors are particularly challenging for smaller businesses, which tend to struggle to attract start-up capital. These factors heighten counter-party risk in Iran.
• Uncertainty about legal exposure due to sanctions. Many foreign companies are concerned about running afoul of the remaining sanctions, particularly in the financial sector. Large fines might undermine any benefit accruing from investment in Iran. While these issues are valid, it is also possible that in some cases sanction worries serve as an excuse for investors worried about the deeper business environment challenges mentioned above.
• Iran’s banks are unable to support the real economy, especially small business. Even aside from the uncertainty about sanctions implementation and the persistence of non-nuclear sanctions, Iran’s banks are vulnerable, being subject to significant sanctions by global anti-money laundering agencies and laden with underperforming assets. Overleveraged banks, related party lending, sizeable non-performing loans, and weak data quality on borrowers add to financial counter-party risks. The government of Iran is well aware of these issues and is working to address them, but these are among the reasons why global banks may be cautious of investing, and why Iran’s government may need to recapitalise the banks to support economic growth. As long ago as 2010, the IMF estimated that Iran’s banks might have non-performing assets of up to 20 per cent of the total asset base, largely due to politically motivated lending during the Ahmadinejad era and losses from the 2008-2010 shock caused by low oil prices and tighter sanctions. Given the domestic financial pressures, these numbers are likely much higher today. From 2012 to 2015, government actors borrowed heavily from banks (many of which were state-owned), crowding out the private sector and many of these projects likely underperformed.
• Vested interests (Islamic Revolutionary Guard Corps and others). The dominance of government-linked entities adds to the uncertainty for foreign investors and foreign nationals operating in Iran. In addition to the political issues mentioned above, several dominant industrial groups capture most of the output in key sectors (automotive, etc.).
• Greater global competition. Weaker global trade demand and structurally lower oil demand implies Iran is re-entering a global environment that is much more competitive than in the mid-2000s or in the period 2010-2012, when countries like China were rapidly expanding demand. Although Iran has a large and relatively cheap labour force (for West Asian, Middle Eastern and European standards) and natural resources that are affordable on the global cost curve, competition for capital has become more intense. Local businesses have suffered from cheap foreign imports (especially from China, but also elsewhere in Asia) and lack of access to bank capital, all of which could make them weaker counterparts to these operations.
• Significant inequality and lack of domestic cohesion. Iran has a relatively high level of inequality across regions and classes, which has been exacerbated by government policies. Iran scores relatively poorly on a measure we call perceived deprivation, which is the difference between internationally determined quality of health, education and related services and the domestic view of the quality of these services. Countries with a significant gap (eg, Argentina) tend to be more vulnerable to policy change given the government’s challenge in implementing policies. Although this high level of perceived deprivation may reflect historical data, it does not bode well for the resilience of Iran’s social fabric and suggests it could be more susceptible to shocks.
• Low foreign currency assets or government stimulus space. Although Iran has little debt and still has net foreign assets (USD 120 billion in foreign reserves), it still has a sizeable government deficit (5 per cent of GDP in 2016). Moreover, many of its foreign currency assets have been used as collateral to finance imports.

Sectoral trends

The next section of the paper assesses the outlook and particular challenges for important sectors in Iran’s economy. Although the energy sector, especially oil, is likely to attract the greatest interest and perhaps largest deals, other parts of the energy complex are higher on the priority list of the government, and services and manufacturing are likely to account for more jobs and economic development in Iran.

The energy sector

With over 100 billion barrels in proven reserves of crude oil—a number which may well rise when foreign companies begin exploration—and 29.6 trillion cubic metres in natural gas^{Footnote 22}, the energy sector will always be a central component of Iran’s attractiveness to global investors.

• Oil. Although Iranian oil exports have picked up quickly, adding about 500,000 barrels per day in the first half of 2016, most of the global increase reflects withdrawals from the world-wide inventory which had accumulated thus far. That being said, oil exports could reasonably attain 2012 levels by the end of 2016. We assume it will reach 3.6 million barrels per day at some point in 2017; however, new production will take place only after contracts are signed and exploration begins with major oil companies. This process has gone more slowly than many Iranian officials had hoped. There are several reasons why these trends have been slow to progress. First, major oil companies assert that Iran has yet to develop and present a “template oil agreement”, implying that there are a lot of uncertainties regarding implementation and profitability. Second, Iranian law limits the sort of production-sharing agreements present in other jurisdictions. While other producers (Iraq among them, as well as the Gulf states) have had little trouble signing service agreements, the details of potential contracts remain obscure in Iran. Third, domestic politics have hampered investment. Local actors remain wary of signing agreements that will limit Iran’s ability to benefit from oil exports and parliament has to sign off on individual deals. These linked issues could delay the signing of a contract for some time, possibly in turn delaying any increase in oil export volumes.
• Natural gas. Exploration and activity in natural gas is moving much more quickly than in the oil sector, and may represent a higher priority for Iranian policy-makers. Iran is slowly becoming a net natural gas exporter. For many years, natural gas exports were finely balanced with imports, as Iran exported natural gas to Tukey and imported other supplies for domestic consumption from Turkmenistan and Azerbaijan. Natural gas was not subject to direct payment sanctions largely due to the fact that such measures would disproportionately affect one country, Turkey, the main buyer. Although past production levels look highly optimistic today, particularly given that many potential buyers like Iraq, Oman and Pakistan may struggle to pay global prices, we expect natural gas volumes will increase swiftly. This will not translate immediately into exports, given domestic requirements, but will improve Iran’s own balance of payments starting in 2018 and help supply an alternate source of power generation within Iran in the long term. International energy companies are less involved in this sector.
• Products and petrochemicals. Iran has sharply scaled up refinery capacity since 2010 when they increased local fuel costs to limit imports. While the quality of these products remains low, Iran has begun exporting these oil products in the region. Should they attract foreign investment, the quality of these products may go up, improving quality of life. Petrochemicals employ a growing population and are a major source of increased exports. These are a high priority for Iran’s leadership, in part because they are more labour intensive and add more value to exports. However, Iran may fall afoul of an oversupplied global industry—Saudi Arabia and China and the US are among countries that have expanded their production and exports.

Manufacturing and related industry

Historically, Iran had a much more diversified economy than other countries in the region, with a sizeable manufacturing industry. These sectors are bouncing back sharply, and account for a growing share of employment within Iran. The auto sector is a case in point. Iran has a large kit-car manufacturing industry, in which key parts are imported from Europe, assembled in Iran and then sold on the domestic market and possibly in other parts of the Middle East and Central Asia. European companies like Renault are important players in this market and other manufacturers may follow. Iran, in this regard, may become a significant competitor to Turkey, which has struggled to attract new FDI. Although Turkey’s workforce is generally of higher quality and its population has much more disposable income, wages there are higher and currency fluctuations not negligible. On a medium-term basis, if Iran addresses some of the business-environment and banking issues described above, it might become a genuine competitor.

Services

The bulk of Iran’s private-sector workforce works in the service sector, in construction, real estate and increasingly, in financial services. These sectors are poised to expand, assuming some of the restrictions on investment and quality of IT infrastructure dissipate. Iran’s performance remains relatively unimpressive in the area of innovation and technology, despite a high level of education. This may reflect a discrepancy between the universities and industry requirements, as well as inconsistent Internet access. The overall quality of infrastructure and technology is improving and has outpaced improvements in much of the region since 2012. Developing financial services and deepening local capital markets is a key priority for the government, which sees this as a way to raise capital, though its simultaneous efforts to deepen the local markets may add to volatility in local assets.

Which countries will benefit?

Europe and Asia currently dominate Iran’s list of trading partners, with Germany, France, China, the UAE, and Turkey among the largest players. The period of intense sanctions from 2011 to 2015 increased Iran’s reliance on China as a buyer and as a supplier of manufactured, capital and basic goods, in effect crowding out other producers and even domestic suppliers. It is likely that some of the countries that continued to buy Iran’s oil during this period of sanctions—Japan, South Korea, India, Turkey, China and Taiwan—will be well positioned to expand their trade. Indeed, much of the initial pick-up for Iranian crude oil and products went to Asian countries. Meanwhile Germany and the UAE dominate exports to Iran, with the latter serving as a conduit for re-exports from countries that may not be willing to take on trade with Iran directly. All of these countries have found ways to gain insurance for Iran-bound cargos, largely due to the entry of state-supported insurance.

There are signs that these trends are changing as some of Iran’s traditional trading partners in Europe and Asia are returning and assessing the opportunities in key sectors. Major oil companies traditionally self-insure many of their investments, but those in other sectors may be less willing to do so.

Areas to watch to gauge the country’s ability to draw investment and sustain growth

• Political dynamics within Iran, including the support for President Rouhani’s policies in the Majlis and the Council of Experts. The upcoming presidential election provides a small window to fully develop a broad coalition for stronger economic growth. Equally important is the role of the IRGC and whether their interests align with those of foreign investors. The public statements regarding the budget should be monitored closely.
• Progress on oil contracts or related sectoral development. Given the political sensitivities mentioned above, the development of these trends will be watched closely.
• Progress on recapitalising the banks or other reforms. Iranian authorities have a choice: to try to recapitalise local banks (perhaps with the help of the IMF or foreign partners, which would require reforms) or to hope to maintain their weak balance sheets as is (avoiding reforms and keeping those banks from supporting domestic actors).
• Fiscal policy in light of stronger oil prices. If Iran’s authorities begin to increase spending on social transfers rather than infrastructure, it could be supportive of domestic demand but would chill medium-term growth.
• Activity towards foreigners, especially dual Iranian nationals. The decentralised implementation of law enforcement has made the business and political environment difficult to navigate. Given that many Iranian expatriates are likely to play major roles in business ventures, these will be particularly important.
• Implementation of insurance and financial sector sanctions. Although the US is reluctant to white‑list banks, European leaders may effectively provide political or economic cover.
• Measures to make it easier for foreigners to bring capital into the country and take it out. Capital controls are still significant, which will, among other factors, limit the attractiveness to portfolio and private-equity investors.